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Finally, the conditional correlation coefficient ij between two assets i and j is then
expressed by the following equation:
t jj ii
t ij
t ij
q t q
q
,
,
,
. ,
=
,
j i and n j i = = , ., ,......... 2 , 1 , (7)
] ) 1 [( ] ) 1 [(
) 1 (
1 , 22
2
1 , 2 22 1 , 11
2
1 , 1 11
1 , 12 1 , 2 1 , 1 12
, 12
+ + + +
+ +
=
t t t t
t t t
t
q q q q
q q
| o | o | o | o
| o | o
(8)
252
As per Engle and Sheppard (2001) and Engle (2002), the DCC model can be estimated by
using a two stage approach to maximizing the log - likelihood function. Let denote
the parameters in D t and the parameters in Rt , then the log likelihood function is as
given below:
( ) u O,
t
I
= =
+ + + + + =
T
t
T
t
t t t t t t t t t
R R D D n
1 1
' 1 ' 2 '
2
)] log ) 2 (log(
2
1
[ )] log ) 2 log( (
2
1
[ t c c t
(9)
The first part of the likelihood function in equation (8) is volatility, which is the sum of
individual GARCH likelihoods. The log likelihood function can be maximized in the
first stage over the parameter in Dt. Given the estimated parameters in the first stage, the
correlation component of the likelihood function in the second stage (the second part of
the equation (8) can be maximized to the estimated correlation coefficients.
The model described by Eqs. (5) and (6), however, does not allow for asset-
specific news and smoothing parameters or asymmetries. Cappiello et al. (2006) modified
the correlation evolution equation as
(10)
where A, B and G are kk parameter matrices, nt = I [
t
c 0]
t
c (I[] is a k1 indicator
function which takes on value 1 if the argument is true and 0 otherwise, while
indicates the Hadamard product
7
) and N= E [
t
n n '
t
]. Eq. (9) is the AG-DCC model. In
order for the Qt to be positive definite for all possible realizations, the intercept,
G N G B P B A P A P ' ' ' must be positive semi-definite and the initial covariance
matrix Q0 be positive definite. An asymmetric scalar DCC model of the following form:
(11)
A sufficient condition for Qt to be positive definite is that the matrix in parentheses is
positive semi-definite. A necessary and sufficient condition for this to hold is a
2
+ b
2
+
og
2
< 1, where o is the maximum eigenvalue [
_
P
1/2
_
N
_
P
1/2
].
The full diagonal version of a scalar A-DCC (the matrices A, B and G are assumed to be
diagonal) of the following form:
(12)
where i is a vector of ones and a, b and g are vectors containing the diagonal elements of
matrices A, B and G, respectively.
This AGDCC allows for series-specific news impact and smoothing parameter
and permits conditional asymmetries in correlation dynamics. Moreover, this
specification enables us to overcome the problem with omitted variables and is well
suited to investigate the presence of asymmetric responses in conditional variances and
correlations during periods of negative shocks. Furthermore, this model interprets
B Q B G n n G A
t t t t t 1 1 1 1 1
A G) N G B P B A P A P ( = Qt
' + ' ' + ' ' + ' ' ' c c
1
2
1 1
2
1 1
2
_
2 2 2
a ) N g P b P a P ( = Qt
+ ' + ' +
t t t t t
Q b G n n g c c
1 1 1 1 1
_
' ' aa' gg' N ) bb' aa' - (ii' P ( = Qt
+ ' + ' +
t t t t t
Q bb n n gg c c
253
asymmetries broader than just within the class of the GARCH models, since it does not
assume constant correlation coefficients over the sample period. Ignoring the asymmetric
frictions would lead to overestimating the benefits of international portfolio
diversification in falling markets. (Kenourgios 2007).
EMPIRICAL ANALYSIS
The summary statistics of stock-index returns in the UK, Japan, BRIC countries and the
United States are presented in Table 2. This indicates that in the crisis period, emerging
markets are relatively risky compared to the developed markets. Even during the crisis
period, the BRIC markets are very highly risky compared to the developed markets. The
stock returns variation (Coefficient of Variation) is large in emerging markets, and
appears unrelated to fundamentals co-movement, consistent with noise trader risk
8
. An
investor in emerging markets should therefore be willing to accept volatile returns, i.e.,
there is a chance for large profits at the risk of large losses. The negative skewness
coefficient for the USA and Brazil implies that the frequency distribution of the return
series has no longer tails to the right and also leptokurtic. Another noteworthy statistic of
the stock-return series shown in Table 2 is a high value of Jarque-Bera. This suggests
that, for these markets big shocks of either sign are more likely to be present and that the
stock-return series may not be normally distributed.
As a conventional way of understanding the contagion we have estimated the
correlation between the equity markets of the USA and the UK, Japan, the BRIC
countries (Table 3). From these tables, it can be see that during the crisis period, there
exists a comparatively high correlation between the equity markets. Russia has much
lower correlations with the US, the UK, Japan, Brazil, China and India. As would be
expected the correlations with the US and the UK, Japan and the BRIC markets after the
crisis are quite high but it is lower in the case of Russia (-0.020). The mean of the
correlation is varying between -0.008 to 0.420 with respect to the USA before the crisis.
The highest correlation found between India and Japan is 0.209 and the lowest coefficient
is between India and China, which is -0.020 before the crisis period. While the
correlations during the crisis period range from -0.017 to 0.730, during the post crisis
period, the correlation range from 0.043 to 0.675. These results clearly show that during
the crisis period correlation are high among the markets.
254
TABLE 2: DESCRIPTIVE STATISTICS ON STOCK RETURNS
Pre Crisis Period (January 1997 to June 2007 )
Mean Std. Dev. C V (%) Skewness Kurtosis
Jarque-
Bera
USA -0.013 0.920 -7076.92 -0.193 7.066 1866.887*
UK -0.007 0.480 -6857.14 0.126 5.634 783.404*
JAPAN 0.001 0.592
Not
defined
0.172 4.987 455.107*
INDIA -0.022 0.661 -3004.55 0.392 7.043 1898.462*
CHINA -0.021 0.908 -4323.81 0.492 128.890 1773793.0*
BRAZIL -0.029 0.964 -3324.14 -0.444 19.094 29075.470*
RUSSIA -0.032 1.166 -3643.75 0.534 9.731 5198.369*
Crisis Period (July 2007 to December 2008)
Mean Std. Dev. C V (%) Skewness Kurtosis
Jarque-
Bera
USA 0.053 0.988 1864.15 -0.032 7.896 391.666*
UK 0.044 0.886 2013.64 -0.041 7.532 335.645*
JAPAN 0.078 1.021 1308.97 0.729 7.663 389.838*
INDIA 0.046 1.043 2267.39 0.248 4.610 46.339*
CHINA 0.083 1.097 1321.69 -0.160 4.095 21.276*
BRAZIL 0.039 1.223 3135.90 -0.130 7.138 280.787*
RUSSIA 0.094 1.688 1795.74 0.146 8.407 478.977*
Post Crisis Period (January 2009, through June 2010)
Mean Std. Dev. C V (%) Skewness Kurtosis
Jarque-
Bera
USA -0.060 0.819 -1365.00 -4.533 56.588 47878.310*
UK -0.010 0.574 -5740.00 0.677 9.080 628.990*
JAPAN -0.005 0.657
-
13140.00
0.027 3.813 10.763*
INDIA -0.060 0.780 -1300.00 -1.491 18.835 4208.36*1
CHINA -0.029 0.736 -2537.93 0.669 4.784 80.619*
BRAZIL -0.048 0.747 -1556.25 -0.065 4.465 35.079*
RUSSIA -0.048 0.901 -1877.08 0.108 4.105 20.528*
Note: *Indicate significance at 1% level Coefficient of Variation
255
TABLE 3A: STOCK RETURNS CORRELATION MATRIX: PRE CRISIS
PERIOD
INDIA CHINA JAPAN BRAZIL RUSSIA UK USA
INDIA 1.00
CHINA -0.02** 1.00
JAPAN 0.20* 0.03* 1.00*
BRAZIL 0.11* -0.00* 0.14* 1.000
RUSSIA 0.02 0.00 0.00 0.011* 1.000
UK 0.16* 0.00* 0.27* 0.314* 0.006 1.000
USA 0.06* -0.00* 0.09* 0.420* 0.001 0.313* 1.000
Note: *indicates significant correlation.
TABLE 3B: STOCK RETURNS CORRELATION MATRIX: CRISIS PERIOD
INDIA CHINA JAPAN BRAZIL RUSSIA UK USA
INDIA 1.000
CHINA 0.323* 1.000
JAPAN 0.499* 0.346* 1.000
BRAZIL 0.388* 0.176* 0.321* 1.000
RUSSIA -0.020 -0.119* -0.018 -0.036 1.000
UK 0.451* 0.144* 0.492* 0.636* -0.027 1.000
USA 0.265* 0.002 0.110* 0.731* -0.018 0.476* 1.000
Note: *indicates significant correlation.
TABLE 3C: STOCK RETURNS CORRELATION MATRIX: POST CRISIS
PERIOD
INDIA CHINA JAPAN BRAZIL RUSSIA UK USA
INDIA 1.000
CHINA 0.270* 1.000
JAPAN 0.321* 0.299* 1.000
BRAZIL 0.403* 0.188* 0.155* 1.000
RUSSIA 0.035 0.005 0.001 0.045 1.000
UK 0.407* 0.163* 0.218* 0.558* 0.040 1.000
USA 0.287* 0.057 0.164* 0.676* 0.043 0.494* 1.000
Note: *indicates significant correlation.
However, correlation coefficients across countries are likely to increase during highly
volatile period (Chiang et al. 2007). It is well established that stock return correlations are
not constant through time. Correlations tend to rise with economic or equity market
256
integration (Longin and Solnik, 1995; Goetzmann, Li and Rouwenhorst, 2005). They
tend to decline in bull markets and increase during bear markets (Longin and Solnik,
2001; Ang and Bekaert, 2002). Longin and Solnik (1995, 2001) shows that correlations
between markets increase during periods of high market volatility, with the result that
correlations would be higher than average, exactly in the moment when diversification
promises to yield gains. Consequently, such changes in correlations imply that the
benefits to portfolio diversification may be rather modest during bear markets (Baele,
2005).
As already noted, the objective of this study is to investigate the dynamic
conditional correlation mechanism among the BRIC, the UK, Japan and the US equity
markets. Results of the multivariate DCC-GARCH model are reported from Table 4 to 6.
The multivariate DCC model applied in the analysis allows for time varying correlation
structure. Parameter corresponds to the mean equation while and represents the
conditional variance of equity returns of the BRIC, the UK, Japan and the US equity
markets, which are modeled by a separate univariate GARCH (1, 1) model. All
parameters except Chinas GARCH coefficient are found significant and positive.
Negative values of the GARCH coefficients were commonly thought of as resulting
either from sampling error or model misspecification. However we have tried with other
variations of GARCH specification but still the problem persists. So the negative and
insignificant GARCH coefficient of China during the crisis period can be treated as zero,
which then implies that the previous period volatility has no impact on the
contemporaneous volatility of the asset. The significance of mean equation parameter
shows the dependence of returns on their lag returns in the precrisis and postcrisis period
except for Japan in the post-crisis period. But this parameter is not significant during
the crisis period for India, the USA, the UK, Japan, China and Russia.
Variance equation parameters and support our modeling technique, i.e.,
multivariate GARCH analysis, by revealing the presence of conditional hetroskedasticity
in the time series. Again GARCH (1, 1) parameters are highly significant confirming the
timevarying variance and covariance process as well as strengthening the use of
multivariate GARCH modeling among the BRIC, the UK, Japan and the US equity
markets.
257
TABLE 4: RESULTS OF THE MULTIVARIATE DCC-GARCH MODEL FOR
THE US, THE UK, JAPAN AND THE BRIC STOCK MARKETS DURING PRE-
CRISIS
Parameters
(Mean)
ARCH
Parameters
GARCH
Parameters
+
Persistence Country
USA(Nasadq)
0.0858*
(3.458)
0.0074*
(2.718)
0.0506*
(10.307)
0.9464*
(177.216)
0.977
UK (FTSE 100)
0.0590*
(3.819)
0.0112*
(4.083)
0.08578*
(9.628)
0.9033*
(96.661)
0.98
Japan(Nikkie)
0.0627*
(2.854)
0.0263*
(4.109)
0.0776*
(8.977)
0.9099*
(90.817)
0.98
India (Sensex)
0.1542*
(6.610)
0.09958*
(7.287)
0.1425*
(13.566)
0.8183*
(67.873)
0.96
China (SSE
composite)
0.1285*
(6.606)
0.2456*
(26.605)
0.2882*
(86.58)
0.7577*
(221.941)
1.04
Brazil(Bovespa)
0.1690*
(5.147)
0.1703*
(6.944)
0.1176*
(15.225)
0.8381*
(68.372)
0.95
Russia(RTS)
0.2245*
(6.527)
0.1764*
(9.102)
0.1910*
(18.042)
0.7970*
(76.215)
0.98
- The value report in the parenthesis is t-statistics
- *indicates the parameter is significant at 5%, ** indicates the parameter is significant at
10%
The sum of the two estimated ARCH and GARCH coefficients
+ (persistence coefficients) in the estimation process of the pre-crisis , crisis and post
crisis periods, except for China and UK, report less than yet nearby one, which is
required to have a mean reverting variance process. In contrast, the sum up of these
parameters for the China and UK is larger than one, suggesting that shocks to the
conditional variance are highly persistent, i.e. the conditional variance process is
explosive. This implies that the shock is always remembered in the case of China and UK
and there is a tendency to dies out the same in other cases. However, there is evidence for
volatility clustering in all series.
258
TABLE 5: RESULTS OF THE MULTIVARIATE DCC-GARCH MODEL FOR
THE US, THE UK, JAPAN AND THE BRIC STOCK MARKETS DURING
CRISIS PERIOD
Parameters
(Mean)
ARCH
Parameters
GARCH
Parameter
s
+
Persistence Country
USA(Nasadq)
0.0637
(0.882)
0.1762**
(2.523)
0.1230*
(3.845)
0.8499*
(25.157)
0.97
UK (FTSE
100)
0.0502
(0.790)
0.2240*
(3.034)
0.1733*
(6.063)
0.7803*
(22.670)
0.95
Japan(Nikkie)
-0.0691
(-0.859)
0.1838**
(2.479)
0.1626*
(5.938)
0.8067*
(25.137)
0.96
India (Sensex)
0.1443
(1.476)
0.3031**
(2.684)
0.1626*
(5.938)
0.8020*
(19.070)
0.96
China (SSE
composite)
-0.1560
(-1.138)
7.4999*
(4.899)
0.1175*
(3.216)
-0.2741
(-1.258)
-.0.15
Brazil
(Bovespa)
0.1645**
(2.034)
0.6287*
(4.064)
0.1306*
(6.176)
0.7856
(0.031)
0.91
Russia(RTS)
-0.0389
(-0.293)
0.0987
(1.394)
0.1368*
(3.937)
0.8192*
(30.351)
0.95
- The value report in the parenthesis is t-statistics *indicates the parameter is significant at
5%, ** indicates the parameter is significant at 10%
TABLE 6: RESULTS OF THE MULTIVARIATE DCC-GARCH MODEL FOR
THE US, THE UK, JAPAN AND THE BRIC STOCK MARKETS DURING POST
CRISIS PERIOD
Parameters
(Mean)
ARCH
Parameters
GARCH
Parameters
+
Persistence Country
USA(Nasadq)
0.2426*
(6.169)
0.2172*
(7.038)
0.4943*
(38.502)
0.5046*
(38.217)
0.99
UK (FTSE 100)
0.1989*
(8.229)
0.0165*
(7.000)
0.2814*
(30.949)
0.7461*
(129.354)
1.02
Japan(Nikkie)
0.0645
(1.065)
0.1058*
(6.148)
0.1084*
(9.971)
0.8440*
(90.331)
0.95
India (Sensex)
0.1623*
(2.973)
0.0078**
(2.084)
0.0601*
(38.612)
0.9343*
(561.452)
0.99
China (SSE
composite)
0.1296*
(1.684)
0.1578*
(10.430)
0.0691*
(9.162)
0.8743*
(137.127)
0.94
Brazil(Bovespa)
0.2481*
(5.122)
0.1473*
(9.657)
0.0966*
(13.348)
0.8480*
(133.741)
0.94
Russia(RTS)
0.2033**
(1.942)
0.2809*
(9.943)
0.0864*
(8.873)
0.8469*
(109.767)
0.93
- The value report in the parenthesis is t-statistics *indicates the parameter is significant at
5%, ** indicates the parameter is significant at 10%.
259
The maximum likelihood estimates of the dynamic conditional correlation (DCC)
and asymmetry generalized conditional correlation (AGDCC) model for the BRIC, the
UK, Japan and the US equity markets before crisis, during crisis and after the crisis are
reported in Table 7.
TABLE 7: RESULTS OF THE MULTIVARIATE DCC AND AGDCC MODEL
FOR THE US, THE UK, JAPAN AND THE BRIC STOCK MARKETS
Period
Symmetric model Asymmetric model
2
i
a
2
i
b
2
i
a
2
i
g
2
i
b
Pre Crisis 0.0065*
*
(2.028)
0.7586*
(4.173)
0.0989*
(6.176)
-0.0044*
(-14.892)
0.8810*
(16.213)
Crisis 0.0351*
(3.467)
0.7850*
(6.602)
0.0346
(0.414)
0.1518*
(3.527)
0.9354*
(17.496)
Post Crisis 0.0146
(1.275)
0.7344*
(4.142)
0.0978**
(2.267)
-0.0018*
(-5.234)
0.8205*
(43.435)
* Significance at the 5% level.
Table 7 reports the results from different parameterizations of DCC models
estimated in order to confirm whether we should adopt a symmetric or an asymmetric
model. All parameters are significantly different from zero. The
2
i
g term in the
asymmetric model is always higher than zero, implying the presence of asymmetric
movements. Furthermore, the asymmetric
2
i
b term is always higher than the
symmetric
2
i
b , providing further support to the use of the asymmetric DCC model in this
study. Therefore, the results show that conditional correlations among the crisis country
and all others are much greater during extreme downside moves than upside moves. The
estimated unconditional correlations among markets show that they increase significantly
during the crises. Moreover, conditional correlations are substantially greater than
unconditional correlations, supporting the presence of asymmetric contagion during the
subprime crises.
CONCLUSIONS
This study investigated the correlated-information channel as a contagion mechanism for
the subprime crisis of 2008, using data from equity markets of the BRIC economies, the
UK, Japan and the USA. To provide a robust analysis of financial contagion, study was
carried out to examine conditional correlation dynamics in a time varying asymmetric
framework, applying DCC and AG-DCC model. Results confirm the existence of
asymmetric contagion to Emerging Market Economies
9
.
Stock market indices are observed to display a persistent and high correlation
between them during and after high volatility periods. Moreover, using the AG-DCC
model, we investigated asymmetries in conditional variances and correlation dynamics
for all countries during crises periods. We found that conditional volatilities of equity
260
indices returns show widespread evidence of asymmetry. The AG-DCC results provide
further evidence for higher joint dependence during stock market crises. When bad news
hits stock markets, equity correlation among the BRICs and the developed markets
increases dramatically.
Consistent with the observations made by Bae et al. (2003) and Kallberg et al.
(2005), our study provides evidence of contagion effects in these BRIC markets in the
early stage of the crisis and then a transition to herding behavior in the latter stage. Here
contagion and herding behavior are distinguished in the sense that contagion describes
the spread of shocks from one market to another with a significant increase in correlation
between markets, while herding describes the simultaneous behavior of investors across
different markets with high correlation coefficients in all markets. It implies that in the
early phases of the crisis, investors focus mainly on local country information, so that
contagion takes place. As the crisis becomes public news, investor decisions tend to
converge due to herding behavior, creating higher correlations. As more and more asset
prices declined in neighboring countries due to the contagion effect spread through
various channels, investors began to panic and withdraw funds from the BRIC
economies. During this process, the convergence of market consensus and the stock
returns in these economies showed a gradual increase in correlation. This phenomenon is
identified during crisis period.
The USA crises hit global economies regardless of their economic integration,
since cross-market correlation dynamics are driven by behavioral reasons, and due to
shifting investor sentiment (increased risk aversion), causing significant changes in the
emerging countries financial structures. The study findings have important implications
for international investors and portfolio managers. Evidence on contagion implies that
diversification sought by investing in multiple markets from different regional blocks is
likely to be lower when it is most desirable. As a result, an investment strategy focused
solely on international diversification seems not to work in practice during turmoil
periods. Since countries and financial markets react differently to sovereign shocks,
stocks from different emerging economies could provide advantages over debt-only or
equity-only portfolios. The results also provide useful implications regarding the ability
of policy makers and multi-lateral organizations to insulate or at least attenuate an
economy from contagious effects.
Finally, the subprime crisis raised the need for a revamped international
financial architecture. The global contagious effects of this crisis and the rejection of the
decoupling hypothesis for the EMEs question the resilience and sustainability of
emerging-market policy performance. It seems that strong economic indicators in many
EMEs before the crisis (high growth rates, massive foreign exchange reserves, balanced
budgets) were not enough to decouple them from the crisis, because of their cyclicality
and endogeneity. A consequence of the contagion on the EMEs would be the redirection
of development loans by the World Bank, the IMF, and the regional development banks
to the public sector, since those funds had been crowded out by private-sector lending
throughout the boom decade (World Bank, Global Development Finance, 2008).
261
ENDNOTES
*Prelimanry version of the Paper was presented in 2
nd
Edition Perm Winter School on Risk
Management and Financial Markets Modeling jointly organized by Perm State University,
Professional Risk Managers International Association (PRMIA) and PROGNOZ Company, Perm,
Russia during February 02-04, 2012.
**
Special thanks to Prof B Kamaiah, University of Hyderabad, India for his suggestions and
comments on the earlier version of the paper. The author is grateful to his Supervisors Dr.
Vijaymohanan Pillai, Dr.Hrushikesh Mallick, Centre for Development Studies (CDS), Kerala for
valuable guidance and encouragement. The usual disclaimer applies.
1
See for example, Bird and Rajan (2000) who note that restraints on capital movements can be
divided into controls on capital account transactions per se (capital controls) and controls on
foreign currency transactions (exchange controls). Capital controls can cover foreign direct
investment (FDI), portfolio investment, borrowing and lending by residents and non-residents,
transactions making use of deposit accounts and other miscellaneous transactions. Exchange
controls regulate the rights of residents to use (remit or receive) foreign currencies and hold
offshore or onshore foreign currency deposits. They also regulate the rights of non-residents to hold
domestic currency deposits onshore. In addition, they may be defined to include taxes on currency
transactions and multiple exchange rate practices, which are aimed at influencing the volume and
composition of foreign currency transactions. Such capital controls may have different effects on
the functioning of the economy, depending on their nature.
2
Source: World Economic Forum, Global Competitiveness Report (various issues).
3
Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange
Restrictions (various issues).
4
See Giles (2008). In its October 2007 World Economic Outlook, for instance, the IMF, although
concerned about the subprime crisis in the US and its potential negative impact on slowing down
growth, still assumed in its baseline forecasts that, market liquidity is gradually restored in the
coming months and that the interbank market reverts to more normal conditions.
5
For overviews of the causes and nature of the financial crisis, see Barth (2008), Felton and
Reinhart (2008) and Taylor (2009).
6
www.worldbank.org/economicpolicy/managing%20volatility/contagion/index.html. Accessed on
February 27th, 2009.
7
Element-wise matrix multiplication.
8
Investor who makes decisions regarding buy and sell trades without the use of fundamental data.
9
These results are consistent with studies on Asian and Latin American economies (IMF, 2008,
2009).
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