A Multivariate GARCH Model Incorporating the Direct and Indirect Transmission of Shocks

Abstract

Theoretical models of contagion and spillovers allow for asset-specific shocks that can be directly transmitted from one asset to another, as well as indirectly transmitted across uncorrelated assets through some intermediary mechanism. Standard multivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models, however, provide estimates of volatilities and correlations based only on the direct transmission of shocks across assets. As such, spillover effects via an intermediary asset or market are not considered. In this article, a multivariate GARCH model is constructed that provides estimates of volatilities and correlations based on both directly and indirectly transmitted shocks. The model is applied to exchange rate and equity returns data. The results suggest that if a spillover component is observed in the data, the spillover augmented models provide significantly different volatility estimates compared to standard multivariate GARCH models.