Dynamic Global Linkages of the BRICS Stock Markets with the United States and Europe Under External Crisis Shocks: Implications for Portfolio Risk Forecasting

• Author: Shawkat Hammoudeh,Walid Mensi,Sang Hoon Kang,Duc Khuong Nguyen
• DOI: http://doi.org/10.1111/twec.12433
• Published date: 01 November 2016
• Date: 01 November 2016

Dynamic Global Linkages of the BRICS

Stock Markets with the United States and

Europe Under External Crisis Shocks:

Implications for Portfolio Risk Forecasting

Shawkat Hammoudeh

1,2

, Sang Hoon Kang

3

, Walid Mensi

4,5

and Duc Khuong

Nguyen

6

1

Lebow College of Business, Drexel University, Philadelphia, PA, USA,

2

Energy and Sustainable

Development (CESD), Montpellier Business School, Montpellier, France,

3

Department of Business

Administration, Pusan National University, Busan, Korea,

4

El Manar University, Tunis, Tunisia,

5

Department of Finance and Investment, College of Economics and Administrative Sciences, Al Imam

Mohammad Ibn Saud Islamic University (IMSIU), Riyadh, Saudi Arabia and

6

IPAG Business School,

Paris, France

1. INTRODUCTION

UNDERSTANDING the characteristics of financial market returns, volatility and interde-

pendence provides important information for investors interested in portfolio diversifica-

tion and risk management, particularly during times of financial distress and crises. Past

studies have extensively examined changes in financial market behaviours such as sudden

changes which also have important implications for the analysis of crisis transmission and

systematic risk (see, among others, Forbes and Rigobon, 2002; Bekaert et al., 2005, 2014;

Dungey et al., 2015; Pragidis et al., 2015). A common result from this strand of the literature

shows that the transmission of shocks as measured by return correlations and dependency as

well as by volatility spillovers from one market to another increases in times of crises, provid-

ing evidence of contagious effects across financial markets. In particular, Bekaert et al. (2014)

use an international three-factor asset-pricing model to analyse the transmission of crises to

country-industry portfolios.

1

The authors define contagion by the presence of unexplained

increases in factor loadings and also find evidence of systematic contagion from the US mar-

ket and the global financial factor, although the effects are not large.

In this paper, we attempt to measure and detect variations in the dynamic linkages of the

BRICS stock markets (Brazil, Russia, India, China and South Africa) with those of the United

States and the European region, with emphasis on the global financial crisis (GFC) of 2008–

09 and the European public debt crisis that dates back to the end of 2009. Our special focus

on the BRICS stock markets is motivated by the important role these countries play in the

world financial landscape and the potential diversification benefits they can offer to global

investors, promoted by their high potential economic growth. It is also inspired by the future

economic aptitudes that can afford from building new institutions such as the benefits from

the establishment of their common ‘New Development Bank’ to foster economic cooperation

and to finance infrastructure and sustainable projects. Those who have dealt with the future of

BRICS show that, for example, China’s GDP which was around US$8.4 trillion in 2012 is

1

The factors considered include the US market factor, global financial factor and domestic market factor.

©2016 John Wiley & Sons Ltd 1703

The World Economy (2016)

doi: 10.1111/twec.12433

The World Economy

expected to rise to about US$16.15 trillion in 2020.

2

Over the same period, the total GDP for

the four BRIC countries without South Africa is expected to grow by 57.53 per cent, rising

from US$14.276 trillion to US$22.49 trillion. In addition, global investors can design dedi-

cated investment strategies for the BRICS markets, given those markets’ common characteris-

tics in terms of high average returns, high idiosyncratic volatility, improved market efficiency,

increased liquidity, enhanced capital mobility and greater dynamic linkages with developed

markets. Several past studies note that these favourable features have largely been the result

of the vast stock market liberalisation reforms which have been implemented by almost all

emerging markets including those of the BRICS since the early 1980s (e.g. DeSantis and

Imrohoroglu, 1997; Bekaert and Harvey, 2000; Kim and Singal, 2000).

Another reason that motivates our investigation of the BRICS market linkages with market s

in the United States and the European region is the occurrence of the recent crises (the GFC and

the European debt crisis in particular), which may have changed the behaviour of return and

volatility in these markets, and in turn portfolio diversification benefits and risk management. In

terms of trade, China is the second largest trading partner with the European region after the

United States, accounting for 14 per cent of total trade in goods compared to 15 per cent for the

United States in 2014. With respect to the United States, China stands as the third largest export

market for US goods during the same year. In fact, the United States’ trade in goods with China

is almost nine times its trade with India. Russia also accounts for 8 per cent of total trade with

the European countries. In 2013, Brazil was the 7th largest goods export market for the United

States. However, the trade ties between the United States and Russia are weak. The US goods

exports to Russia represents less than 0.1 per cent of the US GDP, while the US goods imports

from Russia is below 0.2 per cent of the US GDP. When it comes to India, this country is a

major trading partner with Germany within the European Union and has strong trade links with

the United States (exports) and China (imports). Evidence of increased interdependence should

be indicative of lower diversification gains but greater potential contagious effects if the exter-

nal shocks are severe. Aside from the trade and market linkages, we show how our results affect

risk assessment and forecasting of the stock portfolios involving the BRICS stock markets based

on the Value at Risk (VaR) framework.

The recent literature has examined some critical issues related to the BRICS stock markets

at times of crisis, such as return and volatility behaviour, market comovement, volatility spil-

lovers and contagion risk (e.g. Bhar and Nikolova, 2009; Bianconi et al., 2013; Chiang et al.,

2013; Dimitriou et al., 2013; Cho et al., 2015).

3

Using various econometric methods, these

studies mainly show that: (i) the BRICS markets significantly react to the shocks caused by

the recent GFC and the Eurozone public debt crisis; (ii) there is evidence to suggest a shift

into a regime of increased comovement with the transmission of contagious effects to the

BRICS markets; and (iii) the recent GFC has significant impacts on the behaviour of

2

http://www.statista.com/topics/1393/bric-countries/.

3

See Wang et al. (2003), Bhar and Nikolova (2009), Beirne et al. (2010) and Abbas et al. (2013) for

detailed discussions of the literature on the volatility and return spillover between emerging and devel-

oped markets. For example, Beirne et al. (2010) use trivariate VAR-GARCH models to investigate the

volatility transmission from the regional and global markets to 41 emerging markets in Asia, Europe,

Latin America, and the Middle East and North Africa, and find evidence of spillover effects for most

sample markets. They also document the time-varying nature of cross-market linkages. Some evidence

of the US financial and real news effects on the CDS spreads of emerging market sovereign bonds can

be found in Dooley and Hutchison (2009).

©2016 John Wiley & Sons Ltd

1704 S. HAMMOUDEH ET AL.