Effectiveness of Portfolio Diversification and the Dynamic Relationship between Stock and Currency Markets in the Emerging Eastern European and Russian Markets

This study investigates volatility spillovers and the dynamic relationship between the stock and currency markets in the Czech Republic, Poland, Hungary and Russia using four multivariate GARCH models. We analyze the optimal weights and the effectiveness of diversification for stock-currency portfolio holdings with respect to the following points. First, the empirical results show that the dynamic conditional correlation model with spillovers (DCC-S) generally yields the most effective diversification model, which implies that DCC-S can significantly improve the effectiveness of diversification. Second, we also provide the results of a Value at Risk analysis to determine the amount of capital reserves that investors should set aside to cover potential extreme losses when investing in a currency-stock portfolio. Third, our consideration of the time-varying weighting trend finds that weighting generally increases when economic events occur, except for in Russia, whose economic policies are considered to be unique. We find significant dynamic correlation in all of the countries considered in our analysis. Finally, we apply the unit root test for both time-varying correlations and weightings and find that the variables are stationary at their levels.