Free Flows, Limited Diversification: Explaining the Fall and Rise of Stock Market Correlations, 1890-2001
40 Pages Posted: 12 Nov 2007
Date Written: September 2007
Using a new dataset on capital account openness, we investigate why equity return correlations changed over the last century. Using equity returns from 16 countries for the period 1890-2001, we show that correlations increase as financial markets are liberalized. In addition, countries with similar regulatory regimes show higher correlations. These findings are robust to controlling for both the Forbes-Rigobon bias and global averages in equity return correlations. We show that greater synchronization of fundamentals is not the main cause of increasing correlations. These results imply that the home bias puzzle may be smaller than traditionally claimed.
Keywords: diversification, capital controls, capital flows, home bias
JEL Classification: G15, G18, N20, P16
Suggested Citation: Suggested Citation