The Excess Comovement of International Stock Markets in Bad Times: A Rational Expectations Equilibrium Model

We present an intertemporal, rational expectations equilibrium model where the cross-sectional covariances and correlations of international market returns increase during bad times, as a consequence of an endogenous increase in the “uncertainty” about the global economy. We assume that the drift rates of the fundamental processes of international economies are jointly affected by an unobservable global business cycle indicator. We show that as investors strive to learn the state of the global economy, their uncertainty ßuctuate, thereby affecting the cross-covariances and correlations of asset returns. Excess comovement during bad times is so obtained as a reßection of higher uncertainty. When estimated with data on seven major countries, the model is able to replicate well the historical pattern of international average covariances and correlations.