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
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
◦ 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