International Portfolio Diversification

INTERNATIONAL PORTFOLIO DIVERSIFICATION : US AND CENTRAL EUROPEAN EQUITY MARKET

INTRODUCTION Case of international portfolio diversification was established in 1960s and 1970s (US and other markets become increasingly active in foreign markets) 

Integration of global markets due to liberalization and deregulation in the money and capital markets of developed and developing countries. 

In recent years due to currency crisis and issues of macroeconomics investors like US are moving towards emerging markets of Central Europe. 

Central European countries are endeavouring to line up their markets economies and institutions with Western European countries in hope of joining EU and EMU. 

Purpose of this presentation is to find the diversification of US investors in three most important markets of Central Europe i.e Czech, Poland, Hungary using methodology of cointegration. 

LITRETURE REVIEW Advantages from the international diversification emanating from the low correlation b/w developed and emerging stock markets have been demonstrated in many studies using short term horizons like Wheatly(1988), Meric and Meric(1989), Bailey and stulz(1990). 

Kasa(1992) points out the benefits for investors with long term investment horizons if markets are trending together leading to use cointegration techniques. Kasa(1992) and Arshanpalli and Doukas(1993) found bivariate cointegration of US investors with emerging markets. However Byers and Peel(1993) and Kanas(1998) suggest that there is no such linkage. 

w.r.t emerging capital markets, Defusco(1996) report that the the US market is not cointegrated with thirteen emerging markets of three geographical regions(Pacific Basin, Mediterranean and Latin America) 

Felix(1998) find no long run comovement b/w US and many developing markets. 

MARKET CHARECTERISTICS Fall of Communism in Central Europe lead to reopening of the stock exchanges BSE(Budapest Stock Exchange),WSE(Warsaw Stock Exchange) and PSE(Prague Stock Exchange) which have been closed during post war 

WSE has been the largest in terms of capitalization followed by BSE and PSE. 

BSE lagged in terms of turnover ratios and trading values but has taken over the others. 

WSE opened trading in shares in 5 firms only, which had been privatized at the end of 1990. 

In WSE as well as BSE the number of listed firms has grown slowly, as a result of a gradual approach to privatization. 

PSE opened with large number of private firms listed through in 1996. 

METHODOLOGY Cointegration analysis is used to examine the issue of likely benefits of diversification into Central European equity markets by US. 

Cointegration tests allow us to determine whether stock prices of different national markets move together over the long run, while allowing for the possibility of short-run divergence. 

First step is to test each index series for the presence of unit roots, which would show whether the series are non-stationary. 

Augumented Dickey Fuller (ADF) is used, this test assumes that the errors are statistically independent and have a constant variance. 

Phillips and Perron developed a generalization of the Dickey Fuller test, which is also applied here. 

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Engle Granger methodology 1987 and the Johansen 1988 procedure are the two basic approaches used.

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Engle Granger uses ordinary least-squares OLS regression to estimate the long-run equilibrium relationship and then tests the resulting error term for stationarity.

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If error term is stationary Vector Autoregression(VAR) is used to model longterm relationships.

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Whereas Johansen test determines the rank of coefficent matrix of VAR of the series, with indication of cointegration and its relationships.

DATA •

Data consist of weekly closing price indices of the Czech,Hungarian,Polish and US stock markets for the time period covering july 1, 1995 to August 31, 2001, a total of 310 observations.

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Table provide the descriptive statistics of the data.

RESULT

Conclusion

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Our results support the conclusion that US investors can benefit from diversifying into the Central European equity markets.

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Correlation of returns b/w US and emerging european markets does not depend upon the investment horizon.

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Granger-causality test showed a causality running from the Hungarian to the Polish equity market.

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Degree of long run comovement will increase between US and Emerging European markets.

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Changing nature of diversification benefits will need to be