The Rationale of the International Equity Return Correlation Structure

Abstract

Correlation in international stock market returns is unstable over time. It is empirically shown that for most markets the correlation of negative returns exceeds that for positive returns. With rational consumption based asset pricing, any comovement behavior of asset returns must be linked somehow to the correlation pattern of international consumption streams. The extent of this linkage depends on the degree of market integration. In this paper, I adapt the general equilibrium model of asset pricing by Campbell and Cochrane (1999) to the international context and calibrate the degree of market integration to reproduce the level of international stock market correlations for the countries Canada, France, Germany, UK, and US. The paper then shows how far a purely rational explanation of higher correlations in down-markets can go. It turns out that the model's internal dynamics is not able to produce higher correlations in down-market phases with i.i.d multivariate normal consumption increments. Thus, the empirical behavior must be caused by characteristics of consumption data alone. A historical simulation shows that there is indeed a dependence structure in consumption data supporting this increase in correlation but that there is still room left for alternative explanations like a time-varying degree of market integration.