THE EFFECT OF VOLATILITY IN U.S. AND EAST ASIAN STOCK MARKETS ON THE CORRELATION BETWEEN THEM

Abstract

Recent studies, such as Longin and Solnik (1995), have found an increase in the correlation between developed stock markets (belonging mostly to the G-7 countries) when the volatility in any of them increases. The objective of risk reduction through international portfolio diversification is therefore undermined. In this study we find that volatility in East Asian stock markets does not significantly influence their correlation with the US stock market, though US stock market volatility is significant. This trend is more pronounced in the period after foreign participation in East Asian stock markets was liberalised. This is good news for managers building portfolios from East Asian and US stocks because the correlation (risk) among stocks in such portfolios will not be affected when there is an increase in the volatility in East Asian markets. The probable reason for this phenomenon is the massive increase in portfolio investments in East Asian stock markets by US emerging markets funds. Investments from the US to the East Asian region increased steadily (till 1997), however the allocation of funds among individual East Asian markets, which depended on local regional factors, saw higher volatility. Moreover since all investments in the region came from the same pool of funds, increases to one market meant a corresponding decrease in another thus contributing to the transmission of volatility. This plausibly explains the greater increase of correlation and transmission of volatility among East Asian markets as compared to that with the US market.