Explaining stock market correlation: A gravity model approach

A gravity model, frequently used to explain trade patterns, is used to explain stock market correlations. The main result of the trade literature is that geography matters for goods markets. Physical location and trading costs should be less of an issue in asset markets. However, we find that geographical variables still matter when examining equity market linkages. In particular, the number of overlapping opening hours and sharing a common border tends to increase cross-country stock market correlation. These results may stem from asymmetrical information and investor sentiment, lending some empirical support for these explanations of the international diversification puzzle.