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# Finance Letters, 2005, 3 (1), 64-76

## Brendan O. Bradley a and Murad S. Taqqu b, ∗

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.

## Keywords: Contagion, Local correlation, Correlation breakdown, Crisis period

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)

## where the correlation is

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.

## ISSN 1740-6242 © 2005 Global EcoFinance™ All rights reserved. 64

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.

## 3. LOCAL POLYNOMIAL REGRESSION

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

## which yield the estimators

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

## The weights of the regression at x 0 are given by a kernel function

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

## mˆ (x 0 ) = e1T ˆ(x 0 ) = e1T (X p (x 0 ) T Wh (x 0 )X p (x 0 )) -1 X p (x 0 ) T

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.

## 4. RESIDUAL VARIANCE ESTIMATION

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)

## where Bias (mˆ )= (rˆ ) and

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

## is the vector of diagonal elements of the matrix.

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

## squares, that is, by choosing the α k , k = 0, , p + 3 which minimize n

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

## The denominator of (28) may be estimated by n

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 .

## 5.1. Asymptotic Normality of the Local Correlation Estimator

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

## The proof is given in Section 6.

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

## σˆ 2βˆ ( X ) = eT2 (X Tp1 W h1 X p1 ) ( )−1 e2σˆ 2 ( x0 ) .

−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)

## which does not involve σˆ 2 ( x 0 ) anymore.

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

## Since on the one hand,

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

## and on the other,

Bradley and Taqqu 74

## S n,0 S n,1 S n, p 1 S n,0

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).

## The remainder term R is handled in the usual way. Note that

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

## By the differentiability of g at θ we know that R(θ n − θ 0 ) = o p ( θ n − θ 0 ). Now, since rn ( x 0 )(θ n − θ 0 )

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).

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