Economic Integration and the Correlation of Stock Returns

In this paper we provide, for the first time, empirical estimates of the effect of indicators of bilateral economic integration on the correlation of real stock returns between economies. We concentrate on the role of bilateral real exchange rate volatility, bilateral trade intensity, correlation of output growth and export dissimilarity and find that, when entered in isolation, each indicator has the expected effect. In particular, trade intensity increases the correlation of stock returns and real exchange rate volatility, the asymmetry of output growth and the degree of export dissimilarity decrease it. When we add control variables as determinants of the cross correlation of returns the results change considerably. Only the export dissimilarity and the bilateral trade remain significant in explaining the correlation of stock returns when entered in isolation. Alternatively, we use common membership of a regional trade agreement or the presence of a currency peg or currency band between the currencies of the two countries as indicators of bilateral integration. Now, only common membership in a trade agreement matters for the correlation of stock returns and does so in the expected way, increasing it. When we instrument for participation in these types of agreements we find that, when entered independently, participation in a regional trade agreement or a currency agreement do cause an increase the correlation of stock returns. However, when we instrument for participation in both agreements we cannot uncover a significant effect