Region vs. Industry Effects and Volatility Transmission

This article presents an analysis of the relative importance of region versus industry effects in stock returns, as opposed to the extensively analyzed country versus industry effects. The sample includes the period after the bursting of the technology bubble. Moreover, volatility transmission patterns are analyzed within an industry across regions to assess whether the same international links found in aggregate stock market indices exist at the industry level. The results confirm the dominance of region effects over industry effects, except during the bubble period. The results of the volatility transmission analysis suggest that the importance of spillovers depends on the industry.In recent years, the enhanced availability of financial information has strengthened existing relationships among stock markets. This development could have resulted in portfolio managers changing their investing strategies from country based to industry based to achieve optimal portfolio diversification. For this reason, whether return variations are driven primarily by geographical (or national) factors or by industry factors is important for practitioners and has long been a challenging area of research for academics. In fact, numerous studies have addressed the question of the relative importance of cross-country versus cross-industry diversification. The mixed empirical results presented in the literature suggest that the importance of country and industry factors may have been changing over time. We analyze this issue from a regional perspective rather than a country perspective.The article has two main thrusts. First, we analyze the relative importance of region versus industry effects in stock returns by using a sample that includes the period during and after the telecommunications/media/technology (TMT) bubble. Second, we analyze patterns of volatility transmission within an industry across regions to assess whether the same international links found in aggregate stock market indices exist at the industry level.The dataset consists of daily price indices in U.S. dollars for 10 industry indices in three regions (North America, Europe, and Asia)—all collected from Datastream. The sample is from January 1995 through December 2004 and is also divided into three subperiods to isolate the TMT bubble and ensuing crisis.To analyze the relative importance of region and industry effects, we used a dummy variable approach. The results confirm the overall dominance of region effects over industry effects except during the TMT crisis period.To analyze volatility transmission patterns within an industry across regions, we estimated a trivariate first-order vector autoregressive [VAR(1)]–asymmetric BEKK model for each of the 10 industries. In this case, the results suggest that spillovers are more or less important depending on the industry being analyzed. For example, the information technology industry was less affected by other international markets.The implication of our research for investors is that now that the TMT financial crisis is over, the traditional strategy of diversifying across countries or regions rather than by industries may still be adequate in terms of reducing portfolio risk. Of course, the most risk reduction will be achieved by taking into account the volatility transmission patterns found in this study and diversifying both across regions and across industries.