Industry effects and volatility transmission in portfolio diversification

Abstract

Conventional wisdom in portfolio diversification has always advocated diversification across countries rather than across industries due to low degrees of correlations among the stock markets around the globe. In recent years, with an increase in correlation among markets around the world, diversification across industries is being advocated as a tool to attain risk reduction. This study examines dynamic linkages between US equity market returns and nine biotechnology market returns in order to understand the dominance of country versus industry effects in portfolio diversification. Vector autoregression analysis shows that innovations in S&P500 returns have a significant and positive impact on the biotechnology market returns of the United States, the United Kingdom, Germany, France, Belgium, Switzerland, Japan and Emerging markets. Using GARCH, TGARCH we provide evidence of a positive and significant volatility spillover from S&P500 to biotechnology sector returns of the United States, the United Kingdom, Switzerland, Japan, Germany, France and Emerging markets, which means country effects do not help in risk reduction. Spillover effects are asymmetric for Switzerland, Japan, Germany, France, China and Belgium. © 2012 Macmillan Publishers Ltd.