Measuring Flight to Quality: A Local Correlation Analysis

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.

Keywords: Equity Capital, Risk Management, Bonds, United States of America, United Kingdom, Germany

JEL Classification: F21, G15, G11, G13