Academic journal article Journal of Economics and Finance

Euro Conversion and Return Dynamics of European Financial Markets: A Frequency Domain Approach

Academic journal article Journal of Economics and Finance

Euro Conversion and Return Dynamics of European Financial Markets: A Frequency Domain Approach

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1 Introduction

The international financial literature shows that investors, due to lower correlations between different equity markets, benefit from internationally diversified portfolios (e.g. Grubel 1968; Levy and Sarant 1970; Solnik 1974; Errunza 1983; Elton and Gruber 1995). More recent papers emphasize the time-varying nature of correlation coefficients between countries, and that diversification benefits may have been weakened as international equity markets have become more integrated (e.g. Longin and Solnik 1995; Bekaert and Harvey 1995; Bekaert and Harvey 2000; Goetzmann et al. 2005; Gupta and Donleavy 2009; You and Daigler 2010). Despite this enhanced market integration, studies show that investors can still gain from investing internationally, using a more tailored approach, depending on the investor's country of origin and target market. (e.g. Li et al. 2003; Chiou 2008; Gupta and Donleavy 2009; Berger et al. 2011).

In the same vein, one may expect that the Euro-introduction has enhanced the synchronization of equity markets within the Euro-zone due to more price and information transparency and has, thus, lowered stock market volatility and increased co-movements among Euro-zone equity markets. This may especially be the case for the equity markets of those countries that joined the Euro-zone, since a common currency may have eliminated, or at least mitigated, the systematic risk factor related to exchange rate risk. Subsequently, it may be interesting to study whether the return dynamics of European equity markets have altered with the introduction of the Euro. Studying return characteristics based on volatility and correlation alone, however, does not provide information on the dynamic changes that an event, such as the Euro-introduction, has introduced in the markets. Hence, in this paper, we use a frequency domain approach to study the return dynamics of European equity markets surrounding the introduction of the Euro. The decompo- sition of returns into periodic components may add more insight on the specific dynamic characteristics that are responsible for changes in volatility and co- movements; hence, it may provide additional implications with respect to information transmission among markets, market interdependence and, most importantly, for diversification.

The literature documents an immediate impact of the new currency on Euro-zone interest rates and fixed income markets (Adjaouté and Danthine 2003; Hartmann et al. 2003; Rajan and Zingales 2003), yet, there is less consensus with respect to the Euro's effect on equity markets. In fact, any impact of the Euro on European equity markets has been questioned, as currencies have traditionally played a minor role with respect to equity returns in the Euro-zone area (e.g. Adjaouté and Danthine 2003). To shed more light on the issue, studies have analyzed the impact of the Euro on equity markets with the following findings: Galati and Tsatsaronis (2003) state that the Euro has facilitated industrial sector investments rather than investment strategies based on individual European countries. Along those lines, Flavin (2004) and Moerman (2008) find that for European countries, industrial diversification benefits outweigh country diversification benefits in the post-Euro period. Others have looked more specifically at enhanced stock market integration, though with inconclusive results. For example, Holmes (2003) finds weaker evidence for stock market integration with the introduction of the Euro; while Askari and Chatterjee (2005); Kim et al. (2005); Leon et al. (2007), and Morelli (2010) report an increase in stock market integration. Bley (2009) finds an increase in European stock market integration in the period following the Euro introduction, but states that markets have started to drift apart. Guidi and Gupta (2010), using a Dynamic Conditional Correlation model, find increased correlations between Germany and several Central Eastern European equity markets that joined the EU. …

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