Is the inter- and intra- continental diversification potential disappearing? A vine copula approach

Literature has documented asymmetric nonlinear dependence and disappearing diversification benefit in developed stock markets. This leads to a harder time for international diversification. In this paper, we reexamine the co-movements/interdependence of international stock markets from a new perspective. Specifically, we investigate the inter- and intra- continent dependence of developed stock markets in order to identify possibly further diversification potential. To the best of our knowledge, this is the first paper investigating dependence of international stock markets from the perspective of the continent level. We use the approach of vine copulas to study dependence. A vine copula is a multiple copula built up from a set of pair copulas, while a pair copula is a joint distribution whose marginals are uniform distributions on the interval [0,1]. The advantage of the vine copula approach is that it allows for high dimensions and is also flexible in accommodation of a different dependence structure in each pairs via a rich variety of bivariate copulas as building blocks. We use weekly data from Bloomberg for countries in North America (US and Canada), Europe (UK, Germany, and France) and East Asia (Japan, Korea, Hong Kong, and Singapore). The vine copula identified the overall dependence structure of all pairs considered and shows weaker dependence across different continents than within a continent. We also find that the dependence measured by either the linear correlations or tail dependence is much lower across continents than within the same continent. We further examine the change of dependence before (period 1) and after the 2008 global financial crisis (period 2). The dependence has generally increased within the same continent in period 2 during and after the crisis. The dependence across continents has only slightly increased in the second period, which is especially so across AsiaEurope and Asia-North America. Thus the diversification potential within a continent is disappearing but there exists significant intra- continent diversification potential especially between Asia and other continents.