Interdependence or Contagion? Examining the Correlation between Australia and New Zealand Equity Markets

Purpose: Contagion is defined as a significant increase in cross-market correlation following a rise in volatility in one market. Interdependence refers to a high level of market correlation in all periods. Due to the presence of heteroskedasticity, interdependence between markets can be misdiagnosed as contagion if the test is based solely on the increase in correlation coefficients. To address this, we employ heteroskedasticity-adjusted unconditional correlation to determine whether the nature of correlation between the Australian and New Zealand equity markets is interdependence or contagion. Design/methodology/approach: We gather daily returns data for the ASX 200 and NZX 50 equity indices from LSEG Datastream for 20 years from 2003 to 2023. We compute conditional and unconditional correlations between the two markets. We then identify sample periods that include a stable period followed by a turmoil period - when one market experiences a significant increase in volatility compared to the other market. Next, we test if the conditional (unconditional) correlation during the turmoil period is statistically higher than the conditional (unconditional) correlation of the full sample period. A higher correlation suggests that there was contagion effect during that turmoil period. Several robustness tests are conducted to confirm our findings. Findings: We find that contagion effect is present from the NZX 50 to the ASX 200, but not in the opposite direction. Our further analysis indicates that the correlation between the two markets could largely be driven by their sector allocation. Research limitations/implications: Our research is limited to the Australian and New Zealand equity markets, further research could be extended to include more international equity markets. Originality/value: Our work adds to the discourse on equity investment and portfolio management in the Australian and New Zealand markets, as well as the discussion on contagion effects within these markets.