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Co-movements between US and UK stock prices: the roles of macroeconomic information and time-series varying conditional correlations

Co-movements between US and UK stock prices: the roles of macroeconomic information and time-series varying conditional correlations
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    “Co-movements between US and UK stock prices:the roles of macroeconomic information and time-varying conditional correlations” Nektarios AslanidisDenise R. OsbornMarianne Sensier Document de treball nº -5- 2008 WORKING PAPERS Col·lecció “DOCUMENTS DE TREBALL DELDEPARTAMENT D’ECONOMIA” DEPARTAMENT D’ECONOMIAFacultat de Ciències Econòmiques i Empresarials       Edita: Departament d’Economia Rovira i VirgiliFacultat de Ciències Econòmiques i EmpresarialsAvgda. de la Universitat, 1432004 ReusTel. +34 977 759 811Fax +34 977 300 661  Dirigir comentaris al Departament d’Economia. Dipòsit Legal: T-1029-2008ISSN 1988 - 0812 DEPARTAMENT D’ECONOMIAFacultat de Ciències Econòmiques i Empresarials     1 Co-movements between US and UK stock prices:the roles of macroeconomic information and time-varying conditional correlations Nektarios Aslanidis *  Denise R. Osborn †  Marianne Sensier †   *Department of Economics, University Rovira and Virgili, Spain†Centre for Growth and Business Cycles ResearchEconomics, School of Social SciencesUniversity of Manchester January 2008 Abstract This paper provides evidence on the sources of co-movement in monthly US and UKstock price movements by investigating the role of macroeconomic and financialvariables in a bivariate system with time-varying conditional correlations. Cross-country communality in response is uncovered, with changes in the US Federal Fundsrate, UK bond yields and oil prices having similar negative effects in both markets.Other variables also play a role, especially for the UK market. These effects do not,however, explain the marked increase in cross-market correlations observed fromaround 2000, which we attribute to time variation in the correlations of shocks tothese markets. A regime-switching smooth transition model captures this timevariation well and shows the correlations increase dramatically around 1999-2000.JEL classifications: C32, C51, G15Keywords: international stock returns, DCC-GARCH model, smooth transitionconditional correlation GARCH model, model evaluation.   2 This paper is preliminary. Please do not quote without permission from the authors. Comments on anearlier version of the paper from seminar participants at the University of Essex, University of Alicante, University of Manchester and the Fondazione Eni Enrico Mattei (FEEM) are greatlyappreciated. We would also like to thank Stuart Hyde for comments and Annastiina Silvennoinen andChristos Savva for sharing their program codes with us. 1. Introduction There is a great deal of interest, and a correspondingly large literature, on therelationship between international financial markets. In particular, it is now wellestablished that the correlations of returns across international stock markets are notonly strong, but also time-varying. Important contributions to understanding thenature of this phenomenon include Ang and Bekaert (2002), Cappiello, Engle andSheppard (2006), King, Sentana and Wadhwani (1994), Longin and Solnik (2001),and Ramchand and Susmel (1998).Nevertheless, the question of what drives temporal changes in cross-countrycorrelations remains largely unanswered, since few studies incorporate explanatoryvariables in models designed to capture international stock market linkages. Thisomission is surprising, since investors need to understand the causes of co-movementsin order to evaluate the potential benefits of international portfolio diversification. Forexample, it is often observed that stock markets have become more integrated overtime. Two plausible explanations are, firstly, that the macroeconomic policies andbusiness cycles of countries have become more closely aligned or, secondly, thatcommon shocks have become relatively more important over time. In the former case,international diversification offers protection against both idiosyncratic shocks andchanging economic prospects in individual countries. On the other hand, internationaldiversification offers less advantage if common shocks play an increasingly dominantrole over time. In the light of this, the present paper aims to shed light on the driversof changing correlations between stock market price movements in the US and UK   3since 1980, focusing on the role of macroeconomic effects and, conditional on these,on the patterns of conditional shock correlations.A long and continuing stream of research, initiated by Fama (1981), hasexamined the role of macroeconomic variables (particularly real activity, inflation andinterest rates) for stock returns. However, this research has almost exclusivelyconsidered domestic economic conditions, and hence sheds little light on cross-country linkages. Nevertheless, there are some important exceptions, includingBonfiglioni and Favero (2005), Campbell and Hamao (1992), Canova and De Nicoló(2000), and Nassah and Strauss (2000), all of whom allow foreign economic variablesto affect domestic stock returns. While these studies document the importance of international market linkages, especially with the US, and frequently find that foreignmacroeconomic variables play a role for domestic stock returns, only Bonfiglioni andFavero (2005) focus primarily on explaining the changing nature of such links.Bonfiglioni and Favero (2005) study monthly German and US (log) stockmarket indices in relation to bond yields and (log) analysts’ forecasts of earnings.They propose an innovative methodology that distinguishes between short-run stockmarket interdependence and contagion through the significance, in the equation forGerman stock returns, of dummy variables representing extreme changes in the USmarket. While an incisive contribution, their analysis is nevertheless based on thecrucial assumption that, after allowing for a small number of periods of extremechange, the vector of shocks to the markets is normally distributed with a constantcovariance matrix. However, in the light of the recent literature concerned with time-varying conditional correlations across international financial markets, this is a strongassumption. Baele (2005) takes a different approach, by focusing on time-varyingcorrelations between the US and European markets through a Markov-switchingapproach, and then, in a second stage, considering the role of economic variables in
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