Abstract
We study the effects of contagion around the global financial crisis (GFC) and the Eurozone crisis periods using German and UK returns, each paired with returns from Central and East European (CEE) stock markets that recently joined the European Union (EU). Using bivariate vector error-correction models (VECMs) estimated in GARCH(1,1), we find strong support for long-run equilibrium conditions. This finding suggests that tests of tail dependence using differenced VARs may be mis-specified when long-run equilibrium conditions apply. Past news has more persistence on current volatility in CEE markets than in the developed markets. Past volatility has more persistence in the developed markets compared to the CEE markets. The T-V symmetrized Joe–Clayton (T-V SJC) copula outperforms all other copulas in goodness-of-fit, including, the T-V Gaussian and Student t copulas. This result is supported by a differenced VAR-GARCH (1,1). For CEE and developed market returns, no more than half of our market pairs exhibit significant increases in lower tail dependence, under the T-V SJC copula. Given the number of paired comparisons, the evidence on joint extreme dependence is weak. As such, CEE stock markets experienced little contagion effects during the GFC and Eurozone crisis periods, contrary to prior results. We find that the legal environment negatively impacts financial development, perhaps causing CEE and the EU markets to be isolated.
Highlights
Over the past two decades or so, academic researchers, practitioners and regulators have developed renewed interest in low-probability events associated with the dependence structure of asset returns
We argue that long-run conditions in the vector error-correction models (VECMs)-GARCH would limit divergence in pairs of market returns and lead to more reliable estimates of asymmetric dependence compared to the differenced VAR-GARCH
We suggest that this slow adjustment process contributes to the inability of our VECM-GARCH to outperform the differenced VAR-GARCH, in terms of our copula results
Summary
Over the past two decades or so, academic researchers, practitioners and regulators have developed renewed interest in low-probability events associated with the dependence structure of asset returns. We predict that the long-run equilibrium properties of the VECM-GARCH will constrain price movements, causing more dependence between pairs of markets, compared to the differenced VAR-GARCH (1,1).. We predict that the VECM-GARCH will exhibit more extreme dependence compared to the differenced VAR-GARCH This is because, under the error-correction specification, the variables will not move too far apart when long-run equilibrium conditions apply (Engle and Granger 1987). Under VECM-GARCH, we find strong support for long-run equilibrium conditions, especially for pairs of CEE and UK market returns, during the Eurozone crisis period.. For CEE and German returns, no more than five market pairs exhibit significant increases in lower tail dependence during the Eurozone crisis period (compared to the GFC period).
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