Equity markets in developing and developed economies - relationships, causes & implications

Abstract

The portfolio management theory is based on 2 fundamental concepts – Risk and Return. Investors find innovative ways and newer avenues, alternative investments; financial engineers design financial products; experts study markets and extensive research is carried out on past history of markets all for only one purpose – to maximize return and minimize risk. With this objective in the mind of an investor, knowledge of cointegration (or no cointegration) among equity indices across the globe gains significant importance in portfolio management. The recent wave of stock market liberalization along with the emergence of new capital markets has led to an increase in investors’, or more specifically institutional investors’ interest in International Diversification. Most of the domestic factors which have any significant impact have their effects limited to only that economy and few events have the potential to make their impact felt on the world economy. Returns on securities in any one country are affected by business cycles, government policies and macroeconomic changes whose effects are most strongly seen in that country. Hence, investing in foreign securities provides a larger basket for an investor to choose from and achieve greater diversification. However, the purpose of investing across international markets (which is reducing risk) will be defeated if the portfolio consists of securities in those markets which tend to move together in the long run. Hence, when an investor looks at international markets to construct a portfolio with lesser risk, it is important to determine the absence of cointegration among these markets. Learning from existence of cointegration can also be used for long-term investment analysis. When it comes to international diversification, normally, it is seen that investors in developed and saturated markets devote significant amount of effort in finding out emerging markets which are expected to give higher returns than other markets and hence it makes more sense to invest in emerging markets provided they are not cointegrated with the developed markets. Therefore, we have chosen to study interrelationships between the emerging markets of Brazil, India, China and Russia (BRIC countries) and the developed markets of US, UK and Japan and finally analyzed some of the macroeconomic and market factors among others which have been influential in causing these relationships.