The Co‐movement Dynamics of European Frontier Stock Markets

• Date: 01 June 2014
• DOI: http://doi.org/10.1111/j.1468-036X.2012.00646.x
• Published date: 01 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

E-mails: jakivi@uwasa.fi; jn@uwasa.fi; vanpil@uwasa.fi; tr@uwasa.fi

Abstract

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

frequencies.

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.

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© 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

1990s.

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

market.

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

target.

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

markets).

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.

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2012 Blackwell Publishing Ltd

© 2012 John Wiley & Sons Ltd