International correlations and excess returns in European stock markets: does EMU matter?

The paper analyses the international correlations of the European national stock markets and identifies the potential excess returns which can be reaped by means of international diversification in the emerging European stock market relative to a strategy of purely national diversification both before and after EMU comes into effect. To facilitate a comparison of the pre- and post-EMU effects of international diversification, we construct an EMU index-portfolio as an average of the national stock market indices weighted by the respective national market capitalizations. The performance of the national indices is then compared to the EMU index-portfolio with and without an explicit incorporation of FX volatility. It is found that the excess returns of holding an efficiently diversified European stock market portfolio are positive throughout, with the highest potential for excess returns for Austria, Finland and Italy. However, the results generally indicate that the gains of international diversification are more substantial in the presence of FX volatility. Nevertheless, the national betas are also generally higher when exchange rate variability is accounted for, indicating that the elimination of FX volatility in the wake of EMU is likely to lower to cost of equity in national stock markets.