Studies of time-series versus cross-sectional correlations in Eastern and Western European stock markets

Abstract: Reducing the risk exposure in investment portfolios is a constant topic in financial literature. This thesis aims to discuss and compare the risk level in portfolios of only Eastern or only Western European market indices by studying the correlation within each one of the portfolios. The correlation is estimated with two different methods: the traditional time-series and Solnik and Roulet’s (2000) cross-sectional method. The analysis focuses on how the correlation in each one of the regional portfolios changes over time as well as during a financial market correction. The study and all calculations are based on historical stock markets indices from September 1997 to February 2007 from five Eastern, forming the Eastern portfolio, and five Western European countries, forming the Western portfolio. A deep-dive is made into a five-month period in 2006 when Sweden saw large drops in its market index and a financial market correction took place. The results of the time-series method show that the Western European countries are more correlated than the Eastern ones. However, the cross-sectional correlations are almost equal in the two regions, but with the Western portfolio showing higher correlation volatility. Western Europe is therefore considered more risky to invest in from a correlation perspective. During the financial market correction both regions’ data are less significant and the Eastern portfolio’s risk exposure is higher than during the full period. During this selected five-month period the Western European portfolio has much larger correlation volatility. There are no signs of correlation breakdown or reversed correlation breakdown. The cross-sectional correlations have increased over time in both regions; Eastern European markets are slightly less correlated with one another than those in the Western portfolio. Eastern Europe is therefore the region with the lowest risk exposure from a correlation perspective and the best investment portfolio in this study.