According to a doctoral thesis defended by Kersti Harkmann* at the Tallinn University of Technology, the Baltic and Swedish stock markets are connected by a peculiar ‘umbilical cord’ which we do not share with any other region in Europe or the rest of the world.
In other words, there is cointegration between the Baltic and Swedish stock markets, i.e. a long-term stable equilibrium relationship. Even when the Baltic and Swedish stock markets are temporarily moving in different directions, sooner or later their movements can be expected to realign. In addition, analysis shows that shocks in Swedish stock markets always carry over to Baltic stock markets, Kersti Harkmann notes in her doctoral thesis, which is composed of three articles and is titled ‘Essays on Volatility and Contagion in Financial Markets’.
Meanwhile, there are no similar connections with other markets. The integration of the Baltic stock markets with developed stock markets is explored in the second part of the thesis, where the author investigates whether a long-term stable equilibrium relationship can be identified between the stock markets of Baltic countries and other selected countries in the period 2005–2015. The analysis is based on weekly data and uses the Euro Stoxx 50 index, OMX Helsinki stock index, the Swedish stock market index, and the S&P 500 index in the US as the reference indices for developed stock markets.
The results show that, apart from Sweden, the Baltic stock markets have no long-term equilibrium relationships with other developed stock markets. Additionally, the results confirm that shocks and financial crises carried over due to cointegration cannot be considered contagious in nature. Rather, it is a natural spread due to the integration of and close links between markets. Thus, the Baltic stock markets offer opportunities for portfolio diversification for developed stock markets.
Stock market contagion in times of crisis
The first article in Harkmann’s doctoral thesis, ‘Stock Market Contagion from Western Europe to Central and
Eastern Europe during the Crisis Years 2008–2012’, focuses on short-term co-movements during the global financial crisis in that period. The results of the analysis show that at the time when the financial markets were highly volatile due to the financial crisis, correlations between the selected indices increased sharply. The highest average correlation levels were reached during the bankruptcy of Lehman Brothers and the European debt crisis, when Greece sought financial assistance. These sharp increases are temporary and are indicative of short-term co-movements in the financial markets.
The third article, ‘Optimal Currency Hedge and the Carry Trade’, seeks to answer the question of how institutional and risk-averse investors can reduce the impact of co-movements in financial markets when investing in foreign bonds. The issue is examined from the perspective of a euro area investor, using weekly data and a portfolio of seven government bonds. Using classical regression analysis and the DCC-GARCH model, the author attempts to identify the optimal hedging levels for bond portfolios. Finally, a comparison of unhedged, fully hedged, and optimally hedged portfolios is conducted. The article reveals that currency hedging significantly reduces the volatility of a portfolio of foreign bonds. The best risk–return ratio is achieved with optimal currency hedging. In addition, the analysis results show that for an optimally hedged portfolio, the optimal hedging levels and bond interest rates are negatively correlated: the higher the yield, the lower the optimal hedging level.
* Kersti Harkmann received her doctorate for her doctoral thesis, which is titled ‘Essays on Volatility and Contagion in Financial Markets’, on the 103rd anniversary of the Tallinn University of Technology, on September 17. At the anniversary ceremony, a total of 66 doctoral degrees were awarded, with the welcoming speech for the doctors held by Siret Malmberg, who completed an industrial doctorate at the Department of Materials and Environmental Technology. An academic speech titled ‘Green Transition, University, and Games/Gambling!?’ was held by Professor and Vice-Dean for Research Argo Rosin at the School of Engineering. Additionally, Mente et Manu medals of merit were awarded.