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No Contagion, Only Interdependence: Measuring Stock Market Co-movements

No Contagion, Only Interdependence: Measuring Stock Market Co-movements

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No Contagion, Only Interdependence:Measuring Stock Market Co-movements
1Kristin ForbesM.I.T.-Sloan School of ManagementRoberto RigobonM.I.T.-Sloan School of Management and NBERFirst Version: April 1998This Version: February 2000
Thanks to Rudiger Dornbusch, Andrew Rose, Jaume Ventura, and seminar participants at M.I.T.,Dartmouth, and N.Y.U. for helpful comments and suggestions. All remaining errors are ours.
Com-ments are welcomed to either author:
Kristin Forbes at 50 Memorial Drive, Room E52-446, Cambridge,MA 02142; email:
home page
http:/ / web.mit.edu/ kjforbes/ www/ 
and Roberto Rigobonat 50 Memorial Drive, Room E52-447, Cambridge, MA 02142; email:
home page:
http:/ / web.mit.edu/ rigobon/ www/ 
This paper tests for stock market contagion during recent
nancial crises. It de
nes contagion asa signi
cant increase in market co-movement after a shock to one country (or group of countries).Previous work based on the correlation coe
cient has found strong evidence of this type of contagionduring recent
nancial crises. We show, however, that these tests are biased because the unadjustedcross-market correlation coe
cient is conditional on market volatility. It is possible to correct forthis bias, and when we make this adjustment, there is virtually no evidence of contagion duringthe 1997 East Asian crisis, the 1994 Mexican peso collapse, and the 1987 U.S. stock market crash.There is still a high level of market co-movement during these crisis periods, however, which re
ectsa continuation of strong cross-market linkages which exist in all states of the world. In other words,during these three crises, there was no contagion, only interdependence.
JEL Classi
F30, F40, G15
Contagion, Stock Market, InterdependenceKristin Forbes Roberto RigobonSloan School of Management, MIT Sloan School of Management, MIT50 Memorial Drive, E52-446 50 Memorial Drive, E52-447Cambridge, MA 02142-1347 Cambridge, MA 02142-1347and NBERkjforbes@mit.edu rigobon@mit.edu
1 Introduction
In October of 1997, the Hong Kong market plummeted and then partially rebounded. As shown inFigure 1, these dramatic movements were mirrored in markets in North America, South America,Europe, and the rest of Asia. In December of 1994, the Mexican market cratered, and as shown inFigure 2, this plunge was quickly re
ected in other major Latin American markets. Figure 3 showsthat in October of 1987 the crash of the US market quickly a
ected major stock markets aroundthe globe. These cases show that dramatic movements in one stock market can have a powerfulimpact on markets of very di
erent sizes and structures throughout the world. Does this high rateof stock market co-movement during periods of market turmoil constitute contagion?Before answering this question, it is necessary to de
ne contagion. There is widespread disagree-ment about what this term entails, and this paper will utilize the narrow de
nition of contagionwhich has historically been used in this literature. This paper de
nes contagion as a signi
cant in-crease in cross-market linkages after a shock to one country (or group of countries.)
Cross-marketlinkages can be measured by a number of di
erent statistics, such as the correlation in asset returns,the probability of a speculative attack, or the transmission of shocks or volatility. According to thisde
nition, if two markets show a moderate degree of co-movement during periods of stability, suchas Germany and Italy, and then a shock to one market leads to a signi
cant increase in marketco-movement, this would constitute contagion. On the other hand, if two markets show a highdegree of co-movement during periods of stability, even if they continue to be highly correlatedafter a shock to one market, this may not constitute contagion. It is only contagion if cross-marketco-movement increases signi
cantly after the shock. If the co-movement does not increase signif-icantly, then any continued high level of market co-movement suggests strong linkages betweenthe two economies which exist in all states of the world. This is what we call interdependence.Based on this approach, contagion implies that cross-market linkages are fundamentally di
erentafter a shock to one market, while interdependence implies no signi
cant change in cross-marketrelationships during a crisis.
In a closely related paper, Forbes and Rigobon (1999) propose using the term “shift-contagion” instead of “con-tagion” in order to clarify exactly what this term entails. The term shift-contagion is sensible because it not onlyclari
es that contagion arises from a shift in cross-market linkages, but it also avoids taking a stance on how thisshift ocurred.
It is important to note that this de
nition of contagion is not universally accepted. Some economists argue that

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