What is Co-movement?

Dirk Baur∗
European Commission, Joint Research Center, Ispra (VA), Italy
IPSC - Technological and Economic Risk Management

This version: July 2003

Abstract

The co-movement of financial markets is a primary topic of empirical investigation.

However, the precise meaning and an associated measure of co-movement is not exist-
ing in the economic literature. This paper argues that the term co-movement is used in-
flationary and that the correlation coefficient is not a natural measure of co-movement.
Therefore, a definition for co-movement and an associated measure is introduced. The
measure provides estimates for bivariate and multivariate time series for every time
t. A simulation study describes the properties of the co-movement coefficient and an
empirical analysis of monthly stock market index returns shows that the co-movement
has increased in recent years. We also find different co-movement in crisis periods and
increasing extreme co-movement for markets within the European Monetary Union.
The multinomial logit model used to estimate the co-movement can be viewed as an
alternative to Multivariate GARCH models.
JEL classification: C14, F36, G15
KEYWORDS: copula, co-movement, Multinomial Logit, Multivariate GARCH, tail
dependence

∗
Email: dirk.baur@jrc.it

1
 Dependence among random variables is a nasty business and we usually ignore the nas-

tiness (at our peril) by employing measures of linear association like the Pearson correlation

coefficient.

Roger Koenker (2002)

1 Introduction

The analysis of common stock market movements is important for effective portfolio di-

versification and a possible starting point to investigate the functioning of the global fi-

nancial system. This is particularly important when assessing financial crises and their

contagious effects. The study of common market movements is, however, also interest-

ing in two additional respects. First, there is no clear and unambiguous definition of

’co-movement’ and no unique measure associated with it. Even the spelling is oscillating

between ’co-movement’ and ’comovement’. Second, co-movement is difficult to analyze in a

time-varying context if it is based on the correlation coefficient. For example, Multivariate

GARCH models do provide estimates for time-varying correlations but are often based on

severe restrictions to guarantee a well-defined covariance matrix (e.g. see Kroner and Ng,

1998).

There seems to be a countless number of papers that contain the word ’co-movement’ in

the title (e.g. see Connolly and Wang, 2001, Forbes and Rigobon, 2002, Karolyi and Stulz,

1996, Kroner and Ng, 1998 and Malevergne and Sornette, 2002). However, there is only

one explicit definition of co-movement (see Barberis et al., 2002) where co-movement is

defined as a pattern of positive correlation. Unfortunately, (positive) correlation is a vague

term and can describe many types of relationships. Even if we assume that this definition

is based on the Pearson correlation coefficient (see Pearson, 1901), the definition remains

imprecise and co-movement would only be defined for a particular class of relationships,

2
i.e. linear co-movements.1

We will argue that the correlation coefficient does not adequately measure co-movement.

Furthermore, the correlation coefficient exhibits various inaccuracies that make a defini-

tion and a new measure necessary.

The non-existence of a unique definition of co-movement is also in sharp contrast to

the mathematical formalities that are commonly used in modelling economic and financial

relationships.

This paper proposes a definition of co-movement and an associated measure that pre-

cisely reflects the meaning of co-movement and also reveals the direction and the volatility

of co-movement.

Recently, new non-parametric measures have been developed to describe common (joint)

market movements without recurring to the correlation coefficient. However, these contri-

butions do also not define co-movement. Harding and Pagan (1999) introduce a measure

of ’concordance’ to analyze co-movements. Solnik and Roulet (2000) develop a dispersion

measure to assess market co-movement and Bae et al. (2003) introduce ’co-exceedances’

to capture extreme simultaneous market movements. The co-movement measure used in

this paper can be viewed as a generalization of the concept of Bae et al. (2003) and is

introduced by Baur and Schulze (2003).2

The remainder of this paper is as follows: section 2 introduces the definition and as-

sociated measure of co-movement. Section 3 contains a simulation study that shows the

behavior of the measure. Section 4 is an empirical analysis of co-movement for pairs of

countries and also for multivariate return series and section 5 summarizes the main re-

sults and concludes.

1
A more thorough discussion of this is provided by Embrechts et al. (1999).
2
Both papers focus on contagion with a different data frequency and time-horizon.

3
2 Co-movement

The only explicit though not sufficient definition of co-movement (comovement) can be

found in Barberis et al. (2002): Comovement can be defined as a pattern of positive correla-

tion. This definition is based on the correlation coefficient and does not explicitly describe

the meaning of co-movement. In other words, co-movement is defined with the correlation

coefficient but there is no definition of the term itself.

It is also important to note that ’co-movement’ is a special technical term and can not be

found in a common dictionary (e.g. see Webster’s New World College Dictionary, 1999). It

could be originating from the verb commove which means to move violently or intensely

and the associated noun commotion. There are a several papers that use terms like ’excess

co-movement’ (e.g. Forbes and Rigobon, 2002) and ’extreme co-movements’ (e.g. Malev-

ergne and Sornette, 2002) to describe a phenomenon that could also be called ’commotion’.

However, we believe that co-movement is a construction that is based on the prefix con

which means ’with’. This is consistent with the origin of ’correlation’ which is equivalent to

’con-relation’ and means that there is a reciprocal relationship.3 The word ’correlation’ is

the result of a so-called assimilation.4 Co-movement could also be an adaptation of terms

like ’co-integration’ and will be consistent with our definition of ’co-movement’.

Thus, the definition that shall be introduced here is based on the notion that ’co-movement’

is equal to ’con-movement’ which describes a phenomenon of an asset (price) ’moving with’

another asset (price). We interpret this ’moving with’ as movement which is shared by all

assets or movement that all assets have in common. This is similar to ’co-integration’ that

is equal to ’common (degree) of integration’. Another example is ’co-operation’ which is an

act of operating together or a joint operation. Hence the definition of co-movement can be

formulated as follows:

3
In classic roman, the preposition ’con’ was also shortened into ’co’.
4
e.g. see http://lilt.ilstu.edu/drjclassics/Latin/explanations/assimilation.shtm

4
Definition 1:

Co-movement is the movement of assets that is shared by all assets at time t.

Since the movement (change) of an asset is the return of an asset, co-movement can

also be defined as the return that is shared by all returns at time t.

The associated measure that precisely reproduces this definition of co-movement is given

by

Φt = max(r1t , r2t , ..., rN t )I − + min(r1t , r2t , ..., rN t )I + (1)

where rit is a return of market i at time t and I − (I + ) is an indicator variable that is equal

to one if all returns are negative (positive) and zero otherwise.5

The following examples aim to clarify this measure of co-movement: a return pair (-1,-1)

leads to co-movement Φt = −1 of the underlying assets (prices) since both returns have the

same value. A return pair (-2,-3) leads to co-movement Φt = −2 of the underlying assets

since the maximum of both shocks is −2. Two positive shocks (2,3) lead to co-movement

Φt = 2 since the minimum of these shocks is 2. Return pairs with different signs as e.g.

(3,-1) lead to co-movement Φt = 0 since there is no common movement in one direction. Co-

movement can also be assessed for more than two return series. For example, the returns

of four markets at time t (-2,-1,-3,-1) exhibit a co-movement of −1 and the return vector

(+2,+1,+3,+1) exhibits a co-movement of +1. Consequently, there exists no co-movement

for the return vector (+2,+1,+3,-2) since the returns do not all have the same sign.

Since the co-movement measure introduced above is not based on standardized values

of returns, the relative movement that is shared by all assets can not be assessed directly.

For example, given that the co-movement of two assets is −1 at time t, it is not clear

whether this is a relatively large movement or rather negligible since the means and the

variances of the underlying returns are hidden by the measure.

5
Φt could also be written as follows: Φt (r1t , ..., rN t ) = min(max(r1t , ..., rN t ), 0) + max(min(r1t , ..., rN t ), 0)

5
 This shortcoming can be eliminated by standardizing the underlying returns to have

mean zero and variances equal to one. Then the co-movement is a measure of the common

relative movement of assets. Hence, the definition is given as follows:

Definition 2:

Relative Co-movement is the relative movement of assets that is shared by all assets at time

t.

In other words, relative co-movement is the relative (standardized) return that is shared

by all (standardized) returns.

Since the relative measure of co-movement makes comparisons of the co-movement

among different sets (or portfolios) of returns more straightforward, we focus on this mea-

sure subsequently. The relative measure of co-movement can also be viewed as an appli-

cation of the continuous version of coexceedance introduced by Baur and Schulze (2003).6

One crucial difference why the correlation coefficient does not qualify to be an adequate

measure of co-movement can be outlined by the following example. The correlation coeffi-

cient can be written as the product of the standardized residuals (see Engle, 2002):

Et−1 (²1,t ²2,t )

ρ12,t = q = Et−1 (z1,t z2,t ) (2)
Et−1 (²21,t )Et−1 (²22,t )

where ²i,t is the shock to market i at time t and zi,t is the associated standardized shock.

Assumed that two standardized shocks at t are 0.3 and 0.5, then ρ12,t would exhibit a

value of 0.15. Assumed that both standardized shocks would double, then the correlation

coefficient would yield a value of 0.6 which is four times larger. More severe and more in-

consistent with the notion of co-movement is the event where only one standardized shock

doubles. In this case, the correlation coefficient would double although the co-movement

cannot be assumed to have increased since the common movement is more unequal com-

pared to the initial shocks. This example explains the finding that the correlation coef-
6
The term ’Coexceedances’ is introduced by Bae et al. (2003).

6
ficient is biased by heteroscedasticity reported by Boyer et al. (1999) and Loretan and

English (2000).

Apart from this difference regarding the relation of the measure with the notion of

co-movement, there are additional advantages of the co-movement measure introduced

in this paper: the measure (i) is easy to interpret, (ii) shows the direction (positive and

negative) of co-movements, (iii) can reveal time-varying co-movement for bivariate and

multivariate series and (iv) can detect linear and non-linear co-movement.

The main strength is the possibility to analyze the co-movement for many stock mar-

kets simultaneously without the need to impose any restrictions as this is necessary in

Multivariate GARCH models. Although the co-movement measure is not normalized to be

between −1 and +1 as the correlation coefficient, it is easy to interpret this value and to

compare degrees and evolutions of co-movement among different portfolios of assets.

The next section aims to clarify the advantages and presents a simulation study that

also reveals the relation between the correlation coefficient and the co-movement measure

proposed here. This analysis also shows under which circumstances co-movement can be

coincidental.7

3 Simulation Study

In this section we analyze the behavior of the co-movement for different types of market

association and volatility processes.

We first simulate bivariate normally distributed returns with mean zero and an un-

conditional variance of one consisting of T = 1000 observations, different correlation pro-

cesses and a constant volatility for both returns. The simulated correlation processes are

(i) ρt = 0, (ii) ρt = 0.95, (iii) ρt = −0.95, (iv) ρt = 0.95sin(t/150), (v) ρt = 0.95cos(t/150)

and (vi) ρt = −1 + 0.00099t. The time-varying behavior of the co-movement is depicted in

figure 1. The figure shows that the co-movement does not exhibit any clear time-variation
7
It additionally provides results for the behavior of ’co-exceedances’ introduced by Bae et al. (2003).

7
for the upper three correlation processes. It is clear, however, that the left upper graph

exhibits some co-movement, the middle upper graph strong co-movement and the right

upper graph low co-movement. This is intuitive given the simulated correlation processes

of ρ = 0, ρ = 0.95 and ρ = −0.95, respectively. The lower three graphs clarify the behavior

of the co-movement measure: the co-movement is high for high positive correlations and

lowest for large negative correlations.

Since the simulated processes are not autocorrelated, there is no persistence of positive

or negative co-movement.

Figure 2 presents results for the same correlation processes as in figure 1 but assumes

an increasing (deterministic) volatility for both returns (v1t = v2t = 0.001t where vit is the

volatility of market i at time t). The co-movement increases with increasing volatility and

the time-varying behavior is less pronounced. Note that this effect is less pronounced if

both markets exhibit different volatility processes.

It is important to stress that increased volatility can increase the (extreme) values of

co-movement. However, in contrast to the correlation coefficient (see Boyer et al., 1999 and

Loretan et al., 2000), it cannot be argued that the co-movement measure Φ is biased. High

volatility is characterized by larger absolute returns and this can also affect the values of

the co-movement but does not affect the percentage of occurrences of co-movement.8

Since the extreme values of co-movement can increase with volatility this means that

different periods of market volatility or structural breaks can be identified with the co-

movement measure Φt as proposed in this paper.

We now assume that markets are influenced by a common factor ft that is normally

distributed with mean zero and variance one. In addition, N idiosyncratic shocks ²it are

assumed to be uncorrelated and also normally distributed with mean zero and variance

one. The N return series to be generated do depend on the common factor ft and the
8
The percentage of co-movement occurrences are analyzed below.

8
idiosyncratic shocks ²it as follows:

√ √
rit = aft + 1 − a²it (3)

where rit is the return of market i at time t and a is the constant factor loading. We assume

a = 1, a = 0.5 and a = 0. The plots that show the behavior of N = 5 markets are given by

figure 3. The upper graph is a plot for a = 1, the centered graph for a = 0.5 and the bottom

graph is a plot for a = 0.

It is shown that the co-movement decreases with decreasing factor loadings and with

increasing number of markets. Of course, the true co-movement structure could be charac-

terized by a mixture of these examples. In particular, the factor loading a could also vary

through time.9

We now analyze the frequency of co-movements for a given sample. We generate N

independent, standard normally distributed returns and tabulate the observed percentage

of co-movements in a sample of T observations. To compute this measure, it is only counted

whether there was co-movement (indicator variable equal to 1) or not (indicator variable

equal to 0), independent of the magnitude.

A simulation study with T = 1.000.000 observations is performed and results are given

by table 1. The percentage of co-movements that are tabulated can be viewed as a lower

bound of co-movement for N series. Of course, the upper bound is 1 if all series are equal.

The table shows that two (ten) independent return series exhibit a number of co-movements

equal to 50 (0.20) percent of the total number of observations of the sample.

9
The co-movement can be interpreted as a common factor for all underlying return series at time t for which
every return has a minimum factor loading of 1. Of course, the co-movement Φt could also be modified to yield
maximum factor loadings of 1.

9
 Table 1: Percentage of Co-movement for N independent series

N percentage of co-movement
2 0.5000
3 0.2500
4 0.1250
5 0.0625
6 0.0313
7 0.0156
8 0.0078
9 0.0039
10 0.0020

N number of markets
Simulation results based on T = 106 observations

4 Empirical Analysis

4.1 The data

We use monthly continuously compounded stock index returns of eleven developed stock

markets10 : Australia (AUS), France (FRA), Germany (GER), Hong Kong (HK), Italy (ITA),

Japan (JAP), Singapore (SIN), Spain (SPA), Sweden (SWE), the United Kingdom (UK) and

the United States (US).11

The indices span a time-period of approximately 30 years from December 1969 until

May 2002. The number of observations is T = 389.

The monthly returns for all eleven stock markets are plotted in figure 4. The figure

mainly shows the changing volatilities of the returns, especially around the oil crisis in

1973, the stock market crash in October 1987 and the Asian crisis 1997.

In order to get further information of the returns, descriptive statistics are presented

in table 2. While most of the markets exhibit typical return characteristics, there are

some exceptions: the monthly return of Australia is highly skewed and leptokurtic, the

Hong Kong returns have the largest span between the minimum and maximum return

(−0.5734 and 0.6295) and Japan is the only market that exhibits a return distribution that

is resembling a normal distribution (the probability of the Jarque-Bera test is 0.2444).

10
The data is provided by Morgan Stanley Capital International Inc. (MSCI) and can be retrieved under
www.mscidata.com.
11
The letters in parenthesis are used in the tables below.

10
 Table 2: Descriptive Statistics

Mean Std. Dev. Min Max Skewness Kurtosis Prob (Jarque Bera)

AUS 0.0032 0.0744 -0.5927 0.2211 -1.6125 14.3480 0.0000

FRA 0.0062 0.0657 -0.2716 0.2328 -0.3377 4.4879 0.0000
GER 0.0061 0.0597 -0.1962 0.1827 -0.4053 4.1084 0.0000
HK 0.0097 0.1102 -0.5734 0.6295 -0.5103 8.9954 0.0000
ITA 0.0030 0.0743 -0.2428 0.2686 0.0323 3.5749 0.0786
JAP 0.0077 0.0651 -0.2160 0.2166 0.0007 3.4346 0.2444
SIN 0.0072 0.0877 -0.5350 0.4242 -0.4170 8.4834 0.0000
SPA 0.0028 0.0652 -0.3260 0.2317 -0.4100 5.3996 0.0000
SWE 0.0083 0.0679 -0.2546 0.2055 -0.3580 3.8024 0.0001
UK 0.0057 0.0654 -0.2451 0.4413 0.4651 8.6400 0.0000
US 0.0059 0.0449 -0.2416 0.1596 -0.5621 5.5294 0.0000

The unconditional correlation coefficient is shown in table 3. The highest unconditional

correlations (above 0.5) can be found between Germany and France, Germany and Sweden,

UK and France, UK and US and Australia and the US. The lowest correlations (below 0.25)

can be observed for Italy and Hong Kong and Italy and Singapore.

Table 3: Unconditional Correlation Coefficient

AUS FRA GER HK ITA JAP SIN SPA SWE UK US

AUS 1.0000 0.3955 0.3346 0.4186 0.2560 0.3132 0.4708 0.3691 0.4103 0.4808 0.5012
FRA 1.0000 0.6436 0.2936 0.4708 0.3982 0.3185 0.4591 0.4401 0.5571 0.4704
GER 1.0000 0.3303 0.4286 0.3733 0.3279 0.4495 0.5281 0.4542 0.4267
HK 1.0000 0.2241 0.3161 0.5788 0.3010 0.3200 0.3966 0.3801
ITA 1.0000 0.3533 0.2149 0.4255 0.3868 0.3586 0.2678
JAP 1.0000 0.3618 0.3976 0.3880 0.3760 0.3060
SIN 1.0000 0.2653 0.3818 0.4802 0.4987
SPA 1.0000 0.4732 0.3843 0.3530
SWE 1.0000 0.4329 0.4669
UK 1.0000 0.5249
US 1.0000

4.2 Empirical Results

Since Germany is the biggest market in the European Union and an important financial

market in a global context, we analyze the bivariate co-movement of Germany with the re-

maining markets in the sample of eleven countries. This analysis has exemplary character.

An analysis of all pairs of countries is not performed due to space considerations. In a sec-

ond step, we build ’portfolios’ with equal weights to analyze the multivariate co-movements

among financial markets. We analyze four ’big’ (industrial) countries (GER, JAP, UK, US),

11
European countries (GER, FRA, ITA, SPA, SWE, UK), ’Asian’ (Pacific) countries (AUS, HK,

JAP, SIN), the ’EURO’ countries (FRA, GER, ITA, SPA) and finally, all eleven countries.

We commence with a descriptive analysis of the relative co-movements and then ana-

lyze the evolution of this co-movement through time.

Table 4: Descriptive Statistics, Co-movement

Bivariate Co-movement of GER with ... Mean Std Min Max Skewness Kurtosis Percentage of Co-movement
AUS -0.0049 0.5043 -3.3732 1.8887 -1.5412 11.5270 0.5990
FRA -0.0153 0.7074 -3.2184 2.3466 -0.8831 6.3010 0.6992
ITA -0.0075 0.5057 -3.3732 1.8887 -1.1500 9.9659 0.6247
JAP -0.0061 0.5834 -2.1539 1.7702 -0.3928 5.1828 0.6170
HK -0.0088 0.5515 -2.8716 1.9441 -0.5955 7.0700 0.5861
SIN -0.0202 0.5401 -3.3732 1.9845 -1.6298 12.0113 0.5681
SPA -0.0009 0.6116 -3.3732 1.9420 -1.2222 9.5673 0.6555
SWE -0.0114 0.6311 -3.3897 2.3634 -1.0992 8.2573 0.6838
UK -0.0267 0.5761 -3.3732 1.9845 -0.8589 7.6962 0.6452
US -0.0271 0.6004 -3.3732 1.8887 -1.3780 9.1397 0.6272

Multivariate Co-movement Mean Std Min Max Skewness Kurtosis Percentage of Co-movement
4 markets -0.0165 0.3382 -2.4149 1.4996 -1.3323 13.5043 0.3162
European -0.0158 0.3088 -1.8203 1.1260 -1.5770 13.2890 0.2699
Asian -0.0260 0.3095 -1.6806 1.1541 -1.7898 11.7682 0.3290
EURO -0.0131 0.4192 -2.0728 1.4298 -1.3617 10.6356 0.3830
all -0.0140 0.1698 -1.3227 0.7519 -3.3574 30.6073 0.1183

Table 5: Descriptive Statistics, Multivariate Co-movement

4 markets (GER, JAP, UK, US) Mean Std Min Max Skewness Kurtosis Percentage of Φt
4 markets
t = 1 : 130 -0.0257 0.3576 -2.4149 1.1535 -2.3269 20.0141 0.2288
t = 131 : 260 0.0149 0.3422 -1.3227 1.4996 -0.4197 10.1489 0.3059
t = 261 : 389 -0.0390 0.3135 -1.2730 0.8225 -1.0865 6.4687 0.4139
European markets
t = 1 : 130 -0.0484 0.2577 -1.8203 0.4343 -4.0245 23.6842 0.1825
t = 131 : 260 -0.0059 0.3365 -1.8088 1.0353 -1.6455 13.3952 0.2442
t = 261 : 389 0.0071 0.3260 -1.2730 1.1260 -0.3643 7.3923 0.3830
Asian markets
t = 1 : 130 -0.0056 0.2949 -1.6806 0.6905 -2.2745 13.8554 0.3599
t = 131 : 260 -0.0182 0.2940 -1.3227 1.1541 -1.2520 11.0112 0.2519
t = 261 : 389 -0.0544 0.3382 -1.6292 1.0388 -1.7603 10.5395 0.3753
EURO markets
t = 1 : 130 -0.0503 0.3548 -1.8203 1.2582 -2.1838 13.4287 0.3059
t = 131 : 260 0.0043 0.4564 -2.0728 1.4298 -1.3202 10.5335 0.3599
t = 261 : 389 0.0068 0.4403 -1.9615 1.2028 -1.0371 8.6555 0.4833
t = 261 : 348? 0.0511 0.3978 -1.9615 1.1551 -0.8978 10.4859 0.4545
t = 349 : 389? -0.0883 0.5123 -1.8991 1.2028 -0.9791 6.2739 0.5366
All markets
t = 1 : 130 -0.0181 0.1410 -1.2738 0.2355 -6.3947 52.9501 0.1054
t = 131 : 260 -0.0061 0.1879 -1.3227 0.7519 -2.4546 27.5335 0.0900
t = 261 : 389 -0.0179 0.1779 -1.1592 0.6641 -2.7842 21.7050 0.1594

? T = 349 is the month of the introduction of the EURO currency (January 1999).

Table 4 shows various statistics for the bivariate co-movement between Germany and

12
all remaining ten markets as an exemplary selection and for multivariate co-movement for

four countries (GER, JAP, UK and US), European countries (GER, FRA, ITA, SPA, SWE,

UK), Asian countries (AUS, HK, JAP, SIN), the ’EURO’ countries and all markets simulta-

neously. The table includes the mean, standard deviation, minimum, maximum, kurtosis,

skewness and the percentage of the occurrences of co-movements. The standard deviation

of co-movement varies for the bivariate measure and is clearly smaller for multivariate

co-movements due to the larger number of zeros.

The co-movement of Germany and France exhibits the highest standard deviation and

the highest percentage of co-movements for the bivariate results (0.6992). Note that the

standard deviations of these series are amongst the lowest in the sample. Hence, the high

standard deviation of the co-movement cannot be explained with the standard deviations

of the underlying series. The co-movement between Germany and Singapore is most ex-

tremely skewed and leptokurtic. In addition, almost all bivariate co-movements exhibit a

minimum value close to four standard deviations below their mean (−3.3732) and many a

maximum value around two standard deviations above their mean although the maximum

value is 2.3466 of the co-movement between Germany and Sweden. This means that the

maximum common movement was almost four standard deviations for negative returns

and more than two standard deviations for positive returns.

The second highest percentage of co-movement can be observed for Germany and Swe-

den (0.6838). All percentages of co-movements are considerably above the lower bound for

two independent series of 0.5 but also well below the upper bound of 1.0 for two equal

series.

The negative skewness that exhibit all bivariate co-movements is a clear indicator that

negative co-movements are more pronounced than positive co-movements (see also Ang

and Chen, 2002, De Santis and Gerard, 1997 and Longin and Solnik, 2001). Even if the

original return series are negatively skewed, this does not necessarily imply that large

negative shocks occur at the same time. The return characteristics of Germany and the

13
UK stress this statement since the UK return is positively skewed but the co-movement

with Germany is negatively skewed.

Figures 5 and 6 present the results for a selection of markets (France, UK and the US)

in a graphical manner. The evolution of the co-movement through time and the histograms

show that the co-movement of Germany with France is most frequent (lowest number of

zeros) and most pronounced (largest numbers in the tails).

The multivariate results are different especially with respect to the percentages of co-

movement since the number of markets analyzed is not confined to two. However, the

skewness of the series is again confirming the findings obtained from the bivariate analysis

that negative co-movements are more pronounced than positive co-movements.12

The percentage of co-movements for the first multivariate sample (GER, JAP, UK, US)

exhibits a value of 0.3162 which is well above the lower bound for four independent series

of 0.125 (see table 1). The six European markets exhibit a value of 0.2699 which is even

larger compared to the lower bound benchmark (0.0313). The four Asian markets exhibit

relatively high co-movement (0.3290) but considerably less than the four EURO markets

sharing one common currency (0.3833) in the end of the sample. Finally, the sample con-

sisting of all eleven markets exhibits a value 0.1183. This means that all eleven markets

share common movements every ten months.

The descriptive statistics presented above only provide a limited picture. Hence, we

first take a closer look at three equal subsamples and then analyze the evolution of co-

movement through time. The results of the subsamples are shown by table 5. We focus the

analysis on the skewness and the percentage of co-movements. It can be stated that the

skewness decreases in absolute values compared to the first period (first subsample, t = 1

until t = 130) for all ’portfolios’ but increases in absolute values compared to the second

period for three portfolios.

The percentage of co-movements increases for all ’portfolios’ in the last period com-
12
Note that this is not equivalent to the fact that negative co-movements are more frequent.

14
pared to the first sample period. However, this rise in co-movement is not monotonic. The

co-movement decreased in the second sample period for the Asian markets (from 0.3599

to 0.2519) and for all eleven markets (from 0.1054 to 0.0900). The strongest rise in co-

movement can be observed for the four EURO markets, increasing from 0.3059 to a value

of 0.4833.

The following brief description of the associated figures aims to clarify the results ob-

tained and also shows the time-varying behavior of co-movement. The crisis dates as

defined above are stressed by a dotted thick vertical line.

Figure 7 shows that the co-movement between Germany, Japan, UK and the US is

more frequent in the end of the sample than in the beginning of the sample. However,

there is no clear structure such as a clustering of co-movements or a clear behavior of

the volatility of the observed co-movements. The co-movement for six European markets

shows that the frequency of co-movements has increased, especially after the stock market

crash in October 1987. Interestingly, there is no co-movement in the proximity of the crash

date, neither before nor after. The plot for the four Asian markets is very different to the

previous two examples since there is no clear tendency of more frequent co-movements or

increased co-movements (in magnitude) since 1969. There is some clustering of positive

and negative co-movements especially at the beginning of the sample. The co-movement

of the ’EURO’ markets reveals an increased frequency of co-movement especially after the

introduction of the euro currency in January 1999. Finally, the co-movement of all eleven

stock market indices in the sample is very low and it cannot be concluded that this number

has considerably increased since 1969.

4.3 Estimating the evolution of co-movement occurrences

The previous section has analyzed and interpreted the number of co-movements in per-

centages of the sample observations. We now extend this analysis and estimate the prob-

15
abilities of the occurrences of positive and negative co-movements through time. An ade-

quate model to estimate the probability of different ranges of co-movement (e.g. positive

and negative co-movement) is a multinomial logit model. It can also be viewed as a natural

extension of the descriptive analysis previously done and given by the last column of table

6.

The analysis shall focus on three questions. First, has the probability of co-movement

increased in recent years. Second, are there considerable differences of the probabilities of

positive and negative co-movement and third, has the probability of extreme movements

increased in recent years potentially affecting the stability of the financial system. The

latter model can be viewed as an analysis of the structure of dependence (and not only the

degree of dependence) since extreme values are included in the estimation.13

Since we model positive and negative co-movements separately and additionally include

extreme co-movements we do also analyze the magnitudes (i.e. levels) of co-movements

and not only their occurrence. The number of ranges (i.e. categories) of co-movement

could also be extended to obtain a more detailed picture of the factors that cause markets

to move jointly.

The advantages compared to Multivariate GARCH models are the flexibility of includ-

ing covariates without risking indefinite covariance matrices and the possibility to analyze

more than two markets simultaneously.14

Note that the following analysis is different to the Bae et al. (2003) approach. The only

similarity is the use of a multinomial logit model. Bae et al. estimate the probabilities of

the numbers of coexceedances (or extremes of co-movements) with a focus on contagion by

using daily data. The analysis made here focusses on long-term co-movements and models

the probabilities of the occurrence of co-movements through time for given portfolios of

indices.
13
The differentiation of ’degree of dependence’ and ’structure of dependence’ can be found in Hu (2002).
14
Note also that the computational time necessary is negligible compared to Multivariate GARCH models.

16
 The initial model is estimated with three categories: (i) no co-movement, (ii) positive

co-movement and (iii) negative co-movement. The number of categories is also extended to

analyze extremes of co-movement. Since we are mainly interested in the evolution of the

occurrence of co-movements through time we assume a very simple specification. Hence,

the probabilities are given by

0
eβj xt
P rob(Φt = j) = P2 (4)
βk0 xt
k=0 e

where Φt is the co-movement at time t, j denotes the category, xt is the vector of exoge-

nous variables and βj is a parameter vector to be estimated. Category 0 is the case where

’no co-movement’ at time t occurs, category 1 represents the case in which there is positive

co-movement and category 2 is characterized by negative co-movement at time t. The vec-

tor xt consists of a constant, a trend variable15 to capture the evolution of the probabilities

through time and dummy variables that capture the three main crisis periods as defined

above.

If the categories include lower (upper) extremes of the co-movement distribution, the

probability given by equation (4) can also be interpreted as an estimate of lower (upper)

tail dependence.16 Substituting the categories j in equation (4) by a certain value a yields

the following expression:

0
eβj xt
P rob(Φt ≤ a) = P rob(ri ≤ a|rj ≤ a∀j =
6 i) = P2 (5)
βk0 xt
k=0 e

which is equal to lower tail dependence if the scalar a is sufficiently small or if u → 0 for

a = FΦ−1 (u).

A model that estimates lower and upper extremes of the co-movement distribution is

estimated below. Given that co-movement smaller than a certain value a is equivalent to
15
Longin and Solnik (1995) are using a similar specification but are risking an indefinite covariance matrix
since they use a Multivariate GARCH model.
16
An introduction to tail dependence can be found in Joe (1997) for example.

17
the probability that the underlying returns are jointly smaller than this value a, equation

(5) can also be written as follows:

P rob(Φt ≤ a) = P rob(ri ≤ a∀i) = H(ri ≤ a∀i) = C(Fri (a)∀i) (6)

where H denotes the joint distribution function of the returns, C is the copula function

(see Nelson, 1999 for an introduction to copulas) and Fri is the marginal distribution func-

tion of return i. It can be shown that the copula to compute the probability of co-movement

is the Frechet upper bound (see Appendix).

We estimate the model given by equation (4) and (5) by minimizing the following log-

likelihood function17 :

T X
X 2
ln L = dtj lnP rob(Φt = j) (7)
t=1 j=0

We are aware of the difficulty of the interpretation of the parameter estimates since

they do not represent the marginal effects (see Greene, 2002). Therefore we focus on the

probability estimates rather than the parameter estimates. A graphical exploration of the

evolution of the probabilities shows the marginal effects.

We first report the results of the specification with a trend and the dummy variables

for two categories (positive and negative co-movement) and then report results for an aug-

mentation of categories to analyze extreme co-movements. The evolution of the probability

estimates is reported in separate figures for each portfolio where the left panel represents

the results of the first specification with two categories and the right panel is a plot of

the probability estimates for the second specification with four categories. We report the

significance of the parameter estimates but not the estimation results in general.18

The results for the 4 market sample show that the probability of positive co-movement

is larger than the probability of negative co-movement. Furthermore, there are positive
17
We use a MATLAB program to obtain the estimates.
18
Full results can be obtained from the author.

18
trends for both categories but only significant for the negative co-movement. Figure 8 is

a plot of the probabilities for the three categories through time. The figure particularly

clarifies the declining probability of the occurrence of ’no co-movements’ which is equal to

an increasing probability of the occurrence of co-movements.

The results for the European sample are mainly similar. However, the trend is signif-

icant in both cases and clearly stronger for positive co-movements. The associated plots

of the probabilities in figure 9 also show that the probability of ’no-co-movement’ declines

through time.

The Asian market sample is different to the previous results in some respects. First,

the probability of positive co-movement is declining and the probability of negative co-

movement is increasing. Second, the trend variable is not significant for both categories.

This results in almost constant probabilities for ’no co-movement’ shown by figure 10.

The sample consisting of the EURO markets shows positive and significant trends for

both categories. Figure 11 also shows that the probability of positive co-movement is larger

than the probability of negative co-movement and that the gap between the two probabili-

ties is widening due to the stronger trend of positive co-movements.

The probability of ’no co-movement’ is clearly decreasing.

The sample comprising all eleven markets exhibit a positive and significant trend of

positive co-movement and an insignificant positive trend of negative co-movement. This

results in a slightly decreasing probability of ’no co-movement’ which is also shown by

figure 12.

The effect of the dummy variables capturing the crisis periods is very similar among

the portfolios. The probability of negative co-movement is always increasing and the prob-

ability of positive co-movement is decreasing in all crisis periods and for all portfolios.

However, the decrease of the probability of positive co-movement is stronger than the in-

crease of the probability of negative co-movement in the first crisis period leading to a

higher probability of ’no co-movement’ in this crisis period. This result is in contrast to the

19
common finding that the co-movement always increases in crisis periods.

A summary of the results could be condensed to the fact that the co-movement has in-

creased for all ’portfolios’ of markets analyzed and that negative co-movement is generally

less probable than positive co-movement. It is important to note that this does not mean

that negative co-movement is less pronounced than positive co-movement. Hence, this re-

sults is not in contrast to the conclusions drawn from the skewness of the co-movement in

the previous section (see table 4).

Due to the very simple specification, the R2 is very low. However, the likelihood ratio

tests clearly indicate the joint significance of the model parameters. The Asian sample is

an exception which is consistent with the insignificant estimates for the trend variable.

Now, we extend the number of categories to capture extreme co-movements. We use the

10 percent lowest and highest values of co-movement as additional categories (category

3 and 4, respectively) and restrict the first two categories to values not including these

extremes. In this specification significant results are only obtained for the European and

EURO market sample implying higher probabilities for extreme negative and positive co-

movements. There is no significant effect for the other portfolios. The probability estimates

are shown in the right panels of the figures as referred to above.

The fact that European markets are different to the other portfolios can either be ex-

plained with their geographical proximity and economic interdependence or their common

currency relevant for the end of the sample. Assumed that it is the single currency that

is causing more extreme co-movements compared to other portfolios would suggest that

different currencies help to stabilize financial markets.

20
5 Conclusions

This paper introduces a definition of co-movement with a closely related measure that has

many advantages in comparison to the correlation coefficient and also provides results

that are in accordance with previous findings in the literature and economic intuition, e.g.

the fact that negative co-movements are more pronounced than positive co-movements and

that co-movement has increased in recent years.

Since multivariate co-movement cannot straightforwardly be analyzed with standard

econometric models such as Multivariate GARCH models this paper can be viewed as

an important contribution to obtain additional knowledge about joint movements of stock

markets.

The results found for the European markets sharing the EURO currency suggest that

exchange rates play a crucial role for normal and extreme co-movements. Future research

could further investigate the question how institutional arrangements affect joint market

movements.

21
6 References

Ang, A., Chen, J., 2003, Asymmetric Correlations of Equity Portfolios, Journal of Finan-

cial Economics, 63, 443-494

Bae, K.H., Karolyi, G. A., Stulz, R. M., 2003, A New Approach to Measuring Financial

Contagion, Review of Financial Studies, forthcoming

Baur, D., Schulze, N., 2003, Coexceedances in Financial Markets - A Quantile Regression

Analysis of Contagion, University of Tuebingen, Working Paper No. 253

Barberis, N., Shleifer, A., Wurgler, J., 2002, Comovement, NBER Working Paper No. 8884

Boyer, B. H., Gibson, M. S., Loretan, M, 1999, Pitfalls in Tests for Changes in Correla-

tions, Federal Reserve Board, IFS Discussion Paper No. 97R

Connolly, R., Wang, F.-K. A., 2001, On Stock Market Return Co-movements: Macroeco-

nomic News, Dispersion of Beliefs, and Contagion?, mimeo

De Santis, G., Gerard, B., 1997, International Asset Pricing and Portfolio Diversification

with Time-Varying Risk, Journal of Finance, LII, 5, 1881-1912

Embrechts P., McNeil, A.J., Straumann, D., 1999, Correlation: pitfalls and alternatives,

RISK, 69-71

Engle, R.F., 2002, Dynamic Conditional Correlations - A Simple Class of Multivariate

Generalized Autoregressive Conditional Heteroskedasticity Models, Journal of Busi-

ness and Economic Statistics, 20, 3, 339-350

Forbes, K., Rigobon, R., 2002, No Contagion, Only Interdependence: Measuring Stock

Market Co-movements, Journal of Finance, 57, 5, 2223-2261

Greene, W.H., 2002, Econometric Analysis, 5th edition, Prentice Hall

Harding, D., Pagan, A., 1999, Knowing the cycle, mimeo, University of Melbourne

22
Hu, L., 2002, Dependence Patterns across Financial Markets: Methods and Evidence,

Working Paper, Department of Economics, Ohio State University

Joe, H., 1997, Multivariate Models and Dependence Concepts, Monographs on Statistics

and Applied Probability 73. Chapman and Hall/ CRC

Karolyi, G.A., Stulz, R.M., 1996, Why do Markets Move Together? An Investigation of

US-Japan Stock Return Comovements, Journal of Finance, 51, 3, 951-986

Koenker, R., 2002, Memo-Random Number 1 On Comonotonicity, University of Illinois,

mimeo

Kroner, K.F., Ng, V.K., 1998, Modeling Asymmetric Comovements of Asset Returns, The

Review of Financial Studies, 11, 4, 817-844

Loretan, M., English, W.B., 2000, Evaluating Correlation Breakdowns during Periods of

Market Volatility, Board of Governors of the Federal Reserve System, International

Finance Discussion Papers, Number 658

Longin, F., Solnik, B., 1995, Is the correlation in international equity returns constant:

1960-1990? Journal of International Money and Finance, 14, 1, 3-26

Longin, F., Solnik, B., 2001, Extreme Correlation of International Equity Markets, Jour-

nal of Finance, 56, 651-678

Malevergne, Y., Sornette, D., 2002, Hedging Extreme Co-Movements, Working Paper

mimeo

Nelsen, R. B., 1999, An Introduction to Copulas, Lecture Notes in Statistics 139, Springer

Pearson, K., 1901, Mathematical distributions to the theory of evolution. Philosophical

Transactions of the Royal Society of London (Series A) 197. 385-497

Solnik, B., Roulet, J., 2000, Dispersion as Cross-Sectional Correlation, Financial Analysts

Journal, 56, 1, 54-61

23
7 Appendix

The probability of common market movement below a value a can be written as follows:

P rob(Φt ≤ a) = P rob(ri ≤ a∀i) = H(ri ≤ a∀i) = C(Fri (a)∀i) (8)

where H is the joint distribution function, C is the copula function (see Nelson, 1999 for

an introduction to copulas) and F denotes the marginal distribution of return i (ri ).

The following equation shows that the probability of co-movement is based on the

Frechet upper bound as a copula:

T
1X
P rob(Φt ≤ a) = P rob(ri ≤ a∀i) = I(Φt (r1t , ..., rN t ) ≤ a) = min(Fri (a)∀i) (9)
T
t=1

where I is an indicator variable equal to one if Φt is not zero and the expression min is

the copula function which is the Frechet upper bound (see Nelsen, 1999 for further details).

24
 4 4 0.5

2
2 0
0
0 −0.5
−2

−2 −4 −1
0 500 1000 0 500 1000 0 500 1000

4 4 2

2 2 1

0 0 0

−2 −2 −1

−4 −4 −2
0 500 1000 0 500 1000 0 500 1000

Figure 1: Co-movement of simulated correlation processes, constant volatility

2 4 0.5

1 2
0
0 0
−0.5
−1 −2

−2 −4 −1
0 500 1000 0 500 1000 0 500 1000

2 4 2

1 2 1

0 0 0

−1 −2 −1

−2 −4 −2
0 500 1000 0 500 1000 0 500 1000

Figure 2: Co-movement of simulated correlation processes, increasing (deterministic)

volatility of both series

25
 4

−2

−4
0 100 200 300 400 500 600 700 800 900 1000

−1

−2
0 100 200 300 400 500 600 700 800 900 1000

0.5

−0.5

−1
0 100 200 300 400 500 600 700 800 900 1000

Figure 3: Co-movement of 5 simulated returns with a common factor

0.8

0.6

0.4

0.2

−0.2

−0.4

−0.6
0 45 70 100 150 200214 250 300 331 350 400
October 1987 Asian Crisis (July 1997)
Oil Crisis (October 1973)

Figure 4: Monthly returns of 11 MSCI stock market indices

26
 3
France
UK
US
2

−1

−2

−3

−4
0 50 100 150 200 250 300 350 400

Figure 5: Bivariate Co-movement (GER - FRA, GER - UK, GER - US)

200
France
180 UK
US

160

140

120

100

80

60

40

20

0
−4 −3 −2 −1 0 1 2 3

Figure 6: Bivariate Co-movement, histograms

27
 4 markets European markets
2 2

1
0
0
−2
−1

−4 −2
0 4570 214 300331 400 0 4570 214 331 400
Asian markets EURO markets
2 2

1
0
0
−2
−1

−2 −4
0 4570 214 331 400 0 4570 214 331 400
all markets
1

−1

−2
0 4570 214 331 400

Figure 7: Multivariate Co-movement

28
 fitted probabilities (MLogit) fitted probabilities (MLogit)
1 0.9
Prob no comovement Prob no comovement
Prob categ1 Prob categ1
0.9 Prob categ2 0.8 Prob categ2
Prob categ3
Prob categ4
0.8
0.7

0.7
0.6

0.6
0.5
0.5
0.4
0.4

0.3
0.3

0.2
0.2

0.1 0.1

0 0
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400

Figure 8: Plot of Probabilities (4 markets)

fitted probabilities (MLogit) fitted probabilities (MLogit)

1 0.9
Prob no comovement Prob no comovement
Prob categ1 Prob categ1
0.9 Prob categ2 0.8 Prob categ2
Prob categ3
Prob categ4
0.8
0.7

0.7
0.6

0.6
0.5
0.5
0.4
0.4

0.3
0.3

0.2
0.2

0.1 0.1

0 0
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400

Figure 9: Plot of Probabilities (European markets)

fitted probabilities (MLogit) fitted probabilities (MLogit)

1 0.7
Prob no comovement Prob no comovement
Prob categ1 Prob categ1
0.9 Prob categ2 Prob categ2
0.6 Prob categ3
Prob categ4
0.8

0.7 0.5

0.6
0.4

0.5

0.3
0.4

0.3
0.2

0.2

0.1
0.1

0 0
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400

Figure 10: Plot of Probabilities (Asian markets)

29
 fitted probabilities (MLogit) fitted probabilities (MLogit)
1 0.8
Prob no comovement Prob no comovement
Prob categ1 Prob categ1
0.9 Prob categ2 Prob categ2
0.7 Prob categ3
Prob categ4
0.8
0.6
0.7

0.5
0.6

0.5 0.4

0.4
0.3

0.3
0.2
0.2

0.1
0.1

0 0
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400

Figure 11: Plot of Probabilities (EURO markets)

fitted probabilities (MLogit) fitted probabilities (MLogit)

1 1
Prob no comovement Prob no comovement
Prob categ1 Prob categ1
0.9 Prob categ2 0.9 Prob categ2
Prob categ3
Prob categ4
0.8 0.8

0.7 0.7

0.6 0.6

0.5 0.5

0.4 0.4

0.3 0.3

0.2 0.2

0.1 0.1

0 0
0 50 100 150 200 250 300 350 400 0 50 100 150 200 250 300 350 400

Figure 12: Plot of Probabilities (11 markets)

30