Introduction
Different nations have different economic policies that guide investments in stock markets. Consequently, decisions to invest in the international equities will mean subjection into differing sets of polices opposed to the prevailing domestic conditions.
The dilemma on the differences between the impacts of the factors affecting domestic equity returns and international equity returns has prompted several empirical studies to be done to unveil the differences. The findings of these studies indicate that, among the factors affecting equity returns, domestic factors were more influential than international factors.
From this dimension, the writer gives opinion on why this is so. On the other hand, an immense body of literature presented herein investigates the reasons why there are low returns on equity investments in cross-countries. The focus of the studies is to give insights on the existing correlations on cross-country investment in equities and the low returns on equity investments.
In this light, according to Serra (2000), “some studies claim that the low correlation of returns between countries results from the diverse industrial structures in each country that are mirrored by different industrial compositions of their stock market indices” (p.127).
This means that the correlation between industries is imperfect. Hence, for industries with differing compositions, the correlation for equity markets is also imperfect. From this line of thought, the paper also focuses on giving the writer’s opinion on why industrial membership of a firm is of little importance in forecasting the international correlation structure of a set of international stocks.
Domestic factors and international factors affecting equity returns
Integration is a key factor that makes domestic factors that affect equity returns more salient than international factors. In this regard, there has been an incredible achievement in the integration of markets since the onset of endeavors for economic globalization.
Nevertheless, amid this effort, there is still a room for magnificent levels of segmentation, which truncate into leaping the benefits that accrue from the diversification of international financial assets. Different market policies and varying economic circumstances in different nations often lead to the existence of different fiscal and monetary policies (Eun & Resnick, 2000, p.89).
Therefore, the prevailing economic policies within a country have a direct impact on securities that are traded within the territories of that country. On the other hand, trading of similar securities in differing states would be anticipated to have differing behaviors due to differences in the economic policies adopted by the two countries.
Surprisingly, in the international trade treaties, the existing domestic policies are compared and merged to make regionally acceptable polices for regulating business. This domestic polices are impacted by domestic factors that determine the manner of operation of businesses within a nations’ boundaries.
It is without surprise then that domestic factors have been found to impact security returns more than international factors. To amplify this argument, it is critical to note that, when a firm fails internationally, perhaps the last place for it to fail before it winds up is within its places of establishment.
Therefore, more attentions are paid on the domestically prevailing factors that may lead to its failure. Consequently, the levels of security returns in the domestic market are likely indicators of the performance of securities in the foreign nations when similar success strategies are deployed in the foreign markets.
The performance of stocks domestically constitutes essential mechanisms deployed by firms to assess the impacts of economic conditions on stocks’ performance while placed in other markets whose anticipated performance is widely unknown.
Engaging in investment decisions in markets whose dynamics are unknown by a firm subjects it into more risks in its attempts to foster the generation of capital coupled with the development of decisions on its growth capabilities through issuing of securities.
Equity investments may act as subtle ways through which organizations are capable of ensuring that they experience a reduced risk in investments due to the easiness of trading in equities.
However, foreign market dynamics and factors that may affect the returns of equities may also slow the impacts of firms on the equity returns partly because a firm will need to be double sure about the anticipated performance levels when its trades its stocks in the foreign markets (Abugri, 2008, p.396).
However, even though many empirical studies reveal that domestic factors affecting returns of firms’ equities produce more effects than international/global factors, these findings have attracted mixed reactions from people inclined to the market integration school of thought, as well as those ingrained in the thought of total market segmentation.
The central point of concern is the determination of which of the two factors leads to more impacts on performance of stocks and equities in the markets. Nevertheless, empirical studies on the influence of domestic factors and international factors on the returns in equities document the evidence that domestic factors are more prominent in producing market volatilities.
The proponents of the integration approach peg their arguments on the capacity of international factors to be crucial in influencing returns on equities on the aspects of the equality of risk of premiums across all spectra of markets in case of full integration of markets. This means that, from this paradigm, both integration and diversification are in reverse conditions.
However, a free flow of fund barriers in the international markets exists due to the existence of differing monetary and fiscal policies in different nations.
Arguably, the need to meet all the necessities for each country’s laid out fiscal policies and other economic regulations makes domestic factors that influence the returns on equities more weighty than the international factors especially bearing in mind that practical markets are impartially integrated.
Some empirical studies have also documented immense findings that macroeconomic variables constitute elements that result in differing volatilities of firms’ stocks. Some of these macroeconomic variables include “inflation, real interest rates, industrial production, industrial production index, and terms structure risks” (Abugri, 2008, p.405). This entire sphere of variables has impacts on the performance of stocks.
Since markets are not perfectly integrated, such variables are different in differing countries. Hence, the returns on equities would behave differently in different nations.
In this dimension, it is arguable that standardized models for pricing global assets that are inspired by the perceptions of total integration do not consider cross-country differences in average returns particularly on the emerging markets in their assumptions that international factors are more decisive in determining the performance of stocks than the domestic factors.
Indeed, firms considering exploring new international markets face incredible challenges while endeavoring to penetrate and or offer their equities in the emerging markets due to uncertainties and market volatilities in the new ventures.
Therefore, the decisions on whether to offer the equities in the new markets or not are likely to be based on domestic factors since they form the pivot for evaluation of the effectiveness of such strategies in increasing the returns on investments anticipated by an organization in the international fronts. The argument here is that macroeconomic variables influence returns on stock in different countries differently.
Thus, it is inaccurate to anticipate international factors to prove more imperative in affecting the returns on equities than domestic factors, which are harmonious with all domestic markets. Consequently, industrial production, anticipated, and the unanticipated inflations will have systematic impacts on equity returns in different countries.
These two variables produce harmonious impacts on the returns within the domestic markets. Hence, I agree with the approximation of the various empirical studies on factors that affect returns on equities’ capacity to be more beneficial than international factors.
Industrial membership of a firm and forecasting the global correlation structure of a set of international stocks
Industrial activities adopted by different industries are impacted differently by varying economic policies that regulate the operation of industries in a country. The implication of this argument is that a firm, which has any membership in a particular industry will be subjected to rules and regulations guiding economic policies in its domestic country of operation that is different in other countries.
Consequently, it is impossible to anticipate a firm established in a specific industry to have similar behaviors while operating in a different country. Therefore, it is also impossible for the securities that are issued by such a firm to operate in a similar manner in different countries. Hence, industrial membership of a firm possesses a minimal significance in helping to forecast its correlation structures in a set of international stocks.
Within cross-country markets, the market indices of a particular firm are constructed in different ways to suit the existing economic policies and regulations. Selection of various market indices rests on various criteria among them being market capitalization and or the value traded.
Hence, it is inevitable that particular indices end up being concentrated in a few firms consistent with subjection to evident differences in the operation environment policies advocated for in any country. Since a firm would operate to facilitate optimal returns in its security investments, it is likely that the indices would be widely concentrated in large stocks in nations where conditions are favorable for the operations of a company.
Therefore, regardless of the terms of membership of a firm in any industry, the membership may not be a substantive means of helping to forecast international correlation structures for various sets of international stocks.
In the international fronts, firms face valid return shocks depending on the prevailing economic situation in different nations. This implies that economic variables enormously influence the returns of stocks to a firm at the local and international levels.
In case the economic policies underlying the investment decisions of a firm in stocks are homogeneous internationally, the forces would then influence the equities of the firm in a similar manner in all the nations in which the organization has established industrial membership since all economic shocks would be global.
However, in the event that economic forces are either regional or domestic, the levels of returns in the stocks invested in differing regions would be harmonious if “ business cycles move in tandem” (Serra, 2000, p.135).
International correlation structures of a set of international stocks would then be well forecasted based on the industrial membership of a firm in case any two regions where the firm has established operation are in similar states of the economic cycle. Unfortunately, this is not always the case. In some situations, some regions are in recessions while others are in the recovery phase.
Therefore, a firm would invest in varying magnitudes of stocks in different nations depending on the levels of prohibitive or optimality of returns on the invested stock, its industrial membership notwithstanding. For the last two decades, there has been immense focus on making many economies of the world both regionally integrated and open via monetary unions and through provisions of common economic policies.
Considering this economy, it is anticipated that such firms would face similar international shock across all nations (global shocks).
Therefore, economic shocks would affect all nations’ business cycles. Unfortunately, this is not the case, as evidenced by the weakness of the evidence supporting the importance of the membership of a firm in forecasting the international correlation structures of a set of international stocks especially in the nations, which are experiencing similar economic cycles.
The returns in investments for any firm are arguably not dependent on the industrial membership of the firm but by stipulated levels of returns. These returns are impacted by factors such as the amount required to execute the initial investment, anticipated periodical sales, and periodical costs, among other factors.
As demonstrated by Emery, Finnerty, and Stowe (2007), these factors that affect the value of the investment will determine the investment decisions (p.237). All these factors are functions of the economic policies adopted by a nation in which a firm seeks to establish stock investments amid the industrial membership of an organization. This argument implies that markets are essentially segmented.
The question of stock pricing is also answered in different ways, and this has an impact on the demand for the offered stocks and hence the returns. “Markets can be segmented because of formal or informal barriers that preclude free investment worldwide” (Serra, 2000, p.135).
Consequently, even though the economics underlying the necessity to forecast international correlation structures for various sets of international stocks based on industrial membership of a firm may be valid theoretically, it is somewhat tricky for the stocks to move similarly in different nations apparently because the prices are arrived at differently in various countries.
The policies guiding the pricing strategies are also different in different nations. This aspect makes it impossible for industrial membership of a firm to influence its ability to forecast the correlation structures in a set of international stocks.
Conclusion
Firms anticipate facing different economic policies akin to the differences in the existing monetary and fiscal policies regulating its operations in different countries. Coupled with the fact that markets possess differing levels of integration, this paper has argued that it is impossible to expect returns on equities of firms in different countries to behave in similar ways.
Consequently, domestic factors that determine the returns on equities tend to be more powerful than international factors. Similarly, firms are exposed to different economic shocks often prompting a different construction of market indices in differing countries.
Therefore, amid the membership in a particular industry, a firm that operates in the same industry besides having any operations in different countries cannot be anticipated to behave in the same manner across all countries.
Therefore, the paper holds that it is improbable that securities offered by such firms will also behave in similar ways in all countries where the firm has established operations, its industry membership notwithstanding.
Reference List
Abugri, B. (2008).Empirical relationship between macroeconomic volatility and stock returns: Evidence from Latin American markets. International Review of Financial Analysis, 17(2), 396–410.
Emery, D., Finnerty, J., & Stowe, J. (2007). Corporate financial management. New Jersey: Pearson-Prentice Hall.
Eun, C., & Resnick, B. (2007). International financial management. New York: McGraw-Hill.
Serra, A. (2000). Country and industry factors in returns: evidence from emerging markets’ stocks. Emerging Markets Review, 1(1), 127-151.