Should investors diversify their portfolios with stocks from major trading countries? A comparative multivariate GARCH-DCC and wavelet correlation analysis

Dwihasri, Dhaifina and Masih, Mansur (2015): Should investors diversify their portfolios with stocks from major trading countries? A comparative multivariate GARCH-DCC and wavelet correlation analysis.

Abstract

The existing literature have evaluated the performance of stock markets without taking into account the time-varying correlations and different investment horizons of the investors. The present paper attempts to investigate to what extent the Indonesian sharia stock returns can earn portfolio diversification benefits if they are trading with sharia stocks from its major trading partners (China, Japan, United States). The recent Multivariate GARCH Dynamic Conditional Correlation, the Continuous Wavelet Transform and the Maximal Overlap Discrete Wavelet are applied. Our findings tend to indicate that the Indonesian investors may not enjoy portfolio diversification benefits in all investment horizons if investing in China as better investment opportunities are available by investing in Japan and United States. However, in the long run all markets are highly correlated yielding minimal portfolio diversification benefits.

• Item Type: MPRA Paper
• Language: English
• Keywords: Islamic stocks, portfolio diversification, MGARCH-DCC, Wavelets
• Subjects: C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions

References

Bollerslev, T. (1986), “Generalized Autoregressive Conditional Heteroskedasticity”, Journal of Econometrics, Vol. 31, 307–327.

Bollerslev, T. (1990), “Modeling the Coherence in Short-run Nominal Exchange Rates: A Multivariate Generalized ARCH model”, Review of Economic and Statistics, Vol. 72, 498– 505.

Chowdhury, M.B. (2005). Trade Reforms and Economic Integration in South Asia; SAARC to SAPTA, Applied Econometrics and International Development, Vol. 5 No. 4, 23-40.

Click, R.W. and Plummer, M.G. (2005). Stock market integration in ASEAN after the Asian financial crisis, Journal of Asian Economics, Vol. 16, 5-28.

Dacjman, S., Festic, M., and Kavkler, A. (2012), “European Stock Market Comovement Dynamics During Some Major Financial Market Turmoils in the Period 1997 to 2010 – A Comparative DCC- GARCH and Wavelet Correlation Analysis”, Applied Economic Letters, Vol. 19, No. 13, 1249-1256

Engle, R. (1982), “Autoregressive Conditional Heteroskedasticity with Estimates of the Variance of the United Kingdom Inflation”, Econometrica, Vol. 50, 987–1007.

Engle, R.F. (2002), ‘Dynamic Conditional Correlation:A Simple Class of Multivariate Generalized Autoregressive Conditional Heteroskedasticity Models’, Journal of Business and Economics Statistics, 20(3), 339-350.

Eun, C., Resnick, B., (1994). International Diversification of Investment Portfolios: US and Japanese Perspective. Management Science 40, 140–161.

Fama, E. 1970, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal Of Finance, Vol. 25(2), 383-417.

Gencay, R., Selcuk, F. and Whitcher, B. (2001), “Differentiating Intraday Seasonalities Through Wavelet Multi-scaling”, Physica A, No. 289, 543–556.

Grubel, H. G.,(1968). Internationally Diversified Portfolios: Welfare Gains and Capital Flows, The American Economic Review, Vol.58, No.5, 1299-1314.

Hung, B.W. and Cheung, Y. (1995). Interdependence of Asian Emerging Equity Markets, Journal of Business Finance and Accounting, Vol. 22 No. 2, 281-288.

Ibrahim, M.H. (2005). International Linkages of Stock Prices: The Case of Indonesia, Management Research News, Vol. 28 No. 4, 93-115.

In, F. and Kim, S. (2013). An Introduction to Wavelet Theory in Finance. World Scientific Publishing: Singapore

Indonesia Stock Exchange (2014). “Sharia Stock Index”. Availablefrom:<http://www.idx.co.id/enus/home/productandservices/sharia/shariastockin dex.aspx>

Jorion, P. and Schwartz, E. (1986), “Integration versus segmentation in the Canadian stock market, Journal of Finance, Vol. 41, 603-616.

King, M. A., Wadhwani, S., (1990), Transmission of Volatility between Stock Markets, Review of Financial Studies, Vol. 3, No, 1, 5-33

Ku, Y,H. (2008), “Student-t Distribution Based VAR-MGARCH: an application of the DCC model on international portfolio risk management”, Applied Economics, Vol. 40, No. 13, 1685-1697

Levy, H., Sarnat, M., (1970). International Diversification of Investment Portfolios, The American Economic Review, Vol. 60, No. 4, 668-675.

Longin, F. and Solnik, B. (1995), “Is The Correlation in International Equity Returns Constant: 1960– 1990”, Journal of International Money and Finance, Vol. 14, 3–26.

Madaleno, M & Pihno, C. (2010), ‘Relationship of the Multiscale Variability on World Indices’, Revista De Economia Financiera, 20, 69-92.

Markowitz, H., (1952). Portfolio Selection, The Journal of Finance, Vol.7, No.1, 91.

Mishkin, FS. (2011). ‘Over the Cliff: From the Subprime to the Global Financial Crisis’, Journal of Economic Perspectives, 25(1): 49-70.

Solnik, B.H. (1974), Why Not Diversify Internationally, Financial Analysts Journal, Vol. 30, 48-54.

Yang S,Y. (2005), “A DCC Analysis of International Stock Market Correlations: The Role of Japan on the Asian Four Tigers”, Applied Financial Economics Letters, Vol. 1, No. 2, 89-93