Volatility Spillover Dynamics between Large-, Mid-, and Small-Cap Stocks in the Time-Frequency Domain: Implications for Portfolio Management

Sangram Keshari Jena,Emmanuel Joel Aikins Abakah,Aviral Kumar Tiwari,Ashutosh Dash

doi:10.3390/jrfm14110531

Abstract

The connectedness dynamics between large-, mid-, and small-cap stocks is investigated using the forecasted error variance decomposition (FEVD) spillover framework of Diebold and Yilmaz in the time-frequency domain. Total volatility spillover (i.e., connectedness) is elevated between large-, mid-, and small-cap stocks during the study period. This high level of spillover exists in the short run only, and declines gradually in the medium to long run, thus providing opportunities for portfolio diversification (hedging) in multi-cap investing during the medium-to-long run (short run) only. Like total connectedness, a similar pattern of bilateral connectedness is observed between either of the two indices, thus providing a similar opportunity in the short and long runs. The mid-cap index emerges as the major contributor to total volatility in the system, followed by the small- and large-cap indices, during the analyzed period. The volatility spillover is time-varying in both the time and frequency domains.

Highlights

With the spike in volatility in the Indian stock market towards the middle of 2018, a sharp fall was observed in mid- and small-cap stocks,1 while the large-cap stocks managed to withstand the selling pressure as investors sought refuge in the selected large-cap stocks.2 Wang et al (2014), highlighting capitalization as a style of investing in their study, mentions the relative stability of investment in large-cap stocks. Huang (2007) finds international portfolio diversification opportunities in small-cap stocks because of their low average correlation with their developed market counterparts
A rolling-windows analysis of the volatility spillover between large, mid, and small-cap stocks are presented in the three parts as the total, net, and pairwise time-varying volatility spillover
In the market cap-based style of investment, the stocks are classified as large, mid, and small-cap stocks

Summary

Introduction

With the spike in volatility in the Indian stock market towards the middle of 2018, a sharp fall was observed in mid- and small-cap stocks, while the large-cap stocks managed to withstand the selling pressure as investors sought refuge in the selected large-cap stocks. Wang et al (2014), highlighting capitalization as a style of investing in their study, mentions the relative stability (growth potential) of investment in large-cap (mid-and small-cap) stocks. Huang (2007) finds international portfolio diversification opportunities in small-cap stocks because of their low average correlation with their developed market counterparts. With the spike in volatility in the Indian stock market towards the middle of 2018, a sharp fall was observed in mid- and small-cap stocks, while the large-cap stocks managed to withstand the selling pressure as investors sought refuge in the selected large-cap stocks.. As far as global pricing is concerned, it is more pronounced in large-cap than small-cap stocks, according to Carrieri et al (2004), because the pricing of large-cap stocks is associated with their presence in national stock indices, international operations, cross-listing in foreign stock exchanges, and regular tracking by both domestic and international institutional investors. Small-cap stocks are priced in terms of local, or idiosyncratic, risk factors, whereas large-cap stocks are driven markedly by common global factors, according to Eun et al (2008)

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Conclusion