Cross-fertilization from equity returns studies

It is discussed in Section 4.2.1 that the macroeconomic measures that bring out the clearest results and as such emerge from the debate on international financial integration relative unscathed are the deviations from interest parity conditions. These conditions find best application in financial markets where assets are highly substitutable. Studies on their empirical validity therefore test these conditions predominantly on money market instruments. Money markets represent the short end of fixed income markets. The application of interest parity conditions at the longer end of fixed income markets is rare for reasons that asset substitutability is reduced and this then interferes with any observation on the breach of these conditions. Whenever such studies do apply to the longer dated segment (e.g. Popper, 1993), it is with respect to government bonds where instruments are most alike. Beyond that, the empirical application of interest parity conditions grinds to a halt. Corporate eurobonds, marred by risk characteristics that are just too dissimilar, tend not to be studied in the framework of interest parity. Section 4.2.1. also describes how the field of financial economics provides inspiration for new integration measures to fill this void for the bond markets. It highlights methods to determine the importance of country effects in the variation of returns of bonds with dissimilar risk characteristics as one such integration measure. Such a measure can for once find application with the corporate eurobond markets, as Beale et al (2004) indeed have done.

In order to obtain a better understanding around the methodologies that provide inspiration for such measures, it is useful to lay out the territory of financial economic research on asset return variation in some more detail. From this, it can also be seen where otherwise cross-fertilization with the traditional macroeconomic measures of international financial integration has been and where the best scope for further research lies for the European bond markets that comprises both the government and corporate sector.

In the field of financial economics the relevant debate is on patterns of equity market return volatility and its sources and less on financial integration per se. Catao and Timmerman (2010) provide a highly summarized overview of the distinct literatures that have emerged since Robert F. Engle’s work on volatility modeling in the early 1980s. The first strand of literature asks whether and why equity return volatility is time-varying. Using a range of econometric models capable of estimating rich asset pricing dynamics, these studies typically find that stock returns from broad stock indexes are strongly time-varying. A second body of literature decomposes such time-varying equity return volatility into its country, industry sector and firm-specific components. Using firm-level data instead, the econometric model assigns the importance of the variation in equity returns over a set time period to country and industry characteristics. Heston and Rouwenhorst (1994) are considered the founders of this strand. Theirs and many other studies in this vein typically conclude that country effects explain a larger portion of cross-sectional variation in stock returns. In Europe, around the introduction of EMU, several studies detect a rise in the importance of industry factors in stock returns, but this is not convincingly confirmed as a long-term trend. Underlying the early studies of this literature is the assumption that factors have fixed and constant betas over time. More recent studies overcome these limitations by relaxing either or both. Time-varying betas are for example incorporated on a dynamic arbitrage price theory model or within a GARCH framework. A third strand of literature studies, in view of evidence that country effects play a dominant role in equity return variance, their correlation and covariance structure is studied over time. These studies also go in search of answers to optimal international diversification. Covariances, like is true for correlations, are also found to be time- varying. Other studies from this branch show that distance, information, common institutions and macroeconomic factors play a role in the explanation of equity return comovements between countries. Though not explicitly referred to by Catao and Timmerman, I include studies in the third strand that otherwise build on the importance of country versus industry effects in equity returns in the comparison of mean-variance performance of portfolios diversified either way. Mean-variance tests of spanning and efficiency are applied in Moerman (2008) and in Eiling et al. (2006), and style analysis in the latter study and in Eiling et al. (2010) to effectively determine whether country or industry diversification strategies have more optimal performances. Studies from the third strand tend to use returns data from stock indexes rather than individual assets.

Cross-fertilization between the macroeconomic debate on international financial integration and the financial economics debate on equity returns has been rare, but there are some exceptions. A good example is a recent study from Hardouvelis et al. (2006) taking elements from macro and financial economics to study the integration of stock markets under EMU. They pose that following the adoption of the Euro, money markets and to a high degree the bond markets are fully integrated and ask if similar integration took place in the stock markets of individual Euro zone countries in the 1990s. Theirs is a typical example of the common factor approach that has conventionally been followed for stocks returns to determine financial integration, but use interest rate and currency rate deviations in the explanation of time-varying integration. Specifically, Hardouvelis et al. examine the evolution of the influence of EU-wide risk factors over country-specific risk factors on required rates of returns during the 1990s. They estimate a conditional asset-pricing model where each Euro zone country has its own time-varying degree of stock market integration which is conditioned on a broad set of monetary, currency and business cycle variables. Among them are forward rate and nominal interest rate differentials with Germany, inflation differentials with the EU average and local currency volatilities relative to the Deutschemark. The data sample includes all Euro zone countries (except Greece) plus the UK from 1992 to 1998. The estimation results indicate that in the second half of the 1990s stock markets already integrate to a point where individual Euro zone stock markets appear to be fully integrated into the EU market. The two main drivers of this integration are the evolution of the probability of a country joining the single currency and the evolution of inflation

differentials. These results are reinforced by the observation that the UK does not show any signs of increased integration.

Note that Hardouvelis et al. (2006) borrow from the macroeconomic literature on international financial integration to study Euro stock market integration. Cross-fertilization in the opposite direction also occurs, resulting in the study of Euro bond market integration. Examples include Beale et al. (2004) and Varotto (2003). Baele et al. borrow from the second strand of literature of equity return decomposition models to devise a novel measure for the integration of corporate eurobond markets, as already

mentioned in Section 4.2.1. They way in which they do this is deserves some attention. Following Heston and Rouwenhorst (1994), Beale et al. aim to identify the country component in individual corporate bond yield spreads over government bonds with the argument that the smaller these country effects, the higher the level of integration. However, rather than decomposing country effects directly, it is defined as a residual and estimated in a second-stage after differences in risk characteristics of corporate eurobonds (such as maturity and rating) have been accounted for. Beale et al. (2004) thus find for a sample of Euro zone corporate eurobond yields for 1998 to 2003 that the country-specific spread is statistically significant but relatively small in economic terms. Varotto’s (2003) study of corporate eurobond returns stays much closer to the standard Heston and Rouwenhorst decomposition model. In contrast, he finds that country

effects dominate in corporate eurobond spread returns, though for a sample period that unfortunately does not include EMU.

While studies of country versus industry effects in eurobond return variation remain scarce and their evidence of their importance inconclusive, they do point in a new direction in the study of the integration and diversification opportunities of bond markets that is both compelling and convincing. The decomposition methodology that separates the importance of country effects from industry effects in bond return variation is straightforward yet powerful and can include the eurobond sector beyond that of government bonds. It is above all meaningful in the context of EMU where such effects can be expected to have undergone distinct changes. The analysis has the ability to incorporate bond-specific effects, as Varotto (2003) shows with the inclusion of credit rating, maturity and seniority of eurobonds. This adds to the attractiveness of the analysis. The decomposition analysis can be extended to methods used in mean- variance portfolio analysis. Particularly the spanning and efficiency tests can further determine whether country-based or industry-based portfolios are to be preferred. Again, this is a meaningful analysis in the context of Europe. Spanning and efficiency tests are effectively applied to European stock returns, e.g. by Eiling et al. (2006), but hitherto not to bonds. Mean-variance testing expands the study of the integration of European bond markets based on a decomposition of country and industry effects into a study on the benefit of either as a base for allocation for international portfolio diversification.