Risk Contagion Among International Stock Markets

Abstract

We develop a model of stochastic volatility with jump to analyze how the local equity markets of the European countries are affected by the regional equity market (other European equity markets) and the US equity market. Our approach simultaneously investigates all the three aspects of the interactions between markets, i.e. the correlation, the variance spillover and the jump spillover. We separate three sources of shocks to each European equity market; the shocks from the US market, the shocks from the regional market and the idiosyncratic or local shocks. The key advantage of this approach comparing to the earlier approaches is that it enables us to identify jumps and investigate risk spillover during distress periods. The model allows for time-varying parameters by relating the spillover parameters to the countries' degree of integration. We use Wavelet to filter out all the short-term variations in the variables measuring country integration. Our results show that the US contributions to the country variances lie in general below the contributions from the regional (European) market. We also find that the impact of the regional market on the local European equity markets has increased in pace with the development of the European Union. Finally, the relationship between the correlation and the estimated variances show that a US investor does not gain much from diversification abroad in high volatility periods, since the uncertainty in the US market generally contaminates the other markets. Nevertheless, for most European countries, the relative benefit of the international diversification increases in the high volatility periods.