Asymmetric Volatility Phenomenon: An Application to Major European Countries

[Abstract] This study is aimed at examining the presence of symmetric conditional second moments in major European stock markets and the effect of the Euro in the correlation between the indices of those stock markets. This study is carried out through Dynamic Conditional Correlation (DCC) model of Engle (2002), developed by Sheppard (2002) and the DCC form of the EGARCH model by Nelson (1991). The empirical evidence suggests that index return series show strong symmetric relationships in conditional volatility; it is also found that the correlation increases with the introduction of the Euro; the introduction of the fixed exchange rate leads to a nearly perfect correlation among major European stock markets. [Keywords] Asymmetric; leverage effect; feed back effect; multivariate GARCH; European Introduction A number of studies document that correlation between equity returns increases during bear markets and decreases stock exchange rallies (Ang & Bekeart, 2001; Longin & Solink, 2001). Among other conditional estimates of the second moments, equities often exhibit the "asymmetric volatility phenomenon. " Asymmetric effect occurs when unexpected downward movements in the price of an asset raise the conditional volatility of returns more than when there are unexpected upward movements (Nelson, 1991). Theory offers many explanations for this asymmetric phenomenon at the firm level; the earliest explanation is the "leverage effect," which implies a negative return volatility relation for individual firms. Black (1976) and Christie (1982) argue that a fall in stock price causes an increase in the debt-equity ratio (financial leverage) of the firm and the risk associated with firm increases subsequently. An alternative explanation for a symmetric volatility at aggregate level is "volatility feed back"; according to this approach, an anticipated increase in perceived risk induces high-risk premiums on the stock and the stock price must fall immediately. Campell and Hentschel (1992) report that both the "volatility feedback" effect and "leverage effect" play important roles. The symmetric effect was confirmed by empirical investigations of French et al. (1987), Schwert (1990), and Nelson (1991). The goals of this paper are, first, to investigate whether the indices of major European stock markets exhibit asymmetry in conditional second moments. Second, it explores the dynamics and change in correlation with major European asset markets, focusing attention on whether the variance and correlations of assets are sensitive to past innovations. We also investigate the question of whether or not the formation of the monetary union in Europe increases the correlation among European assets. If correlation increases, along with monetary integration, do investors move capital, which before was allocated within the Euroarea, to other regions? The analysis is carried out through Dynamic Conditional Correlation (DCC) of Engle (2002) and Exponational Generalized Autoregressive Conditional Heteroskedasticity (EGARCH) of Nelson (1991). We preferred the EGARCH-M model, which could provide more accurate results, as the exponential GARCH-M model accommodated an asymmetric relationship between stock price returns and volatility changes, assuming that both the magnitude and sign of volatility are important in determining the correlation between stock price returns and volatility. Thus, the negative and positive sign of the conditional variance allowed the stock price to respond asymmetrically (bad and good news) to rises and falls in stock prices. This study differs from previous research in that we explicitly investigated the differential impact of positive and negative shocks from capital markets on the conditional volatility of these markets, and then we looked at the relationship between stock price returns and conditional volatility. Furthermore, a symmetric phenomenon for individual stock market indices has received little attention; instead focusing on the impact of macroeconomic news announcements on conditional volatility (Cappiello et al. …