No Contagion, Only Interdependence: Measuring Stock Market Comovements

Heteroskedasticity biases tests for contagion based on correlation coefficients. When contagion is defined as a significant increase in market comovement after a shock to one country, previous work suggests contagion occurred during recent crises. This paper shows that correlation coefficients are conditional on market volatility. Under certain assumptions, it is possible to adjust for this bias. Using this adjustment, there was virtually no increase in unconditional correlation coefficients ~i.e., no contagion! during the 1997 Asian crisis, 1994 Mexican devaluation, and 1987 U.S. market crash. There is a high level of market comovement in all periods, however, which we call interdependence. IN OCTOBER 1997, THE HONG KONG STOCK MARKET declined sharply and then partially rebounded. As shown in Figure 1, this movement affected markets in North and South America, Europe, and Africa. In December 1994, the Mexican market dropped significantly, and as shown in Figure 2, this fall was quickly ref lected in other Latin American markets. Figure 3 shows that in October 1987, the U.S. market crash affected major stock markets around the world. These cases show that dramatic movements in one stock market can have a powerful impact on markets of very different sizes and structures across the globe. Do these periods of highly correlated stock market movements provide evidence of contagion? Before answering this question, it is necessary to define contagion. There is widespread disagreement about what this term entails, and this paper utilizes a narrow definition that has historically been used in this literature.1 This paper defines contagion as a significant increase in cross-market linkages after a shock to one country ~or group of countries!.2 According to * Forbes and Rigobon are both from the Sloan School of Management at the Massachusetts Institute of Technology. Thanks to Rudiger Dornbusch; Richard Greene; Andrew Rose; Jaume Ventura; an anonymous referee; and seminar participants at Dartmouth, MIT, and NYU for helpful comments and suggestions. 1 For a discussion of alternate def initions and their advantages and disadvantages, see Forbes and Rigobon ~2001! or the web site http:00www.worldbank.org0economicpolicy0 managing%20volatility0contagion0Definitions_of_Contagion0definitions_of_contagion.html. 2 It is important to note that this definition of contagion is not universally accepted. Some economists argue that contagion occurs whenever a shock to one country is transmitted to another country, even if there is no significant change in cross-market relationships. Others argue that it is impossible to define contagion based on changes in cross-market linkages. Instead, they argue that it is necessary to identify exactly how a shock is propagated across countries, and only certain types of transmission mechanisms ~no matter what the magnitude! constitute contagion. THE JOURNAL OF FINANCE • VOL. LVII, NO. 5 • OCTOBER 2002