The share of foreign trading activity in total stock market volume increased tremendously during the last decade. Today, the amount of gross cross border flows in stocks and bonds is spectacular, exceeding 7 times the GDP (IMF(1998) p.186). The internationalization of capital markets is reflected not only in the addition of foreign securities to otherwise domestic portfolios, but also in active trading in foreign markets. There is surprisingly little evidence, however, on the impact of foreign trading activity on local equity markets. The purpose of this paper is to establish the empirical relationship between foreign trading, the volatility of returns and the correlation of local and world returns.
The motivation for this exercise is straightforward. Despite the benefits of free capital mobility, there are growing concerns that international capital flows are destabilizing. The perception is that by opening capital markets, countries expose themselves to the fickle sentiment of foreign investors. In addition, this sentiment is not only volatile but is also highly dependent on returns in other countries. The required rate of return, which is the cost of capital, depends on the variance of returns and the correlation with world returns. If the impact of liberalization is that the variance and the correlation increase, expected returns must increase. When returns increase, the cost of capital also increases. A higher cost of capital reduces investment and growth, and in this case the opening of the capital account may not be a good idea. The effects of capital account liberalization have been the subject of much recent research. However, the existing literature focuses primarily on the effects of the lifting of restrictions, the introduction of country funds, ADRs, and structural breaks in net capital flows. The impact of foreign trading activity on return volatility and co-movement has not been previously studied. This paper tries to fill in the gap.
There are a number of hypotheses which hold that foreigners often pursue noisy or irrational trading strategies such as herding, quick changes in sentiment (Calvo and Mendoza(1999)), positive feedback trading, overreaction to changes in fundamentals(Dornbush and Park(1995)), and financial crisis and contagion (Kodres and Pritskert(1999)). These hypotheses are related to various market imperfections that occur across national borders, the chief being incomplete or asymmetric information. Some of these theoretical models are supported by empirical work. Kim and Wei(2000) and Choe et al(1999) find evidence that foreign investors in the Korean stock market pursued herding and positive feedback trading strategies. In addition to theoretical reasons and the empirical evidence that foreigners are a noisy kind of investor, there is an overwhelming perception in the popular press that this is the case. For two examples, see Stiglitz’s(1998) article in the Financial Times and Krugman’s(1997) in Fortune.
It is important to point out that even when foreigners are noisy and irrational, their activity does not necessarily have a destabilizing impact. Domestic investors may be powerful enough and the market as a whole sufficiently liquid to accommodate selling or buying pressures from noisy foreigners. As long as domestic investors are not subject to the same imperfections that give rise to noisy trading strategies, foreigners should have no impact on volatility. In a detailed paper, Choe et al(1999) find strong evidence of positive feed-back trading and herding by foreign investors in Korea. However, they find no permanent effects of net foreign order imbalances on prices and volatility. Large sales or purchases by foreigners are quickly accommodated by domestic investors. It can be concluded from this that foreign investors do not destabilize the Korean stock market. Thus, noisy or irrational trading strategies are necessary but not sufficient conditions for foreigners to destabilize local stock markets.
The data I have does not allow me to directly measure herding or positive feedback trading by foreign investors. I consider these strategies on the part of foreign investors to be a possibility, and investigate whether foreign trading has a disproportionate impact on volatility and correlations. I proceed in three steps: First, I look at the relationship between volatility and total trading volume. This relationship has been the subject of much research using U.S. data. I use data for 20 developed and developing countries and compare the results to those for the U.S. Second, I look at the relationship between volatility and the foreign component of trading volume. It is possible that the effect of foreign trading on volatility is different than that of domestic trading. Finally, I look at the effect of foreign trading on volatility controlling for total trading volume.
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Does Foreign Trading Destabilize Local Stock Markets?
