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This study examines the effect of rational and irrational components of U.S. institutional and individual investor sentiment on Istanbul Stock Market (ISE) return and volatility. The results show that there is a significant spillover effect of U.S. investor sentiment on stock return and volatility of ISE. A breakdown of sentiment by the type of investor shows that the impact of institutional sentiment is greater than that of individual sentiment. A breakdown of sentiment by rationality shows that the effect of rational sentiment on ISE return is faster though not necessarily greater than that of irrational sentiment. The conclusion from these results is that the effect of U.S. investor sentiment is systemic and cannot be diversified away. U.S. investor sentiment, therefore, constitutes a priced risk factor and must be accounted for accordingly in international asset pricing models. The findings also provide some evidence of a negative relationship between U.S. investor sentiment and ISE return volatility.

The relationship between stock returns in international capital markets has excited the curiosity of researchers for a long time. Two recent stimuli for this research have been the progressive integration of international capital markets and the globalization of investor portfolios with the concomitant need for effective portfolio diversification strategies. These stimuli have provided the impetus to understand the dynamics of stock prices across national boundaries. The development of increasingly sophisticated statistical techniques and the continued growth of data handling capabilities by ever more powerful computers have established an impressive record of literature which traverses from the simple and mundane to the exotic and esoteric. Most of the earlier literature on this topic only explores the contemporaneous or the lead/lag relationship among international stock markets and seldom questions the underlying sources of interdependence among international capital markets. Some recent papers, which are discussed a little later and which provide the motivation for this study, have begun to address this issue. The objective of this paper is to expand the knowledge of the relationship among international capital markets by examining both their correlations and sources of interdependence. To be specific, this study first examines the correlations (comovements) between six international stock markets, three from the Atlantic region (i.e., New York, London, and Frankfurt) and three from the Pacific region (i.e., Japan, Singapore, and Hong Kong), using stock price data between 1984 and 1989. Selecting three stock markets from each region allows us to examine interregional as well as intraregional correlations. The underlying cause of the comovements among the six international stock markets is then investigated by examining the international transmission of stock returns volatility. An understanding of the structure of interdependence and source of comovements among international capital markets has important implications for formulating international portfolio strategies and forecasting. The Generalized Autoregressive