Higher-order moments and co-moments' contribution to spillover analysis and portfolio risk management

Abstract

Unlike volatility, the skewness and kurtosis of asset returns are often neglected in the analysis of spillovers and risk management, although they capture the return asymmetry and fat-tailedness, respectively, arising from the non-normality of returns. In this paper, we provide evidence of the relevance and utility of considering spillovers in volatility and higher-order moments (skewness, and kurtosis) and co-moments (covariance, co-skewness, and co-kurtosis), and their implications for hedging. Using high-frequency data on the US stock, crude oil, and gold markets, a time-varying spillover approach and portfolio analysis, we reveal the following results. Firstly, besides volatility and covariance, co-skewness and co-kurtosis are relevant spillover transmitters across the stock, crude oil, and gold markets. Secondly, the level of total spillover increases when including not only covariance but also co-skewness and co-kurtosis, suggesting the relevance of considering higher order co-moments beyond volatility when studying spillovers. Thirdly, the inclusion of co-moments in the spillover analysis generates a significant improvement in hedging for all pairs, which is reflected in the significant increase in the utility function when co-skewness and co-kurtosis are considered. This result is noted when the COVID-19 sub-period is considered separately, except for oil‑gold. Overall, the findings matter for the system of interconnectivity across various assets and emphasize the implications and contributions of higher-order moments and co-moments to portfolio allocation and financial risk management.