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Negative Returns Produce Higher Co-movement and Higher Variance in U.S. and Regional Stock Markets
(2010) Basmadjian, Raffi K.
The study of cross-border links in stock market returns is a key issue in specialized finance. The existing literature studies the effect of volatility on stock index co-movement, the relation between the tail returns of two financial assets and the stock index co-movement in post-crisis events, all of which lead to a higher correlation in stock returns. In this paper, we analyze the effects of negative returns of 18 US and 40 regional stock indexes on the magnitude of the co-movement of these stock indexes and on the magnitude of their total variances. We find empirical evidence that negative returns increase the co-movement of these stock indexes as well as the variance of returns. Then we relate this differential correlation of negative returns to behavioral finance, in particular to loss aversion, and specifically the disposition effect, in the sense that the fear of investors in realizing losses leads to a smaller volume of trading, which results in less liquidity and hence higher transaction risk on one hand, and more volatility and hence higher variance of returns on the other hand.