Global transmission of stock returns volatility: a study of international stock markets

Abstract

newline In finance literature, volatility spillover has two connotations: first, the spilling over of volatility or innovations from one time period to another in a chronological order; and second, the transmission of volatility or shock from one market to another. Both of these notions have immense implication in the study of market efficiency, market interdependence, co-movement and co-integration of markets, modeling of volatility and behavioral finance. newlineThe spillover of volatility in the temporal dimension can be explained by the phenomenon called volatility clustering. Mandelbrot (1963) observed that volatility of asset returns follows a trend. A high volatility is usually followed by a high and a low volatility is followed by a low, thus leaving behind a patch of clusters of either swing on a time scale. The theoretical rationale behind such properties of volatility comes from a number of economic fundamentals. Prime among them is the efficiency of the market. If a market is perfectly informationally-efficient, then any new information coming into the market, also known as innovations, will take negligible time to get translated into the price values. Hence, in an informationally efficient market any trend in volatility, ideally, should not persist. Thus, if one observes a trend in volatility, it can be deduced that the market in which the asset is being traded is informationally not efficient. This presents an opportunity to model and predict the future behavior of the asset prices or/and the market as a whole. newlineApart from market efficiency, there are other economic factors such as trade, investments, nature of markets (e.g. leading/lagging, spot/futures, developed/developing etc.), and market microstructure such as openness of market, liquidity in market or individual behavior of market makers, which contributes toward trends in volatility. The interplay of such multiple factors leads to spilling over of volatility from one market to another.