Abstract
Equity market integration is a pervasive issue in asset pricing and risk management. Market integration across countries has been studied extensively over the past decades. The literature has established that the globalization trend at the end of the 20th and start of the 21st century led to increased financial integration for both Developed and Emerging Markets. If markets are found to be increasingly correlated or integrated then benefits from diversification are diminished. At the same time, systemic risk, and tail dependence in general, has received considerable attention in the literature in recent years especially after the disastrous events of the Global Financial Crisis (GFC) of 2008. The GFC highlighted the importance of understanding the interdependence structure of the asset universe. However, integration and tail dependence at the individual firm-level have been overlooked with very few exceptions.
This thesis tackles three important aspects of international finance: i) measurement of firm-level integration and its role in international diversification, ii) the characterization of the determinants of firm-level integration in a panel setting of US companies and iii) the determination of the drivers of firm-level tail dependence in an international sample of stocks.
In the first chapter, I measure market integration at a firm-level for the US stock market with the rest of the world. The properties of firm-level integration are explored across time, firms and industries and I then sort stocks into high- and low-integration portfolios. The role of the least globally integrated US stocks in domestic and international portfolio diversification is assessed. I show that these stocks can statistically and economically augment diversification potential, especially after 2000. The same stocks can be combined with the US market index to create a portfolio that performs at least as well as an international index portfolio in terms of risk-adjusted returns and tail risk.
In the second chapter, I use the same firm-level integration measure for all US companies. While I observe that integration increased through the years for the US as a whole, there are differences across firms according to their characteristics. I document the factors that account for the total panel variation of firm-level integration. The corporate spread between BAA and AAA bond indices is the most important variable that determines the level of integration of a stock followed by size, institutional ownership and foreign sales. When I categorize our variables into groups, I find that Macro, Market and Ownership variables matter the most. In general, Macro variables are the primary drivers of US integration levels and have an effect that is larger than any firm characteristic.
In the third chapter, I measure the tail dependence of international companies with respect to foreign markets at the firm level using copulas. I observe that left tail dependence is always stronger than right tail dependence and their difference widens in recessionary periods suggesting that interdependence increases in crises. I then characterize the factors that account for the total panel variation of firm-level tail dependence using a random forest regression framework. The World Uncertainty Index, the R-square integration measure and coskewness with respect to foreign markets are the most important determinants. Individual Ownership variables such as the number of total or foreign investors dominate the remaining firm-level characteristics in explaining left tail dependence. When I categorize our variables into groups, I find that Market, Ownership and Macro (Profitability) variables matter the most in the US (non-US) sample.
In conclusion, I find that firm-level integration exhibits substantial cross-sectional and time-series variation which I exploit in creating diversification strategies. When I explain this panel variation, I show that Market and Ownership variables dominate as the determinants of both firm-level integration and tail dependence. The role of institutional investors in the convergence of international asset prices has become extremely prevalent in the past 20 years. My results have implications for investors trading globally.
