The socioeconomic determinants of correlations between stock market returns as revealed by a gravity model

Economic variants of Newton's law of universal gravitation have been used to model the flow of trade between two countries as proportional to the attraction created by measures of their economic masses and dampened by their distance from one another. More business will likely take place between big economies that are close to one another. This study uses that same gravity analogy to explore the long-term, or perhaps more accurately, stable determinants of the correlation of stock markets, where in its simplest form, financial mass is represented by the joint market size of two countries and financial distance by the overlap in trading hours of their stock exchanges. Stock market correlations are found to be positively related to these variables and negatively related to joint trading volume. If distance is expanded to include the relative similarity in culture and legal institutions, it is found that correlations are positively related to the disparity in religious pluralism, negatively related to differences in economic freedom, and positively related to the sharing of a common legal system. In all, the gravity models estimated explain almost 11 percent of the cross-sectional variation in the correlations of stock markets, with the incremental influence of the cultural and legal variables being many times greater than that of the financial variables.