Do These Stock Markets Move Together? an Empirical Study of India and Its Major Trading Partners

ABSTRACTThis paper investigates the relationships between the monthly returns of the Indian stock returns, and of some of India 's major trading partners. By using a multivariate co-integration model, we find that the monthly returns of these markets tend to converge in the long run even though they may move in different directions in the short term. The results of our study may provide some insights to investors of Indian stock market who seek to reduce their risk exposure by diversifying in these markets.Keywords: Indian stock market, Co-integration, Diversification, Error CorrectionINTRODUCTIONInvestors constantly seek diversification opportunities to maximize the expected rate of return while minimizing the risk. The benefit of international diversification is based on the belief the stock markets in different countries are not highly correlated, due to domestic, economic, financial, regulatory, or other factors. In other words, what is considered nondiversifiable risk in one country may be considered diversifiable risk when one holds an international portfolio? That is the basis for international diversification. However, with more and more international trade and cross border investments, the economies of some countries become more integrated with some of their major trading partners. The economies of the countries involved become more interdependent and less insulated from each other. That raises a question: will the more integrated economies make it more difficult for investors to reduce risk by investing in these countries? If the stock markets in these countries are driven by the same factors, it will be much harder to reduce risk by diversifying. At the heart of this phenomenon are the comovements in assets prices and stock market integration, which have been studies extensively in international finance (Bai & Green, 2010; Bekeart & Harvey, 1995; Bekeart, Hodrick, & Zhang, 2009; Errunza, Hogan, & Hung, 1999; Jin, 2005; G. Meric, Ratner, & Meric, 2007; Puthuanthong & Roll, 2009; Harper & Jin, 2012. Comovements are defined "as the movement of assets that is shared by all assets at time t" (Baur, 2003, p.2). The study of comovements in asset prices provides significant insight into possible diversification strategies that impact the risk-return relationship for investors who hold portfolios consisting of stock in different countries. Asset price theory provides the theoretical framework for analyzing comovements and stock market integration. If comovements among market become stronger, opportunities for and the benefits of diversification will be reduced (llano & Breaneau, 2009). Understanding market comovements are important for other reasons. Economists are interested in comovements because comovements may affect the flow of capital between countries. Capital market theorists are interested in this because if affects equity market segmentation (Lessig & Joy, 1976). According to Onour (2010), "Integration in stock market may provide some advantage in terms of gains in market efficiency but also entails potential pitfalls. Greater integration among stock market implies stronger comovements between markets; thereby reducing the opportunities for diversification" (p. 30). This has implications for assembling efficient portfolios. Although the study of comovements and stock market integration has been well documented in the literature with respect to developed countries, emerging markets such as India has received less attention (Modi, Patel, & Patel; Wong, Agarwal, & Du, 2004). The purpose of this paper is to study whether the movements of Indian stock market is significantly related with the stock markets of some of its top trading partners, such as Hong Kong (HIS), Malaysia (KLSE), Singapore (ST), Switzerland (SSMI), and the United States (S&P 500). Understanding these relationships may help investors to formulate their investment strategies. …