JourMl”f

INTERNATIONAL
FINANCIAL
MARKETS,
INSTITUTIONS
Journal of International Financial Markets, & MONEY
ELSEVIER Institutions and Money 7 ( 1997) 303-327

International portfolio diversification:

a synthesis and an update
Hany A. Shawky a,*, Rolf Kuenzel a, Azmi D. Mikhail b
a University at Albany, SUNY, Albany, NY 12222, USA
b Ohio Uniwrsity, Athens. OH 45701, USA

Abstract

This paper provides a synthesis of the existing literature on international portfolio diversifi-
cation and presents some new results on the subject. We address the question of whether
international portfolio diversification is always a reasonable method of reducing the risk of
an investment portfolio without negatively affecting its return expectations. Unfortunately,
there is still not a simple answer to this question. When ex-post data is examined, potential
benefits of international diversification can certainly be detected. However, we also argue that
it might be difficult for investors to select an optimal investment strategy a-ante, when the
correlation structure among the international equity is unstable over time. While such findings
do not completely rule out the potential benefits of international diversification, they certainly
make them more difficult to realize in practice. 0 1997 Elsevier Science B.V.

Keywords: Efficiency; Integration; International diversification

JEL class$cation: Gl 1; G1.5

I. Introduction

The benefits of international portfolio diversification continue to be a controversial

issue in the financial literature.’ Its advocates argue that international diversification
helps investors to reduce the risk of an investment while holding the expected return
constant. The opponents to this theory, on the other hand, claim that international
diversification has no economic rationale. In this paper, we attempt to provide a
comprehensive review of the issues and the empirical results relating to international
portfolio diversification.

* Corresponding author. Tel: (5 18) 442-4921: e-mail: has1 S@cnsibm.albanv.edu

’Odier and Solnik (1993) and Solnik (1996) point out that the understanding of the term ‘international’
varies across countries. In this study, it refers to investments in all countries, including the home country
of the investor.

1042-443 l/97/$1 7.00 0 1997 Elsevier Science B.V. All rights reserved
PII S1042-4431(97)00025-5
304 H.A. Shawky et al. 1 Int. Fin. Markets, Inst. and Money 7 (1997) 303-327

More specifically, we shall focus our attention on addressing the following ques-
tions: are international equity markets fully integrated or are they partially seg-
mented? Does it always make sense to diversify equity portfolios internationally?
Are there more effective ways to reduce the risk of an investment portfolio? Do the
potential benefits of international diversification vary over time? To fully explore
these issues, we will present a synthesis of the existing empirical evidence along with
some new results of our own.
The data we employ is presented in Table 1, and is based on the Thursday closing
prices of the Morgan Stanley Capital International indices for the following stock
markets: Austria, Belgium, Denmark, France, Germany, Italy, Netherlands, Norway,
Spain, UK, US and the world index.2 The index values and the rates of return are
adjusted for exchange rate fluctuations relative to the US dollar. The time period
examined is January 1990 to December 1995, which provides for a total of 312
weekly observations.
The remainder of this paper is organized in four sections. Section 2 reviews the
early literature on the issue of the potential gains from international diversification
and whether such benefits vary over time. In Section 3 we examine the time varying
behavior and the stability of the correlation structure among equity markets. In
Sections 4 and 5 we test for two basic requirements for investors to be able to benefit
from international diversification: the existence of partially integrated and informa-
tionally efficient financial markets. Section 6 offers a brief summary and concluding
remarks.

2. International portfolio diversification

2.1. The early evidence

Grubel (1968) uses a simple macroeconomic model in which government bonds

are traded between two countries to empirically examine the advantages of interna-
tional diversification for a US investor. His study is based on monthly data for the
stock market indices of ten industrialized countries and the US, and it covered the
period from January 1959 to December 1966. Grubel unambiguously concludes that
the potential gains from international diversification are substantial3
Levy and Sarnat (1970) used annual data from 1951 to 1967 to calculate the
Markowitz efficient frontier for a set of 28 country indices. Their findings are similar
to those of Grubel. A subset of 15 indices of high-income countries provides only
marginal improvements for a US investor. However, the potential diversification
gains are substantial when developing countries are included in the set of investment
opportunities. Levy and Sarnat also estimate the composition of the market portfolio

’ This data is published in Barron’s - The Dow Jones Business and Financial Weekly on the following
Monday, together with the weekly rates of return.
3 When the range of investment opportunities is limited to the US, Canada, and the European countries,
however, Grubel points out that the benefits of international diversification are less distinct.
Table 1
Descriptive Statistics for Weekly Stock Market Returns, 1/1/90P12/25/95

Austria Belgium Denmark France Germany Italy Netherlands Norway Spain UK US

1/1/9OG12/28/92
Mean -0.106 -0.048 -0.121 0.017 ~0.102 -0.271 0.191 -0.186 -0.177 0.075 0.215
Std Dev. 4.053 2.444 2.822 2.84 2.944 3.49 2.233 3.672 3.549 2.464 1.954
Skewness 0.125 -0.212 -0.195 -0.187 -0.601 PO.429 0.814 0.135 0.051 0.038 -0.019
Kurtosis 4.402 3.424 3.693 3.401 3.599 4.43 1 8.092 2.875 4.801 3.729 5.063
l/4/93- 12125195
Mean 0.103 0.283 0.26 0.168 0.325 0.306 0.351 0.392 0.289 0.204 0.326
Std dev. 2.135 I .778 2.266 2.028 1.955 3.578 I.653 2.575 2.571 1.771 1.34
Skewness 0.145 0.184 0.619 0.217 0.227 0.548 - 0.266 0.23 0.237 0.032 -0.157
Kurtosis 2.821 3.005 3.854 2.93 3.193 3.609 3.004 3.013 3.195 3.456 4.246
l/l/90&12/25/95
Mean -0.001 0.117 0.068 0.092 0.111 0.017 0.271 0.102 0.055 0.139 0.271
Std Dev. 3.238 2.141 2.563 2.466 2.506 3.541 I.964 3.181 3.104 2.144 1.675
Skewness 0.089 -0.176 0.034 -0.113 -0.532 0.082 0.484 0.072 0.035 0.009 -0.091
Kurtosis 5.656 3.716 4.018 3.687 4.244 4.161 7.41 3.228 4.889 4.053 5.561
306 H.A. Shawky et al. 1 Int. Fin. Markets, Inst. and Money 7 (1997) 303-327

using the single index model for various risk-free interest rates and draw similar
conclusions.4
Agmon (1972) criticizes Grubel’s approach, suggesting that country indices are
inadequate measures of the potential benefits of international diversification. This
is because each market has many assets and the composite market index does not
capture all the possibilities for diversification within a local market. Thus, Agmon
argues that the fact that two indices are weakly correlated does not necessarily imply
the superiority of international diversification over national diversification.
Furthermore, Agmon points out that Grubel’s study is based on a single observation
of Markowitz’ efficient frontier and concludes that general inferences about the
gains from international diversification cannot be drawn.5
Solnik (1973) points to further problems with earlier studies on the benefits of
international diversification, including Grubel (1968) and Levy and Sarnat (1970).
He states that the country indices used in these studies are often not representative
and that these studies suffer from small sample bias. Using bi-weekly returns data
for the period from March 1966 to April 1971, Solnik calculated the Markowitz
efficient frontier for a sample of market indices from nine European countries, the
US and Japan. His findings correspond to results of earlier studies, which reveal
large potential gains from international diversification.
In a later study, Solnik (1974) avoids some of the problems of earlier studies.
Using weekly data for the period from 1966 to 1971, he generates international
portfolios of different sizes using a large sample of individual stocks from seven
European countries and the US. Solnik’s study shows that the market risk is
considerably higher for a US portfolio than for an internationally diversified portfo-
lio.6 Lessard (1973) and Lessard (1976) who applied multivariate analysis on a
group of Latin-American countries, also found results that are consistent with the
potential presence of significant gains from international diversification.

2.2. Inter-industry diversification

Solnik (1974) argues that it might be more advantageous to diversify across

industries instead of across countries. However, his results do not support the
industry hypothesis, and thus he concludes that inter-industry diversification is
inferior to inter-country diversification. Roll (1992), and Heston and Rouwenhorst
(1994) are two recent studies on this issue. Using daily data for 24 country indices

4 Investments in the US and Japan account for the majority of the optimal portfolios, but with the
exception of Austria the portfolios virtually exclude the developed countries of Western Europe. Perhaps
the most striking feature of the composition of diversified international portfolios is the relatively high
proportion of investments in developing or borderline income countries such as Venezuela, South Africa,
New Zealand, Mexico and Japan.
5 While Agmon’s point is true, it must be noted that Grubel does not generalize his results. He concludes
that only if past experiences are considered to be indicative of future developments, then these data
suggest that future diversification of portfolios is profitable.
6 A major shortcoming of the study is that it does not consider the expected portfolio returns. One may
argue that the optimal domestic portfolio might dominate the optimal international portfolio.
 H.A. Shawky et al. / Int. Fin. Markets, Inst. and Money 7 (1997) 303-327 307

for the period from April 1988 to March 1991, Roll concludes that a significant
portion of the international structure of return correlations among countries can be
ascribed to the industrial compositions of the country indices.
According to Roll, parts of the benefits of international diversification are the
result of industrial diversification. Heston and Rouwenhorst however, find little
evidence for this fact. For a sample of individual stocks from twelve European
countries, they find that country-specific effects dominate, and that differences in
the industrial structure can only contribute very little to the explanation of inter-
country correlations. When applying Roll’s model to their data, Heston and
Rouwenhorst find results similar to those of Roll, and conclude that the use of index
data leads to biased results because industry and country components cannot be
separated.

2.3. Under-divers@ation and the ‘home bias' phenomenon

Most of the extant literature on international portfolio diversification examined

the issue from the viewpoint of US investors. However, the recent work of Odier
and Solnik ( 1993) and Eun and Resnick ( 1994) are two notable exceptions. Odier
and Solnik investigate the benefits of international diversification from the viewpoint
of investors from different nationalities. By constructing efficient frontiers for
Japanese, German and British investors, they conclude that the optimal international
asset allocations for these investors are similar to those derived earlier for an
American investor.
Eun and Resnick (1994) analyze the gains from international diversification from
the Japanese as well as the US perspective. They use monthly return data for national
bond and stock market indices for the period January 1978 through December 1989.
For the period examined, they concluded that the potential gains from international
diversification are much greater for US investors than for Japanese investors.
Moreover, for the Japanese investors, the gains from international diversification
accrue in terms of lower risk, while for US investors, the gains accrue not so much
in terms of lower risk but in terms of higher returns.7
A rather striking fact about international financial markets is that investors tend
to concentrate heavily in the stocks and bonds of their own country. In a recent
study, French and Poterba ( 1991) present some surprising data on the domestic
ownership shares of the stock markets in the United States, Japan, United Kingdom,
Germany and France. The estimates show very little cross-border diversification. At
the end of 1989, Japanese investors had only 1.9% of their equity in foreign stocks,
while US investors held 6.2% of their equity portfolios overseas. The British, by
comparison, held 18% of their portfolio abroad, divided almost equally among the
United States, continental Europe, and Japan.
To explain the apparent tendency for portfolio investors to overweight their own

7 It should be noted that these results are very time specific. In recent years for instance, the US stock
market has performed better than the Japanese market, which would have likely reversed these
conclusions.
308 H.A. Shawky et al. / Int. Fin. Markets, Inst. and Money 7 (1997) 303-327

equity market, French and Poterba ( 1991) explore both institutional and behavioral
explanations. For the most part, they argue that institutional constraints such as tax
differences, transaction costs and explicit cross-border limits on investments cannot
explain why investors specialize in their home markets, thus implying that incomplete
diversification is the result of investor choices.
A second class of explanations for under-diversification focuses on investor beha-
vior. One important possibility is that return expectations vary systematically across
groups of investors. Specifically, investors are believed to be relatively more optimis-
tic about the performance of their own markets. Another factor that may partially
explain the home bias phenomenon is that investors are better informed about assets
in their own country than about foreign assets. Consistent with this explanation,
Kang and Stulz (1995) have shown that foreign investors in Japan tend to concen-
trate in large stocks, which presumably are better known overseas.

2.4. Emerging equity markets

Traditionally investors have considered only developed markets in their interna-

tional diversification strategy. These markets have been in operation for a long time
and most international performance benchmarks included only developed markets.
However, investor interest in emerging markets appears to have increased signifi-
cantly over the last few years. This interest has resulted in large capital inflows to
these countries in the form of foreign direct investment as well as debt and equity
securities that have become important investment vehicles. The net foreign capital
flow to emerging equity markets in 1993 was around $37 billion.
Six emerging stock markets rank among the top 20 markets in the world in terms
of capitalization. 8 In terms of trading volume, Taiwan, Korea, and Malaysia were
among the 10 most active markets during 1993. Furthermore, trading in these
markets is not concentrated on a few companies. Many emerging markets trade a
large number of domestic companies. For example, 6800 companies are listed in
India, which ranks second only to the US in terms of the number of listed stocks.
Korea has more companies listed than either France or Germany. Nevertheless,
some emerging markets are still very concentrated, with a few companies accounting
for a large proportion of the overall market capitalization.’
Claessens and Gooptu (1994) and Tesar and Werner (1993) have noted the rapid
growth and importance of emerging capital markets. The rapid growth of these
markets has also been accompanied by a similar increase in academic research to
examine issues related to diversification and the degree and speed of integration of
these markets to the world economy. For instance, Bekaert and Harvey (1995)
provide evidence on variations of the degree of the integration of emerging equity
markets over time. Bekaert and Harvey (1995) examines the potential diversification
benefits from investing in emerging equity markets.
Odier et al. (1995) examine the risk-return characteristics of emerging markets

s These countries are Malaysia, South Africa, Mexico, Korea, Singapore and Thailand.
9 Source: Emerging Stock Markets Factbook, 1994, International Finance Corporation, Washington, DC.
 H.A. Shuwky et d. i ht. Fin. Murkrts. ht. trnd Monq, 7 (IYY7) 303-327 309

relative to developed markets. They document evidence of significantly higher returns

offered by many emerging markets, but that these returns are associated with higher
levels of market volatility. The correlation between the returns in emerging markets
and the world index of developed markets is found to be only about 0.31. These
results suggest that emerging markets might provide some good diversification
benefits to a portfolio that is invested solely in developed markets. Mapping efficient
frontiers for global asset allocation with and without emerging markets, Odier,
Solnik and Zucchinetti suggest that a minimum-risk strategy is to be invested 22%
in emerging markets and 78% in developed markets, a proportion not too different
from the relative GNP’s,

3. The time-varying benefits of international diversification

The first studies on the potential benefits of international diversification were

carried out in the early 1970s using data from the 1960s and 1970s. In the last two
decades, the financial markets worldwide have experienced fundamental changes.
Restrictions on foreign investment have been reduced, and modern technology allows
investors to buy and sell securities all over the world almost instantaneously. It is
conceivable that this trend towards greater globalization has caused stronger
co-movements among markets, thus reducing the potential benefits of international
diversification.

3.1. International diversijkation in the 1980’s and 1990’s

Table 2 shows our estimates for the correlations between the returns on ten
European stock market indices and the US market index for the period from January
1990 to December 1995. All the indices are denominated in US dollars. As can be
seen from the table, all the correlation coefficients are well below unity. This implies
that an investment in these indices provided the opportunity for substantial diversifi-
cation gains during the sample period.
Odier and Solnik (1993) examine the potential benefits from international diversi-
fication among the world’s 15 largest stock markets for the period 1980 to 1990.
They report very similar results. The average correlation among the returns on the
indices in their study is approximately 0.5, and they conclude that the investment
in foreign assets provided attractive risk diversification and profit opportunities
during the period observed.
Table 2 reveals two important observations. First, the correlations among the
European indices show a fairly consistent value of about 0.5. This may indicate the
existence of a well-integrated European market. The Italian index is the only excep-
tion to this pattern. Second, the returns on the US market have a comparatively
low mean correlation of 0.36 with the returns on the European indices. This finding
Table 2
Correlations of weekly returns: January l990-December 1995

Austria Belgium Denmark France Germany Italy Netherlands Norway Spain

Austria 1.000 0.593 0.425 0.515 0.678 0.341 0.436 0.371 0.473
Belgium 1.000 0.603 0.608 0.696 0.414 0.606 0.485 0.557 0.518
Denmark 1.000 0.459 0.582 0.416 0.490 0.479 0.470 0.516 0.295
France _ 1.OOo 0.671 0.462 0.530 0.414 0.607 0.584 0.437
Germany _ _ 1.000 0.462 0.592 0.464 0.598 0.562 0.347
Italy _ _ 1.000 0.367 0.220 0.506 0.346 0.232
Netherlands - _ _ 1.000 0.480 0.420 0.560 0.383
Norway - _ _ _ _ 1.000 0.399 0.419 0.346
Spain _ _ _ _ _ _ 1.000 0.490 0.443
UK _ _ _ _ 1.000 0.384
us _ _ _ 1.000
 H. A. Shawky et al. 1 Int. Fin. Markets, Inst. and Money 7 ( 1997) 303-327 311

is surprising, since various other studies have identified a dominant position for the
US among the world stock markets.”
There are at least two explanations that might account for the low correlations
between the US and the European markets. On the one hand, it is conceivable that
the US and the European markets are in fact not very strongly correlated. However,
this would lead to the conclusion that the US market does not have a dominant
position among the world stock markets. On the other hand, trading time differences
might be the reason for the fairly low correlation coefficients in our sample.
The trading time differences argument is based on the following: first, the indices
are computed from the market closing prices on a particular day each week; second,
the trading hours of the European stock markets precede those of the US markets.
An event that occurs in the US after the European markets are closed will affect
the European markets on the following day. Events that affect the European markets
however, will influence the US market on the same day. Thus the low correlation
among the returns might indicate that the US market has a dominant position.
While such an effect may not become apparent in the correlation structure, the low
correlations imply that the influence of the European markets on the US is fairly
small.

3.2. Stability of the correlation matrix over time

The pair-wise correlation coefficients between international stock market indices

may suggest potential gains from international diversification. In this section, we
investigate whether the benefits of international diversification have diminished over
time, and whether past correlations are good predictors of future correlations. The
latter is an important question. An unstable correlation structure would suggest that
the efficient frontier is continuously changing, thus it would be difficult for an
investor to select an optimal investment strategy ex-ante.
Table 3 shows the correlations between weekly rates of return on the US and six
European market indices. Two time periods are reported. The first line shows our
findings for the period January 1990 to December 1995. The following lines are the
correlations reported by Bertoneche (1979) for the period January 1969 to December
1976. Clearly, the pair-wise correlation coefficients reported by Bertoneche for the
earlier period are considerably lower than our estimates. This suggests that the
correlation structure is unstable, and that the inter-country correlations have substan-
tially increased over time, thus reducing the potential benefits of international
portfolio diversification.”
The consistency of the co-movements between international stock market indices
has been examined in several studies. Employing cluster analysis for a sample of

lo See, for example, Eun and Shim, 1989 and Espitia and Santamaria, 1994, both studies apply the VAR
methodology to daily return observations. Kwan et al., 1995 apply the Granger causality test to
monthly data.
” It must be noted that the two studies use ditrerent country indices. This might in part account for the
observed discrepancies.
312 H.A. Shawky et al. / Int. Fin. Markets, Inst. and Money 7 (1997) 303-327

Table 3
Correlation coefficients of weekly rates of return for the US and six European stock market indices. The
first row for each country shows our findings for the period January 1990 to December 1995. The figures
in italics below these estimates are the correlation coefficients reported by Bertoneche (1979) for the
period January 1969 to December 1976. The index returns for each of the countries are adjusted for
exchange rate fluctuations relative to the US dollar

Belgium France Germany Italy Netherlands UK US

Belgium 1.ooo 0.608 0.696 0.414 0.606 0.518 0.397

1.000 0.214 0.146 0.187 0.193 0.102 0.306
France _ 1.000 0.671 0.462 0.530 0.584 0.437
_ 1.000 0.310 0.027 0.345 -0.028 0.166
Germany _ _ 1.000 0.462 0.592 0.562 0.347
_ _ 1.000 0.048 0.592 -0.015 0.091
Italy _ I .ooo 0.367 0.346 0.232
1.000 0.111 0.102 0.095
Netherlands - _ _ 1.000 0.560 0.383
_ 1.000 0.033 0.168
UK _ 1.000 0.384
_ 1.000 0.072
us _ _ 1.000
1.000

weekly return data for twelve major stock market indices, Panton et al. (1976)
conclude that there is a substantial short-run stability up to three-year periods, but
that the longer-run stability is weaker. This suggests that there are possibly long or
intermediate term trends in co-movement patterns that are not perceptible over
shorter time periods. l2
Maldonado and Saunders ( 1981) examine the stability of the correlation structure
between the US market index and the market indices of Japan, Germany and the
UK. Using weekly data for the period from 1957 to 1978, they present evidence
that the correlations are fairly stable in the short run (up to six months). For longer
periods, they find the correlation structure to be relatively unstable. Kaplanis (1988)
analyzes monthly returns on stock market indices of 10 countries for the period
1967-1982, but finds no evidence that the correlations are unstable over time.
A more recent study by Erb et al. ( 1994) covers the period from 1970 to 1993.
Using monthly return data for the G-7 countries, they find that the correlations
between these countries are related to the business cycle. The correlation between
two countries tends to be highest when both economies are in recession, and lowest
when the two economies are expanding. For example, Erb, Harvey and Viskanta
report an average correlation between the US and Germany of 0.492 when both
countries are in recession, and a correlation of 0.024 in expansions. When the
business cycles are out of phase, they find an average correlation of 0.358.
If the above findings can be generalized, we should be able to find similar results

lZThat is, structural movements appear to be slight on a year-to-year basis, but somewhat more pro-
nounced on a long-term basis.
 H.A. Shawky et al. / Int. Fin. Markers, Inst. and Money 7 (1997) 303-327 313

for our present data set. In 1990, the United States experienced a recession, followed
by European countries in 1991 and 1992. The economies started to recover in the
following years. Thus we split the sample in two parts. The first part covers the
period from 1990 to 1992, and the second part consists of the data for the period
1993 through 1995. Though the business cycles of the countries in our sample were
not perfectly in phase, we expect the correlations to be higher in the first period
when all countries were experiencing a recession.
The correlation matrices for the two sub-periods are shown in Tables 4 and 5. To
detect significant changes in the pair-wise correlation coefficients, we test the null
hypothesis that the correlation has remained constant from one period to the next
against the alternative hypothesis that the correlation has changed. The values for
the corresponding z-statistics are shown in Table 6.13
The critical value at the 5% level of significance at which the null hypothesis can
be rejected is zc= 1.96. The correlation declined for 45 out of 55 pairs of countries.
The change was significant at the five-percent level in 13 of the 45 cases. An increase
in the correlation was observed for 10 of the 55 pairs. Only one of these changes
was statistically significant at the five percent level.
These results confirm our expectation that the correlations should be lower in the
second period when the economies recover from the recession. Since our analysis is
limited to only two observations of the correlation matrix with respect to the business
cycle, it would be difficult to confirm or reject the model of Erb, Harvey and
Viskanta. However, our results are generally consistent with their model. Erb,
Harvey and Viskanta further point out that, in the long run, the correlations seem
to have been gradually increasing since 1982. They state that this development is
most apparent for the European countries in their sample.
Longin and Solnik (1995) use a multivariate GARCH model to examine the
correlations of monthly excess returns. Their sample consists of market indices for
seven major countries over the period 1960-1990. They present evidence that the
correlation structure is unstable over time and conclude that the correlation between
the market indices increased modestly during the 30-year period examined. However,
in a more recent study, Solnik (1996) shows that the correlation between the stock
market returns of major industrialized countries has dropped back to a lower level
in the early 1990s.
Another interesting finding of Longin and Solnik is that the correlations seem to
be higher in times of high market volatility. This phenomenon can also be observed
from our data. As pointed out earlier, the correlations are mostly lower during the
second half of our sample period. Table 1 shows the standard deviations of the
returns on the country indices for the period from 1990 to 1992, as well as for the
period from 1993 to 1995. As indicated in the table, the standard deviations are

G, -I,?
I3 Our analysis is based on the statistic z= where rl and r2 are the correlation coefh-

M
cients in the first and the second subperiod, respectively, and n, and n, denote the number of observations
in the corresponding subperiod. The value of zrl is calculated as ;,, =log, ( 1 + v,)/( 1-ri),
 K

Table 4
Correlation coefficients for weekly rates of return, January 1990-December 1992

Austria Belgium Denmark France Germany Netherlands Italy Norway Spain UK US

Austria 1.000 0.629 0.416 0.587 0.734 0.504 0.436 0.409 0.570 0.461 0.373
Belgium _ 1.000 0.639 0.679 0.715 0.586 0.594 0.452 0.622 0.540 0.460
Denmark _ 1.000 0.523 0.610 0.495 0.498 0.493 0.459 0.552 0.379
France _ _ _ 1.000 0.375 0.529 0.491 0.418 0.643 0.592 0.494
Germany _ _ _ 1.000 0.613 0.564 0.453 0.656 0.512 0.398
Italy _ _ _ _ 1.000 0.427 0.245 0.577 0.386 0.344
Netherlands _ _ _ _ _ 1.OOo 0.481 0.387 0.506 0.435
Norway 1.000 0.350 0.422 0.372
Spain _ _ _ _ _ _ 1.000 0.493 0.461
UK _ _ _ _ 1.OOo 0.394
us - 1.000
Table 5
Correlation coefficients for weekly rates of return, January 1993-December 1995

Austria Belgium Denmark France Germany Netherlands Italy Norway Spain UK us

Austria 1.000 0.521 0.325 0.336 0.529 0.085 0.450 0.276 0.230 0.41 I 0.151
Belgium _ 1.ooo 0.535 0.469 0.653 0.189 0.628 0.540 0.425 0.475 0.267
Denmark _ _ 1.000 0.348 0.529 0.319 0.473 0.447 0.483 0.454 0.141
France _ -. 1.000 0.535 0.386 0.603 0.403 0.534 0.566 0.319
Germany 1.000 0.257 0.649 0.473 0.469 0.541 0.230
Italy _ _ ._ _ 1.000 0.294 0.182 0.419 0.300 0.080
Netherlands 1.000 0.474 0.478 0.661 0.279
Norway _ 1.000 0.486 0.412 0.288
Spain 1.000 0.484 0.402
UK _ _ 1.000 0.362
US _ 1.000

Table 6
Z-statistics for a test of the null hypothesis that the pairwise correlation coefficients have not changed from the period 1990-1992 to the period 199331995.
The critical value for rejection at the five % level of significance is z, = 1.96

Austria Belgium Denmark France Germany Netherlands Italy Norway Spain UK

Austria 1.413 1.585 2.833 3.060 4.103 -0.145 1.316 3.625 0.540 2.093
Belgium _ 1.396 2.789 1.017 4.210 -0.475 - 1.024 2.414 0.762 1.967
Denmark _ 1.904 1.056 1.859 0.283 0.519 -0.265 1.150 2.256
France _ 3.000 1.583 - 1.404 0.151 1.470 0.345 1.854
Germany _ _ 3.941 -1.178 -0.217 2.420 0.396 1.643
Italy _ _ 1.349 0.578 1.855 0.852 2.436
Netherlands 0.083 -0.979 -2.081 1.580
Norway _ _ - 1.444 0.108 0.829
Spain _ _ 0.097 0.637
UK _ 0.334
us _
316 H.A. Shawky et al. /Inc. Fin. Markets, Inst. and Money 7 (1997) 303-327

considerably lower in the second period. The only exception is the Italian market
index.
Again, we cannot infer from a comparison of only two sample periods whether
the model is correct or not. However, it can be said that our results are in accordance
with the findings of Longin and Solnik. The fact that the inter-country correlations
tend to go up when markets become more volatile is a major drawback for interna-
tional investors. It implies that the potential benefits of international diversification
tend to diminish when they are most needed, that is, in times of high market
volatility.

4. Segmented versus integrated capital markets

4.1. Concept of integrated capital markets

Whether international capital markets are segmented or integrated is closely

related to the issue of international diversification. The recent literature considers a
capital market fully integrated into a world capital market if assets with the same
risk have identical expected returns, irrespective of the country in which they are
traded. The underlying risk factor is assumed to be the same for all assets. However,
this does not imply that investors must have unlimited access to these markets, and
the existence of restrictions on foreign investment does not necessarily preclude the
existence of an internationally integrated market. l4
This understanding of market integration suggests that markets must be at least
partially integrated for an investor to be able to benefit from international diversifi-
cation. In completely segmented markets, foreign investment is not possible by
definition. In entirely integrated markets, investors can profit from international
diversification only if the assets in the domestic and foreign markets have different
risk-return characteristics.r5 Otherwise, the potential gains from international diver-
sification are the same as those that can be achieved through domestic diversification.
The literature on market segmentation is immense. Most studies assume that
markets are completely segmented, entirely integrated, or partially integrated, and
test whether the empirical data fits the model. Stehle (1977) pursues a different
approach. He explicitly tests the hypothesis that stocks on the New York stock
exchange are priced domestically against the alternative hypothesis of international
asset pricing. However, his results are inconclusive. Recently, Bekaert and Harvey
(1995) examined the degree of integration of twelve emerging markets into the world
market and provided evidence that the degree of market integration of these countries
varied during the 1980’s and the second half of the 1970’s.

I4 See Bekaert and Harvey (1995) and Campbell and Hamao (1992), for example.
” In this case the market portfolio, i.e. the optimal portfolio in the asset pricing model might be different
for domestic and the international set of investment opportunities.
 H.A. Simwk!~ et al. ! ht. Fin. Markets, Inst. and Money 7 (1997) 303-327 317

4.2. The market model in an internationalframework

The above studies suggest that world capital markets are partially segmented.
Thus, we should be able to detect the presence of an international factor in an
international market model regression of the form:

Yi=S(j+ljiY,+Ei. (1)
This equation asserts that the rate of return Ti, on an individual security i, can be
divided into two components. A component ri that is independent of the rate of
return on the overall market, rm, and a component /lirmwhich depends on the market
movements. The parameter Bi is the beta coefficient and Ei is a random distur-
bance term.
The market model has been extensively tested for the US stock market as well as
several of the European stock markets.16 Following Solnik (1996), we apply the
market model in an international framework. The beta coefficient represents the
sensitivity of the security with respect to a common world factor, and can be
regarded as the international market risk of the security. The return on a world
stock index is used as a proxy for the international factor, and thus the return and
risk performance of the various countries is consistently compared. Our results for
the period January 1990 to December 1995 are shown in Table 7.
The coefficient of variation, R2, indicates the percentage of the variation in the
dependent variable that can be explained by the independent variable. This percen-
tage ranges between 18 and 49% for the full sample period indicating that a fairly
influential world factor exists. These findings are consistent with partially segmented
markets implying that investors should be able to benefit from international diversi-
fication.” A comparison of the beta estimates for the sub-periods 1990-1992 and
1993- 1995 shows a fairly unstable behavior over time.
Recent studies by Eun and Resnick (1994) and Jorion (1985, 1986) have shown
that investors can potentially increase the gains from international diversification
by hedging foreign exchange risk. To examine the influence of foreign exchange rate
fluctuations on the risk and return of an investment in a foreign market, we estimate
the extended market model regression described by the following equation:

I’i= Yi+ /jirm + YiSi + Ei. (2)

This equation posits that the rate of return, ri, on an individual security, i, can
be broken into three components: ai which is particular to the security, a component
[jir, which depends on the world factor, r,, and a component ^/pi which depends on
changes in the exchange rate, Si. Again, Ei is a random disturbance. The parameter
yi, represent the sensitivity of the security returns to change in the exchange rate,

” Hawawini ( 1984) provides a fairly comprehensive list of the earlier studies, especially on the application
of the market model to European markets.
I7 It should be noted that these results are based on the correlation and the variance/covariance behavior
between markets and are independent of the unit of currency used in the analysis. These results are also
applicable to investors in any country including the US.
Table 7
Estimates from the regression equation: ri = ai + j&r,,, + ci

1990--95 1990-92 1993-95

ai MSE) RZ GW LAW) R2 aiW) BiW) R2

Austria -0.1100 1.0278 0.3042 -0.0498 1.1099 0.3483 -0.0955 0.7579 0.1708
(0.1532) (0.0882) - (0.2620) (0.1220) ~ (0.1601) (0.1346) ~
Belgium 0.0366 0.7646 0.3849 -0.0104 0.7455 0.4318 0.0684 0.8198 0.2880
(0.0953) (0.0548) - (0.1476) (0.0687) - (0.1236) (0.1039) -
Denmark -0.0130 0.7772 0.2775 -0.0833 0.7535 0.3310 0.0393 0.8428 0.1873
(0.1236) (0.0711) - (0.1849) (0.0860) - (0.1683) (0.1415) -
France - 0.0043 0.9224 0.4223 0.0635 0.9086 0.4750 -0.0899 0.9861 0.3203
(0.1063) (0.0612) - (0.1648) (0.0767) - (0.1377) (0.1157) ~
Germany 0.0118 0.9454 0.4297 -0.0540 0.9408 0.4741 0.0777 0.9457 0.3168
(0.1073) (0.0618) - (0.1710) (0.0796) - (0.1331) (0.1119) -
Italy - 0.0642 0.8783 0.1838 -0.2047 0.8770 0.2892 0.0842 0.8475 0.0760
(0.1817) (0.1051) - (0.2365) (0.1108) - (0.2833) (0.2381) -
Netherlands 0.2028 0.6456 0.3262 0.2204 0.5749 0.3077 0.1162 0.8943 0.3966
(0.0914) (0.0526) ~ (0.1488) (0.0693) - (0.1058) (0.0889) -
Norway 0.0088 0.8854 0.2338 -0.1461 0.7962 0.2183 0.0888 1.1577 0.2738
(0.1580) (0.0909) - (0.2600) (0.1210) - (0.1808) (0.1520) -
Spain - 0.0647 1.1384 0.4059 -0.1191 1.1494 0.4868 0.0039 1.0877 0.2424
(0.1357) (0.0781) - (0.2036) (0.0948) - (0.1843) (0.1549) ~
UK 0.0528 0.8260 0.4481 0.1145 0.7727 0.4566 -0.0643 1.0251 0.4541
(0.0904) (0.0520) - (0.1455) (0.0677) - (0.1078) (0.0906) -
us 0.1996 0.6755 0.4910 0.2486 0.6665 0.5398 0.1386 0.7183 0.3891
(0.6755) (0.0390) - (0.1061) (0.0494) - (0.0863) (0.0725) -
 H. A. Shawky et al. / Int. Fin. Markets, Inst. and Money 7 (1997) 303-327 319

and is expected to incorporate the foreign exchange risk factor into the pricing
model. We estimate this regression equation for the French, the German and the
British market index.
Table 8 presents the results. First, compared to the market model without exchange
risk (Eq. (l)), the value of the adjusted R2 coefficient increases only slightly. This
implies that exchange rate fluctuations explain only a small additional portion of
the variance of the market indices. The contribution of exchange risk to the total
risk of an investment in a foreign stock index seems to be relatively small. Second,
the exchange rate coefficient pi, is positive at the 1% level for all market indices, and
its magnitude ranges between one and two thirds of the size of the world market
factor. This however implies that the exchange rate itself has a comparatively large
influence on the rate of return of an investment in a single market index.
Solnik (1996) examines the impact of exchange rate fluctuations on the risk and
return on international investments over the period from 1971 to 1994.i8 He presents
evidence that the contribution of exchange rate fluctuations to the total investment
risk is fairly small for both an investment in a single stock market index, and an
investment in an internationally diversified portfolio of stock market indices. With
regard to the contribution of exchange rate fluctuations to the investment return,
Solnik points out that the impact of currency fluctuation on the investment return
may exceed that of capital gains or income, especially over short periods of time.
Nevertheless, currency fluctuation has never been the major component of total
return on a diversified portfolio over a long period of time because the depreciation
of one currency is often offset by the appreciation of another.

5. The efficiency of international stock markets

The concept of market efficiency implies that it should not be possible to earn
unusual profits by investing in a particular market based on the observed develop-
ments in other markets. If lead-lag relationships among the international stock
markets exist and remain constant over time, international diversification may not
make much sense. In this case, investors should use the information provided by
the leading markets and invest in the lagging markets accordingly. In this section,
we first present a review of the literature related to market efficiency, and then apply
the Granger (1969) causality test to our data.

5.1. Review of the related literature

Granger and Morgenstern ( 1970) carried out one of the first studies on the
lead-lag relationships among international stock market indices. They apply spectral
analysis to investigate the interrelations between seven European indices and market
indices for the New York, Tokyo, and Sidney stock exchanges. Using weekly data

‘s The results reported by Solnik, 1996 are similar to those of an earlier study by Solnik and Noetzlin,
1982 for the period from 1970-1980.
Table 8
Estimates from the regression equation: ri = cli + Pir, + yisi + ci

ai B, RZ RZ adjusted
(SE) (SE) GE) Model with exchange risk (Eq. (2)) Model without exchange risk (Eq. ( I ))

France 0.0069 0.8627 0.3091 0.4839 0.4803 0.4434

(0.1052) (0.0606) (0.0667) - _ _
Germany 0.0180 0.8710 0.3045 0.4690 0.4653 0.4302
(0.1100) (0.0636) (0.0681) _
UK 0.0678 0.7203 0.4254 0.5484 0.5452 0.4536
(0.0868) (0.0506) (0.553) _ _
 H. A. Shawky et al. 1 Int. Fin. Markets, Inst. and Money 7 (1997) 303-327 321

for the period from 1961 to 1964, they conclude that the market indices are moving
independently of one another during the sample period. The only cases where a
relationship is detected, are those between the New York and the Amsterdam and
between the German and the Amsterdam markets.
Hilliard (1979) uses spectral analysis to examine the co-movements and the
lead-lag relationships among six European indices, and indices for the stock
exchanges in New York, Toronto, Sidney, and Tokyo around the 1973 oil embargo.
His sample consists of daily data for the ten-month period from July 1973 to April
1974. In contrast to Granger (1969) Hilliard finds that some very close relationships
exist. In particular, the North American and the European markets show strong
intra-continental commonalties. Hilliard concludes that, to the extent they are
related, most intra-continental prices move simultaneously, even in the context of
hourly fluctuations. With respect to inter-continental prices however, he finds that
most of them do not seem to be closely related.
A number of more recent studies apply the VAR methodology (vector autoregres-
sive analysis) to detect possible relationships among the world stock markets. Eun
and Shim (1989) examined daily return data for the indices of nine major markets
during the period from 1980 to 1985. They found a substantial amount of interde-
pendence among the markets, and concluded that their findings are broadly consis-
tent with an informationally efficient international stock market. More importantly,
they suggested that there is no national stock market that is nearly as influential as
the US, in terms of its capability of accounting for the error variances of other
markets.
Espitia and Santamaria (1994) applied a similar methodology to daily data for
the period from 1987 to 1992. Their sample includes indices for the stock exchanges
in Tokyo, Madrid, Milan, Frankfurt, Paris, London and New York. This range of
countries overlaps in large part with the countries examined by Eun and Shim
(1989). While the findings of Espitia and Santamaria are consistent with those of
Eun and Shim, a few differences must be pointed out. First, the effects of a shock
to the New York market seem to last longer in the period from 1987 to 1992 (up
to four days) than in the 1980 to 1985 period (two days). Second, Espitia and
Santamaria note that, as compared to the earlier study, the co-movements of the
markets have increased.
Espitia and Santamaria (1994) point out that the strength of the relationships
between markets seems to depend largely on the currency in which the market
indices are denoted.” However, the dominant position of the New York market is
never questioned. Other studies use the Granger (1969) causality test to investigate
the links between international stock markets. Malliaris and Urrutia (1992) examine
the lead-lag relationships among six world stock market indices before, during and
after the market crash of October 1987. They find strong evidence for uni- and

I9 An extreme example is that of the European market indices in their study. When the returns are
measured in local currency, hardly any interrelations can be detected. On the other hand, if the returns
are measured in Swiss Francs, the inter-influences turn out to be substantial.
322 H.A. Shawky et al. / Int. Fin. Markets, Inst. and Money 7 (1997) 303-327

bi-directional relationships between the markets during the month of the crash.
However, no relationships are detected for the periods before and after the crash.
The study of Smith et al. (1993) covers a longer time period. They apply a rolling
Granger causality test to weekly return observations for the market indices of the
US, Japan, the UK and Germany for the period from 1982 to 1991. They find only
short-lived (generally uni-directional) relationships between the US and other mar-
kets. The only exception is the influence of the US on the German market, which
surprisingly, is found to last for almost three years following the 1987 stock market
crash. With regard to the potential benefits of international portfolio diversification,
Smith, Brocato and Rogers conclude that in terms of aggregate data, the results are
consistent with the idea that gains from international diversification are obtainable.
Recently, Kwan et al. (1995) carried out another study using the Granger method-
ology. They examined monthly index data for nine major stock markets during the
period from 1982 to 1991. The authors found evidence of Granger causality in more
than 40% of all cases examined. They detected several feedback relationships among
the Asian-Pacific markets. In addition, they report a dominant position for the US
market. While not influenced by other markets, the US leads four markets in the
sample. Kwan, Sim and Cotsomitis concluded that the markets examined in their
study are not efficient.
The empirical evidence on the relationships between international stock markets
is inconclusive. Even studies that use the same methodology, such as Eun and Shim
(1989), and Espitia and Santamaria (1994), appear to reach different conclusions.
In the case of these two studies, the discrepancy is especially surprising since similar
markets and adjacent time periods are examined. This suggests that the lead-lag
relations between markets are not constant over time, as proposed by Smith et al.
(1993).

5.2. Empirical evidence for Europe and the US: an application of the Granger
causality test

The Granger causality test is essentially a test of the predictive ability of time
series models. It measures precedence and information content, but does not indicate
causality in the common use of the term. A time series variable yt is said to be
Granger caused by another time series variable x,, if better forecasts of the current
value of yt can be obtained by making use of past values of x, and yt, than by using
past values of yt alone. More specifically, yt is considered to be Granger caused by
x,, if at least one of the coefficients yi in the following regression equation is
significantly different from zero:

Yt =@+ f BiYt-i + f yiX,-i +E,. (3)

i=l i=l

This is tested in the usual way by computing the F-statistic

SSE, - SSE,/m
F= (4)
SSEu/(T-2m-1)’
Where
 H. A. Shawky et al. / Int. Fin. Markets, Inst. and Money 7 (1997) 303-327 323

SSE, is the sum of squared errors of the restricted model (yl = yz = . . . = Y,,,=O)
SSEu is the sum of squared errors from the unrestricted model,
T is the total number of observations,
m is the number of lags taken into account.
The null hypothesis of no Granger causality (H,,: y1 = 1~~ = . = yrn= 0) is rejected
if the value of the F-statistic exceeds the critical value for an F-distribution with
[m,(T-2m - l)] degrees of freedom for a given level of significance. We test for
Granger causality among each pair of market indices using a lag length of one
week.” Thus we investigate whether the return on a particular market index in the
current week can be better explained by the previous week’s return on this index
alone, or whether better results can be obtained when the previous week’s return of
an additional index is taken into account.
Our results are shown in Tables 9 and 10. Table 9 presents the F-statistics for the
null hypothesis that the returns on the row index do not Granger cause the returns
on the column index. The corresponding p-values are shown separately in Table 10.
For example, the F-value for the null hypothesis that the returns on the US index
do not Granger cause the returns on the index for the UK is 0.422.‘l The correspond-
ing p-value is 0.517. Thus, we cannot reject the null hypothesis that the returns on
the US index do not Granger cause the returns on the British index at the five %
level of significance.
Interestingly however, we find evidence for Granger causality at the five % level
of significance for 23 out of the 132 possible relationships between the indices in
our sample. In ten cases, or for five pairs of countries, a mutual relationship can be
observed. The UK emerges as the most influential market in our sample. The returns
on the UK index Granger cause the returns on five other market indices. However,
the UK also turns out to be caused by the returns on the market indices for Austria,
Belgium, Denmark and Spain.
It appears that there are a large number of inter-influences among the European
market indices. The fact that the return on a specific market index is Granger caused
by the previous week’s return on another index is not compatible with efficient
markets. However, the crucial question is whether these relationships remain constant
over time. The findings of Smith et al. (1993), who apply a rolling Granger causality
test over the period from 1982 to 1991, suggest that inter-influences among the
world stock markets are short lived.

” A lag length of two weeks was also examined and provided similar results. As in other studies, the lag
length was chosen rather arbitrarily (see, for example, Malliaris and Urrutia, 1992). Kwan et al., 1995
state that the results derived from the &anger causality test may be biased if an incorrect lag length is
used. Other possible sources of bias are nonstationarity of the time series and autocorrelation in the error
terms, For further discussion of these problems, we refer to Kwan et al., 1995, Smith et al., 1993, Malliaris
and Urrutia, 1992, and the references cited therein.
‘I The critical value at the five % level of significance is approximately F,= 3.84. The corresponding value
at the one % level is approximately F,=6.63. The values stated here are those for an F-distribution with
[I,~31 degrees of freedom. However, they approximate the values for the appropriate F-statistic with
[I ,309] degrees of freedom fairly well.
Table 9
Granger causality F-statistics for the null hypotheses that the row index does not Granger cause the column index

Austria Belgium Denmark France Germany Italy Netherlands Norway Spain UK US

Austria 2.076 0.085 5.595 1.752 0.567 0.103 0.164 2.035 7.074 2.496
Belgium 1.434 0.149 3.488 I.719 0.933 0.506 0.261 0.975 6.179 1.065
Denmark I.321 0.490 _ 7.628 I.171 0.088 1.014 1.550 0.726 8.529 0.404
France 0.720 10.305 2.191 _ 3.326 0.214 4.615 I .397 6.012 0.657 0.309
Germany 0.516 0.608 0.016 6.785 0.007 0.003 0.177 0.375 3.558 1.303
Italy 3.61 I 2.619 0.758 8.631 I.199 1.273 0.188 0.000 IO.180 0.679
Netherlands I.019 3.209 0.327 0.780 0.553 0.314 _ 0.290 I .294 0.482 0.514
Norway 0.053 0.006 0.947 0.533 0.795 0.306 0.111 0.186 1.224 I.540
Spain 5.042 0.91 I 0.413 9.140 0.958 0.044 0.120 0.001 _ 7.052 0.303
UK 5.206 7.516 4.271 1.840 3.326 1.976 2.000 5.535 9.177 1.038
us 0.582 4.444 I.655 0.034 1.968 I.491 3.880 3.632 0.122 0.422

Table IO
Granger p-values for the null hypothesis that the row index does not Granger cause the column index

Austria Belgium Denmark France Germany Italy Netherlands Norway Spain UK us

Austria _ 0.151 0.771 0.015 0.187 0.452 0.748 0.686 0.155 0.008 0.115
Belgium 0.007 0.699 0.063 0.191 0.335 0.411 0.610 0.324 0.013 0.303
Denmark 0.251 0.485 _ 0.006 0.280 0.768 0.315 0.214 0.395 0.004 0.526
France 0.397 0.001 0.095 _ 0.069 0.644 0.032 0.238 0.014 0.418 0.579
Germany 0.473 0.436 0.898 0.010 _ 0.935 0.960 0.674 0.541 0.060 0.255
Italy 0.058 0.107 0.385 0.004 0.274 0.260 0.665 0.984 0.002 0.41 I
Netherlands 0.314 0.074 0.568 0.378 0.458 0.576 0.590 0.256 0.488 0.474
Norway 0.817 0.939 0.331 0.466 0.373 0.580 0.739 0.667 0.269 0.216
Spain 0.025 0.341 0.521 0.003 0.328 0.834 0.729 0.980 _ 0.008 0.582
UK 0.023 0.006 0.039 0.176 0.069 0.161 0.158 0.019 0.003 _ 0.309
us 0.446 0.036 0.199 0.853 0.162 0.223 0.050 0.058 0.727 0.517 _
 H. A. Shalvky et al. / ht. Fin. Markets, Inst. and Money 7 (1997) 303-327 325

6. Summary and conclusions

This paper provides a synthesis of the existing literature regarding the potential
benefits of international portfolio diversification. Unfortunately, there is still no
simple answer to this question. When ex-post data is examined, the benefits of
international diversification can be detected. However, it might be difficult for
investors to select an optimal investment strategy in advance, when the correlation
structure among the international markets is unstable over time. While this does
not completely rule out benefits of international diversification, it may make it more
difficult to realize these benefits in practice.
The analysis in this paper points towards two important findings. First, the
existence of an unstable correlation structure makes it difficult for an investor to
select an optimal investment strategy ex-ante. Secondly, the increased worldwide
integration of financial markets might have caused stronger co-movements among
international equity markets, thus reducing the potential gains from international
diversification. Empirical studies do not provide unanimous answers to these ques-
tions. It seems that the conclusions depend largely on the time period examined, the
measurement intervals and the statistical methods which were applied.
Another important issue is that of market efficiency. It is pointed out that if
markets were not efficient, investors can simply take advantage of information
provided by a leading stock market to earn unusual profits in a lagging market. We
found the empirical evidence on the efficiency of international stock markets to be
inconclusive. Although lead-lag relationships among the stock markets exist, they
are unstable over time, and it is not possible to take advantage of them. Furthermore,
we doubt that unusual profits can be earned when transaction costs are taken into
account, even if the lead-lag relationships remained constant over time.
Finally, we believe that there is compelling evidence in favor of international
portfolio diversification as a reasonable method to reduce the risk of an investment
portfolio without negatively affecting its expected return. The case for international
diversification may even be stronger when emerging equity markets are included as
part of the investor’s investment opportunity set. However, we remain convinced
that due to the unstable structural relation between markets, investors are not likely
to be able to take full advantage of the entire scope of possible international
diversification gains.

Acknowledgements

The authors wish to thank the anonymous referee and Ike Mathur, the editor,
for valuable comments and suggestions. R. Kuenzel acknowledges the financial
support of Colonia-Studienstiftung im Stifterverband fuer die Deutsche
Wissenschaft.
326 H.A. Shawky et al. / Int. Fin. Markets, Inst. and Money 7 (1997) 303-327

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