Michael Dueker

English

Research Papers in Economics

September 2000
MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Spring of Disconnect
Across Stock Markets?
Rates of return on broad stock market indices, such
as the composite New York Stock Exchange (NYSE)
and the National Association of Securities Dealers
Automated Quotations System (NASDAQ), are gen-
erally highly correlated with one another.  Although
the two indices are comprised of different stocks,
both of their rates of return are influenced by macro-
economic shocks and a common underlying rate of
discounting future profits.  In the spring of 2000,
however, the NASDAQ and NYSE seemed to discon-
nect, in that their movements were substantially less
correlated than usual.
Mico Loretan and William English suggest that
changes across time in the measured correlation
between financial rates of return can reflect changes
in the volatility of one asset relative to another.1 If
NASDAQ returns, for example, experience an idio-
syncratic increase in volatility that is not shared by NYSE
returns, then the correlation between the returns of the
two indices will be lower than average during the
period of high volatility.  On the other hand, if
events cause the volatilities of NASDAQ and
NYSE returns to increase in tandem, then the
correlation will be higher than average. In the
spring of 2000, NASDAQ returns experienced
unprecedented volatility and NYSE returns did
not.  Of special concern to investors during that
period was uncertainty about the future prof-
itability of internet stocks, which make up a
relatively larger share of the NASDAQ index
than of the NYSE.  This idiosyncratic increase
in the volatility of NASDAQ returns might
help us understand why we observed low cor-
relations between NASDAQ and NYSE returns
last spring.
The attached chart shows 100-day rolling sample
correlations between NYSE and NASDAQ returns
(dark line) and how the sample correlation would be
expected to vary from its long-run average due solely
to changes in the volatilities of returns, holding the
underlying correlation structure constant (gray line).
The volatility-implied degree of correlation proves to
be an imperfect indicator during periods of relatively
high and stable correlation, but tracks the sample cor-
relations accurately when the sample correlations are
far below normal.  Thus, sharp drops in sample corre-
lations do not necessarily represent a fundamental
break in the correlation structure between the two
stock markets.  The link between the idiosyncratic
volatility of NASDAQ returns and the sample corre-
lations between NASDAQ and NYSE returns sug-
gests a gradual return to normal correlations as NAS-
DAQ volatility subsides from the high levels reached
this spring. 
—Michael Dueker
1Mico Loretan and William B. English, “Special Feature:  Evaluating changes
in correlations during periods of high market volatility,” BIS Quarterly Review,
June 2000, pp. 29-36.
1
0.75
0.5
0.25
0
Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00
Sample Correlation (Rolling 100-day Window)
Correlation Implied by Sample Variances (Measured in Rolling 
100-Day Window)

Spring of disconnect across stock markets?

http://research.stlouisfed.org/publications/mt/20000901/cover.pdf

Spring of disconnect across stock markets?

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