Determinants of International Portfolio Investment Risk Diversification in Developing Stock Markets

Abstract

Frustrated by inconsistent returns, the time requirements to effectively implement strategies and inability of even the most seasoned managers to consistently beat the market, securities traders have in recent years turned to professional portfolio management through index investing. Evidence affirms that market index investing fully diversifies unsystematic risk so that the only concern is systematic risk reduction, to which object, developing stock markets have gained preference in recent years. To diversify this type of risk, empirical studies have not presented generalizable patterns of index comovement. This study sought to analyze the determinants of international portfolio investment risk diversification in developing stock markets. To achieve this, the study postulated the following questions: - What is the effect of financial market development level on international portfolio investment risk diversification in developing stock markets? What is the effect of financial market integration level on international portfolio investment risk diversification in developing stock markets? What is the effect of financial market contagion level on international portfolio investment risk diversification in developing stock markets? What is the effect of financial market segmentation level on foreign portfolio diversification in developing stock markets? From a sampling frame of 43 developing stock markets, the study constituted a sample of 20 markets obtained through non-probability multi-stage sampling. Using a data capture sheet, the study collected Time Series index sourced from Wall Street Journal. All the sample market index time series were benchmarked on Financial Times Stock Exchange Index 100 (FTSE 100) for computation of passive risk, based on Roy’s Safety-First Ratio (RSFR). The main analysis technique of this study was the classical linear regression model to judge the predictive significance of the regression coefficients to test the corresponding null hypotheses that: Financial market development level has no significant effect on international portfolio investment risk diversification in developing stock markets, Financial market integration level has no significant effect on international portfolio investment risk diversification in developing stock markets, Financial market contagion level has no significant effect on international portfolio investment risk diversification in developing stock markets; Financial market segmentation level has significant effect on international portfolio investment risk diversification in developing stock markets. In order to ready the data for the hypothesis tests, the benchmark returns were visually inspected through computation of descriptive and diagnostic statistical tests. so that for the first objective, market development rankings were summarized into frontier and emerging, then the Mean and Standard deviation of returns computed, followed by One-Way ANOVA test of return differences and correlation ratio, pre-analysis for objective two used correlation analysis to capture short run dynamics and cointegration analysis for the long run, objective three employed Volume-Volatility Granger causality tests across July 7th 2007 crisis date to determine the spillover patterns, then for the fourth objective, One-Way ANOVA and Kruskal-Wallis test of independent samples were the pre-analyses. The methodology for data presentation included exploratory tables, and the final analysis was done using Ordinary Least Squares (OLS) regression analysis of International Investment Portfolio risk diversification level, first on each independent variable and overall on all of them, with hypotheses tested at 5% significance level. The study found financial market development level to be consequential, financial market integration level, financial market segmentation levels to have disparate effects and financial market integration level to be effective in the short run but, with mixed long run dynamics. The study recommends conservative use of the determinants in combination with further research focused on investor behavioral characteristics.