A Decomposition of Global Linkages in Financial Markets Over Time

Abstract

This paper tests if real and financial linkages between countries can explain why movements in the world's largest markets often have such large effects on other financial markets, and how these cross-market linkages have changed over time. It estimates a factor model in which a country's market returns are determined by: global, sectoral, and cross-country factors (returns in large financial markets), and country-specific effects. Then it uses a new data set on bilateral linkages between the world's 5 largest economies and about 40 other markets to decompose the cross-country factor loadings into: direct trade flows, competition in third markets, bank lending, and foreign direct investment. Estimates suggest that both cross-country and sectoral factors are important determinants of stock and bond returns, and that the U.S. factor has recently gained importance, while the Japanese and U.K. factors have lost importance. From 1996-2000, real and financial linkages became more important determinants of how shocks are transmitted from large economies to other markets. In particular, bilateral trade flows are large and significant determinants of crosscountry linkages in both stock and bond markets. Bilateral foreign investment is usually insignificant. Therefore, despite the recent growth in global financial flows, direct trade still appears to be the most important determinant of how movements in the world's largest markets affect financial markets around the globe.

Determinants of Stock Market Co-Movements between Pakistan and Asian Emerging Economies

“…They report that trade is significantly and positively associated with stock market co-movement. In addition, our results are in line with Forbes and Chinn (2004), Lucey and Zhang (2010). They report that the extent of stock market co-movement is dependent on the extent of strong bilateral trade relationships.…”

“…This feature has attracted the attention of academicians and practitioners towards the identification of the integration and determination of fundamentals that might describe how stock markets of different countries are correlated to each other (Pretorius 2002). Such rise of interests and inspirations can be described for several reasons, but the most appropriate of all includes the quest for likely benefits of risk management, especially portfolio diversification (Forbes and Chinn 2004).…”

Speculators, Commodities and Cross-Market Linkages

“…3 It also links our paper to earlier work on financial vs. fundamental drivers of cross-border market linkages. Part of that economics literature asks if financial shocks are propagated internationally through financial channels such as bank lending (e.g., van Rijckeghem and Weder, 2001) and international mutual funds (e.g., Broner et al, 2006) or if, instead, shocks spill over through real economy linkages such as trade relationships (e.g., Forbes and Chinn, 2004). Our paper presents an interesting counterpoint in commodity markets by showing that, when the TED spread signals elevated levels of financial stress, higher relative spec activity is associated ceteris paribus with weaker (rather than stronger) equity-commodity return correlations.…”

What explains global exchange rate movements during the financial crisis?

“…There is a growing literature on global …nancial linkages and the transmission channels for various types of shocks. An important early study is Forbes and Chinn (2004), who use a factor model and show that trade and …nancial linkages an explain part of cross-country equity returns. Hausman Fratzscher (2008) also analyze interest rate and exchange rate responses.…”