International Journal of Business and Social Science Vol. 3 No. 3; February 2012 50 COMOVEMENTS AND STOCK MARKET INTEGRATION BETWEEN INDIA AND ITS TOP TRADING PARTNERS: A MULTIVARIATE ANALYSIS OF INTERNATIONAL PORTFOLIO DIVERSIFICATION Alan Harper, Ph.D. College of Business South University Virginia Beach, Virginia 23464 USA Zhenhu Jin, Ph.D. College of Business Valparaiso University Valparaiso, Indiana 46385 USA Abstract It has been documented that strong (weak) comovements between stock markets provide less (more) diversification opportunities for investors. This study seeks to determine empirically if investors of Indian stock market can further diversify their portfolios by investing in the stock markets of India’s top trading partners.. This study uses data from India and its major trading partners to conduct principle component analysis. We find that India investors can further diversify their portfolios by investing in the stock markets of a few of its major trading partners. Key Words: Stock Markets, Factor Analysis, India, Portfolio Investments 1. INTRODUCTION The mean–variance relationship that exists in the international equity markets as a result of comovements has drawn the attention of investors seeking diversification. Investors constantly seek diversification opportunities to maximize the expected rate of return. That is the basis of modern portfolio theory. As the economies around the world become more integrated and the developing countries open their emerging markets, more diversification opportunities become available to both individual and institutional investors. At the heart of this phenomenon are the comovements in assets prices and stock market integration, which have been studied extensively in international finance (Bai& Green, 2010; Bekeart& Harvey, 1995; Bekeart, Hodrick,& Zhang, 2009; Errunza, Hogan, & Hung, 1999; Jin, 2005; G. Meric, Ratner, &Meric, 2007; Puthuanthong& Roll, 2009). Comovements are defined “as the movement of assets that is shared by all assets at time t” (Baur, 2003, p. 2). The study of comovements in asset prices provides significant insight into possible diversification strategies that impact the risk–return relationship or the expected return from investing in a portfolio of stocks. Asset pricing theory provides the theoretical framework for analyzing comovements and stock market integration. Ifcomovementsamong markets become stronger, opportunities for diversification and the benefits will be reduced (Ilano&Bruneau, 2009). Understanding market comovements are important for other reasons. Economists are interested in comovements because comovements may affect the flow of capital between countries. Capital market theorists are interested in this because it affects equity market segmentation (Panton, Lessig, & Joy, 1976).Also, integration in stock markets is important as wel l. According to Onour (2010), “Integration in stock markets may provide some advantage in terms of gains in market efficiency but also entails potential pitfalls. Greater integration among stock markets implies stronger comovements between markets, thereby reducing the opportunities for diversification” (p. 30). This has implications for assembling efficient portfolios. Although the study of comovements and stock market integration has been well documented in the literature with respect to developed markets, emerging markets such as India has received less attention (Modi, Patel, & Patel, 2010; Wong, Agarwal, & Du, 2004).The purpose of this study is to investigate the relationships in stock market returns between India and its major trading partners (China, Germany, Hong Kong, Israel, Malaysia, Netherlands, Singapore, Switzerland, U.K., and U.S.).