Term structure of return correlations and international diversification: evidence from European stock markets

The paper examines the term structure of correlations of weekly returns for the stock market in the US, Japan and nine European countries between 1988 and 1994. Stock indices are decomposed into permanent and temporary components using a canonical correlation analysis and then short- and long-horizon return correlations are calculated from these two price components. The empirical results reveal that the relationships of return correlations among these stock markets are not stable across return horizons. While correlations, in general, tend to increase with return horizons, there are several cases showing that correlations decline when investment horizons increase.