CORRELATION COEFFICIENTS, HETEROSKEDASTICITY AND CONTAGION OF FINANCIAL CRISES

A significant increase in the correlation coefficients of returns across countries during periods of high turbulence is regarded as evidence of the contagion of financial crises. However, heteroskedasticity is known to cause correlation coefficients to be biased upward. This note shows that correlation coefficients can be biased downward under heteroskedasticity when returns are following stochastic unit root processes. Further, returns are known to be nonlinear, so correlation coefficients might not be very useful in measuring relations between them. These results indicate that the time-series behavior of returns needs to be more thoroughly studied prior to measuring the contagion of financial crises with correlation coefficients. Copyright Blackwell Publishing Ltd and The Victoria University of Manchester, 2005.