Time-Varying Integration, Interdependence and Contagion

Journal of International Money and Finance 29 (2010) 791818
Contents lists available at ScienceDirect
Journal of International Money

and Finance
journal homepage: www.elsevier.com/locate/jimf
Time-varying integration, interdependence and contagionq

Lieven Baele a, *, Koen Inghelbrecht b,1
a
CentER, Netspar, and Tilburg University, Department of Finance, PO Box 90153, NL 5000 LE Tilburg, The Netherlands
b
University College Ghent, Ghent University, Department of Finance, Voskenslaan 270, B-9000 Gent, Belgium
a b s t r a c t
JEL Classication: Bekaert et al. (2005) dene contagion as correlation over and
G15 above what one would expect from economic fundamentals.
G12 Based on a two-factor asset pricing specication to model funda-
F30
mentally-driven linkages between markets, they dene contagion
F32
as correlation among the model residuals, and develop a corre-
F35
sponding test procedure. In this paper, we investigate to what
Keywords: extent conclusions from this contagion test depend upon the
Contagion specication of the time-varying factor exposures. We develop
Financial integration a two-factor model with global and regional market shocks as
Volatility spillover models
factors. We make the global and regional market exposures
Time-varying correlations
Regime-switching models
conditional upon both a latent regime variable and three structural
instruments, and nd that, for a set of 14 European countries, this
model outperforms more restricted versions. The structurally-
driven increase in global (regional) market exposures and corre-
lations suggest that market integration has increased substantially
over the last three decades. Using our optimal model, we do not
nd evidence that further integration has come at the cost of
contagion. We do nd evidence for contagion, however, when
more restricted versions of the factor specications are used. We
conclude that the specication of the global and regional market
exposures is an important issue in any test for contagion.
2010 Elsevier Ltd. All rights reserved.
q The authors greatly beneted from discussions with Jan Annaert, Geert Bekaert, Paul Ehling, Esther Eiling, Frank de Jong,
Frans de Roon, Sergei Sarkissian, Boriss Siliverstovs, Pilar Soriano Felipe, Bas Werker, Raf Wouters, Rudi Vander Vennet, William
de Vijlder, and seminar participants at the 2008 EFMA Annual Meeting of the European Financial Management Association in
Athens, and Ghent University College.
* Corresponding author. Tel.: 31 13 466 3257; fax: 31 13 466 2875
E-mail addresses: lieven.baele@uvt.nl (L. Baele), koen.inghelbrecht@hogent.be (K. Inghelbrecht).
1
Tel.: 32 9 2432445; fax: 32 9 2424209.
0261-5606/$ see front matter 2010 Elsevier Ltd. All rights reserved.
doi:10.1016/j.jimonn.2009.12.008
792 L. Baele, K. Inghelbrecht / Journal of International Money and Finance 29 (2010) 791818
1. Introduction
To what extent have globalization and regional market integration made equity markets both in the
developed and developing world more vulnerable to contagion? Ever since the series of nancial crises
at the end of the 1990s, this question has received a lot of attention, not only by academics, but also by
policy makers and in the popular press. Despite the considerable amount of papers published on the
topic,2 no consensus has been reached yet on the true existence of contagion.
The disagreement on whether contagion is observed or not stems to a large extent from the lack of
agreement on a denition of contagion, and hence also on an appropriate testing technique. In this
paper, we follow the so-called restrictive denition of contagion which denes contagion as a
signicant increase in cross-market linkages after a shock to one country (or group of countries). As
pointed out by Boyer et al. (1999) and Forbes and Rigobon (2002), one cannot test for this type of
contagion by directly comparing correlations between tranquil and crisis periods, as one would expect
correlations to increase during highly volatile crisis periods even under the null of no contagion. After
correcting for this so-called conditioning bias, Forbes and Rigobon (2002) no longer nd evidence for
contagion during three important turmoil periods (the 1987 crash, the Mexican crisis, and the East-
Asian crisis).
More recently, Bekaert et al. (2005) (BHN, henceforth) proposed an alternative contagion test. They
dene contagion as excess correlations, i.e. correlation over and above what one would expect from
economic fundamentals. The natural interdependence between markets is modeled by means of
a multifactor model. In this setting, equity markets are correlated because they are jointly exposed to
the same fundamental factors. Similarly, correlations will increase with factor volatility, the magnitude
by which will depend upon the actual factor loadings. Having corrected for economically-driven
correlation between markets, BHN test for contagion by investigating whether there is any correlation
left in the models residuals. Their results indicate the presence of contagion during the East-Asian
crisis, but not during the Mexican crisis.
A key challenge of this particular type of contagion test is to correctly describe fundamental market
linkages. In this respect, the null hypothesis is a joint test for no contagion and a correct factor spec-
ication. The main aim of this paper is (1) to develop a model that correctly characterizes fundamental
market linkages in an environment of time-varying market integration, and (2) to investigate to what
extent contagion test results depend on the particular choice and complexity of the dynamic factor
model chosen.
As in previous papers, we choose for a specication with the global and regional equity market
shocks as factors, and potentially time-varying factor exposures. This two-factor model, rst developed
by Ng (2000), constitutes a substantial improvement over the one-factor model of Bekaert and Harvey
(1997), and has been successfully used before by Fratzscher (2002), Baele (2005), and Christiansen
(2007) among others. From an economic point of view, it distinguishes between (partial) global and/or
regional market integration. From an econometric point of view, this type of model outperforms the
one-factor global market model considerably in modeling cross-country correlations, while it is only
slightly outperformed by a more complex APT model (see e.g. Bekaert et al., 2009).
We differ from these papers, however, in how we model the exposures or betas with respect to the
factors. Previous papers have made the global (regional) market exposures, or betas, time-varying by
making them conditional on some structural information variables (see e.g. Bekaert and Harvey, 1997;
Ng, 2000 and Fratzscher, 2002) or on a latent regime variable (see Baele, 2005). A disadvantage of the
rst approach is that while it allows betas to change with structural changes in the economic and
nancial environment, it cannot accommodate cyclical variation in the betas. Similarly, while the
second approach does allow betas to vary over the cycle, it is less suited to deal with permanent changes
in market betas. Instead, we combine both approaches and make the market betas conditional on three
2
See Boyer, Gibson, and Loretan (1999), Kodres and Pritsker (2002), Ribeiro and Veronesi (2002), Sola et al. (2002), Billio
et al. (2003), Billio and Pelizzon (2003), Ciccarelli and Rebucci (2003), Karolyi (2003), Rigobon (2003), Hartmann, Straetmans,
and de Vries (2004), Baele (2005), Billio et al. (2005), Corsetti et al. (2005), Phylaktis and Xia (2006) and Rodriguez (2007) for
a number of recent contributions to the contagion literature.
L. Baele, K. Inghelbrecht / Journal of International Money and Finance 29 (2010) 791818 793
structural variables reecting time-varying integration and market development and a latent
regime variable reecting temporary economic uctuations.
Using a battery of specication tests, we nd that a model with both structural instruments and
a latent regime variable is preferred over more restricted versions in all but one of the 14 European
countries. We show that both global and regional market betas have substantially increased over the
last 30 years, suggesting considerable progress in the degree of European market integration. The
introduction of the euro seems to have strengthened the integration process even further. Interestingly,
the overall increase is relatively larger for global than for regional market betas, indicating that
globalization may at least be as important as regional integration. Overall, we do not nd large
differences between EMU and non-EMU countries, or between small and large markets.
Consequently, we test for contagion using residuals from our preferred model, and from restricted
models. We nd a number of interesting ndings. First, when we use country residuals from our most
general (and preferred) model, we generally do not nd evidence for contagion during any of the crisis
periods we consider, namely the Mexican crisis, the Asian crisis, the Russian/LTCM crisis, the Nasdaq
Rash, the 9/11 terrorist attacks, the (start of the) subprime crisis, and during periods of high market
volatility. Only in the period after the 1987 crash, we nd evidence of excess exposure to regional
European shocks. Second, we nd that contagion test results are indeed vulnerable to suboptimal
specications for the dynamic factor model. For instance, we nd that specications with constant
global (regional) market exposures miscorrectly identify contagion during the 87 crash, Asian crisis, the
9/11 terrorist attacks, the (start of the) subprime crisis, and during periods of high global market
volatility. Similarly, we show that contagion test results can differ substantially depending on how the
time variation in both the structural and cyclical component of the factor exposures is modeled.
The remainder of this paper is organized as follows. Section 2 develops the structural regime-
switching two-factor model with time-varying factor exposures and describes the contagion test.
Section 3 describes the data. Sections 4 and 5 report the main empirical results of respectively the
structural regime-switching spillover model and the contagion test. Section 6 concludes.
2. Methodology
In this section, we rst develop a dynamic factor model that characterizes fundamental linkages
between markets. We provide for a very general specication for the time-varying factor exposures. We
then discuss the estimation and model selection strategy. Finally, we briey describe the contagion test
of BHN.
2.1. A structural regime-switching factor model
Let ri,t represent the excess return of country i, which we decompose as follows:
w reg
ri;t mi;t1 bi;t ew;t bi;t ereg;t ei;t (1)
where mi,t1 is the time t 1 expected return of country i. The unexpected return is decomposed into
a country-specic component ei,t, and a component due to a global market shock ew,t and a regional
market shock ereg,t. The time-varying exposures of country is returns with respect to the global and
w reg
regional market shocks are given by respectively bi;t and bi;t . We include two-factors for a number of
reasons. From an economic point of view, the model distinguishes between (partial) global and/or
regional market integration. From an econometric point of view, it outperforms the one-factor global
market model considerably in modeling cross-country correlations, while it is only slightly out-
performed by a more complex APT model (see e.g. Bekaert et al., 2009).
We differ from existing work in the way we model time variation in the market betas. Previous
papers have made the global (regional) market exposures, or betas, time-varying by making them
conditional on some structural information variables (see e.g. Bekaert and Harvey, 1997; Ng, 2000 and
Fratzscher, 2002) or on a latent regime variable (see Baele, 2005). Both specications individually have,
however, their limitations. While the rst approach allows betas to change with structural changes in
the economic and nancial environment, it cannot accommodate cyclical variation in the betas. The
second approach does allow betas to vary over the cycle, but is less suited to deal with permanent
changes in market betas. Instead, we combine both approaches and make the market betas conditional
on three structural variables reecting time-varying integration and market development and
a latent regime variable reecting temporary economic uctuations:
wreg wreg wreg wreg

bi;t bi Si;t bi Xi;t1 (2)
wreg
where Xi;t1 is a K 1 vector of lagged country-specic structural variables measured with respect to
respectively global and regional markets. The latent regime variable Si,t is allowed to be different for
each country. We do impose the same latent variable on both the global and regional market beta for
each country. Notice that this does not mean that we force global and regional market betas to have the
same evolution over time, as we allow them to vary with structural instruments measured with respect
to respectively global and regional markets. Finally, we limit the number of states to two, which should
facilitate the interpretation of the states as business cycle expansions and recessions.3
The specications for the betas nest a number of restricted versions that have previously been used
in the (contagion) literature. Contagion tests based on the Forbes and Rigobon (2002) methodology
implicitly assume constant market linkages. Baele (2005) allows market exposures to vary with a latent
regime variable, but not with structural regime variables. BHN condition the market betas on one
instrument only, and do not allow for potential cyclicality in the factor exposures. By estimating a more
general factor model than in previous papers, we are not only able to determine the optimal level of
complexity of market beta dynamics, we can also assess to what extent the contagion test results
depend on the particular choice of the beta specication. In the following table, we list the various
specications for the global and regional market betas with increasing complexity:
Model Beta specication

Constant Beta Model bzi;t z
bi;0
Regime-Switching (RS) Beta Model bzi;t z
bi;0 Si;t
Structural Beta Model bzi;t z z z
bi;0 bi Xi;t1
RS Structural Beta Model bzi;t z z z
bi Si;t bi Xi;t1
where z {w, reg}.

Even though we limit the number of states to two, one may still be worried that the regime-
switching component of the market betas picks up contagion episodes instead of business cycle
uctuations. Consequently, as a robustness check, we perform the contagion tests using residuals from
a model where the regime-switching intercept is replaced by the lagged term spread, an instrument
that is often used as a business cycle predictor.
Before we can estimate equation (1), we rst need to identify the global and regional market shocks,
as well as the expected returns. The global market shock ew,t is simply the difference between the
global market return rw,t and its expected component mw,t1. Consequently, we identify region-specic
shocks by estimating the following equation:
w
rreg;t mreg;t1 breg;t ew;t ereg;t (3)
where mreg,t1 represents the expected regional return and ereg,t the region-specic shock. This
decomposition guarantees that the region-specic shocks are orthogonal to the global market shocks.
In our most general specication, the regions global market beta varies with both structural economic
w
instruments Xreg;t1 and a latent regime variable Sreg,t, hereby allowing for both structural and cyclical
changes in the global market beta:

bw w w w
reg;t breg;0 Sreg;t breg Xreg;t1 :
3
We do estimate a three-state regime-switching model for a subset of countries. We nd that the third regime exhibits
spike-like behavior, suggesting that it proxies for extremely short-lived events that are most likely non-fundamental, and
possibly contagion.
Given the focus of this paper on second moments, we do not explore the complex implications of our
factor model for expected returns.4 As a reasonable alternative, we propose the following expected
return specication:
z
mz;t1 gz;0 gz Zt1 (4)
z
where z {w, reg, i}, and Zt1 represents a vector of global, regional, or country-specic information
variables part of the information set Ut1 that have been shown to predict equity returns. To accom-
modate for potentially partial equity market integration, we include both global and local information
variables.5
Finally, we have to provide for a specication of the conditional variance of the global, region-
specic, and country-specic shocks. We model the conditional variance of the global market shocks by
means of a regime-switching Asymmetric GARCH(1,1) model:

ew;t Ut1 wN 0; s2w;t

s2w;t jw;o Sw;t jw;1 Sw;t e2w;t1 jw;2 Sw;t s2w;t1 jw;3 Sw;t e2w;t1 I ew;t1 < 0 (5)
with I{ew,t1 < 0} an indicator function which takes on the value 1 when ew,t1 < 0 and zero
otherwise. The conditional heteroskedasticity of the region and country-specic shocks is modeled
through an Asymmetric GARCH(1,1) model. As we will see further, specication tests indicate that such
model is sufcient once betas are allowed to be time-varying.
2.2. Estimation procedure
To keep estimation feasible, we use a three-step procedure. First, we estimate the global market
shocks. Second, we relate the regional European return to the market shocks obtained in the rst step.
Third, we relate country shocks to both global and regional shocks. To keep the estimation tractable, we
estimate the specications country by country. All estimates are obtained by maximum likelihood.
While we report QML standard errors, we do not correct for sampling error of the global (regional)
market model parameters in the rst (second) stage estimation. Consequently, this approach yields
consistent but not necessarily efcient estimates.
A rst important assumption6 behind this three-step procedure is that regional shocks are inde-
pendent from global market shocks and that country-specic shocks are independent from both
region-specic and global market shocks. Second, country-specic shocks should be mutually inde-
pendent. Recent evidence by Bekaert et al. (2009) suggests that our specications with time-varying
factor exposures should be sufciently rich to eliminate most residual asset correlation. We will
nevertheless test for residual correlation between the asset-specic shocks further on.
Finally, we need to specify how the underlying states evolve over time. We assume a constant
transition probability matrix for the latent regime variable which can take two-states, i.e.

Pz 1 Pz
Pz (6)
1 Qz Qz
where the transition probabilities are given by Pz prob(Sz,t 1jSz,t1 1), and Qz prob(Sz,t 2jSz,t1 2),
and z {w, reg, i}. By imposing this parsimonious structure on the latent regime variable, we hope to limit
the probability that our regime-switching variable also captures contagion episodes. As said before, this
4
See Bekaert and Harvey (1995), De Santis and Gerard (1997), and Carrieri et al. (2004) for models exploring the implications
of partial integration on expected returns.
5
The expected country return is modeled as a linear function of lagged values of both the US and the regional market return,
the US short rate, dividend yield, term spread, the default spread, the local interest rate, and the local return.
6
Appendix A in Bekaert and Harvey (1997) provides a formal derivation of all the conditions under which the joint likelihood
of a similar (yet less complex) system can be decomposed into a number of univariate models. A similar derivation (but for
a two-factor instead of a one-factor model) is available from the working paper version of Baele (2005).
assumption has as an additional advantage that it facilitates the identication of the states as business
cycle expansions and recessions. We use the maximum likelihood algorithm rst introduced by Hamilton
(1989) to estimate the regime-switching beta specications, and the one of Gray (1996) for the regime-
switching AGARCH model for the global market volatility.
2.3. Specication tests
In Section 2.1, we presented a very general dynamic factor model. In practice, however, we may not
need all the exibility offered by this complex specication. To differentiate between various restricted
versions of this model, we use three types of specication tests, namely (empirical) likelihood ratio
tests, a GMM test of normality of the standardized residuals, and a regime-classication measure.
2.3.1. Likelihood ratio tests

To distinguish between nested models, we use standard Likelihood Ratio tests. Unfortunately,
standard asymptotic theory does not apply for tests of multiple regimes against the alternative of one
regime because of the presence of nuisance parameters under the null of one regime. Similar to Ang
and Bekaert (2002a), we use an empirical likelihood ratio test. In a rst step, the likelihood ratio
statistic of the regime-switching model against the null of one regime is calculated. Second, N series (of
length T, the sample length) are generated based upon the model with no regime-switches. For each of
the N series, both the model with and without regime-switches is estimated from at least 5 different
starting values. The highest likelihood values are stored in respectively LRS and LNRS. For each simulated
series, as well as for the sample data, the Likelihood Ratio (LR) test is calculated as
LRNRS4RS 2 log(LNRS LRS). Finally, the signicance of the LR test statistic is obtained by calculating
how many of the LR test values on the simulated series are larger than the LR statistic for the actual
data.
2.3.2. Test on standardized residuals

To check whether the models are correctly specied, as well as to choose the best performing
model, we follow a procedure similar to the one proposed by Richardson and Smith (1993) and Bekaert
and Harvey (1997). Standardized residuals are calculated as wb z;t b
e z;t = b
s z;t . Under the null that the
model is correctly specied, the following conditions should hold:
h i

a E w b z;tj 0 b E w
b z;t w b2 1 b2 1
w 0
z;t z;tj
for j 1, ., s, and z{w, reg, i}. Conditions (a) and (b) test respectively for serial correlation in stan-
dardized and squared standardized residuals. Test statistics are obtained through a GMM procedure
similar to Bekaert and Harvey (1997), and are asymptotically distributed as c2 with s degrees of
freedom. Similarly, to investigate skewness and excess kurtosis, we test whether the following
orthogonality conditions hold:

c E wb3 0 d E wb 4 3 0:
z;t z;t
Both tests are c2(1) distributed. Finally, to test whether the different volatility models capture volatility
asymmetry, we check the validity of the following orthogonality conditions:

n o
n o
d E w b2 1 I w
b z;t1 < 0 0 e E w b2 1 I w
b z;t1 < 0 wb z;t1 0
z;t z;t

n o
f E w b2 1 I w
b z;t1 0 wb z;t1 0:
z;t
These conditions correspond to respectively the Sign Bias test, the Negative Sign Bias test, and the
Positive Sign Bias test of Engle and Ng (1993). The joint test is distributed as c2 with 3 degrees of
freedom.
2.3.3. Regime-classication measure

Ang and Bekaert (2002b) developed a summary statistic which captures the quality of a models
regime qualication performance. They argue that a good regime-switching model should be able to
classify regimes sharply. This is the case when the smoothed (ex-post) regime probabilities
pj,t P(Si,t jjUT) are close to either one or zero. For k 2, the regime-classication measure (RCM) is
given by
T
1X
RCM 400 pt 1 pt (7)
T t 1
where the constant serves to normalize the statistic to be between 0 and 100. A perfect model will be
associated with an RCM close to zero, while a model that cannot distinguish between regimes at all will
produce an RCM close to 100. When the model contains more than one regime variable, we use the
extended RCM measure developed in Baele (2005).
2.4. Contagion tests
In this section, we briey discuss the BHN test for contagion. They rst assume that correlation
induced by fundamentals is well captured by the estimated factor model. Second, they test for
contagion by measuring the correlation of the models country-specic shocks.7 More specically, they
estimate the following time-series-cross-section regression model:
b
e i;t wi vz;t b
e z;t ui;t (8)
vz;t vz;0 vz;1 Dt (9)
where b e i;t and b

e z;t are the estimated idiosyncratic return shocks of country i and benchmark market z
(i.e. global or regional market), and Dt is a dummy variable that takes on a value of 1 in a particular crisis
period and zero otherwise. BHN test whether vz,0 and vz,1 are jointly equal to zero (overall test for
contagion) and whether vz,1 is signicantly different from zero (contribution of particular periods to
contagion).
In the context of this paper, we estimate the following specication:
b
e i;t wi vw;t b
e w;t vreg;t b
e reg;t ui;t (10)
with

vw;t vw;0 vw;1 Dt (11)

vreg;t vreg;0 vreg;1 Dt (12)
The dummy variable Dt represents 7 crisis periods (see Section 3.3 for more details on the exact
specication of the crisis dummies). We test for contagion during a particular crisis period either at the
global or regional level by testing respectively whether vw,1 0 and vreg,1 0. BHN also perform an
overall test for contagion by testing whether vw,0 vw,1 0 and vreg,0 vreg,1 0. In our view, one
should be careful with interpreting a signicant intercept as evidence for contagion. As explained in
detail in A, a negative vw,0 and/or vreg,0 does signal contagion, but a positive vw,0 and/or vreg,0 indicates
misspecication rather than contagion. The systematic underestimation of the betas may be caused by
measurement problems with respect to the global (regional) market shocks or by an omitted factor. In
the empirical part, we focus primarily on the signicance of vw,1 and vreg,1 to test for contagion.
Finally, we also test for excess correlation with idiosyncratic shocks in all other countries, i.e. we test
for a signicant vother,0 and vother,1 in
7
A similar approach is used by Wongswan (2003).

b
e i;t wi vother;0 vother;1 Dt be i;other;t ui;t (13)
Pcsi
where be i;other;t b
cC e c;t , where C denotes the set of all 14 European countries in our sample.
We estimate equations (10) and (13) with xed effects and accommodate for group-wise hetero-
skedasticity. The standard errors of the parameters are corrected for heteroskedasticity using the
White heteroskedasticity consistent covariance matrix.
3. Data description
3.1. Stock returns
We estimate the effect of a particular choice for the beta specication on contagion tests using
a sample of 14 European countries. We use weekly US$ total returns from Datastream for the period
January 1973 till August 2007. The US 1-month Treasury Bill rate is used to calculate excess returns. As
a global market index, we calculate a value-weighted index of all developed equity markets in the
world. Similarly, our European index is a value-weighted index of all developed European equity
markets.
3.2. Structural instruments
As structural instruments in the beta specication, we consider measures of trade integration and
industry structure alignment, as well as a euro dummy. We focus on these three measures because (a)
they are theoretically well-founded, (b) they have been successfully used in previous research, and (c)
they have a high correlation with other potential indicators (such as market development indicators or
Quinn (1997)s integration indicator).
3.2.1. Trade integration

At the country level, the trade integration measure is calculated as the ratio of imports plus exports
over GDP. The empirical model distinguishes between global and regional European market shocks,
and so does our trade measure. More specically, the trade integration measure entering the regional
market beta only considers the countrys trade with other European countries. Similarly, the trade
variable entering the global market beta contains the countrys trade with all countries outside Europe.
In the same spirit, our trade integration measure entering the beta of Europe with the global market is
calculated as the sum of Europes exports and imports with the rest of the global market over Europes
GDP. All data is quarterly and has been obtained from the OECD.8
Previous studies have successfully linked similar trade integration indicators to cross-country
equity returns. Chen and Zhang (1997) for instance found that countries with heavier bilateral trade
with a region also tend to have higher return correlations with that region. Bekaert and Harvey (1997),
Ng (2000), Bekaert et al. (2005), and Baele (2005) found that the exposure of country returns to the
global (regional) equity market typically increases with measures of trade integration. Forbes and
Chinn (2004) showed that, despite the recent growth in global nancial ows, direct trade continues to
be the most important determinant of cross-country equity market comovements. Frankel and Rose
(1998) found that countries with closer trade linkages tend to have more correlated business cycles,
which should in turn result in higher correlation between their equity markets as well. Trade inte-
gration may also proxy for nancial integration, and hence a convergence of cross-country risk
premiums. For instance, Bekaert and Harvey (1995) found that countries with open economies are
generally better integrated with global capital markets.
The evolution of the trade integration measure is depicted in Table 1. We observe a substantial
increase in both intra and extra-regional trade for nearly all 14 European countries. For all countries,
within-region trade is substantially higher than trade with countries outside Europe.
8
The Import and Export data are from the module Monthly Foreign Trade Statistics from the OECD. All data is seasonally
adjusted and converted to a weekly frequency through interpolation. The data is expressed in US dollar.
Table 1
Structural Instruments for Europe and 14 European Countries over Different Periods. This table displays subperiod averages of
the structural instruments for Europe and 14 European countries. The trade integration measure is calculated as the ratio of
imports plus exports over GDP. Data is obtained from the OECD. We make a distinction between trade with the world (W)
(excluding the region Europe) and trade with the region Europe (R). The misalignment measure for Europe is computed as the
square root of the mean squared errors between the industry weights of the region Europe and the industry weights of the world.
For the countries, we make a distinction between the errors relative to the weights of the world (W) and the errors relative to the
weights of the region Europe (R).
Country W/R Trade integration Misalignment
7379 8089 9099 0007 00s v. 70s 7379 8089 9099 0007 00s v. 70s
(% diff.) (% diff.)
Europe 41.21 45.38 44.66 54.98 33.41 13.10 11.72 8.20 9.49 27.57
Austria W 11.41 13.61 11.14 16.84 47.55 48.86 56.77 27.51 23.53 51.85
R 37.08 40.88 44.14 57.54 55.19 45.71 50.94 24.35 18.77 58.94
Belgium W 3.04 7.88 12.65 14.14 365.28 38.55 32.81 35.67 38.34 0.53
R 53.96 66.95 82.32 104.61 93.85 40.71 36.39 35.98 31.28 23.16
Finland W 15.94 19.47 16.74 24.90 56.18 0.00 4.93 36.74 47.63
R 30.18 28.99 32.40 37.37 23.81 0.00 5.14 41.85 57.56
France W 11.54 12.68 10.95 13.79 19.57 21.34 18.29 13.46 13.47 36.86
R 20.44 22.76 25.25 29.96 46.57 23.67 15.90 14.56 11.16 52.85
Germany W 13.58 15.50 13.11 19.33 42.34 26.38 26.07 24.91 20.45 22.47
R 25.68 31.80 29.55 40.25 56.76 28.51 27.80 25.85 22.24 21.98
Ireland W 17.88 22.88 32.54 37.51 109.83 56.60 51.33 34.57 40.30 28.79
R 65.89 70.71 76.02 68.12 3.38 53.29 49.82 30.86 32.70 38.64
Italy W 14.85 14.70 11.23 15.44 3.97% 38.32 41.22 33.65 30.95 19.23
R 20.79 21.48 22.96 26.77 28.76% 36.83 39.23 31.73 23.25 36.87
Netherlands W 20.88 23.37 20.45 29.84 42.91 35.86 39.31 30.14 24.57 31.47
R 55.86 65.06 64.10 73.21 31.06 37.12 38.92 27.50 20.21 45.56
Spain W 11.08 13.28 9.63 13.09 18.10 0.00 9.87 34.38 34.76
R 10.36 14.44 23.52 30.42 193.63 0.00% 11.54 35.45 27.51
Denmark W 11.25 13.32 11.79 14.19 26.20 42.76 31.54 25.63 29.89 30.09
R 36.54 38.99 39.51 47.57 30.18 36.64 28.53 23.26 28.30 22.78
Sweden W 12.04 14.31 13.14 18.22 51.37 0.00 23.56 23.50 21.69
R 33.70 36.97 37.69 46.22 37.17 0.00 26.70 29.68 27.15
UK W 21.21 17.01 15.85 15.78 25.59 16.42 15.76 13.93 18.49 12.60
R 23.73 25.67 26.11 24.32 2.46 16.45 16.46 12.20 12.80 22.19
Norway W 13.33 11.10 11.93 12.55 5.85 0.00 42.22 37.17 40.55
R 38.07 40.59 38.30 40.06 5.22 0.00 43.19 35.92 37.04
Switzerland W 14.79 16.58 15.01 19.39 31.11 40.58 32.33 38.12 32.90 18.93
R 35.96 40.19 39.63 47.98 33.41 41.07 29.33 37.14 31.83 22.50
3.2.2. Misalignment
At the regional and country level, equity market returns could deviate because of differences in the
indices industrial composition, as pointed out by e.g. Roll (1992). This means that as the industrial
structure of a region or country becomes more aligned to that of another region or country, the returns
of the equity portfolios should become more similar. Moreover, as the industrial structure of
a particular region or country resembles that of the global market portfolio, the equity portfolio of that
region or country should behave in a similar way as the global market portfolio. This implies that the
global market beta of regions and countries should converge to levels closer to one as industry
misalignment decreases. The misalignment of the industrial composition of regions/countries relative
to the global market is measured as the square root of the mean squared errors between industry
weights, i.e.
v
u N 2
u X regi
w
Xregi;t t wind;t ww ind;t
; (14)
ind 1
regi
where N is the number of industries, wind;t the weight of industry ind in region reg (country i) and
ww
ind;t
the weight of industry ind in the global market. Weights are computed as the market
capitalization of a certain industry in a particular region (country) to the total market capitalization in
that region (country). Market capitalizations are obtained from Datastream International. For coun-
tries, we also compute the misalignment of the industrial structure of the country relative to the region
it belongs to.
The evolution of the industry misalignment measure is depicted in Table 1. Industry misalignment
has decreased substantially over the last 30 years in nearly all countries, both with respect to the global
market and to the region. Noticeable exceptions are Finland and Sweden, whose stock markets became
both dominated by TMT related rms at the end of the 1990s. The fact that industry structures seem to
be more aligned across countries in the 00s compared to the 70s at least when measured through the
equity market suggests that integration has not yet lead to further specialization in the sense of
Krugman.
3.2.3. Euro dummy

The European integration process culminated in the introduction of a single currency, the euro, in
1999 in 11 European countries. Later on, several other countries joined the euro area, namely Greece
(2001), Slovenia (2007), and Malta and Cyprus (2008). While some European countries, like e.g.
Denmark, did not join the euro, their exchange rate is highly correlated with the euro. The introduction
of the euro may have affected exposures and correlations in a number of ways. First, with the intro-
duction of euro, all exchange rate risk within the euro area disappeared, which should have resulted in
increasing correlations between euro area equity markets. Second, the elimination of exchange rate
risk may have stimulated European investors to invest outside their home country, either directly or
indirectly through a reduction in asymmetric information. A number of studies, including Baele et al.
(2007) and De Santis and Gerard (2006) suggest that the home bias of European investors indeed
decreased substantially after the introduction of the euro. Consequently, the marginal investor will
increasingly become a European rather than a local investor, and stocks in different countries will
increasingly be priced according to a European-wide discount rate, and will less and less depend on the
particular degree of risk appetite of local investors. Third, the euro may have served as a facilitator for
other integration-stimulating policy measures, such as for instance improvements in trading and
settlement infrastructure and corporate governance and reporting procedures.
3.3. Contagion dummies
For the contagion tests, we consider the following crisis periods: the crash of 87, the Mexican Peso
crisis at the end of 1994, the Asian crisis of the second half of 1997 and the beginning of 1998, the
Russian cold in August 1998 (including the LTCM crisis), the Nasdaq Rash in April of 2000, the 9/11/
2001 terrorist attack, and the (start of the) subprime crisis in 2007. Using starting and ending dates
which are commonly used in the contagion literature (see Table 2), we create dummies that take on the
Table 2
The different event windows for constructing the dummies. This table reports the different dummies used in the contagion
analysis. The dates are based on the ones which are traditionally used in the literature. They are also consistent with the
chronology of economic and market events provided by Macro-Dev through their website http://www.macro-dev.com. Macro-
Dev has established itself as a leading web provider of economic forecasts and market analysis. The high global market volatility
state event concerns a dummy which takes on the value one if the smoothed probability of being in the high world volatility
state is higher than 0.5. The probabilities are retrieved from our regime-switching Asymmetric GARCH model, estimated on
global equity market returns. The smoothed probability of being in the high volatility state is presented in Fig. 1.
Event Begin End

Crash 87 19/10/1987 26/10/1987
Mexican crisis 19/12/1994 31/01/1995
Asian crisis 01/04/1997 30/10/1998
Russian crisis LTCM 01/08/1998 30/09/1998
Nasdaq rash 01/04/2000 30/04/2000
09/11 11/09/2001 11/10/2001
Subprime crisis 18/07/2007 15/08/2007
High global market volatility state See Fig. 1
0.8
Probability
0.6
0.4
0.2
0
1970 1975 1980 1985 1990 1995 2000 2005 2010
Year
Fig. 1. Smoothed Probabilities of the Global Market Volatility Regimes plots the smoothed probabilities that the global market equity
returns are in the high volatility state. The probabilities are obtained from estimating the regime-switching Asymmetric GARCH
model outlined in Section 2.1.
value of 1 in a particular crisis period and zero otherwise. In addition, we create a dummy that
distinguishes between high and low volatility periods. We create this dummy based on estimates from
our regime-switching Asymmetric GARCH model on global equity market returns, as explained in
Section 2.1. The dummy has zeros except for times when the smoothed probability of being in the high
global equity market volatility regime is larger than 50% (See Fig. 1).9 We perform the formal contagion
tests for each of the 8 dummies.
4. Estimation results for structural RS spillover model
This section summarizes the main estimation results for the structural regime-switching factor
model outlined in Section 2. We differentiate between this general and more restricted specications
using the specication tests discussed in Section 2.3. In this section, we discuss the estimation results
for the preferred models.10
Panels A, B and C of Table 3 report estimation results of the market betas and volatilities at the
regional European and individual country level. We nd strong evidence that market betas at all levels
are driven both by a latent regime variable and the structural instruments, i.e. we strongly reject the
null hypothesis of unit and constant betas. The regime-switching feature of market betas cannot be
rejected for any of the 14 countries, and neither for Europe as a region. The estimates for P and Q are
nearly always close to one, indicating that the persistence in market betas (see e.g. Ghysels and Jac-
quier, 2005) is to a large extent due to a persistence in regime. Regime-switching betas are (weakly)
correlated with business cycle measures such as the term and credit spread, suggesting that market
betas contain a business cycle component. For none of the countries, the latent regime variable exhibits
a break-type behavior, suggesting that permanent shifts (breaks) are well captured by the structural
instruments.
9
The selection of the 50% cut off point to classify the volatility regimes is not crucial as regimes are well dened (smoothed
probabilities are either close to 0% or to 100%).
10
Detailed model selection statistics as well as estimation results for other models are available on request. We exclude those
large tables to conserve space.
Table 3
802
Estimation Results for Optimal Factor Model. This table reports the estimation results of the beta specication and the volatility specication for the optimal factor model, respectively for the
region Europe and 14 European countries. Panel A shows the results for the beta specication of respectively the world market beta and the regional market beta. The column Model shows
whether the beta specication (b) contains an RS component and/or Instruments (I) and/or a Euro dummy (E).The next two columns show the betas over the two different regimes. The
p-value of the (Wald) test whether betas are signicantly different across regimes is reported between brackets. The columns Trade, Align and Euro show the coefcients of respectively
the two structural instruments and the euro dummy in the beta specication (if applicable). P-values are reported between brackets. The columns P and Q report the transition prob-
abilities with their p-values between brackets. Panel B of the table shows the total beta (rst line) and its structural component (second line) over different subperiods for respectively the
world market beta and the regional market beta. *, y, and z indicate signicance at respectively the 1, 5, and 10 percent level for the t-test whether subperiod betas are equal to the full-period
L. Baele, K. Inghelbrecht / Journal of International Money and Finance 29 (2010) 791818

betas (rst line) and the t-test whether the structural component is equal to zero (second line, italics). The tests are corrected for autocorrelation. Panel C shows the results for the volatility
specication of the optimal factor model. The table shows the coefcients for the Asymmetric GARCH specication. P-values are reported between brackets. The column P/Q reports the
transition probabilities for the world volatility states with their p-values between brackets.
Panel A: Beta Specication
Geographical Model Global Factor Regional Factor P Q
b1 b2 Trade Align Euro b1 b2 Trade Align Euro

Europe b(RS,I) 1.032 0.673 0.111 0.055 0.969 0.968
(0.000) (0.002) (0.018) (0.000) (0.000)
Austria b(RS,I,E) 1.261 0.575 0.205 0.083 0.101 1.367 0.677 0.187 0.014 0.188 0.994 0.997
(0.000) (0.000) (0.042) (0.000) (0.009) (0.000) (0.388) (0.033) (0.000) (0.000)
Belgium b(RS,I) 0.404 0.694 0.185 0.036 0.417 0.573 0.861 0.190 0.017 0.225 0.988 0.984
(0.000) (0.000) (0.087) (0.000) (0.012) (0.000) (0.345) (0.094) (0.000) (0.000)
Finland b(RS,I,E) 1.258 1.066 0.250 0.195 0.359 0.822 4.509 0.144 0.125 0.002 0.986 0.679
(0.800) (0.258) (0.012) (0.107) (0.057) (0.340) (0.153) (0.399) (0.184) (0.314)
France b(RS,I,E) 0.912 0.673 0.035 0.066 0.232 1.107 0.757 0.128 0.003 0.150 0.992 0.981
(0.000) (0.122) (0.032) (0.000) (0.000) (0.032) (0.397) (0.183) (0.000) (0.000)
Germany b(RS,I,E) 0.853 0.523 0.165 0.074 0.325 1.077 0.653 0.079 0.003 0.043 0.975 0.963
(0.000) (0.000) (0.001) (0.001) (0.000) (0.010) (0.397) (0.375) (0.000) (0.000)
Ireland b(RS,I,E) 0.651 1.204 0.023 0.085 0.250 0.972 0.397 0.144 0.014 0.112 0.972 0.302
(0.077) (0.326) (0.049) (0.002) (0.114) (0.012) (0.387) (0.246) (0.087) (0.301)
Italy b(RS,I,E) 0.614 0.741 0.040 0.160 0.147 0.573 0.976 0.088 0.122 0.205 0.995 0.998
(0.008) (0.222) (0.000) (0.065) (0.000) (0.086) (0.019) (0.236) (0.000) (0.000)
Netherlands b(RS,I,E) 1.020 0.648 0.093 0.005 0.167 0.861 0.782 0.034 0.090 0.034 0.980 0.984
(0.000) (0.004) (0.393) (0.085) (0.372) (0.178) (0.002) (0.381) (0.000) (0.000)
Spain b(RS,I) 1.053 0.986 0.142 0.060 1.130 0.740 0.168 0.006 0.991 0.991
(0.211) (0.039) (0.098) (0.018) (0.044) (0.199) (0.312) (0.391)
Denmark b(RS,I) 0.487 0.757 0.236 0.037 0.351 0.872 0.137 0.156 0.990 0.990
(0.031) (0.000) (0.283) (0.000) (0.013) (0.011) (0.000) (0.000)
Sweden b(RS,I,E) 0.983 0.469 0.172 0.185 0.331 0.741 3.654 0.111 0.201 0.082 0.986 0.588
(0.145) (0.000) (0.000) (0.019) (0.000) (0.059) (0.001) (0.360) (0.000) (0.367)
UK b(RS,I,E) 0.806 1.205 0.001 0.059 0.187 1.125 1.883 0.012 0.161 0.284 0.994 0.942
(0.001) (0.399) (0.007) (0.003) (0.000) (0.368) (0.017) (0.000) (0.000) (0.000)
Norway b(RS,I,E) 0.432 1.054 0.064 0.186 0.178 0.521 1.140 0.124 0.097 0.160 0.985 0.985
(0.000) (0.027) (0.036) (0.159) (0.000) (0.087) (0.183) (0.223) (0.000) (0.000)
Switzerland b(RS,I) 0.881 0.568 0.108 0.003 0.833 0.543 0.135 0.023 0.994 0.993
(0.000) (0.000) (0.397) (0.000) (0.001) (0.321) (0.000) (0.000)
Panel B: Subperiod average implied betas
Geographical Global Factor Regional Factor

Europe Model 7379 8089 9099 0007 7379 8089 9099 0007
b(RS,I) 0.659* 0.821* 0.852* 1.027*
0.155* 0.049* 0.027* 0.171*
Austria b(RS,I,E) 0.282* 0.482* 0.628* 0.649* 0.447* 0.587* 0.882* 0.959*
0.357* 0.231* 0.144* 0.322* 0.296* 0.229* 0.007 0.117*

Belgium b(RS,I) 0.347* 0.571* 0.631* 0.929* 0.525* 0.625* 0.751y 1.085*
0.165* 0.071* 0.09* 0.410* 0.155* 0.043* 0.042* 0.397*
Finland b(RS,I,E) 0.564* 0.937* 1.414* 0.860* 0.973* 0.957*
0.051* 0.313* 0.163* 0.012* 0.011 0.005
France b(RS,I,E) 0.785* 0.813* 0.882* 1.132* 0.820* 0.916* 1.014y 1.090*
0.024* 0.009* 0.037* 0.246* 0.135* 0.058* 0.006 0.021*
Germany b(RS,I,E) 0.593* 0.653* 0.774* 1.188* 0.713* 0.854* 0.934* 1.024*
0.058* 0.031* 0.002 0.458* 0.104* 0.007* 0.038* 0.105*
Ireland b(RS,I,E) 0.646* 0.655* 0.763z 0.883* 0.993* 0.918* 0.823* 0.851y
0.026* 0.017* 0.09* 0.211* 0.073* 0.001 0.094* 0.068*
Italy b(RS,I,E) 0.602* 0.581* 0.774* 1.008* 0.685* 0.777* 1.006* 1.087*
0.046* 0.133* 0.043* 0.326* 0.003 0.114* 0.062* 0.298*
Netherlands b(RS,I,E) 0.756* 0.867* 0.762* 1.033* 0.741* 0.706* 0.864* 0.927*
0.005 0.044* 0.031* 0.184* 0.065* 0.114* 0.051* 0.103*
Spain b(RS,I) 0.895* 0.923* 1.035* 0.712* 0.998* 1.115*
0.013* 0.109* 0.011 0.015* 0.010 0.153*
Denmark b(RS,I) 0.420* 0.651* 0.569* 0.874* 0.489* 0.542* 0.790* 0.891*
0.166* 0.075* 0.085* 0.257* 0.054* 0.02* 0.117* 0.290*
Sweden b(RS,I,E) 0.759* 1.088* 1.400* 0.665* 0.87* 1.053*
0.166* 0.124* 0.432* 0.119* 0.022* 0.225*
UK b(RS,I,E) 0.947* 0.851* 0.912* 0.921* 1.432* 1.211* 1.115* 0.858*
0.016* 0.007* 0.09* 0.099* 0.009* 0.015* 0.04* 0.298*
Norway b(RS,I,E) 0.816* 0.736* 0.905* 0.904* 0.824* 0.970*
0.135* 0.100* 0.155* 0.136* 0.099* 0.133*
Switzerland b(RS,I) 0.576* 0.733* 0.718* 0.870* 0.545* 0.654* 0.753 0.987*
0.095* 0.013* 0.088* 0.104* 0.093* 0.030* 0.011 0.261*
Panel C: Volatility specication

Geographical Intercept ARCH GARCH Asym P/Q
GlobalState 1 0.007 0.571 0.008 0.010 0.977
(0.001) (0.000) (0.383) (0.391) (0.000)
GlobalState 2 0.017 0.744 0.194 0.271 0.942
(0.000) (0.000) (0.000) (0.000) (0.000)
Europe 0.002 0.898 0.087 0.000
(0.011) (0.000) (0.000) (0.399)
803
(continued on next page)
804
Table 3 (continued)
Panel C: Volatility specication

Austria 0.004 0.829 0.133 0.048
(0.000) (0.000) (0.000) (0.055)
Belgium 0.001 0.914 0.084 0.003
(0.029) (0.000) (0.000) (0.401)
Finland 0.005 0.848 0.127 0.000
(0.006) (0.000) (0.000) (0.399)
France 0.004 0.883 0.086 0.049
(0.030) (0.000) (0.000) (0.170)
Germany 0.001 0.877 0.123 0.000
(0.018) (0.000) (0.000) (0.399)
Ireland 0.003 0.821 0.150 0.019
(0.003) (0.000) (0.000) (0.250)
Italy 0.004 0.856 0.117 0.036
(0.008) (0.000) (0.000) (0.162)
Netherlands 0.001 0.902 0.098 0.000
(0.069) (0.000) (0.000) (0.399)
Spain 0.002 0.897 0.089 0.000
(0.017) (0.000) (0.000) (0.399)
Denmark 0.006 0.833 0.120 0.046
(0.005) (0.000) (0.000) (0.152)
Sweden 0.002 0.852 0.121 0.048
(0.035) (0.000) (0.000) (0.147)
UK 0.003 0.878 0.092 0.060
(0.039) (0.000) (0.000) (0.031)
Norway 0.004 0.823 0.121 0.000
(0.001) (0.000) (0.000) (0.399)
Switzerland 0.002 0.873 0.051 0.109
(0.000) (0.000) (0.001) (0.000)
The market betas do not only vary with the latent regime variable, but also with our structural
instruments. In fact, our model selection procedure selects models with structural instruments for
Europe as a region and for all countries. The trade integration variable has a signicantly positive effect
on Europes global market beta, and, at the country level, on 8 (10) of the global (regional) market
betas.11 The positive effect of trade on market betas could be the result of a convergence in cash ow
shocks through further economic integration, an increase in cross-market participations of rms
(emergence of more multinationals), or through a convergence in cross-country discount rates (to the
extent that further nancial integration is correlated with higher degrees of trade integration). We nd
that trade has both an effect on global and regional betas, indicating that globalization may be at least
as important in this respect as regional integration.
The second structural instrument, industry misalignment, has a signicantly negative effect on
Europes global market beta, and on 9 (5) of the countries global (regional) market betas.12 This
indicates that betas tend to decrease (increase) when a region/country becomes increasingly different
(similar) in its industry structure from global/regional markets. In Finland and Norway, the relationship
is signicantly positive, which is likely to be caused by their increasing concentration in high beta
industries (respectively Telecom and Basic Resources).
As argued in Section 3.2.3, the introduction of the euro in 1999 may have had an effect on
common market exposures, even on non-euro area countries. At the regional level, we do not nd
a signicant euro effect. At the country level, we nd a signicant euro effect on the global market
betas of 9 of the 14 countries. Except for Austria and Finland, the euro has resulted in an upward
shift in global market betas that is not only statistically but also economically relevant (on average,
0.16). Further research should reveal whether these effects are truly euro effects. Surprisingly, the
effect is on average larger for countries not part of the euro area than for those that are (0.22 versus
0.13). Equally surprising is that there is hardly any effect of the euro on the regional market betas
(on average, 0.02).
Panel B of Table 3 reports both the total beta and its structural component over four subperiods,
namely the 70s, 80s, 90s, and 00s. A number of interesting patterns emerge. First, for Europe as
a region, we observe a gradual structurally-driven increase in its global market beta. While in the 70s
the European global market beta was about 0.16 below its regime-switching component, in the 00s it is
about 0.17 above that level, resulting in a total increase in market beta of nearly 0.33. Second, we nd
a comparable increase in the structural component of global and regional market betas for most
countries. The increase is substantially larger for the global than for the regional market beta (on
average, 0.27 versus 0.16 in absolute value). Surprisingly, we observe only minor differences between
euro area and other European markets. For the UK, we observe a mild increase in the structural
component of the global market beta, but a substantial decrease in its European market beta, especially
in the last period.
Panel C of Table 3 reports volatility estimates for the global, regional European, and country returns.
Global market volatility is best represented by a two-state regime-switching asymmetric GARCH
model. A number of features are noteworthy. First, volatility regimes are well identied both statis-
tically and economically. As can be seen from Fig. 1, the model always attaches a probability close to one
to either the low or high volatility regime. Moreover, the parameter estimates imply the level of
volatility to be more than two times higher in the high volatility state. Second, both volatility regimes
are highly persistent, allowing the GARCH parameter estimate to decrease from 0.88 in the AGARCH
model to 0.57 (low volatility regime) and 0.74 (high volatility regime) in the case of an RS-AGARCH
model. This suggests that the persistence in stock market volatility is also caused by persistence in the
volatility regime and only partly by within-regime volatility persistence. Third, we nd substantial
differences across regimes in the way the conditional volatility reacts to (negative) shocks. While both
the ARCH and asymmetry parameters are insignicant in the low volatility regime, both are strongly
signicant in the high volatility state. Interestingly, in the high volatility state, conditional volatility
increases strongly with negative shocks, but actually decreases in response to positive news. This
11
The regional market betas of Italy, Sweden, and Norway are signicant at the 10 percent level only.
12
In case of Belgium and Spain, the effect is only signicant at the 10 percent level.
further underlines the need to allow for multiple regimes in conditional volatility models. At the
country level, we nd that, once corrected for time-varying global and regional market betas, the
volatility of country-specic shocks is well described by a simple Asymmetric GARCH model. Inter-
estingly, once regime-switches in the betas are allowed for, volatility persistence decreases
substantially.
As discussed in Section 2.2, our three-step estimation procedure requires that the factor models
are sufciently rich to eliminate all residual correlation between the country-specic shocks. We
nd that residual correlations are typically lower than 0.03 in absolute terms, and hence are
negligible. Even for selected subsamples, residual correlations are mostly below 8% in absolute
value and are substantially lower than the corresponding subsample correlations of the raw returns.
Generally, this test suggests that our time-varying factor model does sufciently well in describing
cross-asset correlations. This conrms the ndings of Bekaert et al. (2009), who found that
a specication with both a global and regional factor and time-varying factor exposures adequately
models the ex-post covariance (correlation) structure of a large set of country-industry and
country-style portfolios.
To complete this section, Fig. 2 plots the evolution of the average market-weighted conditional
correlations across the 14 European countries, based on the results of the optimal factor model. The
correlations are fundamental-implied, originating from the joint exposure to the same fundamental
factors, and should be contagion-free. They reect the effect of both cyclical economic uctuations
as well as structural changes in the economy on global and regional betas. We notice a structurally-
driven increase in cross-country correlations over time. Moreover, the correlations appear to be
typically higher in times of economic downturn. Clearly, this correlation asymmetry should not be
mistaken with contagion. Interestingly, as shown by Fig. 3, restricted versions of the beta speci-
cations lead to substantial mismeasurement of the cross-country correlations over time. While
restricted versions, especially the constant beta specication, typically overestimate correlations
before 1990, the opposite is the case thereafter. In the next section, we will investigate whether
such correlation biases also lead to wrong conclusions about contagion.
0.9
0.85
0.8
0.75
0.7
0.65
0.6
0.55
0.5
0.45
0.4
1970 1975 1980 1985 1990 1995 2000 2005 2010
Fig. 2. Average Fundamental Model-Implied Correlations between European countries reports the average fundamental model-
implied cross-country correlations over time for 14 European countries. The implied correlations are computed using the optimal
models as reported in Table 3. World recessions are shaded in gray to illustrate cyclical movements in correlations. The recessions
are identied as the periods from the peaks to the throughs of the detrented world GDP.
0.15
Constant Beta
RS Beta
Instr Beta
0.1
0.05
0.05
0.1
1970 1975 1980 1985 1990 1995 2000 2005 2010
Fig. 3. Average mismeasurement in correlations due to restrictive beta specications reports the average mismeasurement in
correlations due to using the wrong beta specication for 14 European countries. We differentiate between mismeasurement based
on constant beta model (Constant Beta), regime-switching beta model (RS Beta) and instrumental beta model (Instr Beta). The
instrumental beta model concerns the model including both trade integration and industry alignment measure.
5. Empirical results for contagion tests
5.1. Contagion tests based on optimal model
In this section, we test for contagion for a set of 14 European countries based on estimates from our
optimal two-factor model. First, we perform an informal contagion test by comparing unconditional
correlations between crisis and non-crisis periods. Second, we present estimates from the formal
contagion test discussed in Section 2.3.
5.1.1. Preliminary contagion analysis

Table 4 reports correlations between the country-specic shocks and respectively the global,
regional, and the other country-specic shocks, based on the optimal beta specication. We report
correlations for the full sample as well as for tranquil and crisis times. The crisis periods are identied
as the times when at least one crisis dummy equals one. The exact denitions of the crisis periods can
be found in Table 2. The tranquil period corresponds to all non-crisis observations.
Generally, we do not nd evidence of increasing correlation in the crisis periods of local return
shocks with both global and regional market shocks.13 Only for the Netherlands (with 12 percent), we
do nd a signicant increase in correlation of local market shocks with regional market shocks.
Correlations with return shocks from other countries are generally not statistically signicant, indi-
cating that our two-factor model captures the unconditional correlation between countries reasonably
well. We do nd a signicant positive residual correlation over the full period in Austria, Belgium and
Denmark, but the magnitude (between 5.3 and 6.9 percent) is economically small. Finally, we do not
13
p
We test for zero correlations over the different periods according to the following asymptotic distribution: Nb r a N0; 1
w
with N the number of observations in the specic period and b r the estimated correlation.
Table 4
Correlation of Country-Specic Shocks for Full-time Period, Tranquil Period and Crisis Period. This table reports average
unconditional correlations between country-specic shocks and respectively world shocks, region-specic shocks, and the sum
of country-specic shocks of the region where the country belongs to. Market residuals are computed as outlined in Section 2.1.
The correlations of shocks across different European countries are computed over the longest possible overlapping sample
period between the markets. We differentiate between three different periods: full-time period, tranquil period and crisis
period. The latter is the period of crisis events as shown in Table 2. The tranquil period corresponds to all non-crisis observations.
The * symbol
p indicates 5 percent signicance level for a test of zero correlation according to the following asymptotic distri-
bution: T b r a N0; 1 with T the number of observations in the specic period. This implies the following critical values for
w
respectively the full time period, tranquil period and crisis period: 0.046, 0.054 and 0.089.
Geographical World shocks Regional shocks Sum of Country shocks
Full Tranquil Crisis Full Tranquil Crisis Full Tranquil Crisis

Europe 0.021 0.012 0.019 1.000 1.000 1.000 1.000 1.000 1.000
Austria 0.026 0.035 0.002 0.005 0.028 0.056 0.069* 0.057* 0.091*
Belgium 0.014 0.014 0.017 0.000 0.002 0.004 0.053* 0.053 0.058
Denmark 0.034 0.047 0.034 0.020 0.025 0.017 0.053* 0.054* 0.051
Finland 0.019 0.025 0.012 0.010 0.022 0.004 0.030 0.007 0.061
France 0.007 0.007 0.034 0.015 0.024 0.000 0.018 0.008 0.033
Germany 0.011 0.028 0.061 0.007 0.012 0.005 0.024 0.002 0.074
Ireland 0.011 0.052 0.040 0.004 0.026 0.068 0.012 0.005 0.028
Italy 0.009 0.005 0.025 0.018 0.020 0.010 0.030 0.045 0.009
Netherlands 0.008 0.004 0.024 0.030 0.013 0.124* 0.004 0.002 0.019
Norway 0.024 0.006 0.036 0.000 0.007 0.013 0.046 0.038 0.058
Spain 0.022 0.048 0.079 0.002 0.014 0.012 0.024 0.007 0.048
Sweden 0.019 0.016 0.050 0.000 0.028 0.050 0.037 0.034 0.046
Switzerland 0.020 0.018 0.071 0.009 0.022 0.019 0.037 0.033 0.049
UK 0.006 0.028 0.027 0.040 0.074* 0.031 0.244* 0.240* 0.252*
nd that the correlation with other countries return shocks increases in crisis periods.14 Overall, this
preliminary analysis does not provide evidence in favor of contagion.
5.1.2. Formal contagion analysis

Table 5 reports results from the contagion test outlined in Section 2.4, more specically the results
from estimating equations (10)(13). Panel A and B tests whether the country-specic shocks exhibit
excess correlation with respect to respectively global and regional market shocks. Similarly, Panel C
considers the case of excess correlation with respect to shocks in other countries. We differentiate
between different crisis periods, namely the 1987 crash, the Mexican Crisis, the Asian Crisis, the
Russian/LTCM crisis, the Nasdaq Rash, the 09/11 terrorist attacks, and the (start of the) subprime crisis.
We also test for excess comovement in times of high market volatility. For exact denitions on the
crises periods, we refer to Table 2.
Panel A of Table 5 provides little evidence in favor of contagion. First, the estimate of vw,1, i.e. the
increase in correlation between local markets and global markets in crisis periods, is economically
small and statistically insignicant during the Mexican crisis, the Russian/LTCM crisis, during the
period directly after the 9/11 terrorist attacks, and more recently, during the (start of the) subprime
crisis. While vw,1 is positive and marginally signicant during the Asian crisis, the effect is economically
small (about 5 percent). Third, we do not nd a meaningful increase in global market exposures in
times of high global market volatility. Fourth, we nd a statistically signicant decrease in global
market exposure during the 1987 market crash and the more recent Nasdaq Rash. During these two
crisis periods, European equity markets actually became less exposed to global market shocks, which is
good news for both investors and policy makers. Fifth, as expected, the intercept vw,0 is positive15 but
14
While the correlation in crisis periods is statistically signicant for Austria, we cannot reject the null hypothesis that it is
signicantly different from the unconditional correlation over the full sample period.
15
The systematically positive value for vw,0 indicates a systematic underestimation of betas during normal times, possibly due
to measurement error in the global (regional) market shocks or a missing factor. Its estimate is, however, both statistically
insignicant and economically small, underlining the performance of our factor model.
Table 5
Cross-section Analysis of Country-Specic Shocks for Optimal Factor Model. The time-series-cross-section regression model is
estimated as outlined in Section 2.4 for all European countries in our sample, accommodating group-wise heteroskedasticity. We
use the shocks based on the optimal factor model as discussed in Section 2.1. We make a distinction between world shocks (Panel
A), regional shocks (Panel B), and the sum of idiosyncratic shocks in all other countries (Panel C) affecting the country-specic
shocks. The model is estimated for each of the 8 crisis dummies as shown in Table 2. P-values are reported between brackets.
Dummy v0 v1 Wald: v0 v1 0
Estimate p-value Estimate p-value Estimate p-value

Panel A: World shocks
Crash 87 0.002 (0.844) 0.380 (0.017) 5.667 (0.059)
Mexican crisis 0.003 (0.719) 0.031 (0.810) 0.177 (0.915)
Asian crisis 0.000 (0.994) 0.049 (0.073) 3.533 (0.171)
Russian crisis LTCM 0.002 (0.826) 0.090 (0.170) 2.037 (0.361)
Nasdaq rash 0.004 (0.645) 0.175 (0.083) 3.116 (0.211)
09/11 0.002 (0.769) 0.034 (0.598) 0.408 (0.816)
Subprime crisis 0.003 (0.735) 0.010 (0.824) 0.143 (0.931)
High world volatility state 0.006 (0.548) 0.006 (0.680) 0.361 (0.835)
Panel B: Regional shocks

Crash 87 0.005 (0.637) 0.881 (0.002) 9.881 (0.007)
Mexican crisis 0.008 (0.456) 0.162 (0.562) 0.858 (0.651)
Asian crisis 0.009 (0.443) 0.000 (0.999) 0.618 (0.734)
Nasdaq rash 0.009 (0.439) 0.042 (0.869) 0.617 (0.735)
09/11 0.009 (0.408) 0.166 (0.191) 2.222 (0.329)
Subprime crisis 0.009 (0.443) 0.275 (0.107) 3.043 (0.218)
Panel C: Sum of country shocks

Crash 87 0.003 (0.082) 0.060 (0.057) 7.108 (0.029)
Mexican crisis 0.004 (0.052) 0.022 (0.285) 4.553 (0.103)
Asian crisis 0.003 (0.117) 0.008 (0.253) 5.374 (0.068)
Nasdaq rash 0.004 (0.055) 0.002 (0.940) 3.686 (0.158)
09/11 0.004 (0.052) 0.013 (0.553) 3.939 (0.140)
Subprime crisis 0.004 (0.055) 0.021 (0.574) 3.911 (0.141)
statistically insignicant for all countries. A joint test for the null of no contagion, i.e. a test that
vw,0 vw,1 0, cannot be rejected for all crisis periods at the 5 percent level.
Similar results are found for the exposures with respect to regional market shocks (see Panel B of
Table 5). We nd no evidence in favor of contagion during any of the crisis periods, the only exception being
the period directly after the 1987 market crash. While local European equity markets became less exposed
to global shocks, especially those in the US, we observe a strong increase in the exposure to regional
European shocks. As for global market exposures, the intercept vw,0 is positive but statistically insignicant
for all countries. The overall test rejects contagion for all periods except the post 1987 market crash.
Panel C of Table 5 tests for contagion with respect to idiosyncratic shocks in every other market.
Consistent with the ndings from Panel A and B, we do not nd evidence in favor of contagion. While
we do nd excess comovement after the 1987 crash, the increase is only signicant at the 10 percent
level. We do nd a statistically signicant increase in comovement during periods of high volatility,
even though the effect is extremely small in economic terms (about 1 percent). Finally, in contrast to
BHN, none of the estimates of vw,0 is signicant at the 5 level, indicating that our structural regime-
switching two-factor model outperforms theirs in terms of modeling cross-country correlations.
Table 6 investigates whether results are different between EMU and non-EMU countries, and
between small and large countries.16 For the global market exposures, we nd that the negative estimate
16
Big (small) countries are dened as countries with a market capitalization above (below) 100 billion euro. Big countries
include France, Germany, Italy, Netherlands, Spain, Switzerland and the UK. Small countries include Austria, Belgium, Denmark,
Finland, Ireland, Norway and Sweden.
Table 6
Subsample Analysis of Country-Specic Shocks for Optimal Factor Model. The time-series-cross-section regression model is
estimated as outlined in Section 2.4 for respectively all European countries in our sample (All), EMU countries (EMU), non-EMU
countries (Non-EMU), big countries (Big), and small countries (Small), accommodating group-wise heteroskedasticity. Big
(small) countries are dened as countries with a market capitalization above (below) 100 billion euro. Big countries include
France, Germany, Italy, Netherlands, Spain, Switzerland and the UK. Small countries include Austria, Belgium, Denmark, Finland,
Ireland, Norway and Sweden. We use the shocks based on the optimal factor model as discussed in Section 2.1. We make
a distinction between world shocks (Panel A) and regional shocks (Panel B) affecting the country-specic shocks. The model is
estimated for each of the 8 crisis dummies as shown in Table 2. We only report the v1 parameter, as the v0 parameter is qual-
itatively similar for all subsamples. P-values are reported between brackets.
Dummy All EMU Non-EMU Big Small
Estimate p-value Estimate p-value Estimate p-value Estimate p-value Estimate p-value
Crash 87 0.380 (0.017) 0.673 (0.000) 0.091 (0.678) 0.542 (0.005) 0.010 (0.974)
Mexican crisis 0.031 (0.810) 0.112 (0.561) 0.104 (0.331) 0.039 (0.830) 0.187 (0.135)
Asian crisis 0.049 (0.073) 0.070 (0.037) 0.014 (0.763) 0.041 (0.201) 0.067 (0.195)
Russian crisis LTCM 0.090 (0.170) 0.084 (0.272) 0.099 (0.397) 0.052 (0.499) 0.174 (0.157)
Nasdaq rash 0.175 (0.083) 0.265 (0.017) 0.026 (0.879) 0.142 (0.178) 0.250 (0.266)
09/11 0.034 (0.598) 0.034 (0.674) 0.034 (0.749) 0.131 (0.028) 0.181 (0.150)
Subprime crisis 0.010 (0.824) 0.042 (0.487) 0.043 (0.405) 0.033 (0.537) 0.041 (0.625)
High world 0.006 (0.680) 0.022 (0.255) 0.019 (0.471) 0.005 (0.798) 0.010 (0.710)
volatility state

Crash 87 0.881 (0.002) 1.343 (0.000) 0.141 (0.744) 1.173 (0.001) 0.182 (0.731)
Mexican crisis 0.162 (0.562) 0.036 (0.929) 0.492 (0.097) 0.143 (0.698) 0.835 (0.022)
Asian crisis 0.000 (0.999) 0.008 (0.898) 0.014 (0.883) 0.002 (0.979) 0.005 (0.958)
Russian crisis LTCM 0.070 (0.546) 0.086 (0.505) 0.046 (0.836) 0.006 (0.968) 0.212 (0.253)
Nasdaq rash 0.042 (0.869) 0.231 (0.419) 0.500 (0.245) 0.020 (0.944) 0.179 (0.733)
09/11 0.166 (0.191) 0.087 (0.602) 0.299 (0.123) 0.022 (0.860) 0.581 (0.019)
Subprime crisis 0.275 (0.107) 0.369 (0.031) 0.118 (0.735) 0.211 (0.334) 0.418 (0.097)
High world 0.002 (0.947) 0.009 (0.777) 0.018 (0.646) 0.009 (0.755) 0.027 (0.521)
volatility state
for vw,1 after the 1987 crash is entirely due to the large EMU countries. The Asian crisis had a signicant
effect on EMU countries, but not on non-EMU countries. We do nd evidence for contagion in the post 9/
11 period, but only for the larger markets. With respect to regional shocks, we nd that contagion after
the 1987 crash is mostly concentrated in the large EMU markets. During the Mexican, the 9/11, and the
(start of the) subprime crisis, we nd a signicant decrease in the exposure to regional shocks for the
small markets, but a statistically insignicant effect for the large markets. Generally, we nd that our
conclusion of no contagion (except during the period after the 1987 crash) holds even in subsamples, and
that differences between EMU and non-EMU and large and small markets are relatively small.
5.2. Contagion and alternative beta specications
In the previous section, we tested for contagion based on residuals generated from our preferred
model, and found limited evidence for contagion. In this section, we test whether we would have
reached the same conclusion for more restricted versions of our model. Table 7 reports the contagion
tests for a model with constant betas, a model with regime-switching betas, four models with different
sets of structural instruments, and nally a model where the beta is both a function of the structural
variables and a latent regime variable. Specication tests indicated that the latter model outperforms
more restricted versions for all countries.17
17
For the model with regime-switching and instruments, we include a euro dummy for all countries, even though speci-
cation tests indicated that this was not necessary for Belgium, Spain, Denmark, and Switzerland. We checked that the contagion
tests from this model are both qualitatively and quantitatively similar to when residuals from the optimal model are used for
each country.
Table 7
Cross-section Analysis of Country-Specic Shocks for Alternative Beta Specications. The time-series-cross-section regression
model is estimated as outlined in Section 2.4 for all European countries in our sample. We make a distinction between world
shocks (Panel A) regional shocks (Panel B), and sum of idiosyncratic shocks in all other countries (Panel C) affecting the country-
specic shocks. The model is estimated using the 8 dummies as shown in Table 2. Moreover the model is estimated for different
sets of country-specic shocks. We use shocks based on respectively constant beta model, regime-switching beta model,
structural beta model and regime-switching structural beta model. For the structural beta model we differentiate between
a structural beta model with only trade integration (TI) as structural variable, a structural beta model with both trade integration
(TI) and industry alignment (IA) as structural variables, a structural beta model including the euro dummy (Euro) as additional
instrument, and a structural beta model including the euro dummy (Euro) and the term spread (Term) as additional instruments.
The regime-switching structural beta model includes trade integration (TI), industry alignment (IA) and the euro dummy (Euro)
as structural variables. The panel model is estimated accommodating group-wise heteroskedasticity. P-values are reported
between brackets.
Dummy/Model World shocks
v0 v1 Wald: v0 v1 0

Part A: Crash 87
Constant 0.035 (0.000) 0.275 (0.001) 30.222 (0.000)
Regime-Switching (RS) 0.019 (0.016) 0.472 (0.001) 18.444 (0.000)
Structural: TI 0.022 (0.007) 0.237 (0.007) 15.831 (0.000)
Structural: TI IA 0.007 (0.396) 0.234 (0.006) 8.708 (0.013)
Structural: TI IA Euro 0.000 (0.975) 0.231 (0.009) 6.877 (0.032)
Structural: TI IA Euro Term 0.001 (0.930) 0.226 (0.009) 6.907 (0.032)
RS Structural (TI IA Euro) 0.002 (0.844) 0.380 (0.017) 5.667 (0.059)
Part B: Mexican crisis

Constant 0.041 (0.000) 0.061 (0.636) 21.853 (0.000)
Structural: TI 0.024 (0.005) 0.018 (0.876) 7.998 (0.018)
Structural: TI IA 0.008 (0.323) 0.025 (0.822) 1.067 (0.587)
Part C: Asian crisis

Constant 0.045 (0.000) 0.071 (0.012) 24.375 (0.000)
Structural: TI 0.028 (0.001) 0.082 (0.004) 14.266 (0.001)
Structural: TI IA 0.010 (0.225) 0.044 (0.120) 3.019 (0.221)
Part D: Russian crisis LTCM

Constant 0.042 (0.000) 0.102 (0.124) 23.259 (0.000)
Structural: TI 0.025 (0.003) 0.118 (0.077) 10.832 (0.004)
Structural: TI IA 0.009 (0.275) 0.079 (0.219) 2.398 (0.302)
Part E: Nasdaq rash

Constant 0.040 (0.000) 0.193 (0.070) 25.182 (0.000)
Structural: TI 0.022 (0.007) 0.246 (0.022) 13.456 (0.001)
Structural: TI IA 0.007 (0.376) 0.194 (0.077) 4.177 (0.124)

Table 7 (continued)
Dummy/Model World shocks
v0 v1 Wald: v0 v1 0
Part F: 09/11
Constant 0.043 (0.000) 0.178 (0.009) 26.924 (0.000)
Structural: TI 0.024 (0.004) 0.031 (0.644) 8.133 (0.017)
Structural: TI IA 0.008 (0.316) 0.010 (0.887) 1.006 (0.605)
Structural: TITI IA Euro 0.000 (0.979) 0.041 (0.527) 0.411 (0.814)
Structural: TITI IA Euro Term 0.000 (0.954) 0.031 (0.640) 0.218 (0.897)
RS Structural (TI TI IA Euro) 0.002 (0.769) 0.034 (0.598) 0.408 (0.816)
Part G: Subprime crisis

Constant 0.044 (0.000) 0.356 (0.000) 46.458 (0.000)
Structural: TI 0.025 (0.003) 0.080 (0.184) 9.535 (0.009)
Structural: TI IA 0.009 (0.267) 0.066 (0.244) 2.263 (0.322)
Structural: TITI IA Euro 0.001 (0.882) 0.013 (0.792) 0.081 (0.960)
Structural: TITI IA Euro Term 0.000 (0.981) 0.010 (0.828) 0.051 (0.975)
RS Structural (TI TI IA Euro) 0.003 (0.735) 0.010 (0.824) 0.143 (0.931)
Part H: High world volatility state

Constant 0.053 (0.000) 0.021 (0.229) 26.606 (0.000)
Structural: TI 0.015 (0.179) 0.016 (0.336) 8.154 (0.017)
Structural: TI IA 0.001 (0.940) 0.013 (0.410) 1.394 (0.498)
Dummy/Model Regional Shocks
v0 v1 Wald: v0 v1 0

Part E: Nasdaq rash

Part A: Crash 87
Constant 0.051 (0.000) 0.421 (0.018) 25.998 (0.000)
Structural: TI 0.031 (0.010) 0.487 (0.003) 16.480 (0.000)
Structural: TI IA 0.034 (0.004) 0.474 (0.004) 18.033 (0.000)

Constant 0.051 (0.000) 0.188 (0.526) 18.806 (0.000)
Structural: TI 0.033 (0.006) 0.115 (0.688) 7.668 (0.022)
Structural: TI IA IA 0.036 (0.002) 0.135 (0.638) 9.635 (0.008)

Constant 0.048 (0.000) 0.082 (0.130) 22.070 (0.000)
Structural: TI 0.032 (0.008) 0.047 (0.388) 9.182 (0.010)

Part D: Russian crisis IA LTCM

Constant 0.049 (0.000) 0.181 (0.153) 20.431 (0.000)
Structural: TI 0.031 (0.009) 0.145 (0.232) 9.047 (0.011)
Structural: TI IA Euro IA Term 0.027 (0.018) 0.119 (0.318) 7.082 (0.029)
Part E: Nasdaq Rash

Constant 0.051 (0.000) 0.068 (0.803) 18.744 (0.000)
Structural: TI 0.033 (0.005) 0.103 (0.714) 7.803 (0.020)
Structural: TI IA 0.036 (0.002) 0.090 (0.754) 9.688 (0.008)
Part F: 09/11
Constant 0.051 (0.000) 0.177 (0.202) 19.463 (0.000)
Structural: TI 0.034 (0.004) 0.286 (0.050) 11.236 (0.004)

Constant 0.049 (0.000) 0.039 (0.844) 17.589 (0.000)
Structural: TI 0.033 (0.005) 0.334 (0.079) 10.369 (0.006)
Part H: High
world volatility state
Constant 0.027 (0.053) 0.071 (0.006) 24.739 (0.000)
Structural: TI 0.028 (0.050) 0.014 (0.577) 7.761 (0.021)
Structural: TI IA 0.032 (0.022) 0.011 (0.649) 9.586 (0.008)
Dummy/Model Sum of Country Shocks
v0 v1 Wald: v0 v1 0

Panel C: Sum of Country Shocks
Part A: Crash 87
Constant 0.019 (0.000) 0.055 (0.016) 105.279 (0.000)
Structural: TI 0.010 (0.000) 0.059 (0.048) 30.000 (0.000)
Structural: TI IA 0.005 (0.008) 0.064 (0.044) 11.727 (0.003)

Constant 0.019 (0.000) 0.039 (0.068) 103.193 (0.000)
Table 7 (continued)
Dummy/Model Sum of Country Shocks

v0 v1 Wald: v0 v1 0
Panel C: Sum of Country Shocks
Structural: TI 0.010 (0.000) 0.029 (0.162) 27.567 (0.000)
Structural: TI IA 0.006 (0.005) 0.026 (0.209) 9.053 (0.011)

Constant 0.020 (0.000) 0.008 (0.251) 101.701 (0.000)
Structural: TI 0.010 (0.000) 0.001 (0.870) 26.779 (0.000)
Structural: TI IA 0.005 (0.010) 0.004 (0.579) 8.539 (0.014)
Part D: Russian crisis LTCM

Constant 0.019 (0.000) 0.009 (0.562) 102.152 (0.000)
Structural: TI 0.010 (0.000) 0.016 (0.295) 27.456 (0.000)
Structural: TI IA 0.005 (0.009) 0.020 (0.178) 9.698 (0.008)
Part E: Nasdaq rash

Constant 0.019 (0.000) 0.000 (0.997) 102.059 (0.000)
Structural: TI 0.010 (0.000) 0.017 (0.508) 27.060 (0.000)
Structural: TI IA 0.005 (0.005) 0.002 (0.934) 7.931 (0.019)
Part F: 09/11
Constant 0.019 (0.000) 0.052 (0.125) 104.098 (0.000)
Structural: TI 0.010 (0.000) 0.009 (0.664) 26.523 (0.000)
Structural: TI IA 0.006 (0.005) 0.010 (0.647) 8.041 (0.018)

Constant 0.019 (0.000) 0.042 (0.000) 123.943 (0.000)
Structural: TI 0.010 (0.000) 0.010 (0.693) 26.775 (0.000)
Structural: TI IA 0.005 (0.006) 0.017 (0.486) 8.534 (0.014)
Part H: High world volatility state

Constant 0.014 (0.000) 0.014 (0.001) 104.392 (0.000)
Structural: TI 0.006 (0.005) 0.011 (0.015) 28.541 (0.000)
Structural: TI IA 0.002 (0.379) 0.010 (0.021) 10.951 (0.004)
Panel A of Table 7 reports results from the global contagion test. Independently of the crisis
period, we nd that the intercept vw,0 is signicantly negative for models with constant or regime-
switching betas, indicating that these models on average overestimate global market betas.
Interestingly, while vw,0 is insignicant for models with trade integration and industry structure
alignment as instruments, it remains signicantly negative in case only trade integration is used, as
in BHN. We nd a number of interesting ndings with respect to vw,1, our main parameter of interest.
First, a contagion test based on constant global market exposures indicates contagion from global
markets during the Asian crisis, the 9/11 terrorist attacks, and the (start of the) subprime crisis,
while no contagion is found when country-specic shocks are generated with our optimal model.
Second, a model with regime-switching betas would falsely indicate contagion during the 9/11 crisis
and the (start of the) subprime crisis. Third, contagion test results based on models with instruments
only tend to give mostly the same result as those based on the optimal model. The only exception is
the Russian/LTCM crisis, during which contagion is falsely detected using the beta models with
instruments only. Structural beta models generally yield similar contagion results independently on
the number of instruments included.
Panel B of Table 7 reports tests for excess comovement with respect to regional European market
shocks. The intercept vreg,0 is positive and statistically signicant for all specications except the
optimal one, i.e. they systematically underestimate regional market betas. Not surprisingly, the extent
of underestimation tends to decrease with model complexity, to disappear completely for our most
general model. In contrast to the global contagion test, we nd that contagion test results are largely
independent of how the regional betas are modelled. We nd similar results when we test for
contagion with respect to idiosyncratic shocks from other markets (Panel C of Table 7).
Our optimal model allows the global (regional) market exposures to vary with a latent regime
variable. Despite that we limit the number of possible states to two, it is still possible that our regime
variable does not (only) pick up cyclical movements in market betas, but also contagion episodes. If this
would be the case, our tests would be biased against nding contagion. As a robustness check, we
replace the latent regime variable by the lagged term spread, an often used instrument to predict
cyclical movements. As can be seen from line 6 in Panel A and B of Table 7, the contagion test results of
a model with structural instruments and the lagged term spread are similar to our preferred model,18
suggesting that our nding of no contagion is robust to using observed cyclical instruments rather
than a latent regime variable as a proxy for cyclical movements.
6. Conclusion
This paper studies time-varying integration and contagion jointly for a set of 14 European
countries over the last 35 years. We are particularly interested in whether increased nancial inte-
gration has made European equity markets more prone to contagion. As in Bekaert et al. (2005), we
dene contagion as correlation over and above what one would expect from economic funda-
mentals. While this denition has the benet of clarity, its success ultimately depends on a correct
characterization of correlations implied by economic fundamentals. As in previous papers, we use
a dynamic model with global and regional market shocks as factors to describe the fundamental
linkages between markets. We differ from previous work in the way the market exposures, or betas,
are allowed to vary through time. Not only are the factor exposures varying with a wider set of
structural variables, proxying for time-varying economic and nancial integration, we also allow
them to vary over the cycle. Using a battery of specication tests, we show that both components are
necessary to correctly describe the comovements between equity market returns. Both global and
regional market betas have increased substantially over the last three decades, reecting increasing
economic and nancial integration. The introduction of the euro seems to have strengthened the
integration process even further.
18
During the Asian crisis, the optimal model rejects the null op no contagion at the 10 percent level, while the model with
instruments and term spread rejects it at the 5 percent level. In case of the Russian/LTCM crisis, the optimal model cannot reject
the null of no contagion, while the model with instruments and term spread only rejects it at the 10 percent level.
In the absence of contagion, and assuming that the model indeed describes well fundamental link-
ages between markets, one would not expect any correlation between the country residuals during
times of nancial crisis. In the opposite case, country residuals will be positively and signicantly
correlated, i.e. they will exhibit excess correlation. When we use country residuals from our most general
(and preferred) model, we generally do not nd evidence for contagion during any of the crisis periods
we consider, namely the Mexican crisis, the Asian crisis, the Russian/LTCM crisis, the Nasdaq Rash, the 9/
11 terrorist attacks, the (start of the) subprime crisis, and during periods of high market volatility. Only in
the period after the 1987 crash, we nd evidence of excess exposure to regional European shocks. In
a second step, we perform the same contagion tests using residuals from simpler models, i.e. we
investigate to what extent the contagion test depends on the specication of the time-varying factor
exposures. We nd that specications with constant global (regional) market exposures miscorrectly
identify contagion during the 87 crash, Asian crisis, the 9/11 terrorist attacks, and during the (start of the)
subprime crisis. Similarly, we show that contagion test results can differ substantially depending on how
the time variation in both the structural and cyclical component of the factor exposures is modeled.
Appendix A. Contagion versus Model Misspecication
We have the following fundamental two-factor model for countries:

w reg
ri;t mi;t1 bi;t ew;t bi;t ereg;t ei;t (A-1)
where ri,t is the return for country i, mi,t1 the time t 1 expected return of country i, ew,t and ereg,t
w reg
respectively the global and regional market shocks, ei,t the country-specic shock, and bi;t and bi;t the
w
time-varying exposures of country is returns with respect to the global and regional market shocks. bi;t
reg
and bi;t are assumed to capture fundamental and cyclical movements in the returns. The country
residuals could however show excess correlation, whether or not related to crisis periods. To model this
excess correlation, we use the following model:
b
e i;t wi vw;t b
e w;t vreg;t b
e reg;t ui;t (A-2)
with

vw;t vw;0 vw;1 Dt (A-3)

vreg;t vreg;0 vreg;1 Dt (A-4)
After replacing the shocks in equation (15) by their estimated values and substituting in equations
(A-2)(A-4), we obtain
w
reg

ri;t mi;t1 wi bi;t vw;0 vw;1 Dt be w;t bi;t vreg;0 vreg;1 Dt be reg;t ui;t
or, more concise
ri;t m ~w b
~ i;t1 b ~ reg b
i;t e w;t bi;t e reg;t Ct ui;t
with
m~ i;t1 mi;t1 wi (A-5)
w
b~w
i;t bi;t vw;0 (A-6)
reg
b~reg
i;t
bi;t vreg;0 (A-7)

Ct vw;1 b
e w;t vreg;1 b
e reg;t Dt
Ct can be labelled as the contagion component, i.e. the excess return in times of crisis which is common
to all countries. The bias in the global and regional market betas are captured by respectively vw,0 and
vreg,0. This bias can be caused by a number of things. First, in case vw,0 and vreg,0 are negative, the bias is
caused by contagion provided that vw,1 and vreg,1 are positive. Basically when contagion is important
w reg
and the model is not able to capture it, the betas bi;t and bi;t will be biased upwards. Adding contagion
dummies to the specication, the negative values for vw,0 and vreg,0 will bring the betas down in no-
contagion periods, i.e. will account for the bias. The resulting b~w and b ~reg will be unbiased. The excess
i;t i;t
correlation due to contagion, will be captured by a positive vw,1 and vreg,1.19
Second, in case both vw,0 and vreg,0, and vw,1 and vreg,1 are negative, the bias is caused by model
w
misspecication. The negative vw,0 and vreg,0 imply that respectively the global market betas bi;t and the
reg
regional market betas bi;t are systematically overestimated.
Third, model misspecication can also cause vw,0 and vreg,0 to be positive. A positive vw,0 and vreg,0
w reg
imply that respectively the global market betas bi;t and the regional market betas bi;t are systemati-
cally underestimated. This underestimation can be explained by measurement errors. As the actual
global market shock ew,t and regional market shock ereg,t are not know, they must be replaced by
w reg
estimates. The resulting measurement error will bias the estimates for bi;t and bi;t downward. This is
typically called the attenuation bias. Baele and Inghelbrecht (2009) have shown that the global market
betas and the regional market betas do not sum to one.20 They are slightly below one. The attenuation
bias may well account for that.
Finally, note that there may also be excess correlation between the residuals ui,t of each country. This
could signal that there is a missing factor. This is however not the focus of the paper.
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Journal of International Money and Finance 29 (2010) 791818

Contents lists available at ScienceDirect

Journal of International Money

Time-varying integration, interdependence and contagionq

2.1. A structural regime-switching factor model

wreg wreg wreg wreg

Model Beta specication

where z {w, reg}.

2.2. Estimation procedure

2.3. Specication tests

2.3.1. Likelihood ratio tests

2.3.2. Test on standardized residuals

2.3.3. Regime-classication measure

2.4. Contagion tests

vz;t vz;0 vz;1 Dt (9)

where b e i;t and b

3.1. Stock returns

3.2. Structural instruments

3.2.1. Trade integration

Country W/R Trade integration Misalignment

3.2.3. Euro dummy

3.3. Contagion dummies

Event Begin End

4. Estimation results for structural RS spillover model

L. Baele, K. Inghelbrecht / Journal of International Money and Finance 29 (2010) 791818

Panel A: Beta Specication

Geographical Model Global Factor Regional Factor P Q

b1 b2 Trade Align Euro b1 b2 Trade Align Euro

Geographical Global Factor Regional Factor

L. Baele, K. Inghelbrecht / Journal of International Money and Finance 29 (2010) 791818

Panel C: Volatility specication

Panel C: Volatility specication

L. Baele, K. Inghelbrecht / Journal of International Money and Finance 29 (2010) 791818

1970 1975 1980 1985 1990 1995 2000 2005 2010

5. Empirical results for contagion tests

5.1. Contagion tests based on optimal model

5.1.1. Preliminary contagion analysis

Geographical World shocks Regional shocks Sum of Country shocks

Full Tranquil Crisis Full Tranquil Crisis Full Tranquil Crisis

5.1.2. Formal contagion analysis

Estimate p-value Estimate p-value Estimate p-value

Panel B: Regional shocks

Panel C: Sum of country shocks

Dummy All EMU Non-EMU Big Small

Panel B: Regional shocks

5.2. Contagion and alternative beta specications

Dummy/Model World shocks

Estimate p-value Estimate p-value Estimate p-value

Part B: Mexican crisis

Part C: Asian crisis

Part D: Russian crisis LTCM

Part E: Nasdaq rash

(continued on next page)

Dummy/Model World shocks

Estimate p-value Estimate p-value Estimate p-value

Panel A: World shocks

Part G: Subprime crisis

Part H: High world volatility state

Dummy/Model Regional Shocks

Estimate p-value Estimate p-value Estimate p-value

Part E: Nasdaq rash

Part B: Mexican crisis

Part C: Asian crisis

Structural: TI IA Euro 0.031 (0.010) 0.031 (0.566) 8.102 (0.017)