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No Contagion, Only Interdependence: Measuring Stock Market Co-movements
TL;DR: In this article, the authors examined stock market co-movements and applied these concepts to test for stock market contagion during the 1997 East Asian crises, the 1994 Mexican peso collapse, and the 1987 U.S. stock market crash.
Abstract: This paper examines stock market co-movements. It begins with a discussion of several conceptual issues involved in measuring these movements and how to test for contagion. Standard tests examine if cross-market correlation in stock market returns increase during a period of crisis. The measure of cross-market correlations central to this standard analysis, however, is biased. The unadjusted correlation coefficient is conditional on market movements over the time period under consideration, so that during a period of turmoil when stock market volatility increases, standard estimates of cross-market correlations will be biased upward. It is straightforward to adjust the correlation coefficient to correct for this bias. The remainder of the paper applies these concepts to test for stock market contagion during the 1997 East Asian crises, the 1994 Mexican peso collapse, and the 1987 U.S. stock market crash. In each of these cases, tests based on the unadjusted correlation coefficients find evidence of contagion in several countries, while tests based on the adjusted coefficients find virtually no contagion. This suggests that high market co-movements during these periods were a continuation of strong cross-market linkages. In other words, during these three crises there was no contagion, only interdependence.
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TL;DR: In this article, the authors construct model-free estimates of daily exchange rate volatility and correlation that cover an entire decade using high-frequency data on deutschemark and yen returns against the dollar.
Abstract: Using high-frequency data on deutschemark and yen returns against the dollar, we construct model-free estimates of daily exchange rate volatility and correlation that cover an entire decade. Our estimates, termed realized volatilities and correlations, are not only model-free, but also approximately free of measurement error under general conditions, which we discuss in detail. Hence, for practical purposes, we may treat the exchange rate volatilities and correlations as observed rather than latent. We do so, and we characterize their joint distribution, both unconditionally and conditionally. Noteworthy results include a simple normality-inducing volatility transformation, high contemporaneous correlation across volatilities, high correlation between correlation and volatilities, pronounced and persistent dynamics in volatilities and correlations, evidence of long-memory dynamics in volatilities and correlations, and remarkably precise scaling laws under temporal aggregation.
1,689 citations
TL;DR: In this article, the authors describe financial contagion as a wealth effect in a continuous-time model with two risky assets and three types of traders, i.e., convergence traders with logarithmic utility trade optimally in both markets, while noise traders trade randomly in one market.
Abstract: Financial contagion is described as a wealth effect in a continuous-time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long-term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined ~numerically! as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management. DURING THE F INANCIAL PANIC ASSOCIATED with the default of the Russian government in August 1998 and the subsequent collapse of the hedge fund Long Term Capital Management, numerous hedge funds, banks, and securities firms tried simultaneously to reduce exposures to a variety of financial instruments, such as Russian bonds, Brazilian stocks, U.S. mortgages, spreads between on-therun and off-the-run government securities, and spreads between swaps and U.S. Treasuries. Although the fundamental values of these positions would appear to have little correlation, during this financial crisis, the asset prices in these markets exhibited the following common empirical pattern: 1. Financial intermediaries suffered losses as prices moved against their positions; 2. Market depth and liquidity decreased simultaneously in several markets; 3. The volatility of prices increased simultaneously in several markets; and,
902 citations
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01 Jan 2001
Abstract: In recent decades, developments in the financial sector have played a major role in shaping macroeconomic outcomes in a wide range of countries. Financial developments have reinforced the momentum of underlying economic cycles, and in some cases have led to extreme swings in economic activity and a complete breakdown in the normal linkages between savers and investors. These experiences have led to concerns that the financial system is excessively procyclical, unnecessarily amplifying swings in the real economy. In turn, these concerns have prompted calls for changes in prudential regulation, accounting standards, risk measurement practices and the conduct of monetary policy in an attempt to enhance both financial system and macroeconomic stability.
833 citations
TL;DR: The authors found that prices of non-energy commodity futures in the United States have become increasingly correlated with oil prices; this trend has been significantly more pronounced for commodities in two popular commodity indices.
Abstract: The authors found that, concurrent with the rapidly growing index investment in commodity markets since the early 2000s, prices of non-energy commodity futures in the United States have become increasingly correlated with oil prices; this trend has been significantly more pronounced for commodities in two popular commodity indices. This finding reflects the financialization of the commodity markets and helps explain the large increase in the price volatility of non-energy commodities around 2008.
833 citations
TL;DR: In this paper, the authors developed a method for solving the identification problem that arises in simultaneous-equation models based on the heteroskedasticity of the structural shocks, and measured the contemporaneous relationship between the returns on Argentinean, Brazilian, and Mexican sovereign bonds.
Abstract: This paper develops a method for solving the identification problem that arises in simultaneous-equation models. It is based on the heteroskedasticity of the structural shocks. For simplicity, I consider heteroskedasticity that can be described as a two-regime process and show that the system is just identified. I discuss identification under general conditions, such as more than two regimes, when common unobservable shocks exist, and situations in which the nature of the heteroskedasticity is misspecified. Finally, I use this methodology to measure the contemporaneous relationship between the returns on Argentinean, Brazilian, and Mexican sovereign bonds—a case in which standard identification methodologies do not apply.
820 citations
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TL;DR: In this article, the authors studied the correlation of monthly excess returns for seven major countries over the period 1960-90 and found that the international covariance and correlation matrices are unstable over time.
1,998 citations
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TL;DR: In this paper, the short run interdependence of prices and price volatility across three major international stock markets is studied using the autoregressive conditionally heteroskedastic (ARCH) family of statistical models.
Abstract: The short-run interdependence of prices and price volatility across three major international stock markets is studied. Daily opening and closing prices of major stock indexes for the Tokyo, London, and New York stock markets are examined. The analysis utilizes the autoregressive conditionally heteroskedastic (ARCH family of statistical models to explore these pricing relationships. Evidence of price volatility spillovers from New York to Tokyo, London to Tokyo, and New, York to London is observed but no price volatility spillover effects in other directions are found for the pre-October 1987 period.
1,780 citations
"No Contagion, Only Interdependence:..." refers background in this paper
...Hamao, Masulis, and Ng (1990) use this procedure to examine stock markets around the 1987 U.S. stock market crash and find evidence of significant price-volatility spillovers from New York to London and Tokyo, and from London to Tokyo....
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TL;DR: In this paper, the authors investigated why almost all stock markets fell together despite widely differing economic circumstances and found that "contagion" between markets occurs as the result of attempts by rational agents to infer information from price changes in other markets.
Abstract: This paper investigates why, in October 1987, almost all stock markets fell together despite widely differing economic circumstances. The idea is that "contagion" between markets occurs as the result of attempts by rational agents to infer information from price changes in other markets. This provides a channel through which a "mistake" in one market can be transmitted to other markets. Hourly stock price data from New York, Tokyo and London during an eight month period around the crash offer support for the contagion model. In addition, the magnitude of the contagion coefficients are found to increase with volatility.
1,779 citations
TL;DR: In this paper, the authors explore the fundamental factors that affect cross-country stock return correlations and find that large shocks to broad-based market indices (Nikkei Stock Average and Standard and Poor's 500 Stock Index) positively impact both the magnitude and persistence of the return correlations.
Abstract: This article explores the fundamental factors that affect cross-country stock return correlations. Using transactions data from 1988 to 1992, we construct overnight and intraday returns for a portfolio of Japanese stocks using their NYSE-traded American Depository Receipts (ADRs) and a matched-sample portfolio of U. S. stocks. We find that U. S. macroeconomic announcements, shocks to the Yen/Dollar foreign exchange rate and Treasury bill returns, and industry effects have no measurable influence on U.S. and Japanese return correlations. However, large shocks to broadbased market indices (Nikkei Stock Average and Standard and Poor's 500 Stock Index) positively impact both the magnitude and persistence of the return correlations. STOCK RETURN CROSS-COUNTRY COVARIANCES play a key role in international finance. Changes in these covariances affect the volatility of portfolios and asset prices. As these covariances increase, one expects that: (a) fewer domestic risks are internationally diversifiable, so portfolio volatility increases; (b) the risk premium on the world market portfolio increases;1 (c) the cost of capital increases for individual firms; and, (d) the domestic version of the CAPM becomes increasingly inadequate.2 Despite the important economic consequences of changes in cross-country covariances, the determinants of the levels and dynamics of these covariances have been little studied from an academic
1,002 citations
TL;DR: This article examined recent developments in emerging equity markets in Asia and Latin America and longer term trends and cycles in capital flows to Latin American economies and their sensitivity to events in the larger countries in the region.
Abstract: The issue of "spillover or contagion" effects has acquired renewed importance in light of the Mexican crisis in December 1994 and the effect that this event has had on other emerging market economies. Relatively little empirical analysis exists on how small open economies are affected by economic developments in their neighbors and what role financial markets play in the transmission of disturbances. This paper attempts to fill that gap by examining recent developments in emerging equity markets in Asia and Latin America and longer term trends and cycles in capital flows to Latin American economies and their sensitivity to events in the larger countries in the region.
623 citations
"No Contagion, Only Interdependence:..." refers background in this paper
...Calvo and Reinhart (1996) use this approach to test for contagion in stock prices and Brady bonds after the 1994 Mexican peso crisis....
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