Investment Implications of a Single European Capital Market

Abstract

European Monetary Union has cause fundamental changes in the way capital markets interact. Some of these are gradual, some instantaneous. One of the more slowly moving process is the increasing integration of European equity markets. The author documents these increases in correlations and evaluates the repercussions on the risk profile of diversified equity portfolios. The disappearance of currency risk and the emergence of one Euro term structure are sudden and instantaneous, and will lead to an overnight shift in risk of European fixed-income portfolios. The author quantifies the potential magnitude of these risk changes for Euro and non-Euro-based investors. An increase in correlations and the disappearance of risk sources also imply a significant reduction in the opportunities for active managers to add value. Through a Monte Carlo simulation the author illustrates how much harder the life of active managers will become in this new regime.