International Portfolio Diversification Benefits among Developed and Emerging Markets within the Context of the Recent Global Financial Crisis

Introduction

Portfolio management, in general sense, is the design of optimal portfolios that match the rational investor’s objectives with the future prospects of portfolio manager. Modern portfolio theory states that investors constantly attempt to maximize the expected rate of return through diversification opportunities. The increasing trend in the free capital flows, technological developments in communication and trading systems, thereby, reduction in cost of information and the introduction of new financial products create more diversification opportunities for both individual and institutional investors. Rational investors make their decisions based on their risk aversion rather than maximizing the expected utility. Therefore, international investors have begun to implement international portfolio diversification as a tool for reducing the expected portfolio risk and maximizing the expected rate of return.

One of the main principles of international diversification is the existence of uncorrelated return among markets. When returns from investments in different countries’ stock markets are not correlated, the opportunities generated from portfolio diversification are more profitable, according to modern portfolio theory (Elton & Gruber, 1995; Farrell, 1997, Strong, 2000). In recent years, however, globalization, economic and financial integration and assimilation between countries have enhanced the interdependency of global markets and these phenomena seem to affect the decisions of investors in the allocation of financial assets. It is well accepted that integration of financial markets, is primarily linked to economic growth through risk sharing benefits, improvements in allocation efficiency, and reductions in macroeconomic volatility (Pagano, 1993). Since greater integration exists between national stock markets, investors prefer to make an investment in the emerging markets to exploit benefits of international diversification, in the belief that there may be low correlations between developed and emerging markets. In this context, reflecting the trend towards greater integration of stock markets, this chapter explores how application of international portfolio diversification occurs among developed and emerging markets through an assessment of the impact of recent global financial crisis.

The recent global financial crisis is entitled as one of the most severe, because of its global nature. The crisis started in the US and spread through major stock markets all over the world, leading to confusion among policy makers and investment practitioners, and raising many questions relating to the subject of international financial integration. Characterized by turbulent financial markets and widespread economic slowdown across the countries since the middle of 2007, this crisis could be fuelling entirely negative impacts on international financial integration. Given that significant changes have occurred across the world financial markets, it appears timely and interesting to examine whether the relationships among these markets have changed over this crisis period. Therefore, understanding the interaction of global markets across countries interact could provide crucial inputs for policy purposes in dealing with crises spreading from one country to another.

This chapter concentrates on the following questions:

• 1.

  What is indicated by any dynamic long-run relationship among emerging and developed stock markets over the period?

• 2.

  Have the long-run relationships across stock markets changed since the recent global financial crisis?

• 3.

  What are the short-run linkages and causality effects between major developed and emerging stock markets over the period?

• 4.

  Are there any specific changes in the short-run and causal relationship among the sample countries after the recent global crisis?

• 5.

  How does the recent global crisis affect the integration of emerging and developed stock markets’?

• 6.

  What are the key implications of the recent global financial crisis on stock market integration?