Measuring the effects of geographical distance on stock market correlation

Recent studies suggest that the correlation of stock returnsincreases with decreasing geographical distance. However, there is some debateon the appropriate methodology for measuring the effects of distanceon correlation. We modify a regression approach suggested in the literatureand complement it with an approach from spatial statistics, the mark correlationfunction. For the stocks contained in the S&P 500 that we examine,both approaches lead to similar results: correlation increases with decreasingdistance. Contrary to previous studies, however, we find that differences indistance do not matter much once the firms’ headquarters are more than 40miles apart, or separated through a federal border. Finally, we show throughsimulations that distance can significantly affect portfolio risk. Investorswishing to exploit local information should be aware that local portfolios arerelatively risky.