The role of industrial structure on the variation in international stock market indices

The Heckscher-Ohlin theory has served as the pre-eminent theory of international trade. The theory points out the importance of country differences in factor endowments and comparative advantage in determining trade. This study provides an indirect test of the Heckscher-Ohlin theory by re-examining the role of industry and country factors in explaining the differences in volatility and the low correlation across international stock market indices. The important role of industry factors indicates the differences in factor endowment and comparative advantage across countries. In addition, it sheds additional light on the debate over the relative importance of country versus industry factors for international portfolio diversification strategies, as documented in previous studies by Roll (1992) and Heston and Rouwenhorst (1994).;Using monthly stock returns on 4,089 firms from G-7 countries and 12 industries from January 1991 to December 1995, the study suggests that, after adjusting stock returns for firm size and heteroscedasticity, the combined industry---global and local---factors are important in explaining the variation of international stock returns across firms. Furthermore, the differences in country index return volatility and the low correlation across country indices are due in part to the differences in industrial structure across countries. The important role of industrial structure found in this study is consistent with the Heckscher-Ohlin theory and Roll's (1992) study, but in sharp contrast to Heston and Rouwenhorst's (1994) findings.;The relative importance of country and industry factors has an important implication for international portfolio diversification strategies. After adjusting stock returns for firm size and heteroscedasticity, the importance of country factors in country index returns is similar to that of the sum of industry factors in industry index returns. The implication is that industry diversification is at least as good as country diversification for achieving risk reduction.