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Measuring flight to quality: a local correlation analysis

Author

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  • A. Can Inci
  • H.C. Li
  • Joseph McCarthy

Abstract

Purpose - The purpose of this paper is to use the local correlation technique to measure flight to quality, which is defined as a pronounced and generally rapid increase in risk aversion. Flight to quality between American, British, German, Japanese, and Hong Kong spot equity indices and index futures is examined. Design/methodology/approach - The technique of non-linear local correlation is employed to detect flight to quality in both spot and futures markets. The use of this methodology allows us to properly process both normally or non-normally distributed time series. In addition, the estimation of local correlation minimizes the theoretical restrictions resulting from the selection of conditional events and the use of linear regression. Findings - As market risk grows, an increase in flight to quality is documented. For example, a crash in the US stock market results in the flight of capital to the Treasury bond market. Evidence of flight to quality from domestic and foreign spot equity markets to US Treasury bonds is provided. Furthermore, flights to quality from domestic and foreign index futures to US bond futures are revealed. The strength of the reaction from one market to the other is measured and reported. Surprisingly, the authors observe that when market risk becomes extremely high, flight to quality diminishes. Originality/value - To the best of the authors' knowledge, this is the first study that examines flight to quality in the futures markets by applying local correlation analysis. This study broadens the application of local polynomial regression and local correlation analysis.

Suggested Citation

  • A. Can Inci & H.C. Li & Joseph McCarthy, 2011. "Measuring flight to quality: a local correlation analysis," Review of Accounting and Finance, Emerald Group Publishing, vol. 10(1), pages 69-87, February.
  • Handle: RePEc:eme:rafpps:v:10:y:2011:i:1:p:69-87
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    References listed on IDEAS

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    1. Brière, Marie & Chapelle, Ariane & Szafarz, Ariane, 2012. "No contagion, only globalization and flight to quality," Journal of International Money and Finance, Elsevier, vol. 31(6), pages 1729-1744.
    2. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
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    4. Bernanke, Ben & Gertler, Mark & Gilchrist, Simon, 1996. "The Financial Accelerator and the Flight to Quality," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 1-15, February.
    5. Guler, Bulent & Ozlale, Umit, 2005. "Is there a flight to quality due to inflation uncertainty?," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 345(3), pages 603-607.
    6. Sébastien Laurent & Luc Bauwens & Jeroen V. K. Rombouts, 2006. "Multivariate GARCH models: a survey," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 21(1), pages 79-109.
    7. William Miles, 2001. "Can money market mutual funds provide sufficient liquidity to replace deposit insurance?," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 25(3), pages 328-342, September.
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    9. Kim, Suk-Joong & Moshirian, Fariborz & Wu, Eliza, 2006. "Evolution of international stock and bond market integration: Influence of the European Monetary Union," Journal of Banking & Finance, Elsevier, vol. 30(5), pages 1507-1534, May.
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    11. Engle, Robert, 2002. "Dynamic Conditional Correlation: A Simple Class of Multivariate Generalized Autoregressive Conditional Heteroskedasticity Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 339-350, July.
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    13. Tonn, Victor Lux & Li, H.C. & McCarthy, Joseph, 2010. "Wavelet domain correlation between the futures prices of natural gas and oil," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(4), pages 408-414, November.
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    Cited by:

    1. Mariya Gubareva & Maria Rosa Borges, 2013. "Typological Classification, Diagnostics, and Measurement of Flights-to-Quality," Working Papers Department of Economics 2013/15, ISEG - Lisbon School of Economics and Management, Department of Economics, Universidade de Lisboa.
    2. Brière, Marie & Chapelle, Ariane & Szafarz, Ariane, 2012. "No contagion, only globalization and flight to quality," Journal of International Money and Finance, Elsevier, vol. 31(6), pages 1729-1744.

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