Linkages Between the US and European Stock Markets: A Fractional Cointegration Approach

• Date: 01 April 2016
• Author: James C. Orlando,Guglielmo Maria Caporale,Luis A. Gil‐Alana
• DOI: http://doi.org/10.1002/ijfe.1537
• Published date: 01 April 2016

LINKAGES BETWEEN THE US AND EUROPEAN STOCK MARKETS: A

FRACTIONAL COINTEGRATION APPROACH

GUGLIELMO MARIA CAPORALE

a,

*

,†

, LUIS A. GIL-ALANA

b

and JAMES C. ORLANDO

c

a

Brunel University London, London, UK

b

ICS, University of Navarra, Pamplona, Spain

c

University of Navarra, Pamplona, Spain

ABSTRACT

This paper analyses the long-memory properties of US and European stock indices, as well as their linkages, using fractional

integration and fractional cointegration techniques. These methods are more general and have higher power than the standard

ones usually employed in the literature. The empirical evidence based on them suggests the presence of unit roots in both the Stan-

dard and Poor’s 500 Index and the Euro Stoxx 50 Index. Also, fractional cointegration appears to hold at least for the subsample

from December 1996 to March 2009 ending when the global financial crisis was still severe; subsequently, the US and European

stock markets diverged and followed different recovery paths, possibly as a result of various factors such as diverging growth and

monetary policy. Establishing whether the degree of cointegration has changed over time is important because past literature has

shown that diversification benefits arise when markets are not cointegrated. Copyright © 2015 John Wiley & Sons, Ltd.

Received 11 February 2015; Revised 10 September 2015; Accepted 22 September 2015

JEL CODE: C32; G15

KEY WORDS: Stock markets; linkages; fractional integration; fractional cointegration

1. INTRODUCTION

Globalization has led to international financial markets becoming increasingly interconnected, with equities

displaying a high degree of co-movement across countries. This paper analyses linkages between US and

European stock markets. Specifically, it applies fractional integration and cointegration techniques with the aim

of testing co-movement between the Standard and Poor’s (S&P) 500 Index and the Euro Stoxx 50 Index over

the period from 1986 to 2013. Interestingly, we find that following the Great Recession of 2008 and early

2009, the pattern of co-movement changed, namely, after the trough in both US and European stock markets in

the first quarter of 2009, the recovery paths were very different. It is well-known that Europe and the USA have

experienced diverging growth and monetary policy in recent years (e.g., Pisani-Ferri and Posen, 2011). The global

financial crisis that had originated in the USA then led to a serious debt crisis in the Eurozone and to the European

Central Bank (ECB) eventually adopting its own version of Quantitative Easing (QE) in the form of the so-called

long-term refinancing operation (LTRO) in December 2011. The initial monetary policy response had been much

more expansionary in the USA, the Fed immediately espousing QE; tight fiscal policy was another factor leading

to much weaker growth in Europe than in the USA, which also meant lower Treasury yields.

It has been shown that whether financial investors can benefit from diversification by investing in two different

markets depends on their degree of cointegration (Driessen and Laeven, 2007). This motivates our analysis, which

suggests that US and European stock markets were (fractionally) cointegrated up until March 2009 (during the

financial crisis), when this linkage broke down. Therefore, a European (US) investor could gain greater

*Correspondence to: Guglielmo Maria Caporale, Department of Economics and Finance, Brunel University London, UB8 3PH, UK.

†

E-mail: Guglielmo-Maria.Caporale@brunel.ac.uk

Copyright © 2015 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 21: 143–153 (2016)

Published online 3 November 2015 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1537