Thesis I.J. Furda

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  • Volatility Spillovers Across Stock Indices:

    Empirical Evidence from Developed Markets

    I.J. Furda

    Masters thesis, MSc. Finance

    ABSTRACT

    This study aims to investigate volatility spillovers between global equity markets. Five major

    equity indices, United States (S&P 500), Canada (Toronto 300 Composite), United Kingdom

    (FTSE 100), Germany (DAX 30) and Japan (Nikkei 225) are being investigated over the years

    2002 to 2015. Main findings are that during the great financial crisis overall linkages and spillovers

    between the five indices intensified. Strong evidence is found that market linkages, and thereby

    volatility spillovers, are increasing over time.

    JEL codes: C22, F21, F65, G01, G15

    Keywords: volatility spillovers, market linkages, contagion, financial crisis, MGARCH-DCC

    Date Thesis: 14/01/2016

    Author: Ivo Jurrin Furda

    Student ID number: s1854356

    Student email: i.j.furda@student.rug.nl

    Name Supervisor: Marnix Reijenga

  • 1

    Table of Contents

    Introduction ..................................................................................................................................... 3

    1. Literature review ...................................................................................................................... 5

    Introduction ...................................................................................................................... 5

    Information flow .............................................................................................................. 5

    Economic fundamentals versus market contagion ........................................................... 5

    Financial crises ................................................................................................................. 7

    Interlinkages between the foreign exchange market and the stock market ...................... 7

    Empirical methods............................................................................................................ 8

    2. Hypotheses............................................................................................................................. 10

    Introduction .................................................................................................................... 10

    Hypotheses ..................................................................................................................... 10

    3. Data & Methodology ............................................................................................................. 12

    Introduction .................................................................................................................... 12

    Sample collection ........................................................................................................... 12

    Correlations .................................................................................................................... 13

    Intraday volatilities ......................................................................................................... 13

    Overnight and daytime rate of return ............................................................................. 14

    Descriptive statistics ....................................................................................................... 14

    ARCH family of statistical models ................................................................................ 16

    Volatility spillover effects .............................................................................................. 17

    Multivariate Dynamic Conditional Correlation Model .................................................. 19

    4. Results ................................................................................................................................... 21

    4.1 Introduction .................................................................................................................... 21

    4.2 Correlations .................................................................................................................... 21

  • 2

    4.3 Intraday volatilities ......................................................................................................... 24

    4.4 Volatility spillover effects .............................................................................................. 25

    4.5 Multivariate Dynamic Conditional Correlation Model .................................................. 27

    4.6 Conclusion ...................................................................................................................... 30

    5 Discussion & Conclusion ...................................................................................................... 32

    5.1 Introduction .................................................................................................................... 32

    5.2 Discussion ...................................................................................................................... 32

    5.3 Limitations ..................................................................................................................... 33

    5.4 Future research ............................................................................................................... 33

    5.5 Conclusion ...................................................................................................................... 34

    Appendix ....................................................................................................................................... 35

    References ..................................................................................................................................... 43

    Acknowledgments: I would like to sincerely thank my supervisor Marnix Reijenga for all of the

    help and guidance given throughout the course of producing this dissertation.

  • 3

    Introduction

    The last decades have shown an increased globalization of financial markets. It can be argued that

    globalization makes the overall system more efficient and leads to lower prices for consumers,

    however it definitely causes difficulties as well. As within a globalized system market movements

    become more intertwined, creating a well-diversified portfolio suddenly seems a lot more

    complex. As an example, if volatility easily transmits from one market to another, there is no real

    reason for investors to include both markets within the same portfolio.

    Not only does higher integration among capital markets make it harder for investors to

    diversify risks, it also makes the system more vulnerable to a financial crisis (Bttner, 2011). As

    global trade among countries, nowadays, is expanding at a rapid pace, better knowledge about

    volatility spillovers between markets seems rather important. It directly affects the private and

    professional investors of this world but also yields important implications for politicians and

    multinational firms. According to one source the importance of investigating volatility spillovers

    is, therefore, self-evident (Mozumder, 2015, p. 44).

    This study employs daily open and close data of five stock indices, for the years 2002 to 2015,

    chosen from the G-7 countries. The five stock markets used for this research are the S&P 500

    (United States), Toronto 300 Composite (Canada), FTSE 100 (United Kingdom), DAX 30

    (Germany) and Nikkei 225 (Japan). For a more detailed picture about the data and criteria being

    used, see Chapter 3. The main research question of this thesis yields:

    Is volatility of a stock market leading the volatility of other stock markets?

    Besides addressing this question the thesis constitutes three sub questions (derived and related to

    the main research question). The sub questions being addressed are:

    (1) Do volatility spillovers between stock indices increase during a financial crisis?

    (2) Are volatility spillovers between stock indices increasing within the long-run?

    (3) Is geography still a determinant factor for co-movements between equity markets?

    More detailed explanations on why these questions have been chosen can be found in Chapter 2.

  • 4

    The thesis is structured as follows. Chapter 1 provides the reader a literature overview on

    where and how volatility spillovers do originate. Chapter 2 outlines the hypotheses. Chapter 3

    describes the process of data collection and the methodology being used for the research of

    volatility spillovers between the five stock indices. Chapter 4 depicts and reflects on the results of

    the analyses. Chapter 5 discusses and concludes on the results of this study.

  • 5

    1. Literature review

    Introduction

    In this chapter the conceptual framework of this research is being developed. First we take a look

    at what explains volatility. Secondly we analyze how it evolves, during crises for instance and over

    time. The chapter concludes with a brief literature coverage of how volatility spillovers between

    financial markets can be researched.

    Information flow

    Volatility and risk are interrelated. When an asset or index shows greater movements, stability of

    returns becomes more uncertain and thereby risk of the initial investment increases. According to

    Ross (1989) price volatility equals information vol