Diversification benefits in the smaller European stock markets

This paper examines the diversification benefits available to U.S. and Japanese investors over the period 1974-94 in seven of the smaller European stock markets (SESMs): Austria, Belgium, Greece, Holland, Ireland, Italy, and Spain. With reference to a simplified International CAPM that accommodates both contemporaneous and delayed information flows, we employ correlation, principal components, and cointegration analysis in studying monthly observations from national basket indices. The empirical evidence is conclusive in showing that the SESMs have behaved differently, at least since the October 1987 crash, with stronger contemporaneous interdependencies and integration between them and with the U.S. market. Cointegration analysis found no significant common trend shared between the SESMs and the U.S. and Japanese markets. We conclude that despite the increasing international integration there still exist opportunities for diversification investment in the smaller and less studied European stock markets.The present study is an extensively revised version of a paper presented at the 42nd Atlantic Economic Society Conference in Washington, DC, October 1996. We are indebted to the attendants and discussants of our session, especially Nicholas Apergis, Erotokritos Varelas, and George Zestos for their constructive comments and arguments. We also thank Terence Mills and two anonymous referees for their comments on this paper. Finally, we wish to thank Jay Smith, Leading Market Technologies, Cambridge, MA for providing us theEXPO/NeuralNet andEXPO/Econometrics software used in this study. For any remaining errors, the authors are fully responsible. Raphael Markellos is grateful for financial support received from the Department of Economics and the School of Humanities and Social Sciences, Loughborough University, United Kingdom.