The Co‐movement Dynamics of European Frontier Stock Markets

Date01 June 2014
Published date01 June 2014
European Financial Management, Vol. 20, No. 3, 2014, 574–595
doi: 10.1111/j.1468-036X.2012.00646.x
The Co-movement Dynamics
of European Frontier Stock Markets
Jarno Kiviaho, Jussi Nikkinen, Vanja Piljak
and Timo Rothovius
Department of Accounting and Finance, University of Vaasa, Finland
We examine, through application of wavelet coherency, the co-movement of
European frontier stock markets with the USA and developed markets in Europe.
We f ind that the strength of co-movement varies considerably across the frontier
markets, at different frequencies (time horizons), and over time. Co-movement is
relatively weaker for the frontier markets of Central and Southeastern Europe
than in the Baltic region. Of the markets examined, Slovakia in particular shows
low dependence, whereas Lithuania seems to be the most dependent market. Co-
movement is stronger at lower frequencies (longer horizons) and increases during
the turbulent period of the global financial crisis of 2008/2009. Weidentify several
macroeconomic factors related to variations in co-movement at different time
Keywords: frontier market,co-movement of stock returns,wavelets
JEL classification: C40, F30, F36, G15
1. Introduction
This paper focuses on the co-movement of stock returns between the European frontier
markets and major developed markets. Interaction among international stock markets
is an important issue in the international portfolio diversification literature (see, e.g.,
The authors are grateful to the anonymous referee and John Doukas, the editor of the
journal, for their comments on earlier version of this paper. The authors also wish to
thank the participants of the Southern Finance Association (SFA) 2011 annual meeting
and the 9th INFINITI Conference on International Finance for their valuable comments and
Juha Kotkatvuori- ¨
Ornberg for research assistance. The financial support of the Academy
of Finland (projects 136955 and 132913), Evald and Hilda Nissi Research Foundation, the
Finnish Savings Banks Research Foundation, and the Finnish Foundation for Economic and
Technology Sciences-KAUTE is gratefully acknowledged. Correspondence: Vanja Piljak.
2012 Blackwell Publishing Ltd
© 2012 John Wiley & Sons Ltd
The Co-movement Dynamics of European Frontier Stock Markets 575
Forbes and Rigobon, 2002; Bessler and Yang, 2003).1A growing body of literature has
documented that international stock markets have become increasingly interdependent
since the mid-1990s (Brooks and Del Negro, 2004; Pukthuanthong and Roll, 2009).
It is unclear, however, whether this phenomenon is permanent or temporary in nature.
Arguing for its permanence, some authors attribute this interdependence to an increase
in equity market integration (Ayuso and Blanco, 2001) or to the decline in importance
of country-specific effects relative to global industry factors (Ferreira and Ferreira,
2006; Hargis and Mei, 2006). By contrast, Brooks and Del Negro (2004) argue that this
phenomenon is temporary in nature, linking it to the stock market bubble of the late
Most of the literature focuses on the co-movement among developed markets (see,
e.g., Lin et al., 1994; Longin and Solnik, 1995; Engsted and Tanggaard, 2004) and, more
recently,between developed and emerging markets (Bekaert and Harvey,1995; Chambet
and Gibson, 2008). In contrast, empirical evidence concerning the dynamics of equity
co-movements and integration of the European frontier markets is limited.2One recent
study, Berger et al. (2011), provides evidence of signif icant diversif ication potential for
frontier markets worldwide due to very low integration of these markets with the world
Interest in investing in frontier stock markets has grown over the last decade. As a
result, the first fully investable index for frontier equity markets (S&P/IFCG Extended
Frontier 150 Index) was launched by Standard & Poor’s in 2007. By the following
year, several more index providers emerged (including MSCI Barra and FTSE) to track
and maintain index data on frontier stock markets. Establishment of frontier market
exchange-traded funds and mutual funds facilitated investing in these markets and
contributed to the further promotion of frontier markets as an attractive investment
This study investigates the stock return co-movement of European frontier markets
with the US market and the three largest developedmarkets in Europe (UK, Germany, and
France) by applyingthree-dimensional analysis of wavelet coherency.This advantageous
approach enables simultaneous consideration of two important domains (time and
frequency) in international co-movements of stock returns, making the co-movement
analysis more comprehensive and useful for investors.3Assessment of co-movement
in terms of frequency is very important for international investors when choosing a
short-term or long-term prof ile in investment strategies (see Smith, 2001). Short-term
investors consider information on co-movement at higher frequencies more valuable
than that of co-movement at lower frequencies, and vice versa for long-term investors.
Hence, analysis of co-movementrelationships and the potential economic factors driving
1The importance of this topic stems from the relevant implications for managing asset
allocation and creating global investment strategies.
2Some of the European frontier stock markets are included in studies investigating Central
and Eastern European markets. For example, Wang and Shih (2011) investigate time-
varying world and regionalinteg ration in emergingEuropean markets (including f ivefrontier
3Several studies apply a wavelet approach in f inancial time-series analysis. For example,
Fernandez (2005) focuses on return spillovers in stock markets at different time scales. Kim
and In (2005) use wavelet correlations to study the relationship between stock returns and
inflation. Nikkinen et al. (2011) apply wavelet cross-correlation techniques to analyse the
cross-dynamics of exchange rate expectations.
2012 Blackwell Publishing Ltd
© 2012 John Wiley & Sons Ltd

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