4 - Multivariate MSM

Abstract

Joint movements in volatility across asset markets influence the distributionof returns at the portfolio level and therefore play an important role in riskmanagement, portfolio selection, and derivative pricing. Comovements involatility provide an understanding of financial markets and shed lighton issues such as contagion and the transmission of shocks through the financial system. This chapter investigates possible linkages between the Markov-Switching Multifractal (MSM) volatility components of three currencies and several macroeconomic and financial indicators over the 1973–2003 period. No robust pattern is identified between MSM components and variables such as inflation, money supply, interest rates, industrial production, and stock market volatility. On the other hand, oil and gold prices both correlate positively with currency volatility over the past three decades, consistent with the view that these commodities may act as proxies for global economic and political risk. This finding motivates the development of bivariate MSM, a multifrequency model of comovement in stochastic volatility and covariation in financial prices. The model permits a parsimonious specification of bivariate shocks with heterogeneous durations, capturing the economic intuition that shared fundamentals may have different innovation frequencies.