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Country and Industry Dynamics in Stock Returns

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Author Info
Catão, Luis A. V.
Timmermann, Allan G

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Abstract

An important question in international finance is to what extent stock return volatility is influenced by country location, industry affiliation, and global factors. This Paper develops a new methodology to measure these effects, in which portfolios mimicking ‘pure’ country and industry factors are first constructed and their joint dynamics then modelled as regime-switching processes. Applying this methodology to a uniquely long set of international firm level data, we identify well-defined high and low volatility states over the past 30 years, and show that the contribution of industry and country factors to stock return volatility varies markedly across such states. In particular, we find that the country factor contribution drops markedly when global equity market volatility rises, and that country return correlations become tighter when global and industry factors are both in a high volatility state. Key implications for global portfolio allocation are discussed.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4368.

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Date of creation: Apr 2004
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Handle: RePEc:cpr:ceprdp:4368

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Related research
Keywords: diversification; international financial markets; risk; volatility states;

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Find related papers by JEL classification:
C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - General
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

References listed on IDEAS
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  1. Christopher M. Turner & Richard Startz & Charles R. Nelson, 1989. "A Markov Model of Heteroskedasticity, Risk, and Learning in the Stock Market," NBER Working Papers 2818, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  2. King, Mervyn & Sentana, Enrique & Wadhwani, Sushil, 1994. "Volatility and Links between National Stock Markets," Econometrica, Econometric Society, vol. 62(4), pages 901-33, July. [Downloadable!] (restricted)
    Other versions:
  3. Hamilton, James D., 1988. "Rational-expectations econometric analysis of changes in regime : An investigation of the term structure of interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 385-423. [Downloadable!] (restricted)
  4. Beckers, Stan & Grinold, Richard & Rudd, Andrew & Stefek, Dan, 1992. "The relative importance of common factors across the European equity markets," Journal of Banking & Finance, Elsevier, vol. 16(1), pages 75-95, February. [Downloadable!] (restricted)
  5. Schwert, G William, 1989. " Why Does Stock Market Volatility Change over Time?," Journal of Finance, American Finance Association, vol. 44(5), pages 1115-53, December. [Downloadable!] (restricted)
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  6. Pagan, Adrian R. & Schwert, G. William, 1990. "Alternative models for conditional stock volatility," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 267-290. [Downloadable!] (restricted)
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  7. Gabriel Perez-Quiros & Allan Timmermann, 2000. "Firm Size and Cyclical Variations in Stock Returns," Journal of Finance, American Finance Association, vol. 55(3), pages 1229-1262, 06. [Downloadable!] (restricted)
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  8. James H. Stock & Mark W. Watson, 1998. "Diffusion Indexes," NBER Working Papers 6702, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  9. Sola, M. & Driffill, J., 1992. "Testing the Term Structure of Interest Rates from a Stationary Switching Regime VAR (forthcoming Journal of Economic Dynamics and Control, 1994)," Discussion Paper Series In Economics And Econometrics 9202, Economics Division, School of Social Sciences, University of Southampton.
  10. Bekaert, Geert & Harvey, Campbell R., 1997. "Emerging equity market volatility," Journal of Financial Economics, Elsevier, vol. 43(1), pages 29-77, January. [Downloadable!] (restricted)
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  11. Robin Brooks & Luis Catão, . "The New Economy and Global Stock Return," IMF Working Papers 00/216, International Monetary Fund.
  12. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September. [Downloadable!] (restricted)
  13. Turner, C.M. & Startz, R. & Nelson, C.R., 1989. "The Markov Model Of Heteroskedasticity, Risk And Learning In The Stock Market," Discussion Papers in Economics at the University of Washington 89-01, Department of Economics at the University of Washington.
    Other versions:
  14. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 15(4), pages 1137-1187.
  15. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June. [Downloadable!] (restricted)
  16. Serra, Ana Paula, 2000. "Country and industry factors in returns: evidence from emerging markets' stocks," Emerging Markets Review, Elsevier, vol. 1(2), pages 127-151, September. [Downloadable!] (restricted)
  17. Lin, Wen-Ling & Engle, Robert F & Ito, Takatoshi, 1994. "Do Bulls and Bears Move across Borders? International Transmission of Stock Returns and Volatility," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 7(3), pages 507-38. [Downloadable!] (restricted)
  18. Roll, Richard, 1992. " Industrial Structure and the Comparative Behavior of International Stock Market Indices," Journal of Finance, American Finance Association, vol. 47(1), pages 3-41, March. [Downloadable!] (restricted)
  19. Geert Bekaert & Campbell R. Harvey, 2003. "Market Integration and Contagion," NBER Working Papers 9510, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  20. Heston, Steven L. & Rouwenhorst, K. Geert, 1994. "Does industrial structure explain the benefits of international diversification?," Journal of Financial Economics, Elsevier, vol. 36(1), pages 3-27, August. [Downloadable!] (restricted)
  21. Timmermann, Allan, 2000. "Moments of Markov switching models," Journal of Econometrics, Elsevier, vol. 96(1), pages 75-111, May. [Downloadable!] (restricted)
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  22. Robert B. Davies, 2002. "Hypothesis testing when a nuisance parameter is present only under the alternative: Linear model case," Biometrika, Oxford University Press for Biometrika Trust, vol. 89(2), pages 484-489, June.
  23. K. Geert Rouwenhorst, 1998. "European Equity Markets and EMU: Are the Differences Between Countries Slowly Disappearing?," Yale School of Management Working Papers ysm103, Yale School of Management. [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Carrieri, Francesca & Errunza, Vihang & Sarkissian, Sergei, 2006. "The Dynamics of Geographic versus Sectoral Diversification: Is There a Link to the Real Economy?," Working Papers 06-4, University of Pennsylvania, Wharton School, Weiss Center. [Downloadable!]
  2. Bekaert, Geert & Hodrick, Robert J. & Zhang, Xiaoyan, 2005. "International Stock Return Comovements," Working Papers 06-3, University of Pennsylvania, Wharton School, Weiss Center. [Downloadable!]
    Other versions:
  3. John Ammer & Jon Wongswan, 2004. "Cash flows and discount rates, industry and country effects, and co-movement in stock returns," International Finance Discussion Papers 818, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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