Equity markets and ESG dynamics: Assessing spillovers and portfolio strategies through time-varying parameters

Abstract

Motivated by the recent surge of socially responsible activism, we examine the return and volatility transmission between the global Environmental, Governance, and Social index and traditional equity markets of G7 countries. For this purpose, we employ the TVP-VAR model on the returns and volatilities from 04 April 2011 to 09 September 2023. The variance co-variance matrix of the TVP-VAR model is used for portfolio analysis. Our finding indicates a significant level of connectedness between green and traditional equity markets. Moreover, green equity functions as a transmitter of both return and volatility spillovers to the traditional equity markets. In addition, our analysis of dynamic connectedness reflects a spike in both total return and volatility spillover amid the COVID-19 period. This indicates that the relationship between green and traditional equity markets intensifies during times of market stress and uncertainty which further infer implications for portfolio diversification. Furthermore, we calculated optimal asset allocation within portfolios and identified effective hedging ratios for different ESG and G7 equity pairs. The implications of the study include informing portfolio diversification strategies, and guiding decision-making for policymakers, hedge fund managers, and portfolio professionals amidst market uncertainties, based on identified market dynamics and connectedness.