Forecasting Chinese stock market volatility: the role of rare event shocks from US stock market

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ABSTRACT This paper investigates the role of rare event shocks (RES) from the US stock market in forecasting Chinese stock market volatility. In doing so, we use the jumps in VIX to capture the RES from the US stock market, and extend the realized EGARCH-MIDAS (REGARCH-MIDAS) model to accommodate the spillover information of RES. Our empirical results show that RES positively impacts Chinese stock market long-term volatility through investor sentiment and market liquidity. The proposed REGARCH-MIDAS-RES model outperforms competing models in out-of-sample forecasting, with findings robust to DM test, R o o s 2 test, different volatility states, different forecast horizons, Granger causality test, an alternative proxy for RES, and an alternative emerging market. Furthermore, incorporating RES into a volatility-timing strategy generates significant economic gains for a mean-variance utility investor. This finding is robust to different risk-aversion levels.