FINANCIAL INTEGRATION AND PORTFOLIO RISK DECOUPLING IN SOUTHEAST EUROPEAN EQUITY MARKETS: A MULTI-STAGE FAVAR AND PORTFOLIO OPTIMIZATION APPROACH

Abstract

Abstract The research provides an empirical assessment of the dynamic macro-financial linkages, financial integration, and risk decoupling mechanisms within the equity markets of Southeast Europe (SEE) specifically focusing on Croatia (ZSE/CROBEX), Serbia (BELEX), and Bosnia and Herzegovina (BIRS/SASX) over the period 2000 to 2026, and to project these interactions into the 2027 efficient frontier to optimize regional asset allocation from January 1, 2000, to April 29, 2026. The research, based on a multistage econometric framework that incorporates FAVAR (Factor-Augmented Vector Autoregression) approach with GMM-PVAR model, interrogates the drivers of asset returns during the two decades of transition and the epoch for the adoption of the Euro in 2023. The analysis additionally involves robust sets of possible explanatory variables, among them being market depth, interest rate spread, global shocks, regulatory environment, average trading volumes, market contagion (CDS spreads), and exchange rate shocks. The simulation results shown sharp but short volatility profiles where the single-country market shocks vanish rapidly; yet regional correlations remain persistent. An additional significant finding unveils the optimum asset allocation, 32/11/57 for Croatia, Serbia, and Bosnia as the efficient frontier given the tangency portfolio point, which guaranteed the highest reward-to-risk ratio (Sharpe Ratio) in the post-2023 Eurozone era. The aggregate investment capital was to be distributed as follows: 32% in Croatia (ZSE/CROBEX) acting as the stability anchor; 11% to be put into Serbia (Belex index) to serve as the structural bridge while the remainder (57%) be put into Bosnia and Herzegovina (BIRS/SASX) to act as the alpha engine. Consequently, exchange rate shocks and CDS spreads are the most robust permanent stress (event) factors that drive the risks of return variance (risk), outweighing substantially the internal liquidity considerations. Interpretatively, the euro adoption sharpens informative trading volumes, reinforcing the price discovery. By engaging an advanced optimization analysis of the portfolio, it was established that Croatia’s Eurozone integration has instanced a structural shift and transposition triggering the maximization of diversification benefits. The tangency portfolio identified implies that coupling Eurozone-backed stability with frontier markets alpha (Serbia and Bosnia) entails positive risk-return value, thereby providing an empirical model guideline for institutional investment in the region. JEL Classification: G11, G15, F31, F36, C33, C38, O52.