Working Paper: CEPR ID: DP4368
Authors: Luis Cato; Allan G Timmermann
Abstract: An important question in international finance is to what extent stock return volatility is influenced by country location, industry affiliation, and global factors. This Paper develops a new methodology to measure these effects, in which portfolios mimicking ?pure? country and industry factors are first constructed and their joint dynamics then modelled as regime-switching processes. Applying this methodology to a uniquely long set of international firm level data, we identify well-defined high and low volatility states over the past 30 years, and show that the contribution of industry and country factors to stock return volatility varies markedly across such states. In particular, we find that the country factor contribution drops markedly when global equity market volatility rises, and that country return correlations become tighter when global and industry factors are both in a high volatility state. Key implications for global portfolio allocation are discussed.
Keywords: diversification; international financial markets; risk; volatility states
JEL Codes: C10; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| country factors (O57) | market volatility (G17) |
| industry factors (L19) | market volatility (G17) |
| industry-specific events (L89) | stock returns (G12) |
| global volatility states (F69) | average correlations between country portfolios (C10) |
| nonlinear dynamic dependencies (C69) | stock return dynamics (G17) |