Academic journal article Journal of International Business Research

The Effect of the Euro on European Equity Markets and International Diversification

Academic journal article Journal of International Business Research

The Effect of the Euro on European Equity Markets and International Diversification

Article excerpt

ABSTRACT

Interest in global investing has increased tremendously over the last two decades. Investors seek to reduce risk by diversifying globally. The risk reduction benefits hinge upon the relationships among international stock market indexes. Many research studies have shown that international diversification may provide risk reduction when an investor's portfolio is expanded to include foreign securities.

On January 1, 1999, the European Economic Community (EEC) introduced the Euro as the currency of eleven Member States of the European Union: i.e. Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. As a result of that, the national currencies of these countries ceased to exist. At the world level, the economic weight of the EEC has become roughly equal to that of the US. As a consequence, the euro is considered to be an alternative international currency to the dollar.

The introduction of the euro as a single currency (Euro) and the disappearance of currency risk implied that investors would be concerned with the benefits of diversification. Especially, if correlation coefficients among European equity markets are significantly increased, then diversification may fail to deliver the benefits which investors seek. The author found a significant increase in the correlation among stock returns between pre and post Euro periods. The results showed that diversification opportunities have largely decreased at a country level within the European Union for post euro periods. The author also tested the hypothesis that high correlation coefficients among equity markets (in the European Union) provided evidence of contagion or interdependence.

INTRODUCTION

Diversification has become more important as financial markets have become increasingly global. Previously, investors who were investing in France, Germany and England had to recognize the exchange rate risk of these countries. However, on January 1, 1999, the Euro became the currency of these countries and the national currencies of these countries ceased to exist. The question that this paper intends to answer is if the introduction of the Euro has changed the exchange rate risk for the investors? To examine this question, we will analyze the effect of the Euro on the international market indexes and then examine the effects of the euro on U.S. investors' investment strategies.

This first part of the paper addresses the impact of the Euro on portfolio diversification opportunities. In this study, the author found a significant increase in the correlation between the returns on any two stocks. Diversification opportunities within the Euro-area have thus been reduced. The culprit appears to be the disappearance of currency risk, rather than the convergence of economic and/or the homogenization of economic structures across the European member states. This development should eliminate pure country allocation strategies within Europe. If no other investment alternatives were available, the increased correlation coefficients would imply that international diversification does not benefit the European investors.

The second part of the paper tests the concept of contagion among European stock markets. Several empirical studies have shown that a significant increase occurred in the market co-movement after changes in financial or economic factors. Do these periods (pre and post Euro) of highly correlated stock market co-movement provide evidence of contagion or interdependence?

Finally, given the support for international diversification, has the introduction of the Euro as a single currency in Europe changed the dimensions of international portfolio diversification? Is it still possible to enhance risk-return relationships by investing in European Economic Community (EEC)?

REVIEW OF THE RELATED LITERATURE

The case for diversification was made in Markowitz's seminal article "Portfolio Selection" in which he presented the theory of efficient diversification of investments. …

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