Non-technical summary of ESM Working Paper 76: 
Financial market interdependence, contagion and jumpy risk exposure

This paper contributes to the long-standing debate on the extent to which common movement of financial markets reflects interdependence due to structural factors such as globalisation, or a contagious transmission of shocks during times of turmoil. The conclusions of previous studies vary, depending on the markets analysed and the applied definition of contagion. This distinction matters for policymakers, as contagion can amplify crises and undermine financial stability even when economic fundamentals are sound. This paper proposes a new way to disentangle gradually changing interdependence across European stock markets from sudden changes in the transmission of shocks, potentially reflecting contagion effects.

We develop a flexible econometric model that separates common market movements across stock markets from country-specific ones. In this framework, the degree of country-specific equity market interdependence is measured by the share of stock market returns that can be explained by the common component during normal times. By contrast, we consider a situation as indicative of contagion where a country’s exposure to a common shock suddenly increases and exceeds what would be implied by gradually changing interdependence.

Applying the model to daily return data for 19 European stock markets from 1995 to 2025, our factor model captures most of the common movement across markets. On average, market interdependence increased steadily up to around 2011–2012, after which some evidence of decoupling emerges. The analysis also uncovers numerous short-lived but sharp increases in countries’ exposure to common shocks, many of which coincide with well-known financial and political events and are interpreted as contagion episodes. Finally, the model improves forecasts of downside risk measures compared to simpler alternatives, suggesting that explicitly accounting for unusually strong exposure to common shocks can improve the assessment of financial risk.