Global Financial Market Linkages

International Economic Integration
International economic integration refers to the extent and strength of real- sector and financial-sector linkages among national economies. Real-sector linkages occur through the international transactions in goods and services while the financial-sector linkages occur through international transactions in financial assets.
Sources for Integration
  To seek new markets.
  To seek new supplies of raw materials.
  To gain new technologies.
  To gain production efficiencies.
  To avoid political and regulatory obstacles.
  To reduce risk by diversification.
Henry Lowenfeld, 1909
“It is significant to see how entirely all the rest of the Geographically Distributed stocks differ in their price movements from the British stock.  It is this individuality of movement on the part of each security, included in a well-distributed Investment List, which ensures the first great essential of successful investment, namely, Capital Stability.”
                       From:  Investment and Exact Science, 1909.
Diversification: 18th Century Mutual Funds
  In the portfolio construction the fund “will observe as much as possible an equal proportionality”
  “Because nothing is completely certain, but subject to fluctuations, it is dangerous to allocate all capital to a single security”
  “Nobody will have reason to believe that all securities will stop paying off at the same time thereby losing the entire invested capital”
Globalization and Financial Linkages
  Common wisdom is that globalization and integration of markets accentuates financial linkages (correlations)
      Business cycle synchronization
      Policy coordination
      Coordination of institutions
      Decrease in “home bias” of investors
      Globalization of firms
  Globalization and integration also allows country specialization
  Expansion of investment opportunities
  Lowering of transactions costs
      Trade where costs are lowest
      Competition among exchanges
      Cross-listing / depository receipts / global shares
  Cost of capital / Expected returns
  Change in covariance structure of returns affecting portfolio risk / benefits of diversification
What is the overall effect?
  Decrease in expected returns
  Higher correlation between asset markets
  More markets for investment
  Increase in the types of marketed securities
  Potential synchronization of business cycles
  Increased policy coordination
                                                Net effect?
The Role of Emerging Markets
  Expand the investment opportunity set
  Are imperfectly correlated with existing markets
  What is the relative contribution of changing correlations and evolution in the investment opportunity set for diversification benefits?
Globalization: How do Correlations Change?
  Does location of a firm matter?
  Industry membership may become more important
  What happens to residual risk?
Emerging Equity Markets
  Increased industry importance
  Countries become less important
      Why does it still matter?
  Residual risk is increasing: cost of not being diversified is going up
Global Linkages of Other Markets
  Bond markets
      Interest rate correlations have increased in Europe before EMU
      Reduction of Bond market diversification
  Real estate markets
      Non-tradable goods
      But linked through
  business cycle correlations
  Interest rate correlations
  exchange rate correlations
Bottom Line: International Diversification Does Not Work as it Used to...
         Trade barriers disappear (NAFTA, EU, ASEAN, etc.)
         Globalization of Business Enterprises,
         Wave of intra-industry M&A (incl. cross-border M&A)
“…active portfolio managers will have increasing difficulty adding value by using a top-down strategy through European country allocation.” (Freiman, 1998)
International Financial Linkages - Summary –
  There is reason to believe that international financial linkages are becoming stronger.
      World is not yet a global place
  Expansion of investment opportunity set should give some compensation for investors who seek diversification
      Number of markets
      Expansion of tradable assets: new markets / securities

Lecture presented by Dr. Babar Zaheer Butt to MS and PhD scholars at Iqra University Islamabad