Horizontal commonality: Meaning, Criticisms & Real-World Uses

What Is Horizontal Commonality?

Horizontal commonality refers to the phenomenon where various financial assets or markets exhibit similar price movements, risk factors, or behavioral characteristics at the same time, often across different sectors, industries, or geographic regions. This concept is a critical aspect of financial stability and portfolio theory, influencing how widespread shocks can affect the broader economic landscape. Understanding horizontal commonality is essential for investors and regulators alike, as it can highlight hidden vulnerabilities within investment portfolios and the global financial markets.

History and Origin

The recognition of horizontal commonality, particularly in the context of financial contagion, gained significant prominence following major market crises throughout history. While market movements have always exhibited some degree of co-movement, the increasing interconnectedness of global finance has amplified the effects of horizontal commonality. Academic and policy discussions intensified after events such as the Asian Financial Crisis in the late 1990s and, more notably, the Global Financial Crisis of 2008. These periods underscored how localized shocks could quickly propagate across borders and asset classes due to shared risk exposures and rapid information dissemination. Former Federal Reserve Vice Chair Janet Yellen, in a 2013 speech, discussed how interconnections among financial intermediaries, while offering benefits, also have potentially harmful side effects, illustrating the core challenge posed by horizontal commonality.⁵

Key Takeaways

Horizontal commonality describes similar price or risk behaviors across diverse financial assets or markets.
It highlights interconnectedness, where a shock in one area can spread to seemingly unrelated segments.
This phenomenon is a significant consideration in risk management and regulatory policy.
Its impact can challenge the effectiveness of traditional diversification strategies.
Understanding horizontal commonality is vital for assessing overall financial system resilience.

Formula and Calculation

Horizontal commonality is not typically represented by a single, universally accepted formula, as it is a qualitative characteristic rather than a direct quantitative metric. However, its presence can be inferred and measured using various statistical techniques that quantify the co-movement or correlation among different assets or market segments. Common methods involve analyzing:

Correlation Coefficients: Measuring the statistical relationship between the returns of multiple assets. A high positive correlation coefficient among disparate assets suggests strong horizontal commonality.
$\rho_{XY} = \frac{Cov(X, Y)}{\sigma_X \sigma_Y}$ $ρ_{X Y} = \frac{C o v ( X , Y )}{σ _{X} σ _{Y}}$
Where:
- (\rho_{XY}) = Correlation coefficient between asset X and asset Y
- (Cov(X, Y)) = Covariance between the returns of asset X and asset Y
- (\sigma_X) = Standard deviation of returns for asset X
- (\sigma_Y) = Standard deviation of returns for asset Y
Factor Analysis: Identifying underlying common factors that drive the returns of multiple assets. If a single factor or a few common factors explain a large portion of the variance in a broad set of assets, it indicates strong horizontal commonality.
Co-integration Tests: Determining if two or more time series move together in the long run, even if they deviate in the short term.

These analytical approaches help identify the extent to which assets share common sensitivities, going beyond simple paired correlation to reveal broader market dependencies.

Interpreting Horizontal Commonality

Interpreting horizontal commonality involves recognizing that assets or markets, despite their apparent differences, are influenced by shared systemic drivers. A high degree of horizontal commonality implies that the benefits of traditional portfolio diversification may be significantly reduced, especially during periods of market stress. For example, if a broad range of equity sectors or even different asset classes like bonds and real estate begin to move in lockstep, it suggests that a common force—such as a shift in monetary policy or a major global event—is overriding their individual characteristics. This increased interdependence can amplify market volatility and accelerate the spread of financial shocks.

Hypothetical Example

Consider a hypothetical scenario during a period of unexpected rapid inflation. Company A is a technology giant, Company B is a major airline, and Company C is a large agricultural firm. Traditionally, these companies operate in distinct sectors with different business models, suggesting their stock prices might respond differently to various economic conditions.

However, due to horizontal commonality, if the inflation shock is severe and pervasive, it could trigger a broad sell-off across the entire financial markets. Investors might panic and indiscriminately withdraw capital from all types of companies, regardless of their specific industry or fundamentals. In this scenario:

Company A's stock drops by 15% due to overall market apprehension and rising interest rate concerns impacting future growth valuations.
Company B's stock drops by 12% as rising fuel costs and reduced consumer spending outlooks hit its sector, exacerbated by the general market decline.
Company C's stock, despite potentially benefiting from higher commodity prices in a different environment, also drops by 10% as liquidity concerns and broad investor fear dominate, overshadowing specific sector tailwinds.

This uniform downward movement, despite varied underlying business exposures, illustrates horizontal commonality. The commonality in decline isn't driven by a direct problem with each company, but by a pervasive macroeconomic shock and resulting investor behavior that affects a wide range of assets simultaneously, challenging typical diversification benefits.

Practical Applications

Horizontal commonality has significant practical implications across various aspects of finance. In risk management, it underscores the importance of looking beyond traditional diversification metrics to understand aggregated exposures. Financial institutions use stress testing to model how extreme but plausible scenarios could impact seemingly unrelated parts of their portfolios simultaneously, accounting for horizontal commonality.

For regulators, understanding horizontal commonality is crucial for maintaining financial stability. The Securities and Exchange Commission (SEC), for example, continually works to promote market resiliency and protect investors by assessing risks that may spill across the financial system. Thi⁴s includes scrutinizing market structures and interdependencies that could amplify shocks. Central banks, like the Federal Reserve, also focus on preventing the spread of instability through interconnectedness, recognizing that complex interactions among market actors can amplify existing frictions. Ide³ntifying the sources of commonality helps policymakers implement macro-prudential policies aimed at mitigating systemic risk and preventing widespread financial distress.

Limitations and Criticisms

While horizontal commonality is a recognized phenomenon, its precise measurement and prediction remain challenging. Critics point out that identifying true commonality versus coincidental parallel movements can be difficult, as many factors influence financial markets. Some academic research suggests that commonality in expected stock returns is stable, with determinants related to risk, liquidity, and growth potential, but interpretations of this evidence can vary.

Fu²rthermore, the concept can sometimes lead to oversimplification of market dynamics. Not every simultaneous movement indicates an underlying horizontal commonality; sometimes, various factors independently drive assets in the same direction. Another limitation is that relying too heavily on historical data to predict future horizontal commonality might be misleading, as the drivers of market behavior and interconnectedness can evolve rapidly with changes in technology, regulation, and global economic cycles. Therefore, continuous monitoring and adaptive regulatory oversight are necessary.

Horizontal Commonality vs. Contagion

Horizontal commonality and Contagion are closely related but distinct concepts in finance, both pertaining to the spread of financial instability.

Horizontal commonality describes a scenario where assets or markets exhibit similar behaviors or movements due to shared underlying factors or exposures, even if there isn't a direct cause-and-effect transmission of distress. It's about a simultaneous, parallel response to common influences, such as a shift in global monetary policy, a change in investor sentiment towards a particular type of asset, or a broad economic shock. Horizontal commonality can exist without a crisis, reflecting routine market correlations.

Contagion, on the other hand, specifically refers to the transmission of financial shocks from one market or institution to others, often through unexpected or illiquid channels, leading to a cascade of failures or severe distress. It implies a causal link where the failure or significant decline in one area directly causes issues elsewhere. Contagion typically describes a negative phenomenon, signifying the spread of adverse conditions. While strong horizontal commonality can facilitate contagion by creating a fertile ground for shocks to spread, contagion is the process of that spread, often exceeding what would be expected based on fundamental linkages alone. For instance, the Federal Reserve Bank of San Francisco has noted the crucial role of its liquidity provision in maintaining a sound and stable financial system during disruptions, highlighting efforts to prevent the spread of adverse conditions.

##¹ FAQs

What causes horizontal commonality?

Horizontal commonality can be caused by various factors, including shared macroeconomic shocks (like inflation or interest rate changes), changes in investor sentiment, herd behavior, common liquidity demands, or the increased interdependence of global financial markets.

How does horizontal commonality affect diversification?

Horizontal commonality can diminish the effectiveness of traditional diversification strategies. If diverse assets start moving in the same direction, the benefits of holding a variety of asset classes to reduce risk are reduced, particularly during periods of high market volatility.

Is horizontal commonality always a negative phenomenon?

While often discussed in the context of negative events like crises, horizontal commonality isn't inherently negative. It simply describes shared movements. However, its implications are often negative when it leads to a widespread downturn, as it suggests reduced protection from risk in investment portfolios.

How do regulators address horizontal commonality?

Regulators monitor horizontal commonality by analyzing market interconnectedness and conducting stress testing. Their goal is to identify potential vulnerabilities and implement policies that promote financial stability and mitigate systemic risk, such as enhanced capital requirements or liquidity regulations for financial institutions.