Extreme Correlation of International Equity Markets

TLDR

Testing whether international equity market correlation rises during volatile periods is difficult and past studies have been misleading due to spurious correlation–volatility relationships. The study aims to model the distribution of extreme correlation in international equity markets using extreme value theory. The authors apply extreme value theory to multivariate distribution tails to derive the extreme correlation distribution for a broad class of return distributions. Empirical tests reject multivariate normality for the negative tail, find no link between correlation and volatility but a link to market trend, and show correlation rises in bear markets but not in bull markets.

Abstract

ABSTRACT Testing the hypothesis that international equity market correlation increases in volatile times is a difficult exercise and misleading results have often been reported in the past because of a spurious relationship between correlation and volatility. Using “extreme value theory” to model the multivariate distribution tails, we derive the distribution of extreme correlation for a wide class of return distributions. Empirically, we reject the null hypothesis of multivariate normality for the negative tail, but not for the positive tail. We also find that correlation is not related to market volatility per se but to the market trend. Correlation increases in bear markets, but not in bull markets.