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Abstract:
Using daily returns from 1980-2006, we find a significant contemporaneous association between all European Union (EU) equity markets and Germany. There is, however, no significant indication that the German stock market leads or lags the movements in the other EU stock markets. A higher share of imports by Germany from other EU countries, as well as fluctuations and increased volatility in the exchange rate, have negative effects on stock market co-movements. Conversely, the difference in equity market capitalization with Germany, the greater the foreign direct investment by Germany, and the fact of belonging to the eurozone all contribute to greater stock market co-movement.
INTRODUCTION
Capital market integration provides the opportunity for better diversification as investors shift to higher risk and expected return projects because they are able to diversify their overall risk (Obstfeld 1994). Not surprisingly then, international market integration has been the subject of considerable empirical investigation. Since expected returns and variances are required to construct optimal risk/ return portfolios, investors, portfolio managers, and financial market regulators can benefit from new insights into the comovements among international equity markets. Early research by Lessard (1976) and Ibbotson, Carr, and Robinson (1982) report on the covariances between stock markets. In general, empirical evidence shows that both developed and emerging markets are partially integrated with the world market.1 The nature of the international transmission of stock returns and volatility has also been a focus of extensive research. Lin, Engle, and Ito (1994) offer an excellent summary of these extensive empirical studies: (1) the volatility of stock prices is time-varying, (2) when volatility is high, the price changes in major markets tend to become highly correlated, (3) correlations in volatility and prices appear to be causal from the US to other countries, and (4) lagged spillovers of price changes and price volatility are found between major markets.
Similar to these studies on major international stock markets, there has also been a growing interest on researching the stock markets within Europe. Early research by Taylor and Tonks (1989) and Corhay, Rad, and Urbain (1993) show evidence of cointegration among several major European equity markets in the late 1970s and 1980s. Since then, Western Europe has gone through a period of extraordinary economic, monetary, and financial integration,...