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a

Acadian Asset Management Inc., USA

b

Boston University, USA

Abstract

A definition of contagion between financial markets based on local correlation was introduced in Bradley and

Taqqu (2004) and a test for contagion was proposed. For the test to be implemented, local correlation must be

estimated. This paper describes an estimation procedure based on nonparametric local polynomial regression.

The procedure is illustrated on the US and French equity market data.

JEL classification: C12, C14

1. INTRODUCTION

There is no universally accepted definition of contagion in the financial literature. Typical definitions

involve an increase in the cross-market linkages after a market shock. The linkage between markets is usually

measured by a conditional correlation coefficient, and the conditioning event involves a short post-shock or

crisis time period. Contagion is said to have occurred if there is a significant increase in the correlation

coefficient during the crisis period. This phenomenon is also referred to as correlation breakdown. Statistically,

correlation breakdown corresponds to a change in structure of the underlying probability distribution governing

the behavior of the return series. Most tests for contagion attempt to test for such a change in structure, but these

tests may be problematic. One difficulty was pointed out by Boyer, Gibson and Loretan (1999) who showed that

the choice of conditioning event may lead to spurious conclusions. The reader is referred to Bradley and Taqqu

(2004) for an extensive discussion. We proposed in that paper to use local correlation in order to measure

contagion. The goal of the present article is to develop the statistical methodology behind such an approach.

Applications can be found in (Bradley and Taqqu, 2005).

Suppose that X and Y represent the returns in two different markets. The local correlation provides a

measure of dependence for the model

Y = m( X ) + σ ( X )ε , (1)

where ε is mean zero, unit variance and is independent of X . Thus X affects Y in two ways: through the

mean level m( X ) and through the standard deviation σ ( X ) associated with the noise ε . If m( X ) is linear and

σ ( X ) equals the constant σ , one recovers the standard linear regression model

Y = α + β X + σε , (2)

σX σXβ

ρ = Corr ( X , Y ) = β = . (3)

σY σ X2 β 2 + σ 2

* Corresponding author: Email: murad@bu.edu We would like to thank Ashis Gangopadhyay, Vladas Pipiras and Stilian

Stoev for many valuable comments which led to an improved exposition of this material. This research was partially

supported by the NSF Grants ANI-9805623 and DMS-0102410 at Boston University.

Bradley and Taqqu 65

This last formula motivates the following definition of local correlation for the non-linear model (1).

Definition 1.1. Let X and Y be two random variables with finite variance. The local correlation between

Y and X at X = x is given by

σ X β ( x)

ρ ( x) = (4)

σ β 2 ( x) + σ 2 ( x)

2

X

where σ X denotes the standard deviation of X , β ( x) = m′( x) is the slope of the regression function

m( x) = (Y | X = x) and σ 2 ( x) = Var (Y | X = x) is the nonparametric residual variance.

The local correlation ρ (x ) was introduced by Bjerve and Doksum (1993). Since it measures the strength

of dependence between X and Y at different points of the distribution of X , we can use it do define (spatial)

contagion.

Definition 1.2. Suppose that X and Y stand for the returns, over some fixed time horizon, of markets X

and Y respectively. We say that there is contagion from market X to market Y if

ρ ( x L ) > ρ ( xM ) (5)

where x M = FX−1 (0.5) is the median of the distribution FX ( x ) = { X ≤ x} of X and x L is a low quantile of

that distribution.

See Bradley and Taqqu (2004) for a detailed discussion of this definition and of the choice of x L . Our goal

here is to present the theory behind the estimation of ρ ( x 0 ) at a target point x 0 . We shall use nonparametric

curve estimation techniques to estimate ρ ( x 0 ) . The procedure is illustrated on the US and French equity market

data. Applications to contagion in financial markets and to flight of quality from the US equity market to the US

government bond market can be found in the companion paper Bradley and Taqqu (2005). We make the

software written in support of this work freely available and describe its use in the appendix of Bradley and

Taqqu (2005).

2. ESTIMATION PROCEDURE

In order to estimate the local correlation measure ρ ( x 0 ) at a target point x 0 we assume that our

observations ( X i , Yi ), i = 1, n , are an independent sample from a population ( X , Y ) 1 and we apply a method

similar to those set forth in Bjerve and Doksum (1993) and Mathur (1998). The method consists of estimating

the functions m( x 0 ) , β ( x 0 ) and σ ( x 0 ) through consecutive local polynomial regressions of degrees p1 and

p 2 at x 0 . To obtain ˆ (x 0 ) . Bjerve and Doksum (1993) first use a local linear regression to estimate β with a

bandwidth equal to the standard deviation σ X which has no asymptotically optimal properties), then perform a

local linear regression with a bandwidth selection based again on σ X on the squared residuals to obtain an

estimate of σ 2 ( x 0 ) . In contrast, we follow a suggestion of Mathur (1998):

(a) we apply a local quadratic regression to estimate β ( x 0 ) using an estimate of the asymptotically optimal

bandwidth for that regression (this reduces the bias),

(b) apply a local linear regression on the squared residuals to estimate σ 2 ( x 0 ) using again an estimate of

the asymptotically optimal bandwidth appropriate for this regression (by using techniques developed by Ruppert

et al. (1997),

(c) obtain ˆ (x 0 ) and show that it is asymptotically normal.

1 ~

When dealing with practical applications, one can first filter the data for heteroscedasticity by assuming X i = σ X ,i X i

~

(~ ~ )

and Yi = σ Y ,i Yi and perform the local correlation estimation procedure on X i , Yi .

Bradley and Taqqu 66

See the monograph of Fan and Gijbels (1996) for details on local polynomial regression. Step (a) is

developed in Section 3 and step (b) in Section 4. These steps require the specification of a bandwidth, which is

done in Section 5. Step (c) is then presented in Section 5.1. We illustrate the estimation procedure for local

correlation using the US and French equity market data in Section 7.

Let ( X i , Yi ), i = 1, , n be the return data for the US and French equity markets respectively. Let X p ( x 0 )

be any target point at which we would like to know the local correlation ρ ( x 0 ) . For our definition of contagion

we will use the target points x L and x M from Definition 1.2 for x 0 . We therefore require estimates of the local

slope β ( x 0 ) and local residual variance σ 2 ( x0 ) . To that end, assume the regression function m(x) is p + 1

times differentiable. Using a Taylor series expansion of the regression function about the target point x 0 we

know that

m (2 ) ( x0 ) m ( p ) ( x0 )

m( x) ≈ m( x0 ) + m (1) ( x0 )( x − x0 ) + ( x − x0 ) 2 + + ( x − x0 ) p . (6)

2! p!

This polynomial estimate of the regression function is fit locally at x 0 using weighted least squares

regression. That is, the terms m (k ) ( x 0 ) / k! , k = 0, , p are estimated as the coefficients of the weighted least

squares problem

2

n p

k

min Yi − β k ( x0 )( X i − x0 ) wi ( x0 , h), (7)

(β0 ( x0 ), , β p ( x0 ) ) i =1 k =0

mˆ ( k ) ( x 0 ) = k! βˆ k ( x 0 ). (8)

1 X i − x0

wi ( x0 , h) = K h ( X i − x0 ) = K .

h h

We will defer discussion of the choice of kernel function K and bandwidth h for the time being. The

regression problem (7) may be rewritten in matrix notation. Let

1 (X 1 − x0 ) ... (X 1 − x0 ) p

X p ( x0 ) =

1 (X 1 − x0 ) ... (X n − x0 ) p

be the n × ( p + 1) design matrix for the grid point x 0 . Let

β 0 (x 0 )

Y1

β1 ( x0 )

y= and β ( x 0 ) =

Yn

β p ( x0 )

be the response and regression parameter vectors respectively. The local polynomial regression problem may

then be written as

T

min (y − X p (x 0 ) ( x 0 ) ) W h (x 0 )(y − X p (x 0 ) ( x 0 )) , (9)

(x0 )

where W h (x 0 ) = diag(w1 (x 0 , h), ..., w n (x 0 , h)) . The solution to (9) is known to be given by

Bradley and Taqqu 67

βˆ ( x 0 ) = ( X p ( x 0 ) T Wh ( x 0 ) X p ( x 0 )) −1 X p ( x 0 ) T Wh ( x 0 ) y. (10)

Notice that the estimated value of the regression function at target point x 0 may be written as

Wh (x 0 ) y ,

where e1 = (1,0,...,0) T . Because the observations are {( X i , Yi ), i = 1, , n} and we need to obtain the residuals,

ri Yi Yi Yi m Xi , i 1, n , we will need m evaluated at the observation points X 1 , ,Xn .

T n

Letting mˆ = (mˆ ( X 1 ) , ..., mˆ ( X n )) ∈ be the vector of estimated values of the regression function at the

observed values X = ( X 1 , , X n ) we see that

m = H p,h y (11)

nxn

for the smoother matrix H p ,h ∈ . Its (i, j ) th entry is given by

( H p ,h ) i , j = e1T ( X p ( X i ) T W h ( X i ) X p ( X i )) −1 X p ( X i ) T W h ( X i )e j , (12)

where ei = ( 0, ... , 0, 1, 0, ... , 0 )T is a unit vector for the i th position of the appropriate dimension. In (12),

X p ( X i ) denotes the matrix X p ( x 0 ) with x 0 = X i . The following result will be used in the sequel and is

proved in Section 6.

Proposition 3.1. The smoother matrix H p , h preserves constant vectors in the sense that H p ,h 1 = 1.

Local polynomial regression, aside from being easy to implement, has two additional benefits for our

problem. First, the local correlation ρ ( x 0 ) is a function of the local slope β ( x0 ) = m ′( x0 ) of the regression

function m( x 0 ) . By choosing the degree p ≥ 1 of the polynomial fit in (6), local polynomial regression gives us

an immediate estimate of the local slope

mˆ ′( x 0 ) = βˆ1 ( x 0 ) (13)

in the regression equation (9). The second benefit of locally polynomial regression is a reduction in the bias of

the estimated regression function and its derivatives at the boundaries of the support of the distribution of the

covariate x . In classical kernel-based nonparametric regression methods, also called locally constant

regression, the regression function m( x) = (Y | X = x) is approximated by m( x 0 ) for x close to x 0 , ( p = 0

in (6)) and m( x 0 ) is estimated by

n n

wi ( x 0 , h)Yi K h ( X i − x 0 )Yi

i =1 i =1

mˆ ( x ( 0 ) = n

= n

,

wi ( x 0 , h ) K h ( X i − x 0 )Yi

i =1 i =1

that is, by a weighted average about the target point x 0 . If the target point x 0 is near the boundary of the

support X the weighted average may be strongly biased, even when the kernel has compact support, since more

interior points than exterior points may be used in computing the local average. This bias may be reduced by

fitting locally a polynomial in x 0 instead of a constant.

Using the local polynomial regression above, Fan and Gijbels (1996) show2 that under certain non-

restrictive regularity conditions the asymptotic conditional bias and variance of the local derivative estimator

2

See Theorem 3.1 of Fan and Gijbels (1996) or Theorem 4.2 of Ruppert and Wand (1994). Its proof may be found in

Ruppert and Wand (1994) or Fan and Gijbels (1996). The regularity conditions require that f X ( x 0 ) > 0 and that f X (⋅) ,

m ( p +1) (⋅) and σ 2 (⋅) are continuous in a neighborhood of x 0 . Additionally, we require that n → ∞ , h → 0 such that

nh → ∞ .

Bradley and Taqqu 68

mˆ (υ ) ( x 0 ) , υ ≤ p are given by

υ!

(

Bias mˆ (υ ) ( x 0 ) ) = eυT

+1 S

−1

cp

( p + 1)!

m ( p +1) ( x 0 )h p +1−υ + o p (h p +1−υ ) (14)

υ!σ 2 ( x 0 )

(

Var mˆ (υ ) ( x 0 ) ) = eυT

+1 S

−1

S * S −1 eυ +1 1+ 2υ

+op (

1

1+ 2υ

). (15)

f X ( x 0 )nh nh

Equation (14) for the conditional bias is valid for the case p − ν odd and has a slightly different form

otherwise. For our purposes, we will use p = 2 and ν = 1 and so we concentrate on this case. The vectors and

matrices in the expressions for the bias and variance above are either constants or functions of the kernel

function. To define them, let µ j = u j K (u ) du and υ j = u j K 2 (u ) du be moments of K and K 2

T (p +1 ) ( p +1) x ( p +1)

respectively. Then the vector c p = ( p +1 , ... , 2 p +1 ) ∈ and the matrices S ∈ and

( p +1) x ( p +1)

S* ∈ are given by S = ( µ j + l ) 0≤ j ,l ≤ p and S * = (υ j +l ) 0≤ j ,l ≤ p .

Figure

Consistent with Bjerve and Doksum (1993), we choose the Epanechnikov kernel

K (u ) =

3

4

(

1− u 2 ).

+

3

Figure 1. The Epanechnikov kernel K (u ) = (1 − u 2 ) +

4

The kernel is plotted in Figure 1. This choice of kernel is typical in local polynomial modelling. In fact, for

local polynomial estimators it may be shown that the Epanechnikov kernel is optimal in the sense that for all

choices of p and ν it minimizes the asymptotic mean squared error. See Theorem 3.4 of Fan and Gijbels

(1996) for a more detailed discussion of this point3.

The choice of the degree of the polynomial is typically taken to be p = ν + 1 . This choice gives a first order

reduction in the bias of mˆ (υ ) without substantially increasing its variance. Since we are primarily concerned

with reducing the bias of the local slope estimate we choose ν = 1 , p = 2 and the Epanechnikov kernel. This

3

The proof may be found in Fan et al. (1997). The minimization is over all non-negative, symmetric and Lipschitz

continuous functions.

Bradley and Taqqu 69

yields

1 0 1/ 5 3/5 0 3 / 35

S= 0 1/ 5 0 , S* = 0 3 / 35 0 ,

1 / 5 0 3 / 35 3 / 35 0 1 / 35

and c 2 = (0, 3 / 35, 0) T . For our problem, we are interested in the local slope, βˆ ( x 0 ) ≡ mˆ ′( x 0 ) = βˆ1 ( x 0 ) , (see

Definition1.1 and (8)). Applying (14) and (15), we obtain that the asymptotic conditional bias and variance of

the local slope are given by

(

Bias βˆ ( x 0 ) ) = 141 m (3)

( x 0 )h 2 + o p (h 2 ) (16)

2

(

Var βˆ ( x 0 ) ) = 157 f σ( x( x)nh) 0

3

+ op (

1

nh 3

). (17)

X 0

In fact, Fan and Gijbels (1996) show that under certain non-restrictive regularity conditions, as the number

of data points n → ∞ , the bandwidth h → 0 and nh → ∞ , conditional on , the above estimator of the local

slope is asymptotically normal. Applying their Theorem 5.2, one gets

Theorem 3.1. Suppose β̂ is the estimator described above4. Suppose also that the following regularity

conditions hold: f X ( x) , m (3) ( x) and (d / dx)σ 2 ( x) are continuous, the residual variance σ 2 ( x) is positive

and finite and (Y 4 | X = x ) is bounded. Then for f X ( x 0 ) > 0 , we have

1/ 2

7 f X ( x 0 )nh 3

2

[ βˆ ( x 0 ) − β ( x 0 ) − (h 2 m 3 ( x 0 ) / 14 + o(h 2 )] → (0, 1) , (18)

15σ ( x 0 )

as n → ∞ , h → 0 and nh → ∞ .

Observe that (18) involves the leading terms of the variance in (17) and of the bias in (16). Relationship

( )

(18) implies that if h =o n −1 / 7 , then

1/ 2

7 f X ( x 0 )nh 3

[ βˆ ( x 0 ) − β ( x 0 )] → (0, 1) (19)

15σ 2 ( x 0 )

and βˆ ( x 0 ) is asymptotically unbiased. Observe that asymptotic unbiasedness is not necessarily optimal because

the asymptotic variance may be large. In section 5 we will choose a bandwidth h1 for which h1 = O(n −1 / 7 ) but

which optimizes the bias-variance tradeoff.

Our estimate of the local correlation in (4) still requires an estimate of the local residual variance σ 2 ( x 0 ) .

The estimation procedure is similar to the one used above. It was first introduced by Mathur (1995) and its

asymptotic properties were established by Ruppert et al. (1997). Let p1 and h1 denote the degree of the

polynomial and bandwidth for the smooth of the y vector used above, namely the values of p and h used to get

4

β̂ is the local slope estimator of a local quadratic regression using the Epanechnikov kernel.

Bradley and Taqqu 70

m̂ (see (11)). Let rˆ = (Y1 − mˆ ( X 1 ) , ... , Yn − mˆ ( X n )) T be the vector of estimated residuals from the above

estimation of the regression function. Note that rˆ = ( I − H p 1 , h 1 ) y for the smoother matrix H p 1 , h 1 in (11).

Following Fan and Yao (1998) and Ruppert et al. (1997) we propose to estimate σ 2 ( x0 ) in a manner analogous

to a second smooth of the estimated squared residuals r̂ 2 by H p 2 , h 2 rˆ 2 . The matrix H p 2 , h 2 here is as above

with elements given by (12), but the values for the degree of the polynomial p = p 2 and bandwidth h = h2 may

be different from the values p1 and h1 used for m̂ .

A natural requirement is that the estimator σˆ 2 ( x) be unbiased in the case of homoscedastic regression error

σ 2 ( x) = σ 2 . As shown in Section 6, this implies the following proposition.

n

Proposition 4.1. Let rˆ = ( I − H p 1 , h 1 ) y ∈ be the vector of residuals from an initial smooth H p 1 , h 1 of

nxn

the data and let H p 2 ,h2 ∈ be a second smoother matrix. If the residual variance σ 2 ( x) is constant,

that is σ 2 ( x) = σ 2 , then

( H p 2 , h 2 rˆ 2 ) = H p 2 , h 2 [Bias 2 (mˆ ) + σ 2 (1 + ∆)] , (20)

∆ = diag (H p 1 ,h 1 H Tp ,h − 2 H p 1 ,h 1 ) (21)

1 1

Recall from Proposition 3.1. that H p , h 1 = 1 for all polynomial smoothers H p ,h . If m̂ is unbiased for m

then ( H p 2 , h 2 rˆ 2 ) = σ 2 (1 + H p 2 , h 2 ∆ ) , which suggests the following estimator for the residual variance:

H p 2 , h 2 rˆ 2

σˆ 2 = , (22)

1+ H p 2 , h 2 ∆

where multiplication and division are taken componentwise. The estimator is unbiased at each of the

observation points X i , that is (σˆ 2 ( X i ) ) =σ 2 .

Even though our estimator m̂ is biased (see (14)), the estimator of the residual variance at the observation

points X 1 , , X n given by (22) and the structure of the smoother matrix given by (12) motivate the following

residual variance estimator at target point x 0 :

T −1 T 2

e1T ( X p 2 ( x 0 ) W h 2 ( x 0 )( X p 2 ( x 0 )) X p 2 ( x 0 ) W h 2 ( x 0 )rˆ

σˆ 2 ( x 0 ) = . (23)

1 + e1T ( X p 2 ( x 0 ) T W h 2 ( x 0 )( X p 2 ( x 0 )) −1 X p 2 ( x 0 ) T W h 2 ( x 0 )∆

Recall the vectors r̂ and ∆ are functions of the degree p1 of the initial polynomial fit with bandwidth h1 .

The asymptotic properties of the estimator (23) are established in Theorem 2 of Ruppert et al. (1997). They

show, under certain regularity conditions and for p 2 odd, that if

[h12

( p1 +1)

+ (nh1 )−1 ] =o h2 p2 +1( ( )) (24)

then

(

σˆ 2 ( x 0 ) = σ 2 ( x 0 ) + O p h2( p2 +1) + (nh2 ) −1 / 2 . ) (25)

A similar result hold for p 2 even. We will use this result in Section 5.1, along with the asymptotic

normality result (18) from above, to show asymptotic normality of our estimator of local correlation. When

estimating the residual variance we take p 2 = 1 .

Bradley and Taqqu 71

5. CHOICE OF BANDWIDTH

In order to carry out the local regressions of degrees p1 = 2 and p 2 = 1 described above we need to choose

the appropriate bandwidths h1 and h2 . The choice of bandwidth is crucial to local polynomial modelling. A

bandwidth too small results in our under-smoothing the data. Since in this case only data points X i close to the

target point x 0 are used in the fit, the resulting estimator has a small bias but large variance. When the

bandwidth is too large, we have an over-smoothing of the data and an estimator with small variance but large

bias. This is the typical bias versus variance tradeoff in statistics. We will use a data-driven bandwidth selection

rule from Section 4.2 of Fan and Gijbels (1996) which, as we will see, is asymptotically optimal in the sense that

it minimizes the weighted Mean Integrated Squared Error (MISE)

2

~ ( x)dx

[Bias (mˆ (υ ) ( x)) + Var (mˆ (υ ) ( x))]w (26)

~ ( x) . Equations (14) and (15) give the asymptotic conditional bias and

for some non-negative weight function w

variance of mˆ (υ ) respectively as a function of bandwidth h . Expressing (26) as MISE(h), we get

( )

MISE(h) = ah 2 p + 2 − 2υ + bn −1 h −1− 2υ + o p h 2( p +1−υ ) + (nh1+ 2υ ) −1 for some constants a and b . This implies that

( )

the optimal choice of bandwidth is hopt =O n −1 / (2 p +3) . In fact, it is straightforward to verify that (14) and (15)

imply

1 / (2 p + 3 )

~ ( x) / f ( x )dx

σ 2 ( x) w

n −1 / (2 p + 3) .

X

hopt = Cν , p ( K ) (27)

{ } 2 ~

m ( p +1) ( x) w ( x)dx

The constant Cν , p ( K ) is a function of the kernel K , the degree of fit p and the order of the derivative ν . It is

given by

−1 / (2 p + 3 )

( p + 1)!2 (2ν + 1) Kν∗ (t )dt

Cν , p ( K ) =

2( p + 1 −ν ) { t p +1Kν∗ (t )dt }

2

where K υ* (t ) = eυT +1 S −1 (1, t , ... , t p ) T K (t ) (see Section 3.2.2 of Fan and Gijbels, 1996). Kν∗ is called the

equivalent kernel.

The optimal bandwidth hopt in (27) depends on unknown quantities and must be estimated. In fact, one

must do this before going through the steps described above in Sections 3 and 4. In order to estimate hopt , we

start with a preliminary and rough estimators m( x) for m( x) and σ 2 ( x) for σ 2 ( x) . This is because our goal

here is not to estimate the parameters m( x) and σ 2 ( x) , but only to obtain an estimate of the optimal

bandwidth. We obtain m( x) by fitting a polynomial of order p + 3 to m( x) 5. This is done using a global least

i =1 (Y −

i

p +3

k =0 α k X i

k 2

)

. This yields the

estimator m( x ) = α 0 + α1 x + + α p +3 x p +3 . The estimator for the p + 1 st derivative of the regression function

is then given by

( p + 3)!

m ( p +1) ( x) = ( p + 1)!α p +1 + ( p + 2)!α p + 2 x + α p +3 x 2 .

2!

The residuals Yi − m( X i ) of this fit are used to obtain the usual global sample variance estimator

n

σ2 = 1

n −1 i =1 (Yi − m( X i )) 2 for σ 2 . Now let w0 ( x) be some specified weight function. After the change of

variables w~ ( x) = w ( x) f ( x) and assuming a constant residual variance σ 2 the optimal bandwidth (27) may

0 X

be written

5

We use a p + 3 degree fit in order to obtain a quadratic fit for the p + 1 st order derivative of m .

Bradley and Taqqu 72

1 /( 2 p + 3)

2

σ w0 ( x)dx

h = Cυ , p ( K ) = (28)

n m { ( p +1)

}2

( x) w0 ( x) f ( x)dx

i =1 {m ( p +1)

}2

( X i ) w0 ( X i ) which yields the estimator

1 /( 2 p + 3)

σ 2 w0 ( x)dx

hˆopt = Cυ , p ( K ) (29)

n

i =1

{m ( p +1)

} 2

( X i ) w0 ( X i )

We choose w0 to give equal weight to all data points in the central 95% of the empirical distribution of X .

The estimation procedure outlined above results in an estimator of the local correlation of the form

s X βˆ ( x 0 )

ρˆ ( x 0 ) = . (30)

s X2 βˆ 2 ( x 0 ) + σˆ 2 ( x 0 )

n

The estimator s X2 = 1

n −1 i =1 ( X i − X ) 2 is the sample estimator of variance σ X2 . Recall that the estimator

βˆ ( x 0 ) is the result of the local quadratic regression using a bandwidth h1 =O n −1 / (2 p1 +3) (see (27)) with ( )

( )

p1 = 2 , that is h1 =O n −1 / 7 . The estimator σˆ 2 ( x 0 ) is given in (23) and is the result of a local linear

( ) ( )

regression ( p 2 = 1 ) with bandwidth h2 =O n −1 / (2 p2 +3) =O n −1 / 5 . Notice that in this case Relation (24) holds

and therefore so does (25). In fact, the following result holds.

Theorem 5.1. Suppose that (i) x 0 is an interior point of the support of f X (x) , (ii) m(x) has 4 continuous

derivatives in a neighborhood of x 0 , (ii) σ 2 ( x) has 3 continuous derivatives in a neighborhood of x 0 , (iii)

f X (x) and σ 4 ( x) are differentiable in a neighborhood of x 0 where the innovations ε in (1) have finite fourth

moment, (iv) the local regressions are performed with p1 = 2 and p 2 = 1 and (v) h1 → 0 , h2 → 0 , nh1 → ∞ ,

nh2 → ∞ such that h1 = o(n −1 / 7 ) and h2 = o(n −1 / 5 ) . Then for the estimators described in (30) above, we

have

1/ 2

7 f X ( x 0 )n h13

15σ 2

[1 − ρ ( x ) ] 0

2 −3 / 2

[ρˆ ( x 0 ) − ρ ( x 0 )] → (0, 1). (31)

X

Equations (31) and (18) relate the conditional asymptotic variance of the estimator ρˆ ( x 0 ) to that of βˆ ( x 0 ) :

σ 2X

Var ( ρˆ ( x 0 ) ) = Var( βˆ ( x 0 ) ) 2

σ (x 0 )

[ 3

1− ρ (x0 ) 2 . ] (32)

Let σˆ 2ρˆ ( x ) and σˆ 2ˆ denote estimators of the conditional variance of ρˆ ( x 0 ) and βˆ ( x 0 ) respectively.

0 β (x )

0

Relation (10) gives βˆ ( x 0 ) and implies that its conditional covariance matrix is given by

Bradley and Taqqu 73

Cov( βˆ ( x 0 ) (

) = Cov X p ( x0 ) T Wh ( x 0 ) X p ( x0 ) ) −1

X p ( x0 ) T Wh ( x 0 ) y

(

= X Tp1 Wh1 Xp1 )−1 X Tp Wh Cov(y )Wh Xp (X Tp Wh Xp )−1

1 1 1 1 1 1 1

(

= X Tp1 W h1 X p1 )−1 X Tp 1 (

X p1 X Tp1 W h1 X p1 )−1 (33)

where the dependence of X p 1 and Wh 1 on x 0 has been dropped and = diag ( wi2 ( x 0 , h1 )σ 2 ( X i )) for

i = 1, , n . Since σ 2 ( X i ) is unknown, instead of estimating it as in (23), it is sufficient in this context to

estimate it by σˆ 2 ( x 0 ) , that is to assume that it is locally homoscedastic. Hence is estimated by

diag( wi2 ( x 0 , h1 )σˆ 2 ( X i )) and

−1 2

X Tp1 W h1 X p1 X Tp1 W h1 X p1 (34)

0

The vectors e2 pick off the second diagonal element of the covariance matrix of βˆ ( x 0 ) since this is the term

related to the local slope β ( x 0 ) of the local regression. In view of (32) this gives the following estimator of the

conditional variance of ρˆ ( x 0 ) :

s 2X

σˆ 2ρˆ ( x0 ) = σˆ 2βˆ ( x

0) σˆ 2

(x )

[1 − ρˆ ( x ) ] 0

2 3

(

= eT2 X Tp1 W h1 X p1 )−1 X Tp W 2h X p (X Tp Wh X p )−1 e2 s 2X [1 − ρˆ ( x0 ) 2 ]3 ,

1 1 1 1 1 1

(35)

6. PROOFS

Proof of Proposition 3.1. The form of the i, j th element of the smoother matrix Hp,h is

( H p ,h ) i , j =e T1 ( X p ( X i ) T W h ( X i ) X p( X i )) −1 X p ( X i ) T W h ( X i )e j .

Let H i represent the i th row of Hp,h. Dropping for notational simplicity the dependence on the target point

X i , we get

(

H i = e1T X Tp W h X p )−1 X Tp Wh .

It suffices to show that H i 1 = 1 , that is, H i (1, ..., 1) = 1 .

( p +1) x ( p +1)

Let S n = X Tp W h X p ∈ . Then H i = e1T S n−1 X Tp W h where the matrix S n has the form

n

(S n )i, j = S n ,i + j − 2 , 1 ≤ i, j ≤ p + 1, where S n,k = K h ( X l − X i )( X l − X i ) k .

l =1 wl

1 1 w1 S n ,0

X1 − X i X n− X i w2 S n ,1

X Tp W h 1 = = ,

(X 1 − X i ) p (X n − X i ) p wn S n, p

Bradley and Taqqu 74

S n,1 S n,2 S n, p +1 0 S n,1

S n e1 = = ,

S n, p S n, p +1 S n, 2 p 0 S n, p

we have

X Tp Wh 1 = S n e1 .

This implies that

H i 1 = e1T S −n 1 X Tp W h 1 = e1T S n−1 S n e1 = e1T e1 = 1 ,

which concludes the proof.

Proof of Proposition 4.1. Assume all vector multiplications, including powers, are taken component-wise.

Let m = (m( X 1 ), ... , m( X n ) )T , mˆ = H p1,h1 y, σ 2 = σ 2 ( X 1 ), .... , σ 2 ( X n ) ( )

T

= σ 2 1, ε = (ε 1 , ... , ε n )T and let

rˆ 2 = ( y − mˆ )2 . Then

(rˆ 2

) = ( [y − mˆ ] 2

)

= ( [m + σ ε − mˆ ] ) 2

= ( [m − mˆ ] + σ ε + 2σ ε m − 2σ ε mˆ

2 2 2

)

= MSE ( mˆ ) + σ 2 1 − 2 H p ,h 1 1

(σ m ε + 2 2

)

since (ε 2 ) = 1, (ε ) = 0 and mˆ = H p1,h1 y = H p1,h1 (m + σ ε ) . hence

(rˆ 2

) = Bias ( mˆ

2

) + Var ( mˆ ) + σ 2 (1 − 2diag( H p ,h )) . 1 1

Now, note that Var ( mˆ ) = diag (Cov ( mˆ )) = diag (H p ,h Cov (y, ) H Tp ,h ) = σ 2 diag (H p ,h 1 1 1 1 1 1 H Tp1,h1 )

since, by assumption, Cov ( y, ) = σ 2 I n . Letting ∆ = diag (H p ,h H Tp ,h − 2H p ,h ) , we get 1 1 1 1 1 1

(rˆ 2

) = Bias ( mˆ 2

) + σ 2 (1 + ∆)

and the result follows.

Proof of Theorem 5.1. First note that the regularity conditions of Theorem 5.1 are those of Theorem 3.1

and of Theorem 2 of Ruppert et al. (1997). We have

s X βˆ ( x 0 ) def

ρˆ ( x 0 ) = g(θ n ) ,

s 2X βˆ 2 ( x 0 ) + σˆ 2 ( x 0 )

where θ n = ( s X , βˆ ( x 0 ), σˆ 2 ( x 0 )) T .Observe that ρ ( x 0 ) = g (θ 0) where θ 0 = ( s X , β ( x 0 ), σ 2 ( x 0 )) T .

Expanding g (θ n ) in a Taylor series about θ 0 we get

β ( x0 )

[ ] [s X − σ X ] + σ X βˆ ( x 0 ) − β ( x 0 ) − .....

[ ]

3/ 2

ρˆ ( x 0 ) − ρ ( x 0 ) = 1 − ρ 2 ( x 0 )

σ ( x0 ) σ ( x0 )

I II

σ X β (x0 )

σ 3 / 2 ( x0 )

[σˆ 2

( x0 ) − σ 2 ( x0 ) ] + R (θ n − θ ) , (36)

III

Bradley and Taqqu 75

and so

[1 − ρ 2

( x0 ) ]

−3 / 2

[ρˆ ( x 0 ) − ρ ( x 0 )] = I + II − III + R(θ n − θ ) . (37)

When multiplied by

1/ 2

def 7 f X ( x 0 )n h13

rn ( x 0 ) , (38)

15σ 2 X

only term II contributes to the asymptotics. Indeed, h1 = o(n −1 / 7 ) implies rn (x 0 ) = o(n 2 / 7 ) . For term I we

know that n 1 / 2 [s X − σ X ] → (0, V ( X )) and so rn ( x 0 )[s X − σ X ] = o p (1) .The asymptotics of term III are

determined by equation (25). For p 2 = 1 and h2 = O (n −1 / 5 ) we have that σˆ 2 ( x 0 ) − σ 2 ( x 0 ) = O p (n −2 / 5 ) .This

[ ]

implies that rn ( x 0 ) σˆ 2 ( x 0 ) − σ 2 ( x 0 ) = o p (1) . The contribution of term II is determined as follows. In view of

(38), equation (19), which is an immediate corollary of Theorem 3.1, implies that

σX ˆ

rn ( x 0 )

σ ( x0 )

[

β ( x0 ) − β ( x0 ) →] (0, 1).

R(θ n − θ 0 ) = g (θ n ) − g (θ 0 ) − ∇g ( s ) T s =θ 0 (θ n − θ 0 ). (39)

converges in distribution, it is uniformly tight (Prohorov's theorem). Multiplying both sides of (39) by rn ( x 0 ) ,

this implies that rn ( x 0 ) R(θ n − θ ) = o p (rn ( x 0 ) θ n − θ ) . The tightness of rn ( x 0 )(θ n − θ ) implies that

( )

rn ( x 0 ) θ n − θ = O p (1) and since o p O p (1) = o p (1) , the theorem follows.

7. ILLUSTRATION

Figure 2 illustrates the procedure for French equity returns Y as a function of the US equity returns X .

The data are described in Bradley and Taqqu (2005). The procedure is applied to 101 equidistant target points

x 0 located in the central 95% of the empirical distribution of the US equity returns. The correlation curve plot

shows a clear increase in the local correlation between the French and US equity markets as the US market does

poorly. That is, when the US market is doing badly (negative x 0 ), the corresponding local correlation is high.

Additionally, the plots indicate an increase in both the local slope βˆ ( x 0 ) and local residual standard deviation

σˆ ( x 0 ) . In this case, the increase in the local residual standard deviation is not sufficient to overcome the

increase in the local slope and the local correlation increases as a result. Had the model been Y = m(X ) + ε

instead of (1), then the residual standard deviation σˆ ( x ) would be assumed constant and the large increase in

the local slope βˆ ( x) would have contributed (recall the definition of local correlation in (4)) to a large increase

in the local correlation ρˆ ( x ) . That increase, which would not have been mitigated by the increase in σˆ ( x ) (now

assumed constant), would have been dramatic and spurious. However, in accordance with our intuition, we see

that the residual variance σˆ ( x ) is roughly an increasing function of | x | , the absolute value of the returns of the

US equity market. That is, conditional upon large (absolute value) returns x in the US market, the variance of

the French market increases as | x | increases.

Bradley and Taqqu 76

Figure 2. The correlation curve, local mean, slope, and residual standard deviation for the French equity

market as a function of the (log) returns, expressed as a percent, of the US equity market.

95% confidence levels are attached using normality of the estimator and equation (35).

REFERENCES

Bjerve, S. and K. Doksum (1993) Correlation curves: measures of association as functions of covariate values, Annals of

Statistics, 21, 890-902.

Boyer, B., M. Gibson and M. Loretan, M. (1999) Pitfalls in tests for changes in correlations, Technical Report, Board of

Governors of the Federal Reserve System, International Finance Discussion Paper.

Bradley, B. and M. Taqqu (2004) Framework for analyzing spatial contagion between financial markets, Finance Letters, 2

(6), 8-15.

Bradley, B. and M. Taqqu (2005) Empirical evidence on spatial contagion between financial markets, Finance Letters, 3 (1),

to appear.

Fan, J., T. Gasser, I. Gijbels, M. Brockmann and J. Engel (1997) Local polynomial regression: optimal kernels and

asymptotic minimax efficiency, Annals of the Institute of Mathematical Statistics, 49, 79-99.

Fan, J. and I. Gijbels (1996) Local polynomial modelling and its applications, Chapman & Hall.

Fan, J., I. Gijbels, T. Hu and L. Huang (1996) A study of variable bandwidth selection for local polynomial modelling,

Statistica Sinica, 6(1), 113--127.

Fan, J. and Q. Yao (1998) Efficient estimation of conditional variance functions in stochastic regression', Biometrika, 85,

645-660.

Mathur, A. (1995) On the estimation of residual variance function, Paper presented at the Joint Statistical Meetings.

Mathur, A. (1998) Partial correlation curves, PhD Thesis, University of California, Berkeley.

Ruppert, D. and M. Wand (1994) Multivariate locally weighted least squares regression, Annals of Statistics, 22 (3), 346-

1370.

Ruppert, D., M. Wand, U. Holst and O. Hössjer (1997) Local polynomial variance function estimation, Technometrics, 39,

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