University. We are especially grateful for suggestions from Geert Bekaert, Bob Hodrick, and Ken Singleton. We also thank an anonymous referee whose comments and suggestions greatly improved the paper.

We test for asymmetry in a model of the dependence between the Deutsche mark and the yen, in the sense that a different degree of correlation is exhibited during joint appreciations against the U.S. dollar versus during joint depreciations. We consider an extension of the theory of copulas to allow for conditioning variables, and employ it to construct flexible models of the conditional dependence structure of these exchange rates. We find evidence that the mark–dollar and yen–dollar exchange rates are more correlated when they are depreciating against the dollar than when they are appreciating. 1.

contagion captures the co-incidence of extreme return shocks across countries within a region the extent of contagion, its economic significance, and its determinants using a multinomial 1990s, we find that contagion, when measured by the co-incidence within and across regions of changes, and conditional stock return volatility. Evidence that contagion is stronger for extreme September 2001 Associate Professor, College of Business Administration, Korea University ** Professor of Finance and Dean's Distinguished Research Professor, Fisher College of Business, Ohio State University *** Professor of Finance and Reese Chair of Banking and Monetary Economics, Fisher College of Business, Ohio State University, Research Associate, National Bureau of Economic Research. The authors are grateful to the Dice Center for Research on Financial Economics for support. We thank Tom Santner, Mark Berliner, Bob Leone, and Stan Lemeshow for useful discussions on methodology, Steve Cecchetti, Peter Christoffersen, Craig Doidge, Barry Eichengreen, Vihang Errunza, David Hirshleifer, Roberto Rigobon, Richard Roll, Karen Wruck and, especially, an anonymous referee and the editor, Cam Harvey, for comments. Comments from seminar participants at Hong Kong University of Science and Technology, Korea University, McGill University, Yale University, Michigan State University, Universiteit Maasstricht, Ohio State University, Rice University, Monte Verita Risk Management Conference (Ascona, Switzerland), Federal Reserve Bank of Chicago Annual Conference on Bank Structure and Competition, Global Investment Conference on International Investing (Whistler), and the NYSE Conference on Global Equity Markets in Transition (Hawaii) improved the paper.

1 Software used in the estimation of this paper can be found at http://weber.ucsd.edu/~ksheppar in the research section. Kevin Sheppard would like to acknowledge financial support from the European Central Bank. While all efforts have been made to ensure that there are no errors in the paper, remaining errors are the sole responsibility of the authors. The opinions expressed herein are those of the authors and do not necessarily represent those of the European Central Bank. This paper can be downloaded without charge from

Contagion in equity markets refers to the notion that markets move more closely together during periods of crisis. One of the most interesting aspects of the contagion debate is the disagreement

We propose a dynamic equilibrium model of a multi-asset market with stochastic volatility and transaction costs. Our key assumption is that investors might be forced to liquidate their portfolios when their performance falls below a threshold. This generates a preference for liquidity which is time-varying and increasing with volatility. We show that during volatile times, assets ’ liquidity premia increase, investors become more risk averse, the correlation between the market and the volatility becomes more negative, assets ’ pairwise correlations increase, and the market betas of illiquid assets increase. Moreover, an unconditional CAPM understates the risk of illiquid assets because these assets become riskier when investors are the most risk averse.

This paper investigates to what extent globalization and regional integration lead to increasing equity market interdependence. I focus on the case of Western Europe, as this region has gone through a unique period of economic, financial, and monetary integration. More specifically, I quantify the magnitude and time-varying nature of volatility spillovers from the aggregate European (EU) and US market to 13 local European equity markets. To account for time-varying integration, I allow the shock sensitivities to change through time by means of a regime-switching model. I find that these regime switches are both statistically and economically important. While both the EU and US shock spillover intensity has increased over the 1980s and 1990s, the rise is more pronounced for EU spillovers. In most countries, shock spillover intensities increased most strongly in the second half of 1980s and the first half of the 1990s. Increased trade integration, equity market development, and low inflation are shown to have contributed to the increase in EU shock spillover intensity. Finally, I find some evidence for contagion from the US market to a number of local European equity markets during periods of high world market volatility.

We review the international finance literature to assess the extent to which international factors affect financial asset demands and prices. International asset pricing models with mean-variance investors predict that an asset’s risk premium depends on its covariance with the world market portfolio and, possibly, with exchange rate changes. The existing empirical evidence shows that a country’s risk premium depends on its covariance with the world market portfolio and that there is some evidence that exchange rate risk affects expected returns. However, the theoretical asset pricing literature relying on mean-variance optimizing investors fails in explaining the portfolio holdings of investors, equity flows, and the time-varying properties of correlations across countries. The home bias has the effect of increasing local influences on asset prices, while equity flows and cross-country correlations increase

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Integrated risk management in a financial institution requires an approach for aggregating risk types (market, credit, and operational) whose distributional shapes vary considerably. In this paper, we construct the joint risk distribution for a typical large, internationally active bank using the method of copulas. This technique allows us to incorporate realistic marginal distributions, both conditional and unconditional, that capture some of the essential empirical features of these risks such as skewness and fat-tails while allowing for a rich dependence structure. We explore the impact of business mix and inter-risk correlations on total risk, whether measured by value-at-risk or expected shortfall. We find that given a risk type, total risk is more sensitive to differences in business mix or risk weights than to differences in inter-risk correlations. There is a complex relationship between volatility and fat-tails in determining the total risk: depending on the setting, they either offset or reinforce each other. The choice of copula (normal versus Student-t), which determines the level of tail dependence, has a more modest effect on risk. We then compare the copula-based method with several conventional approaches to computing risk.