H.W.C. Vreedenburgh
ERASMUS UNIVERSITY ROTTERDAM
ERASMUS SCHOOL OF ECONOMICS
MSc Economics & Business
Master Specialisation Financial Economics
July 2010
ABSTRACT
Integration in the EMU stock markets has some major implications for investors, their international portfolio diversification possibilities and the way they should price stocks. This paper will add an insight and provide evidence in the discussion whether or not the EMU stock market is can regarded as an integrated market, and what this means for the way stocks should be priced. This paper’s main contribution is providing evidence of EMU stock market integration by using a non-correlation method and asset pricing models, and what asset pricing model is able to price the stocks best in the integrated EMU zone. Using the principal component analysis, we have shown that there is an increasing degree of integration in the EMU zone. Although the rate of the smaller EMY countries is higher, the larger EMU countries were already quite integrated.This article also uses local, EMU and combined (EMU and local) factor models to see which model is able to price EMU stocks as a way of testing integration. We show that the Fama and French three factor model is better at pricing stocks for individual countries better than CAPM. This article shows that the EMU factors are doing quite well on pricing stocks, especially in the larger countries, although local factors still have an impact. Considering different time frames, we see that the local factors have lost much of their additional explanatory power in the post-2001 period. Finally, this paper shows that an EMU factor model is able to price all EMU stocks better than countries individually.
Keywords: Asset pricing, Portfolio Choice, International Financial Markets, Financial Aspects of Economic Integration
JEL: F36, G11, G12, G15
Introduction
After the completion of the European Economic and Monetary Union (EMU), with the signing of the Maastricht Treaty in 1992, and eventually the introduction of the euro in 1999, Europe is supposed to have seen a remarkable economic integration ever since. As the euro was only introduced relatively recently, there are still limited academic studies on what impact the EMU (and the introduction of the euro) has on the EMU stock market, the integration of the EMU stock markets and its impact on stock pricing alone.
Integration in the EMU equity markets has some major implications for investors, their international portfolio diversification possibilities and the way they should price stocks.
This paper will add an insight and provide evidence in the discussion whether or not the EMU stock market can be regarded as an integrated market, and what this means for the way stocks should be priced.
This paper’s main contribution is providing evidence of EMU stock market integration by using a non- correlation method and asset pricing models, and to show what asset pricing model is best to price the stocks in the integrated EMU zone.
The structural changes in the financial markets of the EMU zone have resulted in a changing approach to the use of EMU stocks in international portfolio management. An integrated European market could have a major impact on the way investors price stocks and how to achieve a well-diversified portfolio. Although the size of the EMU equity market is - compared to the United States- not that big in terms of global market value, it has attracted a large number of non-EMU investors for its diversification benefits.
These investors have looked for opportunities to reduce portfolio risk by investing in stocks across different national markets where low correlations in return exist, while keeping the expecting return at the same level.
However, the assumed integration process of the EMU zone could potentially limit these benefits, as correlations between the EMU countries will rise. This could result in new optimizations in the commonly used mean-variance frontier in modern portfolio theory (Markowitz, 1952) for investors in the EMU zone.
On the other hand, the integration will lead to new opportunities and policies. The integration of the EMU stock market could result in one big investment area instead of several different ones, resulting in better risk sharing benefits, improvements in allocation efficiency and a reduction in economic volatility (Baele et al., 2004).
The creation of the EMU made it also possible for investors to buy EMU stocks without any limitations, as it is supposed to be a single market. Often, (institutional) investors were often restricted (for a certain amount) to a certain country (or currency). This limitation could be removed if the EMU appears to be actually one single market. This could result in more investments in the EMU zone. It could also limit the question which EMU country is a better option, as the EMU zone will appear as one investment opportunity, and shifts the question to which industry in the EMU is a better investment.
In this paper we assume that the integration in the EMU market means that every stock within the EMU countries is subject to same (financial) circumstances and sensitive to the same (financial) shocks, regardless of the country in which they are traded. There should be no market frictions within the EMU stock markets and EMU countries.
This means that every investor in the EMU has the same opportunity set, the same limitations, same costs and risks when investing in stocks. We consider this as a fair expectation of an integrated market, however, we will look for evidence to support this assumption.
If this is the case (which we expect), then it is interesting to know if the stocks could be priced by the same risk factors, which could indicate if the market is really integrated. Do national risk factors still add something to the pricing of EMU stocks? Or is one EMU risk factor able to price all EMU stocks?
If we think about risk factors, it is a logical step to come to the Capital Asset Pricing Model (CAPM). At present, the CAPM is a model which probably is the most widely used model to price assets in the financial market. Even in the corporate world the CAPM is present, as it is the foundation to calculate the cost of equity. Hence it has a major impact in calculating the Weighted Average Cost of Capital (WACC), as the cost of equity is directly related to CAPM (investors want compensation for being exposed to none diversifiable risk) (Arzac, 2005).
The CAPM is presumed that in a case of a fully integrated market, with the assumption that purchasing power parity holds, CAPM should be able to price all assets (Grauer et al., 1976).
From the ‘basic’ CAPM - a one factor model - the multifactor extension by Fama and French is the most widely used (1992, 1993, 1995, 1996, 1998); the Fama and French Three Factor Model (3FM). They showed in their papers that the two variables (risk factors) ‘size’ and ‘value’ add to the explanatory power of the model. So it is interesting to see how the CAPM and 3FM perform in an integrated EMU market.
In this paper we will compare the two models and see if they are able to price the EMU countries and the EMU zone as a whole. As both models are based on the same principle, it is easy to compare them and it is interesting which one significantly performs better at pricing the European market.
This paper could also contribute to the methodological discussion on which asset pricing models perform better. Although most academic papers provide evidence that the 3FM performs better than CAPM, most research has been focused on the United States (US) and on European countries individually (the United Kingdom in particular). Limited articles are written about the EMU as a whole or on the EMU countries together. This is mostly because of the lack of data, different currencies before the euro and the small number of stocks in many European countries.
The creation of the EMU created potentially a new data area in which different theories could be tested, besides the UK, Japan and the US. The empirical results in this paper could contribute to the discussion if the models are able to explain the returns of stocks and possibly add support for (one of) the models. At first, we will look (a) if there is evidence for the stock markets of the 12 initial EMU countries (which do not contain current EMU members Cyprus, Malta, Slovenia and Slovakia) to be integrated. We will use the principal component analysis (PCA) for the EMU zone in order to see if the equity markets in the EMU equities are correlated with the first principal component.
By doing this we want to find evidence which supports our assumption that the EMU zone is integrated and is subject to (some of) the same financial circumstances. Also we want to see what the impact of the EMU is on the integration in the EMU stock markets.
Secondly, we will construct the CAPM and the Fama and French three factor model (3FM) for the 12 EMU countries and for the EMU zone as a whole. We will compare the results in order to see if the CAPM is better a pricing EMU stocks then 3FM (b) when using national factors and (c) when using EMU factors.
We also add national factors to the EMU CAPM and 3FM to see (d) if the addition of these factors to an EMU 3FM has any significant impact. We can look if the EMU risk factors are able explain the returns, which could be evidence for EMU integration in the stock markets. We will look (e) if there is evidence that the EMU got more integrated after 2001 by looking at the impact of national factors in the asset pricing models.
Finally, we will look (f) for evidence if the EMU factors are able to price the EMU zone as a whole. We will test the PCA for the period January 1992 until December 2009, while the CAPM and 3FM will be tested for the period of July 1993 until June 2009 by using the adjusted R2 and – only for the CAPM and 3FM - the pricing error α (Jensen, 1968).
This paper is structured as follows. Section 2 will provide background information and a review of prior research. Section 3 describes the data employed. Section 4 defines the methodology used. Section 5 shows how the risk factors are constructed. Section 6 presents the descriptive statistics used and the results. Finally, section 7 will conclude the paper.
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