LONGIN François and SOLNIK Bruno
Abstract: Correlation in international equity returns is unstable over time. It has been suggested that the international correlation of large stock returns, especially negative ones, differs from that of usual returns. It is in periods of extreme negative returns that the benefits of international risk diversification are most desired and that the question of international correlation is most relevant to risk-averse agents. If return distributions are not multivariate normal, the usual standard deviation and correlation of returns do not provide sufficient information. Additional information can be gained by focusing directly on the properties of extreme returns. While the interest in stock market crashes and booms is large, no study has specifically focused on the correlation between large price movements. A major econometric issue is to specify the multivariate distribution of extreme returns implied by a given distribution of returns. In this paper, we work directly on large returns and study the dependence structure of international equity markets during extremely volatile periods. We use the results of extreme value theory to model the multivariate distribution of large returns, using monthly data from January 1959 to December 1996 for the five largest stock markets. We find that the correlation of large positive returns are not inconsistent with the assumption of multivariate normality. However, the correlation of large negative returns is much greater than expected, suggesting that the benefits of international risk reduction in extremely volatile periods have been overstated.
20 pages, April 22, 1998
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