Saturday, September 5, 2015

Stock Market Volatility Connectedness – September 2015 Update

We updated the connectedness measures for stock, sovereign bond, and FX markets using data up to the end of August.  The results provide us with lots of material to write about.   In this blog I analyze the behavior of the volatility connectedness in global stock markets. Bond and FX markets will follow next.

Before I start with the stock market volatility connectedness, I want to highlight one development that affected volatility connectedness in all three markets, albeit at varying degrees. Having a quick look at dynamic connectedness graphs show that there is an upward move in the volatility connectedness of stock, sovereign bond and FX markets immediately around mid-October 2014. Actually, all three markets were affected by the volatility jump in the U.S. bond market on October 15, 2014.  Market observers linked the jump in daily bond market volatility to electronic trading and named the developments on October 15, 214 as the “flash crash”.

Following the “flash crash” volatility connectedness across stock markets increased gradually to reach 65% in mid-February.  After that peak the volatility connectedness came down steadily. The stand-off between Greece and the EU in late June about the implementation of economic policies dictated by the IMF, the European Commission and the ECB led to a quick increase in the stock market volatility connectedness from 56.7% on June 24 to 61.1% on July 10. Once the Greek government decided to implement the dictated policies the volatility connectedness across stock markets declined gradually to 53.8 on August 20.

Chinese stock market declined by around 40% from its peak in June to mid-August. This downward trend in the volatility connectedness index was realized despite the troubles in the Chinese stock market. However, there was a big jump in the index on August 24. From 55.4% on Friday August 21, the total volatility connectedness index jumped to 64.4% on Monday, August 24. That is the day when the Chinese market dropped 8.3%.  During the day all eyes focused on the Chinese market.  Many followed the jump in the VIX index from 19 to 41, the highest level since the European debt crisis in 2011. Yet, a look at the directional volatility network as of August 31 reveals that the European countries were the most important generators of volatility connectedness. Actually, European stock markets were generating connectedness towards each other more than the stock markets in other parts of the world. One can talk about the presence of a European cluster where the country nodes located towards the center of the cluster all have red color, while the ones on the periphery have orange and brown colors.

Leaving the European countries aside, U.S. stock market generated the highest connectedness to others. It generated most of the connectedness toward Latin American and European markets, Canada, India and Indonesia. China, on the other hand, was a net recipient of volatility connectedness from others.  China’s pairwise connectedness with Hong Kong was the highest. It was a net recipient of connectedness from all European countries.