Framework for Analyzing Spatial Contagion between Financial Markets

We present an alternative definition of contagion between financial markets, which is based on a measure of local correlation. We say that there is contagion from market X to market Y if there is more dependence between X and Y when X is doing badly than when X exhibits typical performance, that is, if there is more dependence at the loss tail distribution of X than at its center. The dependence is measured by the local correlation between X and Y. This yields a test for contagion, which does not require the specification of crisis and normal periods. As such, it avoids difficulties associated with testing for correlation breakdown, such as hand picking subsets of the data, and it provides a better understanding of the degree of dependence between financial markets