A common factor analysis for the US and the German stock markets during overlapping trading hours

The purpose of this study is to investigate the shortand longrun relationships between the US and the German stock markets during overlapping trading hours. We employ the framework of a bivariate common factor model for our empirical analysis to establish a permanent-stationary decomposition of the two major indices (the Deutsche Aktienindex (DAX) for Germany and the Dow Jones Industrial Average (DJIA) for the US). Based on a novel highfrequency data set for 2003 we are able to compute various measures to identify the fundamental dependencies between the two indices. Our findings can be summarized as follows: (1) we reveal a significant cointegration relationship between the DAX and the DJIA and identify a common trend shared by both stock indices; (2) we find that the DJIA contributes up to 95% to the total innovation of the common factor, clearly demonstrating the dominant role played by the US market during overlapping trading hours; (3) we show that both markets adjust within minutes to a system-wide shock and to shocks coming from either direction; and (4) analyzing the relevance of each individual factor component we verify that the DJIA is in fact the main driving force in the transatlantic system of stock indices.