Concluding remarks and implications

The main purpose of this dissertation was to investigate the returns and the financial risks involved in investing in Emerging Eastern European countries. The objective is to identify information on stock market development in Emerging Eastern Europe and the financial risks involved in investing in these markets. Armed with such knowledge, one could devise strategies for financial risk diversification to avoid global contagion effects. To study this hypothesis, eight research questions were posed.

The first article of the present dissertation answers the first question: Are global and local sources of risk priced into Emerging Eastern European countries? Motivating the study was the controversial role of global and local sources of risk in the empirical literature and challenges in devising ways to price risk in these markets. The conclusion of this article is that most markets exhibit extensive segmentation. The local aggregate emerging market portfolio, rather than the global market portfolio, is the primary driver for the countries. Moreover, country-specific currency and interest rate risks are significant sources of risk when investing in Eastern European countries, suggesting that investors care most about country-specific risks.

The second article asks: Are Emerging Eastern European markets integrated, and if so, to what extent? To answer this question, the relationships between stock prices and foreign exchange are investigated. The results of the study provide evidence of direct linkages between equity markets in terms of both returns and volatility.

Similarly, interdependence between foreign exchange rates in Emerging Eastern Europe is found. Interestingly, while analyzing the relationship between foreign exchange and equity markets, unidirectional volatility spillovers from FX rates to stock prices is observed. Moreover, the Czech stock prices are found to affect the

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exchange rate. The overall results show that currency risk is a significant source of risk for investors and shows evidence of integration within the region for stock prices and exchange rates.

The third article focuses on contagion effects in Eastern European stock markets before and after the 2004 EU accession. This study addressed four questions. Were Emerging Eastern European stock markets involved in transferring financial risk to EU members? If so, and in contradiction to the familiar rule that only developed markets define volatility: Which sectors of these stock markets play such a role?

Third: Are there certain stock markets sectors, which are partially isolated from the corresponding sectors of other European stock markets manifested in terms of stock returns and stock price volatility?? And finally: Was there a significant change in the market interactions after the 2004 EU accessions of Poland, Hungary and the Czech Republic?

The results suggest that bidirectional shocks transfer risk among all local stock markets. Moreover, the Polish consumer goods sector, Hungarian telecommunications sector and Czech financial sectors are found to be less integrated with their sectoral counterparts in Europe compared other industries. However, these sectors play a significant role for European markets, as their risk spills over to their counterparts, but they are strong enough to parry shocks from other market sectors. Finally, when the stock market interactions after the 2004 EU accession are examined, evidence of increased shock transmissions between similar sectors on stock markets is found. The results of this study support the hypothesis of increased integration in Eastern European markets and increasing susceptibility to contagion. These findings are consistent with those of Phylaktis and Xia (2009) and Kaltenhaeuser (2003). The third article provides evidence of partial segmentation in Eastern Europe and identifies opportunities for sectoral diversification in portfolio investments.

The fourth article examines Emerging Eastern European markets on the impact from foreign and local macroeconomic announcements. The final two questions asked are as follows: Do macroeconomic announcements affect the pricing of stocks, and if so, what differences in the announcements make the stock market reaction vary? And does foreign news from geographically proximate and otherwise closely related countries affect local stock markets? The estimated results show that Emerging

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Eastern European stock markets depend on local and foreign macroeconomic announcements, supporting the hypothesis of stock market integration in Emerging Eastern Europe. The general finding is that macroeconomic news affects local stock market volatility and, in rare cases, even asset pricing in the long run. Moreover, an asymmetric effect on volatilities in the markets is found; shocks from negative news are found to generate higher levels of next-period conditional volatility compared to shocks from positive news.

The results show that the impacts of announcements are diverse for different categories of news. Nevertheless, macroeconomic news related to consumer, external and industry sectors, the labor market and national accounts as a rule affects asset pricing in Russia, Poland and the Czech Republic. News related to external, government and industry sectors, the labor market, money and finance, prices, surveys and cyclical indices impacts volatility in emerging Eastern European markets.

The impact of foreign macroeconomic announcements on market volatility is obvious and varied across markets. In particular, volatility in the Russian market is influenced by macroeconomic releases from the Czech Republic, whereas volatility in the Polish market follows changes in Russian macroeconomic indicators. In both countries, foreign macroeconomic news is found to impact the stock markets by increasing the volatility of local markets. However, Polish and Hungarian releases are not found to impact the volatilities of any emerging stock markets in the study, suggesting that Poland and Hungary are less integrated with other Emerging European countries. The results reveal that foreign macroeconomic releases are more fundamental than local macroeconomic news for Emerging Eastern European markets.

This thesis begins with the proposal that some countries and particular industries are more highly integrated into regional and world financial processes than others and thus are more prone to contagion. The results of the analysis show that it is possible to ascertain markets providing risk-diversification opportunities and sectors isolated from changes in European financial markets. This finding would permit the application of portfolio management based on geographical and sectoral diversification to selected Emerging Eastern European markets. Assets in these countries and their industries may be treated as separate classes of investments.

Moreover, this dissertation defines the risks in investing in Emerging Eastern

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European markets and the most attractive markets with regard to return-to-risk ratios, enabling the construction of an effective investment portfolio based on the results of this study. The possibility of the flight to safe havens in the midst of widespread financial instability has obvious implications for portfolio managers in their risk diversification strategies.

Moreover, this thesis yields some useful insights for investors and portfolio managers rethinking the reallocation of their investment portfolios to protect value or obtain higher returns. The results have implications for asset pricing and portfolio selection for international financial institutions and portfolio managers assessing their investment decisions in light of macroeconomic news releases.