NBER WORKING PAPER SERIES MARKET INTEGRATION AND CONTAGION. Geert Bekaert Campbell R. Harvey Angela Ng

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1 NBER WORKING PAPER SERIES MARKET INTEGRATION AND CONTAGION Gr Bkar Campbll R. Harvy Angla Ng Workng Papr 9510 hp:// NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachs Avnu Cambrdg, MA 0138 Fbruary 003 Ths work s parally suppord by h Earmarkd Gran of h Rsarch Grans Councl of Hong Kong. W hav graly bnfd from h commns of an anonymo rfr. W apprca h commns of Jo Chn, Monka Pazzs Andrw Frankl, h parcpans a h 00 Europan Fnanc Assocaon mngs n Brln and h 003 Economrc Socy mngs n Washngon, DC. Ka-Chun Ip, Chng-Ka Chu and Sangha Ramalngam provdd xclln rsarch asssanc. Plas snd commns o gb41@columba.du, cam.harvy@duk.du or anglang@.hk. Gr Bkar acknowldgs h suppor of a NSF rsarch gran. Th vws xprssd hrn ar hos of h auhor and no ncssarly hos of h Naonal Burau of Economc Rsarch. 003 by Gr Bkar, Campbll R. Harvy, and Angla Ng. All rghs rsrvd. Shor scons of x no o xcd wo paragraphs, may b quod whou xplc prmsson provdd ha full crd ncludng noc, s gvn o h sourc.

2 Mark Ingraon and Conagon Gr Bkar, Campbll R. Harvy and Angla Ng NBER Workng Papr No Fbruary 003 JEL No. G15, G1, F3, F36, F15 ABSTRACT Conagon s ually dfnd as corrlaon bwn marks n xcss of wha would b mpld by conomc fundamnals; howvr, hr s consdrabl dsagrmn ardng h dfnons of h fundamnals, how h fundamnals mgh dffr across counrs, and h mchansms ha lnk h fundamnals o ass rurns. Our rsarch aks, as a sarng pon, a wofacor modl wh m-varyng bas ha accommodas varo dgrs of mark ngraon bwn dffrn marks. W apply hs modl o sock rurns n hr dffrn ons: Europ, Souh-Eas Asa, and Lan Amrca. In addon o provdng nw nsghs on conagon durng crss prods, w documn parns hrough m n world and onal mark ngraon and masur h proporon of volaly drvn by global, onal, and local facors. Gr Bkar Campbll R. Harvy Gradua School of Bnss Fuqua School of Bnss Columba Unvrsy Duk Unvrsy 30 Broadway/ 80 Urs Hall Durham, NC 7708 Nw York, NY 1007 and NBER and NBER cam.harvy@duk.du gb41@columba.du Angla Ng Hong Kong Unvrsy of Scnc and Tchnology Clar War Bay, Kowloon Hong Kong

3 1. Inroducon Conagon n quy marks rfrs o h noon ha marks mov mor closly oghr durng prods of crss. On of h mos nrsng aspcs of h conagon dba s h dsagrmn ovr a prcs dfnon. Forbs and Rgobon (001) dclar ha hr s no consns on xacly wha consus conagon or how should b dfnd. Rgobon (001) sas paradoxcally,... hr s no accordanc on wha conagon mans. Wha s clar s ha conagon s no smply rvald by ncrasd corrlaon of mark rurns durng a crss prod. From a complly sascal prspcv, on would xpc hghr corrlaons durng prods of hgh volaly. 1 Forbs and Rgobon (001) prsn a sascal corrcon for hs condonng bas and argu ha hr was no conagon durng h hr mos rcn crss. W dfn conagon as xcss corrlaon ha s, corrlaon ovr and abov wha on would xpc from conomc fundamnals. Unforunaly, hr s dsagrmn on h dfnons of h fundamnals, h ponal counry-spcfc naur of h fundamnals, and h mchansm ha lnks h fundamnals o ass corrlaon. Our papr aks an ass prcng prspcv o h sudy of conagon. For a gvn facor modl, ncrasd corrlaon s xpcd f h volaly of a facor ncrass. Th sz of h ncrasd corrlaon wll dpnd on h facor loadngs. Conagon s smply dfnd by h corrlaon of h modl rsduals. By dfnng h facor modl, w avod a problm wh h bas corrcon for corrlaons ha Forbs and Rgobon (001) propos, ha h bas corrcon dos no work n h prsnc of common shocks. Dfnng h facor modl dos man ha w ffcvly ak a sand on h global, onal and counry spcfc fundamnals, as wll as h mchansm ha ransfrs fundamnals no corrlaon. Of cours, any samns on conagon wll b conngn on h corrc spcfcaon of h facor modl; hrfor, w sar wh a modl ha has h maxmum flxbly. 1 S Sambaugh (1995), Boyr, Gbson and Loran (1999), Loran and Englsh (000), Forbs and Rgobon (001), and arly work by Pndyck and Rombrg (1990, 1993). Work lnkng nws, volaly and corrlaon ncluds Kng and Wadhawan (1990), Hamao, Masuls and Ng (1990), and Kng, Snana and Wadhwan (1994). 1

4 W apply a wo-facor modl wh m-varyng loadngs o small sock marks n hr dffrn ons: Europ, Souh-Eas Asa, and Lan Amrca. Th wo facors ar h U.S. quy mark rurn and a onal quy porfolo rurn. Our framwork nss hr modls: a world capal ass prcng modl (CAPM), a CAPM wh h U.S. quy rurn as h bnchmark ass, and a onal CAPM wh a onal porfolo as h bnchmark. W s h ass prcng spcfcaons by addng local facors. Sgmnaon and ngraon play a crcal rol n our ss. If h counrs n a parcular on ar globally ngrad for mos of h sampl prod, bu suddnly s hr nra-onal corrlaons rs dramacally durng a onal crss, our s wll rjc h null hypohss of no conagon. If, howvr, hs counrs do no follow a global CAPM, bu rahr a onal CAPM, h ncrasd corrlaons may smply b a consqunc of ncrasd facor volaly. Our volaly modl s rlad o Bkar and Harvy (1997) and Ng (000) n ha quy rurn volals follow unvara gnralzd auorssv condonal hroskdascy (GARCH) procsss wh asymmry. Hnc, ngav nws ardng h world or onal mark may ncras volaly of h facor mor han posv nws and lad o ncrasd corrlaons bwn sock marks. Morovr, our modl ncorporas m-varyng bas, whr h bas ar nfluncd by h rad parns. Chn and Zhang (1997) fnd ha h crossmark corrlaons of sock rurns ar rlad o xrnal rad among counrs. Prvo suds on nrnaonal mark lnkags hav focd manly on on sourc of rsk or on h ffcs of a sngl nrnaonal mark (ofn h U.S. or world mark) on ohr sock marks. 3 In fac, a conmporano papr (Tang, 001) s a dfnon of conagon smlar o h on w propos, bu rsrcs h modl o a world CAPM. Our srucur, whch allows world mark ngraon o b a spcal cas, bars som rsmblanc o h s-up n Chan, Karoly and Sulz (199). Howvr, h xsng lraur has prmarly focd on world mark ngraon, and onal ngraon has bn scarcly dscsd. Excpons nclud Engl and Sml (1993), who group h daa accordng o m zons and sarch for common onal Longn and Solnk (1995) rpor an ncras n cross-counry corrlaon durng volal prods. Ohr mprcal suds (for xampl, Erb, Harvy, and Vskana, 1994 and D Sans and Grard, 1997) fnd dffrn corrlaons n up and down marks, whl Longn and Solnk (001), Ang and Bkar (00) and Das and Uppal (001) documn hghr corrlaons n bar marks. 3 S, for xampl, Hamao, Masuls, and Ng (1990), Bkar and Hodrck (199), Bkar and Harvy (1995, 1997), Karoly (1995), Karoly and Sulz (1996), Harmann, Sramans and d Vrs (001), and Connolly and Wang (00).

5 nws facors, and Chung, H, and Ng (1997), who xamn common prdcabl componns n rurns whn a on. Our man conrbuon s o xamn prods of crss and nvsga whhr our modl can gnra suddn ncrass n corrlaons across counrs. Our approach, howvr, producs many ohr ful mprcal ss and mplcaons. Indd, our framwork provds a naural s for world and onal mark ngraon. In addon, w analyz h m varaon and crosssconal parns n onal vrs world mark corrlaons, addrssng h quson of whhr corrlaons bwn counry rurns and h world or onal mark hav ncrasd ovr m. Fnally, w masur h proporons of varanc drvn by global, onal and local facors, and how hs proporons chang hrough m. Th rmandr of h papr s organzd as follows. Scon prsns h mprcal modl spcfcaons and svral sabl hypohss. Scon 3 dscrbs h daa and prsns h mprcal rsuls. Som conclons ar offrd n h fnal scon.. Framwork Th nrnaonal vrson of h condonal CAPM of Sharp (1964) and Lnnr (1965) undr h assumpon of purchasng powr pary (PPP) prdcs h xcss rurn on a world mark porfolo, wh h facor of proporonaly bng h counry-spcfc condonal ba. Rahr han focng on currncy rsk [s Frson and Harvy (1993), and Dumas and Solnk (1995)], w xnd h radonal CAPM from a on-facor o a wo-facor sng, by dvdng h world mark no h U.S. and a parcular on, and also allow for local facors o b prcd..1 Th Modl L R, b h xcss rurn on h naonal quy ndx of counry n U.S. dollars. Th modl has h followng form: R ' = Z 1 + 1µ, 1 + 1µ, 1 + 1, + 1, + δ, (1) ( σ ) I,, 1 ~ N 0, () 3

6 σ, (3) = a + bσ 1 + c 1 + d η 1 whr µ 1 and µ 1 ar h condonal xpcd xcss rurns on h U.S. and onal,, marks, rspcvly, basd on nformaon avalabl a m -1,, s h dosyncrac shock of any mark ncludng h U.S. and onal porfolo, η s h ngav rurn shock of counry ha s, η = mn{ 0, }, and I 1 ncluds all h nformaon avalabl a m -1. Th vcor Z 1 conans a consan and h local dvdnd yld, whch hlp sma h xpcd rurn of mark. Th dvdnd ylds ar laggd by on monh. Th varanc of h dosyncrac rurn shock of mark follows a GARCH procss n (3) wh asymmrc ffcs n condonal varanc, as n Glosn, Jagannahan, and Runkl (1993) and Zakoan (1994). Th snsvy of quy mark o h forgn nws facors s masurd by h paramrs and 1 1. Followng Bkar and Harvy (1995, 1997) and Ng (000), w modl hs rsk paramrs o b m-varyng as:, (4) ' ' w 1 = p1, X 1 + qx 1 w, 1 ' ' w p X + q X 1 w ), (5) 1 =, 1 1 (, 1 whr w, 1 dnos h mark capalzaon of h U.S., rlav o h oal world mark capalzaon, a m -1. In (4)-(5), w furhr nroduc hr dffrn ss of local nsrumns, X, 1 X and 1 X w 1. Th s X ( X 1 1 ) consss of nformaon varabls ha capur h covaranc rsk of mark wh h U.S. (h on). W a consan and h sum of xpors o and mpors from h U.S. (h rs of h world) dvdd by h sum of oal xpors and oal mpors. W ry o capur whn h on rad by all rad mn h U.S. Whl hs s only a proxy, mposs a clan rlaon bwn X, 1 X and 1 X w 1. No ha our srucur allows h condonal bas o b mpacd by rad. Chn and Zhang (1997) sudy h rlaon bwn cross-mark rurn corrlaon and blaral rad and fnd ha counrs wh havr xrnal rad o a on nd o hav hghr rurn corrlaons wh ha on. Smlarly, h nformaon s X consss of local nsrumns ha should capur h w 1 4

7 covaranc rsk of mark wh a world porfolo. Hr, w nclud a consan and h counry s oal sz of rad as a prcnag of GDP. All of h rad varabls ar laggd by sx monhs. 4 Th U.S. and onal marks modls ar spcal cass of (1)-(5). For h U.S. mark (wh = ), p 1, = p, = q = 0 (ha s,, 1 =, 1 = 0 ) and Z, 1 conans a s of world nformaon varabls, ncludng a consan, h world mark dvdnd yld, h sprad bwn h 90-day Eurodollar ra and h 3-monh Trasury-bll yld, h dffrnc bwn h U.S. 10-yar Trasury bond yld and h 3-monh bll yld, and h chang n h 90-day Trasurybll yld. For h onal porfolo (wh = ), p, = q = 0 (ha s, = p X ', 1 1,, 1 and, 1 = 0 ), Z, 1 ncluds a consan and h onal mark dvdnd yld (wghd by mark capalzaon), and X conans a consan and h sum of h on s oal xpors, 1 o and mpors from h U.S. dvdd by h sum of oal xpors and mpors of h on. As shown n (1), h xpcd xcss rurn on mark s a lnar funcon of som local nformaon varabls and h xpcd xcss rurns on h U.S. and onal marks, ha s, ' [ R 1 1 ] = δ 1 + 1µ, 1 1, 1 ' ' ' Z + + ]( δ Z ) ( δ Z ) µ I Z (6) 1 = E + µ = δ 1 [ 1 1, 1, 1 + 1, 1. Hnc, h ffc of h world mark nformaon orgnang from h U.S. on mark s xpcd rurn has wo componns a drc mpac, as masurd by 1, and an ndrc ffc va s nflunc on h onal mark, as masurd by. 1, 1 Smlarly, h unxpcd poron of h mark rurn s drvn no only by shocks from h local mark, bu also by wo forgn shocks orgnang n h U.S. and h on, ha s, ε, (7) = 1, + 1, + whr ε dnos h rurn rsdual of mark. To compl h modl, w furhr assum ha h dosyncrac shocks of h U.S., onal mark, and counry ar uncorrlad. As a rsul, h modl mpls h followng varanc and covaranc xprssons: h [ ε ] = ( ) σ + ( ) σ + σ = E 1 1, 1, I, (8) 4 Th appndx provds a dald dscson of h consrucon of h nformaon varabls. 5

8 h h h [ ε ε ] σ, E, 1 = 1, = I, (9) [ ε ε ] = σ σ, E, 1 1, 1, + 1, = I, (10) [ ε ε ] = σ σ j, E j, 1 1 j, 1, + 1 j, 1, = I. (11) Equaon (8) shows ha h rurn volaly of mark s posvly rlad o h condonal varancs of h U.S. and onal marks. Consqunly, w can nvsga whhr ponal asymmrc ffcs n h U.S. and/or onal marks nduc asymmry n h condonal rurn volaly of any quy mark. Th condonal covaranc dynamcs gvn n (9)-(11) hav svral mporan mplcaons. Frs, a mark s covaranc wh h U.S. (onal) mark rurn s posvly rlad o s counry-spcfc ba wh h U.S., (on, 1 1 ). Scond, provdd ha h counryspcfc ba paramr s posv, hghr volaly n h U.S. mark nducs hghr 1 rurn covaranc bwn h U.S. and mark. Thrd, h covaranc wh h onal mark or any ohr naonal mark j whn h sam on ncrass n ms of hgh rurn volaly n h U.S. and/or h onal mark. Ths naural mplcaon of any facor modl, coupld wh asymmrc volaly, could lad o h apparanc of conago bar marks. Whras hs pons, whch follow mmdaly from (9)-(11), apply o covarancs, hy ar also ru for corrlaons. 5 j Noc, ha ncrasd rad ngraon (changs n for j =, ) may also ncras h corrlaon wh h U.S. or onal mark and bwn counrs. In h mprcal scon, w sudy h m varaon and cross-sconal parns n onal vrs U.S. mark corrlaons of mark. Th U.S. and onal corrlaons ar gvn by: 1 ρ ρ,, 1σ, = (1) h, 1σ, = (13) 1, 1σ, + h h, 5 I s sraghforward o show hs formally, bu s also clar nuvly. If h varanc of h common facor gos o zro, hn h rurns ar only drvn by dosyncrac shocks. A h ohr xrm, f h varanc of h common facor gos o nfny, h dosyncrac shocks bcom rrlvan and h flucuaons n rurns ar fully xpland by h common shock. Hnc, h corrlaon bcoms on. 6

9 whr h ( ) σ + σ,, 1,, = s h condonal varanc of h onal mark rurn. W also xamn h (rlav) proporons of condonal rurn varanc ha ar accound for by h U.S. and h on. Th followng varanc raos ar compud: VR ( ) 1 σ, =, h (14) VR ( ) 1 σ, =. (15) h Clarly, hs varanc raos ncras whn h facor varanc (US or onal mark) ncrass. W ar spcfcally nrsd n h crss prods and nvsga whhr h modl can gnra suddn ncras n corrlaons across marks followng a crss.. Tsabl hypohss ardng mark ngraon Th spcfcaon prsnd n (1)-(5) s a gnral wo-facor modl ha allows o xamn svral sabl hypohss. Frs, f h wo-facor modl holds, ha s, f h wo forgn rsk facors ar suffcn n xplanng h xpcd rurn on mark h local nsrumns should hav no xplanaory powr on hr own mark rurn and, h, δ = 0. Consqunly, w nrpr hs s as a s of mark ngraon, whr ngraon can b global or onal. Scond, h modl nss h on-facor CAPM as a spcal cas. Undr h consran ha p, = 0 ( p 1, = 0 ) and q = 0, oghr wh δ = 0, h modl rducs o h radonal CAPM, wh h U.S. (h on) bng h bnchmark mark and ( 1 1 ) qual o h condonal ba of mark wh h U.S. (onal) mark. Th modl hn mpls ha mark s fully ngrad wh h U.S. (onal) mark. Undr hs sng, w should b abl o dc dvaons from h on-facor ngrad modl. W nrpr h s, p 1, = q = δ = 0, as a s of onal mark ngraon. Thrd, our modl ncompasss a world mark ngraon modl. Suppos ha h world mark s sparad no h U.S. and a parcular on, and ha ach mark s fully ngrad wh h world capal mark. Ths happns whn p 1, = 0 and p, = 0, ha s, 7

10 w and 1 w ). Hnc, w 1 = 1 w, 1 1 = 1 (, 1 w ' w = q X 1 1 s h condonal ba of mark wh h world mark porfolo n h radonal CAPM. Hnc, our framwork ncompasss h world mark ngraon modl prsnd n Chan, Karoly and Sulz (199)..3 Conagon dfnons and ss W masur conagon by masurng h corrlaon of h modl s dosyncrac shocks or unxpcd rurns. W sablsh a basln lvl of conagon by xamnng shock corrlaons smad ovr h full sampl prod; howvr, w ar mos nrsd n h shock corrlaons durng parcular prods. Our ss nvolv h m-srs cross-scon rsson modl: ˆ v = w + v ˆ g, = v 0 + v D 1 + u whr ˆ and, ˆ ar h smad dosyncrac rurn shocks of mark and on g, g, rspcvly. For h onal rsduals, hr cass ar consdrd: ˆ =, ˆ g, = ˆ,, and g ˆ,, ˆ = j ˆ whr G dnos a parcular counry-group. In sudyng h mark rsduals,,, g j G j counrs ar cagorzd no h followng counry-groups: Europ, Europ xcludng Turky, Asa, and Lan Amrca. D, s a dummy varabl ha rprsns fv sampl prods: h scond sub-sampl prod, h Mxco crss prod from Novmbr 1994 o Dcmbr 1995, h Asan crss prod from Aprl 1997 o Ocobr 1998, abnormally ngav U.S. unxpcd mark rurns (.., h unxpcd rurns ar on sandard dvaon blow zro), and abnormally ngav onal unxpcd mark rurns. Our ss drmn whhr v 0 and v 1 ar zro (ovrall conagon), and whhr v 1 s sgnfcanly dffrn from zro (conrbuon of parcular prods o conagon)..4 Esmaon mhod Th modl prsnd n h frs scon can b xprssd n a mulvara sng. L R [, R, R R ], [ ] ' ' ' ' δ Z δ Z, δ Z δ Z = R, 1, N,,,..., 1 =, 1,, 1 1 1, 1,..., N N, 1 µ, and 8

11 [,, ] =, 1, N,,,...,, whr N s h numbr of counrs whn h parcular on. Th gnral (N + ) mulvara modl has h followng form: R Σ = Φ I 1 = E 1 ~ N 1 ( 0, Σ ) ' [ I ] = dag{ σ }, whr j =,,1,..., N, µ j, (16) wh Φ 1 1, = φ1, 1 M φ N, , 1 M N, L L I ( N ) 0 0 and 1 1, = 1, 1 M N, , 1 M N, L L I ( N ) 0 0, whr φ and I ( N ) s a (N N) dny marx. 1 = 1 + 1, 1 W sma h jon mulvara lklhood funcon for h rurns n hr sags. Gvn ha h dnsy of h U.S. rurn, condonal on I 1, dpnds only on θ [ δ, a, b, c, d ], n h frs sag, w sma h (unvara) modl n (1)-(5) for h = U.S. mark. In h scond sag, basd on h U.S. smas from sag 1, w xamn h modl for h onal mark porfolo. Condonal on I 1 and R,, h dnsy funcon of h onal mark rurn dpnds only on [ θ, θ ], whr θ = δ, p, a, b, c, d ] [ 1, and, h, conssn smas of θ ar oband by maxmzng h unvara lklhood for h onal mark rurn. Fnally, n h hrd sag, w sma h unvara modl n (1)-(5) counry by counry, condonng on h U.S. and onal mark modl smas. Ths mhodology s smlar o h on proposd by Bkar and Harvy (1997)..5 Modl slcon and spcfcaon ss Bca asymmrc and symmrc GARCH modls produc vry dffrn condonal varancs, our modl slcon focs on ha ssu. Morovr, s concvabl ha asymmrc ffcs a h U.S. or onal mark lvl mak h counry-spcfc asymmry suprfluo. W frs carry ou a lklhood rao (LR) s for h null hypohss of no asymmry n h condonal varanc of h local rurn rsdual. If h LR s rjcs h null hypohss a h 9

12 5% lvl, h modl wh asymmry s chosn; f h p-valu of h s sasc s grar han 15%, h modl whou asymmry s slcd. For h nrmda cas, w rss h squard rurn rsduals for boh modls on h smad condonal varancs, as n Pagan and Schwr (1990), and slc h modl wh h hghr R. ẑ W conduc spcfcaon ss on h smad sandardzd dosyncrac shocks, = ê / ˆ σ for all ng h gnralzd mhod of momns. Undr h null hypohss ha h modl s corrcly spcfd, [ ˆ, ] = 0 E, (17a) z [ ẑ ẑ ] = 0 E, for s = 1,..., τ, (17b), s [ 1] = 0 E, (17c) ẑ [( ẑ 1)( 1) ] = ẑ 0 E, for s = 1,..., τ, (17d), 3 [ ] = 0 ẑ s E, (17) 4 [ 3] = 0 E. (17f) ẑ Equaons (17b) and (17d) ar a consqunc of h corrc spcfcaon for h condonal man and varanc, and hs wo consrans ar sd sparaly by a χ s wh τ dgrs of frdom. Th uncondonal momns n h ohr four consrans ar sd jonly by calculang a χ sasc wh four dgrs of frdom. W also carry ou a jon s of all sx rsrcons, whch has τ + 4 dgrs of frdom. In all of h spcfcaon ss, τ s s qual o 4. Th Mon Carlo analyss n Bkar and Harvy (1997), n a smlar sng, confrms ha h small sampl dsrbuon of h s sascs s rlavly wll dscrbd by χ dsrbuons, dsp h mul-sag smaon. 10

13 3. Rsuls 3.1 Equy mark daa Our sampl of naonal quy marks ncluds daa for boh dvlopd marks, as compld by Morgan Sanly Capal Inrnaonal (MSCI), and mrgng marks from h Inrnaonal Fnanc Corporaon (IFC) of h World Bank. Th sampl prod bgns n January 1980 for mos of h MSCI daa and January 1986 for h IFC daa. Th sampl nds n Dcmbr W sudy a oal of counrs ha ar groupd no hr gographcal ons Asa, Europ, and Lan Amrca. Th onal quy ndcs w xamn ar h MSCI Europ ndx, as wll as our own Asa and Lan Amrca mrgng mark ndcs. Th Asa (Lan Amrca) mrgng mark ndx s a wghd avrag of all h Asan (Lan Amrcan) mrgng marks, xcludng h counry undr nvsgaon. Hnc, w compu h Asa or Lan Amrca mrgng mark ndx, R R / = wk, Rk, wk,, k k /, as wh k ndxng h Asan or Lan Amrcan marks, xcp mark and w k, dnong h mark capalzaon of mark k. I s no always h cas ha counry rurns ar mor hghly corrlad wh a onal ndx han wh hr h U.S. or MSCI world ndx rurns. For xampl, all Europan counrs ar mor hghly corrlad wh h MSCI World and Europ ndcs han wh h U.S., bu Indonsa, Kora and h Phlppns hav hghr uncondonal corrlaons wh h U.S. han wh hr onal ndx. Whn h Lan Amrcan group, Brazl, Chl, Colomba and Mxco hav hghr corrlaons wh h U.S. han wh hr onal ndx. Dald summary sascs ardng corrlaons ar avalabl on rqus. As scon.1 ndcad, w a subsanal numbr of boh conomc and fnancal nformaon varabls, whch ar dald n h appndx 3. U.S. and onal modls Tabl 1 dals h U.S. and onal mark modl smaon. Th frs row (Wald s I) shows ha, conssn wh prvo rsarch, hr s sgnfcan varaon n h condonal man for h U.S. rurn. Our rsuls srongly rjc h hypohss of no asymmry n h 11

14 condonal varancs. All hr spcfcaon ss fal o rjc h U.S. modl spcfcaon. Th jon s fals o rjc h spcfcaon a h 5% lvl, bu provds som vdnc agans h spcfcaon a h 10% lvl. 6 Whl w ar consrand by daa bgnnng n h 1980s for Asan and Lan Amrcan mrgng marks, h U.S. and Europan daa ar avalabl arlr. W hav ndpndnly conducd alrnav smaons ng, n parcular, h U.S. mark modl smad ovr a longr sampl. Ths rsuls ar avalabl on rqus. Ovr h longr sampl, h U.S. mark xhbs h sam srong asymmry. Furhrmor, h hr spcfcaon ss and h jon s fal o provd vdnc agans h spcfcaon. Fnally, all h rsuls w rpor ardng ngraon and conagon ar qualavly rob o h of hs U.S. rsduals. Th nx par of Tabl 1 prsns h onal modl smaon. W fnd ll vdnc of asymmrc volaly od h U.S. W fal o rjc symmry n h Europan, Asan and Lan Amrcan onal porfolos. Th hr spcfcaon ss and h jon s fal o provd vdnc agans h spcfcaons a convnonal sgnfcanc lvls. Th local nsrumns hav sgnfcan xplanaory powr n Asa, bu no n Lan Amrca or Europ. Tabl 1 also prsns a s of whhr h coffcns on h rad varabl accoun for varaon n h ba wh rspc o h U.S. (Wald s II), and w fnd no sgnfcan ffc. Howvr, do fnd ha h ba wh rspc o h U.S. (Wald s III) s sgnfcanly dffrn from zro for Europ and Lan Amrca. For Asa, h p-valu s W also rpor h avrag condonal bas and corrlaons of h hr onal porfolos wh h U.S. Europ has h hghs avrag condonal corrlaon wh h U.S. (0.587), followd by Lan Amrca (0.43), and Asa (0.146). Lan Amrca s hgh (around on) ranslas no lowr corrlaon and a low proporon of varanc xpland by U.S. shocks bca of s rlavly hgh rurn varably. In Europ, mor han 30% of h condonal rurn varanc can b arbud o U.S. shocks. Ths condonal bas and corrlaons ar h cornrson of our ss of conagon and mark ngraon. W ar nrsd n whhr hs bas and corrlaons ncras durng crss prods. Our framwork gvs h ably o dcompos h ncrasd corrlaon of 6 Whn w do no xplcly mnon h s lvl, w 5% ss o judg sgnfcanc. 1

15 rurns no wo componns: h par h ass prcng modl xplans and h par h modl dos no xplan. Th xpland par provds ponal nsghs abou mark ngraon hrough h movmns n h bas. W dfn conagon as h corrlaon of h unxpland poron. 3.3 Counry modls and ngraon Our framwork nss a las hr dsnc modls: an ass prcng modl wh a sngl facor (a onal porfolo rurn), an ass prcng modl wh a sngl U.S. facor, and a world capal ass prcng modl. Dald counry-by-counry rsuls ar avalabl upon rqus. Hr w summarz h man fndngs. In Europ, mos counry rsduals sll dsplay asymmrc volaly, bu n h ohr ons only half h counrs do. Our rsdual spcfcaon ss ypcally fal o rjc. Th jon s s h mos powrful, rjcng a h 1% lvl n hr counrs (Grc, Turky and Colomba), and a h 5% lvl n four ohr counrs. W also s whhr laggd local nformaon nrs h man quaon (s of δ = 0 ). If h ass prcng modl s proprly spcfd, hs laggd nsrumns should no nr h modl. Tha s, h ass prcng modl hrough s m-varyng rsk and rsk prmums should capur varaon n h counry s condonal man. Ths s can b hough of as a s of whhr h condonal alpha (or prcng rror) s zro and, undr h null hypohss of h onal or world CAPM, as a s of mark ngraon. Th hypohss ha local nformaon s unrlad o h prcng rrors s rjcd n svn of 10 Europan counrs. In Asa, local nformaon s mporan for xplanng h prcng rrors n Kora, Malaysa, h Phlppns, and Tawan. Local nformaon s also mporan for h prcng rrors n Argnna, Chl, Colomba, and Mxco. Smlar o our onal analyss, w ar nrsd n whhr h ba wh rspc o h U.S. s nfluncd by rad wh h U.S. and, mor gnrally, whhr h ba s qual o zro (s whhr p 1, = 0 ). W fnd ha U.S. rad mpacs h condonal bas n gh of 10 Europan counrs (xcpons ar Ara and Porugal), fv of sx Asan counrs (xcpon s h Phlppns), and wo of sx Lan Amrcan counrs. Th ss of whhr h bas ar 13

16 qual o zro closly mmc h ss of whhr rad s mporan. Th ba wh rspc o h U.S. s sgnfcanly dffrn from zro n gh of 10 Europan sampl counrs. Th ba wh rspc o h U.S. s no zro a h 5% lvl for all Asan counrs xcp for h Phlppns (whr s sgnfcan a h 10% lvl). In Lan Amrca, hr of h counrs, Chl, Colomba and Vnzula, hav sascally sgnfcan non-zro bas wh rspc o h U.S. A h counry lvl, w can also xamn how rad wh h rs of h world mpacs h onal ba and, mor gnrally, whhr h ba wh rspc o h onal bnchmark s qual o zro (s whhr p, = 0 ). Trad wh h rs of h world s mporan for nn of 10 Europan marks onal bas. In Asa, fv of h sx counrs hav onal bas ha ar sgnfcanly nfluncd by rad (a h 10% lvl). Th onal ba of hr Lan Amrcan counrs (Chl, Colomba and Mxco) s nfluncd by rad. In h mor gnral ss of whhr h onal bas qual zro, w fnd ha gh of 10 Europan counrs hav non-zro bas, and ha Ara dos whn h s s conducd a h 10% lvl. In Asa, h bas ar non-zro (a h 5% lvl) for all counrs xcp for h Phlppns, whr h s rjcs a h 10% lvl. In conras, only wo of Lan Amrcan counrs onal bas ar sascally nonzro: Chl and Colomba. W also s h sgnfcanc of h oal rad sz as a prcnag of GDP n h U.S. and onal bas. Hr, w fnd ha rad mpacs h bas of nn of 10 Europan counrs (h xcpon s Ara), fv of sx Asa counrs (h xcpon s Thaland), bu only on of sx Lan Amrcan counrs (Chl). Th mor nrsng ss rsrc wo ss of paramrs. If boh p 1, = 0 and q = 0, hn h modl rducs o a CAPM wh a sngl onal facor. Ths onal facor modl s rjcd a h 5% lvl for all counrs xcp for Vnzula. If boh p, = 0 and q = 0, h modl rducs o a sngl facor modl wh h U.S. mark rurn as h rlvan bnchmark. Ths modl s rjcd for 0 of counrs a h 5% sgnfcanc lvl, wh Mxco and Vnzula bng h only wo xcpons. If boh p 1, = 0 and p, = 0, h modl rducs o a sandard world CAPM modl. Th smpl world CAPM s rjcd n 0 of counrs a h 10% lvl, and 1 of counrs a h 5% lvl. Th counrs adhrng o h world CAPM ar Porugal and Vnzula (a h 10% lvl). 14

17 Ths Wald ss rval ha h spcal cass ar ually rjcd. Consqunly, a onal nrnaonal modl s no a good dscrpon of h daa by slf, bu h covaranc wh on onal bnchmark s a sgnfcan drmnan of xpcd rurns n mos marks. Tabl rpors avrag bas, corrlaons and varanc raos for all h counrs wh rspc o h U.S. and h onal marks. No ha our modl producs m-varyng bas, corrlaons and varanc raos, bu w only rpor h sampl avrag of hs condonal varabls. Frs, l foc on h small Europan marks. Th bas and corrlaons wh rspc o h U.S. mark ar surprsngly small for mos marks, and vn ngav for Turky. Th xcpons ar Fnland (domnad by Noka, a vry nrnaonal, U.S. lsd company) wh a ba of and Norway, an ol snsv conomy, wh a ba of Howvr wh h xcpon of Grc, bas and corrlaons wh h onal mark (h Europan ndx) ar always largr han wh h U.S. mark. Gvn h small sz of hs marks and hr corrspondngly small wgh n h ndx, hs s no spuroly accound for by ndx composon. No surprsngly, hs mpls ha h fracon of h rurn shock varanc xpland by U.S. facors s small. I s mosly n h 15-% rang. Th onal mark accouns for 5-35% of oal shock varanc, wh h xcpons bng Grc (clos o 0%) and Turky (3.4%). Th qualav naur of h rsuls s dfnly n ln wh wha w would xpc gvn h rlav dosyncrac naur of varo marks. Th rsuls for h Asan marks ar somwha surprsng. Th bas wh rspc o h U.S. mark facor ar qu hgh, xcdng 0.7 n four of h sx marks. Only Kora and Tawan dsplay vry small bas. Th corrlaons ar lowr, bca of h hghr dosyncrac volaly of hs marks. Excp for Kora and Tawan, s always h cas ha h ba wh rspc o h U.S. s largr han h ba wh rspc o h onal mark. In rms of varanc raos, Tawan and Kora ar smlar o Grc and Turky: h U.S. and onal facors do no accoun for vry much of h oal varaon of rurn shocks. Howvr, h ohr marks ar closr o wha w s for h Europan marks, wh h onal and U.S. facors jonly accounng for ovr 30% of h varanc of rurn shocks. For h Lan-Amrcan counrs, hgh bas wh rspc o h U.S. mark ar no surprs, bu hr s subsanal cross-counry varaon: hy rang from for Vnzula o 1.05 for 15

18 Brazl. Th onal bas ar always much smallr han h U.S. bas. Ths s also ru, o a lssr xn, for h corrlaons, wh h xcpons bng Argnna and Brazl. Ovrall, hs analyss suggss ha onal ngraon may no b as srong a phnomnon as prvoly hough. Examnng h varanc raos, n four of h sx counrs w xplan lss han 0% of h shock varanc wh boh h U.S. and onal facors. Only n Argnna and Brazl do w xplan around 8% of h varanc, whch s sll lowr han wha w obsrv for mos Europan and h Asan marks. Ths rsuls also hlp calbra h rsuls on changs n bas, corrlaons and varanc raos durng crss ms. 3.4 Parns n onal and global ngraon W nvsga parns n onal and global ngraon by xamnng how h smad bas and corrlaons chang durng parcular prods. W also xamn h parns n h varanc raos (amoun of varanc n h counry s unxpcd rurn accound for by h U.S. or on). W consdr fv dffrn sampl prods: h scond half of h sampl (or subsampl), h Mxcan crss, h Asan crss, prods of abnormally ngav U.S. unxpcd rurns, and prods of abnormally ngav onal unxpcd rurns. Abnormal s dfnd as mor han on sandard dvaon blow zro. W run panl rssons of ach of our masurs on a consan and on a dummy varabl ha aks a valu of on durng hs dsgnad prods. Th frs panl of Tabl 3 compars h frs half of h sampl o h scond half, whch s domnad by h 1990s. For mos counrs, h bas, corrlaons and varanc raos wh rspc o h U.S. and h on ncras, ladng o posv slop coffcns. Ths ncras suggss ncrasd lnkags among h varo counrs. In Asa, hr s a sharp ncras n h onal bas, corrlaons and varanc raos n h scond half of h sampl. In gnral, h onal corrlaons, bas and varanc raos ncras by mor han hr U.S. counr pars. Thr ar som xcpons. In Europ, h bas wh rspc o h U.S. ncras somwha mor han h onal bas. Ths s somwha surprsng gvn ha h scond sub-sampl s a m whn Europ s movng furhr owards unfcaon and a sngl currncy. Howvr, s probably bs o nrpr hs rsuls as showng ncrasd corrlaon boh whn h on and wh rspc o h U.S., gvn ha hr s ll conomc dffrnc bwn h ncrass. 16

19 Panl B of Tabl 3 xamns h Mxcan crss. For Lan Amrca, hr s no sgnfcan ncras n h onal ba or corrlaon durng h crss. A only 0.004, h ncrmn o onal corrlaon s no vn on sandard rror from zro. Indd, h onal ba dcrass whl h ba wh rspc o h U.S. ncrass, bu nhr chang s sgnfcanly dffrn from zro. Th onal varanc rao chang s no sgnfcanly abov zro. Ovrall, h modl suggss no chang n corrlaon durng hs crss prod. Th Asan crss prsns a complly dffrn sory. Th onal corrlaons, bas and varanc raos for Asa n Panl C of Tabl 3 ncras by conomcally manngful magnuds n Asa, and h chang appars sascally sgnfcan. Th fac ha h ffc s conomcally much smallr for corrlaons and varanc raos han for bas s du o hghr ovrall volaly durng hs prod. Comovmns wh h U.S. appar o hav dcrasd durng h prod, suggsng ncrasd conomc onal ngraon durng hs m. Inrsngly, h sam onal ffcs ar vdn n boh Lan Amrca and Europ durng hs prod, bu hy ar smallr and, n fac, ar domnad by ncrasd comovmn wh h U.S. mark. Th las wo panls of Tabl 3 xamn prods of larg ngav rurns. In prods of ngav abnormal rurns, w would xpc h asymmrc modl o gnra hghr corrlaons. Alhough hs ngav abnormal rurns ar ually assocad wh hghr corrlaon, h ncrmn n corrlaon s subsanally smallr han ha xprncd durng h Asan crss. Indd, h las wo panls hlp o calbra h mporanc of Asan crss wh rspc o our comovmn varabls. 3.5 Conagon Th ncrasd corrlaon dcd durng h Asan crss s no slf vdnc of conagon. Th hypohss of conagon would b suppord f h modl s dosyncrac shocks xhb sgnfcan corrlaon. Tabl 4 provds a basln sma of conagon ovr h full sampl. W xamn h corrlaon of h counry dosyncrac shocks wh h U.S. rsduals, h onal rsduals, and vry ohr counry s dosyncrac rsduals. To assss h sascal sgnfcanc of h rsdual corrlaons, w prform a boosrap xrcs basd on 5,000 draws of h acual rurn rsdual s, wh h sam numbr of 17

20 obsrvaons as n our sampl. Th boosrap xprmn s consrucd as follows. Frs, w compl all h dosyncrac shocks from all marks, ncludng h U.S. and onal ndcs, oghr no on grand vcor of rurn shocks. Scond, n ach rplcaon, w draw from h grand rurn shock vcor o consruc a marx of rurn shocks wh h sam numbr of obsrvaons as n h sampl (rows) and numbr of counrs (columns), and hn compu h bvara corrlaon and cross-counry corrlaon marx. W 5,000 rplcaons n all. Fnally, w rcord h 95% valus for h bvara corrlaon and h cross-counry corrlaon marx. In h frs panl of Tabl 4, w fnd ha hr s no vdnc of xcss corrlaon bwn h Europan counrs and h U.S. Thr s on counry, Grc, whch has xcss corrlaon wh h onal rsdual. Howvr, mos nrsngly, w fnd vdnc n all bu on counry (Blgum) of conagon among h Europan counrs. Tha s, h rsdual corrlaons among h dffrn counrs ar sgnfcanly abov zro. In h scond panl of Tabl 4, w fnd no vdnc of xcss corrlaon wh h U.S. rsdual or h onal rsdual for any of h Asan counrs; howvr, hr s sharp vdnc of avrag conagon whn Asa. Evry counry xcp Tawan has sgnfcan xcss corrlaon wh ohr Asan counrs. Indd, h magnud of hs corrlaons s roughly doubl wha w documnd for Europ. Th Lan Amrcan counrs ar prsnd n h fnal panl of Tabl 4. Only on counry, Mxco, has xcss corrlaon wh h U.S. porfolo. No counry has xcss corrlaon wh h onal porfolo. Only wo counrs, Colomba and Vnzula show sgnfcan xcss corrlaon wh ohr Lan Amrcan counrs. Ths analyss masurs h corrlaon of dosyncrac rsduals ovr h nr sampl. W ar mos nrsd n h m-srs parns of hs rsduals. Tabl 5 s h fv m prods nroducd n Tabl 3 o xamn parns n h rsduals. W a panl rsson of h counry dosyncrac shocks ono a counry-spcfc consan and a rlvan bnchmark rsdual wh h slop coffcn allowd o chang durng h m prods of nrs. W sma h panl modl accommodang group-ws hroskdascy. 7 7 W also hav conducd h smaon assumng an AR(1) modl for h rsdual. Ths alrnav smas yld qualavly smlar rsuls. 18

21 In panl A, h v 1 coffcn masurs h addonal corrlaon n h scond half of h sampl. Rgardlss of h bnchmark or on, v 1 s posv, suggsng ha h dosyncrac rsduals ar mor corrlad n h scond half of h sampl. Th corrlaon wh rspc o h U.S. ndx rsduals s sgnfcanly hghr only for Asa; howvr, h corrlaon wh h onal rsduals s sgnfcanly hghr for all ons n h scond half of h sampl. Consdrng h sum of h counry-spcfc rsduals, w fnd ha h corrlaon jumps sgnfcanly n h scond half of h prod for boh Asa and Lan Amrca. Th jon s of v = v 0 s an ovrall s of conagon. W rjc a h 5% lvl for Asa 0 1 = wh rspc o h U.S. ndx, for Lan Amrca wh rspc o onal rurn rsduals, and for all ons wh rspc o h sum of ohr rsduals bnchmark. In h lar cas, v 0 s by slf also sgnfcan for hr ons. Clarly, counry rsduals whn a on ar corrlad byond wha s capurd n our modl, suggsng vdnc of conagon. Ovrall, conagon worsnd n h scond half of h sampl, bu s only conomcally and sascally sgnfcan for Asa and Lan Amrca. Panl B of Tabl 5 xamns h Mxcan crss. Our rsuls show ha hr s no sgnfcan ncras n rsdual corrlaons whn Lan Amrca. Insgnfcan ffcs ar also found for Europ and Asa durng h Mxcan crss, suggsng ll vdnc of conagon rsulng spcfcally from h Mxcan crss. Howvr, h ovrall conagon ss confrm h rsuls of panl B, ndcang conagon across counrs n h on. Panl C of Tabl 5 prsns h rsuls for h Asan crss. Hr w s sgnfcanly hghr rsdual corrlaons among Asan counrs for all rsdual bnchmarks. Th ncras n corrlaon for Asa s many ms largr han h ncras n corrlaon for hr Lan Amrca or Europ whn nvsgang comovmns wh U.S. rurn rsduals or h sum of h dosyncrac rsduals, bu h ncras n corrlaon s of h sam ordr of magnud whn xamnng onal rsduals. For Lan Amrca and Europ, sascal sgnfcanc s only rachd n hs lar cas. Hnc, h Asan crss worsnd conagon. Panls D and E of Tabl 5 pu h hsorcal crss prods n prspcv. Compar h ncrass n onal xcss corrlaon n panl E (abnormal ngav onal unxpcd rurns) wh hos rpord for h Asan crss. Th ncras n rsdual corrlaons whn 19

22 onal rurns ar ngav s of h sam ordr of magnud as h ncras obsrvd durng h Asan crss, n panl C, xcp for h sum of dosyncrac rsduals, whr h ncras durng h Asan crss s much largr. Th U.S. unxpcd rurns n panl D yld an ncras n corrlaons for Asa of h sam ordr of magnud as obsrvd for all of panl C, vn for h sum of dosyncrac rsduals. On nrpraon of hs rsul s ha our modl fals o capur fully asymmrc volaly (hghr volaly n bar marks) and h ponal ffcs has on corrlaons durng crss prods. 8 If hs s h cas, wha w call conagon hr for Asa may no longr b consdrd conagon vs-à-vs a rchr modl. 5. Conclons Conagon s a lvl of corrlaon ovr and abov wha s xpcd. Consdrabl rsarch has nvsgad whhr h crss n boh Mxco and Asa n h 1990s rsuld n conagon. Our rsarch drcly addrsss h ssu of wha s xpcd. W prsn a wo-facor ass prcng modl and dfn conagon as corrlaon among h modl rsduals. I s mporan hr o opra whn h framwork of a modl. Indd, ncrasd rurn corrlaon bwn wo counrs durng a prod of crss could smply b h consqunc of hr xposurs o a common facor. Tha s, s ncssary o undo h naural changs n corrlaon ha rsul from an ass prcng modl, bfor makng samns abou conagon. Our framwork allows for m-varyng xpcd rurns as wll as m-varyng rsk loadngs for h counrs w xamn. Our rsuls suggs ha hr s no vdnc of addonal conagon cad by h Mxcan crss. Howvr, w fnd conomcally manngful ncrass n rsdual corrlaon, spcally n Asa, durng h Asan crss. Dungy and Marn (001), ng a dffrn mhodology, fnd smlar rsuls for Asa and xplor h rol of currncy rsk n quy mark conagon. On ful xnson of our mhodology could b o nvsga conagon n currncy marks and o lnk quy o currncy conagon. In fac, our framwork s vry dffrn from h ypcal mprcal sragy d n h nrnaonal conomcs lraur, whr crss ndcaors n on counry (.g. h probably of a spculav aack or h magnud of a crss 8 Ang and Bkar (00) rpor ha GARCH modls (alhough smplr han h ons w sudy hr) do no capur asymmrc corrlaons vry wll and propos a m swchng modl. 0

23 ndcaor) ar drcly lnkd o ndcaors n ohr counrs (s D Garo and Valds (001) and Echngrn, Ros and Wyplosz (1997)). As Rgobon (1999) also srsss, hs approach s problmac n h prsnc of common unobsrvabl shocks and ncrasd varancs durng crss prods. Our ass prcng approach, whch drcly modls h shock and corrlaon srucur, and s crss and non-crss prods for dnfcaon, dos no suffr from hs problms. Of cours, s possbl ha our modl of corrlaons s ncorrc and ha conagon could smply b a rsul of modl msspcfcaon. Nvrhlss, w blv ha s mor dsrabl o fram samns abou xcss corrlaon n h conx of an ass-prcng modl. Appndx: Informaon varabl spcfcaon In smang h m-varyng ba modl n (1)-(5), w nroduc svral ss of nformaon varabls n h mprcal modl. Ths appndx provds a dald dscson of hs nformaon varabls. Sag 1: U.S. Modl Th U.S. nsrumn s, Z, 1, ncluds: a consan, h laggd world mark dvdnd yld, h laggd sprad bwn h 90-day Eurodollar ra and h 3-monh Trasury-bll yld; h dffrnc bwn h US 10-yar Trasury bond yld and h 3-monh Trasury-bll yld, and, fnally, h chang n h 90-day Trasury-bll yld. Sag : Rgonal Modl Th onal nsrumn s, Z, 1, ncluds: a consan and onal mark dvdnd yld. No ha for h MSCI Europ, h mark-capalzaon wghd dvdnd yld ncluds h larg, dvlopd marks, such as Franc, Grmany, Ialy, h Nhrlands, Swzrland, and h U.K. Th Asan or Lan Amrcan mrgng mark ndcs ar mark-capalzaon wghd ovr all h marks n Asa or Lan Amrca xcp for h on undr xamnaon. 1

24 Th rad daa s, X 1,, from h World Bank CD-ROM, ncluds: a consan and h adjd rad wh U.S. (.., sum of xpors o and mpors from h US dvdd by h sum of oal xpors and mpors) laggd 6 monhs. For h MSCI Europ, w agga ovr Franc, Grmany, Ialy, h Nhrlands, Swzrland, and U.K. For our Asan or Lan Amrcan mrgng mark ndcs, w agga ovr all h marks n Asa or Lan Amrca xcp for h on undr xamnaon. Sag 3: Indvdual counry modls Th ndvdual counry nsrumn s, Z 1, ncluds a consan and h local dvdnd yld (Sourc: IFC). Th rad daa s wh h U.S., X 1 ncluds a consan as wll as adjd rad wh U.S. (.., sum of xpors o and mpors from h US dvdd by h sum of oal xpors and mpors) laggd 6 monhs. No, for Blgum, hr ar many mssng valus n s rad wh h U.S. ; hrfor, w rplac h daa for Blgum wh h avrag of Franc, Grmany, and h Nhrlands. Th rad daa s wh h on, X 1, ncluds a consan and h sum of xpors o and mpors from h rs of h world xcp o and from h U.S., dvdd by h sum of oal xpors and mpors, laggd 6 monhs. Th rad wh h rs of h world daa s, X w 1, ncluds a consan and oal rad by GDP, laggd 6 monhs.

25 Rfrncs Ang, Andrw and Gr Bkar, 00, Inrnaonal Ass Allocaon undr Rgm Swchng, Rvw of Fnancal Suds, 15, Ang, Andrw and Josph Chn, 00, Asymmrc Corrlaons of Equy Porfolos, Journal of Fnancal Economcs 63, Ba, K-Hong, G. Andrw Karoly and Rn M. Sulz, 001, A Nw Approach o Masurng Fnancal Conagon, Rvw of Fnancal Suds, forhcomng. Bkar, Gr and Campbll R. Harvy, 1995, Tm-Varyng World Mark Ingraon, Journal of Fnanc, 50, Bkar, Gr and Campbll R. Harvy, 1997, Emrgng Equy Mark Volaly, Journal of Fnancal Economcs, 43, Bkar, Gr and Campbll R. Harvy, 000, Forgn Spculaors and Emrgng Equy Marks, Journal of Fnanc, 55, Bkar, Gr and Robr J. Hodrck, 199, Characrzng Prdcabl Componns n Excss Rurns on Equy and Forgn Exchang Marks, Journal of Fnanc 47, Bkar, Gr and Guojun Wu, 000, Asymmrc Volaly and Rsk n Equy Marks, Rvw of Fnancal Suds, 13, 1-4. Boyr, M. S., B. H. Gbson, and M. Loran, 1999, Pfalls n Tss for Changs n Corrlaons, Inrnaonal Fnanc Dscson Papr, 597, Board of Govrnors of h Fdral Rsrv Sysm, Washngon, DC. Chan, K.C., G. Andrw Karoly and Rn M. Sulz, 199, Global Fnancal Marks and h Rsk Prmum on U.S. Equy, Journal of Fnancal Economcs, Chn, Na-fu and Fng Zhang, 1997, Corrlaons, Trads and Sock Rurns of h Pacfc Rm Marks, Pacfc Basn Fnanc Journal, 5, 1997, Chung, Yn-Wong, Ja H and Llan Ng, 1997, Wha Ar h Global Sourcs of Raonal Varaon n Inrnaonal Equy Rurns? Journal of Inrnaonal Mony and Fnanc, 16, Connolly, Robr A. and F. Albr Wang, 00, Inrnaonal Equy Mark Comovmns: Economc Fundamnal or Conagon, Pacfc Basn Fnanc Journal, forhcomng. D Goro, José and Rodrgo G. Valdés, 001, Crss Transmsson: Evdnc from h Db, Tqula, and Asan Flu Crss, World Bank Economc Rvw 15, D Sans, Gorgo and Bruno Grard, 1997, Inrnaonal Ass Prcng and Porfolo Dvrsfcaon wh Tm- Varyng Rsk, Journal of Fnanc, 5, Dumas, Brnard and Bruno Solnk, 1995, Th World Prc of Forgn Exchang Rsk, Journal of Fnanc, 50, Dungy, Mard and Vanc L. Marn, 001, Conagon Across Fnancal Marks: An Emprcal Assssmn, Unpublshd workng papr, Aralan Naonal Unvrsy. Echngrn, B., A. K. Ros, and C. Wyplosz, 1996, Conago Currncy Crss, NBER workng papr

26 Engl, Robr. F. and Raul Sml, 1993, Common Volaly n Inrnaonal Equy Marks, Journal of Bnss & Economc Sascs, 11,. Erb, Claud, Campbll R. Harvy and Tadas Vskana, 1994, Forcasng Inrnaonal Equy Corrlaons, Fnancal Analyss Journal, Novmbr/Dcmbr, Frson, Wayn E. and Campbll R. Harvy, 1993, Th Rsk and Prdcably of Inrnaonal Equy Rurns, Rvw of Fnancal Suds, 6, Forbs, Krsn and Robro Rgobon, 001, Conagon n Lan Amrca: Dfnons, Masurmn, and Polcy Implcaons, Economa, 1, Forbs, Krsn and Robro Rgobon, 001, No Conagon, Only Inrdpndnc: Masurng Sock Mark Comovmns, Journal of Fnanc, forhcomng. Glosn, Lawrnc R., Rav Jagannahan, and Davd Runkl, 1993, On h Rlaon Bwn h Expcd Valu and h Volaly of h Nomnal Excss Rurn on Socks, Journal of Fnanc, 48, 5, Hamao, Yash Ronald W. Masuls and Vcor Ng, 1990, Corrlaons n Prc Changs and Volaly Across Inrnaonal Sock Marks, Rvw of Fnancal Suds 3, Harmann, P., Sramans, S., d Vrs, C. G., 001. Ass mark lnkags n crss prods. Workng papr, Europan Cnral Bank. Karoly G. Andrw, 1995, A Mulvara GARCH Modl of Inrnaonal Transmssons of Sock Rurns and Volaly: Th Cas of h Und Sas and Canada, Journal of Bnss and Economc Sascs 13, Karoly G. Andrw and Rné M. Sulz, 1996, Why do Marks Mov Toghr? An Invsgaon of US-Japan Sock Rurn Comovmns, Journal of Fnanc, 51, Kng, M., Wadhwan S., Transmsson of volaly bwn sock marks. Rvw of Fnancal Suds 3, Kng, M., Snana, E., Wadhwan S., Volaly and lnks bwn naonal sock marks. Economrca, 6: Longn, Francos and Bruno Solnk, 1995, Is Corrlaon n Inrnaonal Equy Rurns Consan: , Journal of Inrnaonal Mony and Fnanc, 14, 3-6. Longn, Francos and Bruno Solnk, 001, Exrm Corrlaon of Inrnaonal Equy Marks, Journal of Fnanc, 56, Loran, M. and Englsh, W. B., 000. Evaluang corrlaon brakdowns" durng prods of mark volaly. Fdral Rsrv Board, Mmo. Ng, Angla, 000, Volaly Spllovr Effcs from Japan and h U.S. o h Pacfc-Basn, Journal of Inrnaonal Mony and Fnanc, 19, Pagan, A. R. and G. W. Schwr, 1990, Alrnav Modls for Condonal Sock Volaly, Journal of Economrcs, 45, Pndyck, R. S., Rombrg, J. J., 1990, Th xcss co-movmn of commody prcs. Economc Journal 100, Pndyck, R. S., Rombrg, J. J., Th comovmn of sock prcs. Quarrly Journal of Economcs 108,

27 Rgobon, Robro, 1999, On h Masurmn of h Inrnaonal Propagaon of Shocks, Unpublshd workng papr, Naonal Burau of Economc Rsarch, Rgobon, Robro, 001, Conagon: How o Masur I? n Sbasan Edwards and Jffry Frankl Ed., Currncy Crss Prvnon, Naonal Burau of Economc Rsarch, forhcomng. Sambaugh, Robr, 1995, Unpublshd dscson of Karoly and Sulz (1996), Naonal Burau of Economc Rsarch Unvrss Confrnc on Rsk Managmn, May. Tang, J.W., 001, Conagon: An Emprcal Ts, Unpublshd workng papr, Duk Unvrsy. Zakoan, J., 1994, Thrshold Hroskdasc Modls, Journal of Economc Dynamcs and Conrol, 18,

28 Tabl 1: Th U.S. and Rgonal Mark Rurn Modl Th followng modl s smad: ' R = δ Z + ˆ µ + ˆ 1 I = p 1 1 ' 1, X 1 1 ~ N(0, σ ), 1 1, + σ = a + bσ r 1 + c 1 + d η 1 η 1 = mn{0, } whr ˆ µ, 1 and ˆ, ar h condonal xpcd xcss rurn and rsdual of h U.S. mark. For h U.S. mark (.., = ), p 1, = 0, and Z,-1 rprsns a s of U.S. or world nformaon varabls, whch ncluds a consan, h world mark dvdnd yld, h sprad bwn h 90-day Eurodollar ra and h 3-monh Trasury-bll yld, h dffrnc bwn h U.S. 10-yar Trasury bond yld and h 3-monh Trasury-bll yld, and h chang n h 90-day Trasury-bll yld. All hs U.S. nformaon varabls ar laggd by on monh. For h onal mark (.., = ), Z,-1 rprsns a s of onal nformaon varabls, whch ncluds a consan and h onal mark dvdnd yld wghd by h mark capalzaon, and X a consan, and h sum of h on s oal xpors o and mpors from h U.S. dvdd by h sum of oal, 1 xpors and mpors of h on. Th dvdnd yld s laggd by on monh and h rad varabl s laggd by sx monhs. All monhly rurns ar calculad n xcss of h U.S. on-monh Trasury-bll ra and n U.S. dollars. Th sampl covrs h prod from January 1980 o Dcmbr 1998 for h U.S. and Europ, whl h daa for Asa and Lan Amrca sar from January Rurn daa for h U.S. and Europ ar from Morgan Sanly Capal Inrnaonal (MSCI), whras Asa and Lan Amrca daa ar from h Inrnaonal Fnanc Corporaon (IFC). Th Asa or Lan Amrca mrgng mark ndx s a valu-wghd avrag of all h Asan or Lan Amrcan mrgng marks n h sampl. To s for modl spcfcaon, h man s s basd on h frs four auocovarancs of h scald rsduals (17b); h varanc s s basd on h frs four auocovarancs of h squard scald rsduals (17d); h momn s s basd on four momns (17a,c,,f); and h jon s s basd on all h rsrcons n (17). Thr hypohss ar sd. Wald I s a s of h sgnfcanc of h onal nformaon n h man,.., δ = 0; Wald II s a s of h sgnfcanc of h rad varabl n ; and Wald III s a s of h 1 sgnfcanc of h onal varabls on,.., p 1 1, = 0. Sampl mans and sandard dvaons of h mpld ˆ, h condonal corrlaon bwn h U.S. and onal, 1 mark ( ˆρ ), and h varanc rao of condonal varanc of h onal porfolo accound for by h U.S. facors ( ˆ ) ar rpord. P-valus ar gvn n bracks.,, Modl Spcfcaon ss Wald ss (p-valu) Impld sascs Mark (Asy/Sym) Man Momn Varanc Jon I II III Man Sd. dv. Man Sd. dv. Man Sd. dv. U.S. Asy [0.817] Europ Sym [0.148] Asa Sym [0.464] Lan Amrca Sym.935 [0.569] 4.96 [0.91] [0.319] 11.1 [0.05] 3.07 [0.553] [0.308].738 [0.603] [0.788].134 [0.711] 0.90 [0.05] [0.193] 0.15 [0.064] [0.336] <0.001 ˆ, 1 V R ˆρ, < < < VR, 6

29 Tabl : Impld Sascs of h Counry-Spcfc Modl Th followng modl s smad for h counry porfolos: ' R = δ Z + ˆ µ + ˆ µ + ˆ + ˆ η σ I, 1 1 = a 1 ~ N + b σ = mn ( 0, σ ) 1 { 0, }, 1 1, 1 + c d η 1, 1 1, 1, + whr s h dosyncrac shock of mark ˆ µ and, 1 ˆ, ( ˆ µ and, 1 ˆ, ) ar h condonal xpcd xcss rurn and rsdual on h U.S. (onal) mark.z -1 rprsns a s of local nformaon varabls. Th on mark s rprsnd by h MSCI Europ ndx, and h Asa and Lan Amrca mrgng mark ndcs, a valuwghd avrag of all h Asan (Lan Amrcan) mrgng marks, xcludng h counry undr consdraon. Sampl avrag of sandard dvaon of h mpld ba paramrs ( ˆ and ˆ ), corrlaons wh h U.S. and onal marks ( ˆρ and,, accound for by h U.S. and on ( VR, and VR, ) ar rpord. Sandard dvaons ar gvn n parnhss. ˆρ,, ), and varanc raos Mark Europan Counrs ˆ ˆ ˆρ,, Ara (0.155) (0.4) (0.11) (0.105) (0.055) (0.15) Blgum (0.081) (0.103) (0.16) (0.119) (0.119) (0.1) Dnmark (0.15) (0.154) (0.19) (0.093) (0.11) (0.106) Fnland (0.97) (0.77) (0.150) (0.136) (0.143) (0.084) Grc (0.31) (0.100) (0.117) (0.061) (0.040) (0.006) Norway (0.77) (0.071) (0.166) (0.093) (0.146) (0.05) Porugal (0.49) (0.9) (0.150) (0.179) (0.16) (0.156) Span (0.64) (0.177) (0.184) (0.168) (0.151) (0.100) Swdn (0.143) (0.057) (0.137) (0.093) (0.136) (0.067) Turky (1.73) (0.511) (0.93) (0.168) (0.119) (0.034) Asan Counrs (wh h Asa mrgng mark ndx bng h onal mark) Indonsa (0.615) (0.964) (0.194) (0.46) (0.140) (0.37) Kora (0.049) (0.047) (0.053) (0.108) (0.01) (0.064) Malaysa (0.333) (0.69) (0.04) (0.47) (0.18) (0.118) Phlppns (0.398) (0.464) (0.15) (0.314) (0.116) (0.184) ˆρ,, VR, VR, 7

30 Tabl (connud) Mark ˆ ˆ ˆρ,, Tawan (0.696) (0.78) (0.4) (0.110) (0.080) (0.098) Thaland (0.365) (0.343) (0.01) (0.176) (0.16) (0.146) Asan Counrs (wh MSCI Pacfc bng h onal mark) Indonsa (0.96) (0.76) (0.148) (0.147) (0.063) (0.050) Kora (0.175) (0.1) (0.111) (0.160) (0.08) (0.101) Malaysa (0.508) (0.160) (0.53) (0.193) (0.11) (0.04) Phlppns (0.381) (0.536) (0.190) (0.5) (0.151) (0.151) Tawan (0.419) (0.183) (0.180) (0.17) (0.068) (0.064) Thaland (0.41) (0.45) (0.181) (0.1) (0.138) (0.089) Lan Amrcan Counrs Argnna (0.03) (0.33) (0.178) (0.09) (0.135) (0.137) Brazl (0.57) (0.174) (0.16) (0.186) (0.17) (0.113) Chl (0.093) (0.139) (0.104) (0.06) (0.091) (0.10) Colomba (0.075) (0.069) (0.074) (0.109) (0.033) (0.014) Mxco (0.03) (0.4) (0.134) (0.197) (0.114) (0.050) Vnzula (0.445) (0.131) (0.170) (0.16) (0.084) (0.013) ˆρ,, VR, VR, 8