Hypohesis Identification
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Define the business research and its purpose. Abstract
Abstract
The correlation structure of the world equity markets varied considerably over the past 150 years and was high during periods of economic integration. We decompose diversification benefits into two parts: one component due to variation in the average correlation across markets, and another component due to the variation in the investment opportunity set. From this, we infer that periods of globalization have both benefits and drawbacks for international investors. Globalization expands the opportunity set, but as a result, the benefits from diversification rely increasingly on investment in emerging markets.
We test two null hypotheses. The first is that the correlation matrices from two periods are equal element by element. This is equivalent to a joint hypothesis that the correlation coefficients of any two countries are the same in the two periods of interest. The second hypothesis is that the average of the cross-country correlation coefficients are the same in two periods. In most cases, the second hypothesis is a weaker version of the first. In the appendix we discuss the details of the test and address issues of the size and power.
Explain the business problem(s) under investigation
Considering the widespread belief in the benefits to international diversification over the past 100 200 years and the current importance of diversification for research and practice in international finance, we believe that it is important to examine how international diversification has actually fared, not just over the last 30 years since the beginnings of academic research, but over much longer intervals of world market history. In this paper, we use long-term historical data to ask whether the global diversification strategies developed by Henry Lowenfeld and his predecessors actually served investors well over the last century and a half. In addition, we consider the long-term lessons of capital market history with regard to the potential for international diversification looking forward.
Essentially, two general data problems confront our analysis. The first is that markets may have existed and been available for investment in past periods for which we have no record, and are thus not a part of this study. For example, the origins of the Dutch market date back to the early 1600s, but we have no market index for the Netherlands until 1919. The second is that we have historical time-series data from markets that existed but were not available for investment or for which the surviving data provide a misleading measurement of the returns to measurement. To get a better sense of these two classes of problems, we collected what information we could on the known equity markets of the world. These data are represented in tabular form in. More than 80 markets appear to have existed at some time, currently or in the past. As a guide to future potential data collection, we represent what we believe to be the periods in which these markets operated and for which printed price data might be available.
The sequence of World War I, hyperinflation, Great Depression, World War II, the rise of Stalinist socialism, and the de-colonialization of much of the world had various and combined effects on global investing, affecting not only the structural relationship across the major markets such as the United States, United Kingdom, France, Germany, and Japan but also the access by less developed countries to world capital. While world market correlations of the major markets affect the volatility of a balanced international equity portfolio, at least as important to the international investor of the twentieth century is the number, range and variety of markets that emerged or re-emerged in the last quarter of the twentieth century following the reconstruction of global capitalism on postcolonial foundations.
Identify the parties involved in conducting the research
Considerable academic research documents the benefits of international diversification. Grubel (1968) finds that between 1959 and 1966, U.S. investors could have achieved better risk and return opportunities by investing part of their portfolio in foreign equity markets. Levy and Sarnat (1970) analyze international correlations in the 1951 67 period and show the diversification benefits from investing in both developed and developing equity markets. Grubel and Fadner (1971) show that between 1965 and 1967 industry correlations within countries exceed industry correlations across countries. These early studies marked the beginning of an extensive literature in financial economics on international diversification. However, the benefits to international diversification have actually been well-known in the investment community for much longer. The eighteenth century development of mutual funds in Holland was predicated on the benefits of diversification through holding equal proportions of international securities.1 The quantitative analysis of international diversification dates at least to Henry Lowenfelds (1909) study of equal-weighted, industry-neutral, risk-adjusted, international diversification strategies, using price data from the global securities trading on the London Exchange around the turn of the century. His book, Investment, an Exact Science, is illustrated with graphs documenting the imperfect comovement of securities from various countries. Based on these, he argues that superior investment performance can be obtained by spreading capital in equal proportion across a number of geographical sectors and carefully rebalancing back to these proportions on a regular basis.
Describe the method(s) used to conduct the research project.
In addition to studies in economic