An International Perspective of Volatility Spillover Effect: The Case of REITs

(ProQuest: . denotes formulae omitted.)I. INTRODUCTIONIn managing a global portfolio where the risk-adjusted return, such as the Sharpe ratio, is a primary focus, the size of correlation and the change in correlation over time are critical factors. Global diversification is beneficial to the extent that managers are successful in risk reduction, i.e. allocating capital to low correlation markets. Risk reduction is not easily attainable once co-movements between the securities or between the markets increase significantly usually due to systematic events like the Asian Financial Crisis in 1997 and real estate meltdown in 2007. In particular, investors add real estate to an existing portfolio to increase yield, hedge against inflation, and reduce the overall risk of the portfolio. Investing in international real estate properties and real estate investment trusts (REITs) became increasingly popular after the collapse of technology firms and the rise in bankruptcies in the early 2000s in the United States and other countries. The purpose of this paper is to examine the volatility transmission effect from the U.S. real estate (public and private) to the real estate markets of Europe and vice versa. Returns, volatility, and the risk/return ratios of the indexes are also examined.We study the 1999-2011 period for volatility spillover between the U.S. and European real estate markets. The sample period is divided into two mutually exclusive sub periods: pre-crisis (1999-2007) and post-crisis (2007-2011). Note the rumors about Lehman Brothers were spreading in late 2007, and the actual bankruptcy occurred in 2008 followed by other crisis events. Therefore, splitting the period around the year 2007 is warranted in terms of the timing of the crisis. Real estate investment performance is proxied by several measures for robustness: equity REITs, private real estate indices and real estate firms. The primary result is the finding of volatility transmission from public U.S. real estate markets to public European real estate markets. However, there is no strong evidence that European markets spillover to U.S. real estate markets for either the public or private real estate.There is a sizeable volume of research in the area of intermarket volatility effect. The authors believe this research is relatively unique not only in terms of focusing on REITS and the periods before and after crisis, it also examines the volatility effect in four directions: the US (private) to Europe, Europe to the U.S. (private), the U.S. (public) to Europe, and Europe to the U.S. (public). We organize this paper into six sections. In Section II, we offer a selected review of the literature on volatility transmission effect. Sections III and IV describe the methodology and the data used in this study, respectively. The empirical results are provided in Section V followed by a summary conclusion in Section VI.II. LITERATURE REVIEWA number of studies focused on inter-market volatility transmission effect after the financial crisis of the 1990s and the early 2000s during which corporate bankruptcies increased and many technology firms failed. Research on correlation breakdown and volatility spillover within and between domestic and global markets received more attention after the real estate and financial crisis, which began around 1996. Koutmos and Booth (1995) empirically documented how the announcement of bad news that affects one region easily spreads to several other regions. Specifically, they described the case of inter-market spillover effects among the markets in Japan, the United States and United Kingdom. Using autoregressive models, Reyes (2001) focused on market value indexes and showed that not only does the inter-market spillover exist, but it is also influenced by firm size (market capitalization). In a similar study of the U.S. and U.K. markets, Michayluk, Wilson and Zurbruegg (2006) applied an asymmetric dynamic covariance model in which they identified a directional spillover effect between markets in the US and Europe. …