No Room for Diversification: The Myth of Portfolio Gains in the Integrated European Stock Markets

Abstract

This study explores the integration in the stock markets of Germany, Europe, Switzerland, the United Kingdom, Spain and the Netherlands. Daily data is collected, and for studying the long-term relationship, Co-integration is used, which shows that European stock markets are cointegrated. For checking the short-run relationship, Vector Error Correction Model is applied which reveals that significant imbalances has been taken place but it’s the IBEX only which moves in the opposite direction to correct these changes while the short run error correction shows that adjustment process is more prominent in the stock markets of DAX, SWISS, LSE, IBEX as compared to the EURONEXT and FTSE. Granger Causality results show that LSE is leading the majority of the European Capital market. Furthermore, the Impulse response test shows that the stock markets of all the countries respond significantly to their own markets, except the EURONEXT and SWISS, which respond to the DAX instead of their own. Variance decomposition test shows that the majority of the correction in the stock markets of DAX, LSE, IBEX and FTSE is done by their own while in the case of SWISS & EURONEXT, such correction is done by the LSE. In the long run, the potential gain from international portfolio diversification in the European stock markets won't work at all on account of the strong integration of these capital markets, and investors have to move towards the emerging economies to get the portfolio gains.