Does Latin America affect the Spanish stock market?

Using a simple Markov regime switching model, a time-varying measure of the effect of the return on a Latin American portfolio on the Spanish stock returns is obtained. The evidence can be summarised as follows. First, the effect is positive but not very large. However, it has increased since the mid-1990s. Second, evidence for the returns on size portfolios shows that most of the effect accrues indirectly through common risk factors. The portfolio comprising stocks with low capitalisation is affected most. Nevertheless, the relative effect of Latin America respect to the effect of the whole world only increases for the portfolio comprising stocks with high capitalisation since the mid-1990s. Third, evidence for the returns on sectoral portfolios shows that telecommunications and banking are affected most. Fourth, in relative terms, there is no clear relationship between β-risk and flows of foreign direct investment.