European Financial Integration and Equity Returns: A Theory-Based Assessment

This paper reassesses, at the light of economic and financial theory, the well-documented recent evolution of the euro area public debt and equity markets. Doing so leads to associating the EMU and the single market with the changes in fundamentals and financial integration with convergence in pricing. For the public debt market, we stress the observation, conform with predictions, that risk free interest rates are now less volatile in the euro area. But also the fact that the establishment of a single public debt market is still not completed. The current fragmentation is costly to Treasuries and taxpayers and understanding its cause is important to evaluate the prospects of currently considered measures of financial integration.European financial integration, country and sector effects, asset allocation

EMU and Portfolio Diversification Opportunities

This paper studies the impact of EMU on portfolio diversification opportunities. We find a significant increase in the correlation between stock returns, whether they are computed on the basis of market or sector indices. This is true for two definitions of the pre-convergence and convergence periods. Diversification opportunities within the Euro-area have thus been reduced. The culprit appears to be less the disappearance of currency risk than the convergence of economic structures and/or the homogenisation of economic shocks (across the Euro-15 member states). This evolution should mark the end of pure country allocation strategies within Europe. If these are the alternatives, the increased conformity of stock returns implies that international diversification does not pay: the cost of the home bias within Euroland has been lowered (in some cases to zero). Diversification across both countries and sectors, however, remains the much superior investment strategy, and, in light of this option, the cost of the home bias continues to be significant.EMU; portfolio diversification; home bias

Portfolio Diversification in Europe

Have the euro and accompanying measures of financial integration had a discernable impact on the degree of diversification of European investors? This is an empirical question that this paper tries to answer by exploring four alternative avenues. First we focus on the final outcome: If European investors are indeed better diversified, their consumption should be increasingly correlated. Second we check more directly what is known about the composition of Europeans’ portfolios. A third perspective focuses on the evolution of returns and prices. If indeed European investors are attempting to exploit new arbitrage opportunities opened up by the euro and European financial integration, then it is likely that these behavioral changes will be matched by significant changes in returns or in the nature of the return generating process. Finally, we explore the possibility that the answer to our question may be better revealed by examining the changes that have taken place in the investment process itself.Risk sharing, Portfolio holdings, financial market integration, cross sectional dispersion

From Home Bias to Euro Bias: Disentangling the Effects of Monetary Union on the European Financial Markets

Following the launch of the Euro in 1999, integration among Euro area financial markets increased considerably. As a result, portfolio home bias declined across the European financial markets. However, greater market integration has generated a new bias: portfolio Euro bias, a situation where Euro investors tend to hold large proportion of assets issued within the Euro region. The first part of this paper presents an empirical analysis of the economic factors at play behind the switch from home bias to Euro bias. We find that decline in default risk and transaction cost are two key determinants of the rise in portfolio Euro bias. The second part of the paper goes deeper into the effects of Euro bias on Euro area bond and equity markets. We observe that both government and corporate bond markets revealed clear signs of strain during the recent financial turmoil. Our results also reveal that the risk-reduction potential from geographic diversification within the Euro equity market is lower than that of the Euro sector diversification

Equity Returns and Integration: Is Europe Changing?

This paper analyses the consequences of the process of financial and economic integration on European equity markets. It documents significant changes in ‘fundamentals', notably an increased synchronization of macroeconomic activities, and a non-negligible evolution in pricing, with a decrease in the cost of capital and converging equity premiums. As to equity returns themselves, in the face of what could turn out to be long-run upward trends in the correlations among both country and sector returns and a narrowing of the superiority of country factors, the benefits to be gained from finding diversification opportunities at a more disaggregated level appear to be higher than eve