Asset market interconnectedness can give rise to significant contagion risks during periods of financial crises that extend beyond the risks associated with changes in volatilities and correlations. These channels include the transmission of shocks operating through changes in the higher order comoments of asset returns, including changes in coskewness arising from changes in the interaction between volatility and average returns across asset markets. These additional contagion channels have nontrivial implications for the pricing of options through changes in the payoff probability structure and more generally, in the management of financial risks. The effects of incorrectly pricing risk has proved to be significant during many financial crises, including the subprime crisis from mid 2007 to mid 2008, the Great Recession beginning 2008 and the European debt crisis from 2010. Using an exchange options model, the effects of changes in the comoments of asset returns across asset markets are investigated with special emphasis given to understanding the effects on hedging risk during financial crises. The results reveal that by not correctly pricing the risks arising from higher order moments during financial crises, there is significant mispricing of options, while hedged portfolios during noncrisis periods become exposed to price movements in times of crises.

A general measure of asset market interdependence based on higher order comoments is developed and applied to studying weekly U.S. and eurozone equity returns from 1990 to 2017. A new test of independence is also developed. The empirical results show that interdependence peaks during the global financial crisis with the covariance and covolatility comoments being the dominant factors. Conditioning the interdependence measure on volatility does not change the overall qualitative results. Implications of the results for constructing diversified portfolios reveal economic benefits from portfolios based on higher order comoments than the usual assumption of bivariate normality, especially during the GFC. The empirical results also provide evidence that European Union membership led to higher interdependence than did the adoption of the common currency.