Measuring financial contagion between major european stock markets via the regime-switching vine copula model

Abstract

Using regime-switching copula models, this study investigates co-movements of financial markets, including four major stock markets of European countries (UK, French, Germany, and Italy) in stable, stressful, and extremely stressful market conditions during 2004–2017. We introduce vine copulas to describe high-dimensional dependence structure between markets in modelling. In addition, we integrate copula methods with advanced regime-switching detection to identify different volatility regimes. Because of the characteristics of stock returns, we also release the assumption of joint normality to capture markets' tail dependence. The results show increasing tail dependence and asymmetry during stressful and extremely stressful market conditions, validating the financial contagion phenomenon, the spread of market turmoil. Further, our findings show continuing risk spillover after the 2008 financial crisis. The lasting effects make markets vulnerable for a long time after the crisis, which may be a cause of the decreasing time intervals between financial crises in recent years. Moreover, before the crisis the tail dependence strengthened first in the low volatility regime, followed by joint volatility strengthening between markets. Therefore, observing changes in tail dependence may provide early warnings of the next financial crisis.