Volatility Spillovers and Financial Contagion in the CEE Stock Markets MSc. Student: ânaru Mihai Supervisor: Professor PhD. Moisă Altăr Academy of Economic Studies Doctoral School of Finance and Banking

Summary Introduction Methodology Data description Estimation results Conclusions References

Introduction The spread of crises throughout the financial system at the global or regional level has been (loosely) defined as contagion. Despite the large interest in the subject, there is no generally accepted definition for contagion. The implications of contagion in the pricing of risk and for financial regulators are of outmost importance. The methodologies employed in the scientific literature vary with the definitions for contagion:  Spillovers in return and volatility across financial markets – modeled with simple GARCH models in Engle et al. (1988), Hamao et al. (1990), or multivariate GARCH models as in Beirne et al. (2008).  Restrictive definition – change in the cross-market shock transmission mechanism that takes place during crises – study of cross-market correlation coefficients: King and Wadhwani (1990), Forbes and Rigobon (2002), Dungey et al. (2005).

Introduction In the light of Bekaert, Harvey and Ng (2005), this study adopts the restrictive definition of contagion as “correlation over and above what one could expect from economic fundamentals”. Motivations of this study:  To develop a model that correctly accounts for the cross-market fundamental linkages, and therefore, gives an accurate description of the cross-market volatility transmission mechanism.  To verify to what extent does the model choice influence contagion test results. I construct a two-factor spillover model for the CEE stock markets, with global (US) and regional (European) risk loadings:  It distinguishes between regional and global market integration.  It outperforms the one-factor model in modeling cross-market correlations – Bekaert et al. (2008).

Methodology 1. The Bivariate Global – Regional Specification The framework for the joint process of US and EU returns:  with - return vector  - expected mean: lagged information variables, US and EU returns.  - vector of unexpected returns.  - joint conditional variance-covariance process specified by Engle and Kroner’s bivariate BEKK(1,1). The orthogonalization process to obtain the US and EU idiosyncratic shocks:, with,

Methodology 2. The Univariate Volatility Spillover Model General model for the return of CEE stock market index i, at time t: , with  - conditional mean: (lagged) US return or local dividend yield.  - unexpected return composed of global, regional and local idiosyncratic shocks. The restricted models for the global/regional risk factor exposure or ‘beta’:  Constant ‘beta’ :  Structural ‘beta’ :, with - a trade integration measure as in Bekaert et al. (2005).  Regime-switching ‘beta’:, with - a latent regime variable as in Baele (2005).

Methodology 2. The Univariate Volatility Spillover Model This study employs the flexible ‘beta’ specification as in Baele et al. (2010): where:  - structural economic instrument that reflects time-varying integration measure.  - regime-switching component that reflects temporary fluctuations in financial markets conditions. The latent regime variable follows a Markov chain process with constant transition probabilities: and.

Methodology 2. The Univariate Volatility Spillover Model When the spillover model for the individual market i: entertains regime-switching component in the market ‘betas’, then:  Case 1: and  Case 2: - GARCH(1,1) variance process. The estimation of the regime-switching specification is done through the maximization of the sample log-likelihood function:

Methodology 3. Variance Ratios and Conditional Correlations The depicted models are complete with the assumption: of zero correlation between the local idiosyncratic shocks and US/EU specific innovations. The total conditional variance of market i can be decomposed: Variance ratios and conditional correlations are given by:

Methodology 4. The Contagion Test An unconditional correlation (over the full sample) does not guarantee that there has not been contagion across some episodes of time. The following specification is estimated to test for any remaining correlation, separately for each market and through a panel regression: where: represents a dummy to account for crisis (high volatility) periods in the global/regional equity markets. Significant, parameters signal contagion.

Data description All data spans between Jan 2005 – Mar 2010, 262 weekly (Tue) observations. Equity market data: returns of the S&P500 for the global market, MSCI Europe for the regional market and of the most liquid stock market indices in Romania (BET), Hungary (BUX), Poland (WIG) and Czech Republic (PX) for the CEE markets. Information variables : CDS prices for CEE 5Y sovereign debt and EUR/CEE currencies exchange rates; (first difference of) US default spread, TED spread, US 10Y Treasury Bond yield, local dividend yields. Structural data : the sum of imports and exports between an individual country and US/EU divided by the sum of the total imports and exports for that country. The crisis dummy equals 1 during periods:  the peak of the recent global economic and financial crisis between Sep 2008 and the beginning of May 2009, when VIX volatility index was more than 1 std. dev. above the sample mean;  when both the S&P and MSCI returns were 1 std. dev. below the sample mean.

Estimation Results 1.The US and EU joint specification The BEKK(1,1) model results: There are significant unidirectional news and volatility spillovers from the US market to the aggregate European equity market. Specification tests: The Ljung-Box tests find that no autocorrelation remains in the (squared) standardized residuals of BEKK(1,1) model.

Estimation Results 2. The Dynamic Factor Regime-Switching Models The orthogonalized US and European residuals are plugged as components in the unexpected returns of the individual CEE indices. The various specifications of market ‘betas’ are tested for statistical significance:  For all CEE indices, the model with constant ‘betas’ and the model with time- varying structural ‘betas’ are statistically valid.  When the most flexible ‘beta’ specification as proposed by Baele and Inghelbrecht (2010) does not fit the data, less-complex specifications are employed, at least one factor loading involving a regime-switching component. The specification tests on the models with regime-switching are Ljung-Box tests on the generalized (regime-independent) residuals as in Smith (2007). The Hansen (1992, 1996) standardized LR test is employed for the general validity of the switching hypothesis.

EU market ‘beta’: US market ‘beta’: Estimation Results 2. The Dynamic Factor Regime-Switching Models Romania BET index Specification tests

EU market ‘beta’: US market ‘beta’: Estimation Results 2. The Dynamic Factor Regime-Switching Models Poland WIG index Specification tests

Estimation Results 2. The Dynamic Factor Regime-Switching Models EU market ‘beta’: US market ‘beta’: Czech Republic PX index Specification tests

Estimation Results 2. The Dynamic Factor Regime-Switching Models EU market ‘beta’: US market ‘beta’: Specification tests Hungary BUX index

Estimation Results 2. The Dynamic Factor Regime-Switching Models Graphs of smoothed probabilities of being in the low volatility regime

Estimation Results 2. The Dynamic Factor Regime-Switching Models The models involving regime-switching are the best-fitted by the measure of Hansen’s test – the null of one state is rejected at 90% confidence level for all the CEE indices. The generalized residual-based tests find no evidence of linear dependence or ARCH type effects for residuals from RS models. The switching component pertains only to the US spillover effects for all the CEE markets. Poland and Czech equity markets are more integrated at the regional level, while US shock spillovers are prevalent for the Romanian and Hungarian equity markets. The high local volatility states coincide with the peak of the recent global financial crisis in

Estimation Results 3. Economic determinants of switching between states The logit regressions for switching states  Dependent variable in the regressions is a binary dummy: equals 1 if smoothed probability of high volatility regime is greater than 50%, 0 otherwise.  The CDS price entertains a positive effect for switching from low to high local volatility state for all markets.  EUR/RON conditional volatility positively influences switching to a high volatility state for the BET index returns.  Higher US default spread and TED spread turn CEE equity markets turbulent.

Estimation Results 4. Variance ratios and Conditional Correlations Average variance ratios and conditional correlations from best-fitted models Over full sample, US volatility spillovers explain cross-sectional approx. 25% of the variance of CEE indices returns; the average EU variance ratio is 5%. During crisis periods, volatility spillovers from US market account for about 30% cross-sectional average for the CEE markets volatility, while EU spillover effects only increase to 6% on average. The increase of conditional correlations during crisis periods is not evidence for contagion, but an effect of the natural interdependence between markets.

Estimation Results 5. Contagion Tests – individual markets Romania Poland

Estimation Results 5. Contagion Tests – individual markets Czech Republic Hungary

Estimation Results 5. Contagion Tests – CEE markets group The panel tests of contagion  There is no evidence for contagion to the Romanian and Polish equity markets, regardless of the cross-market linkages model employed.  Contagion from the global or regional level is identified during crisis periods to the Czech and Hungarian equity markets, except for the RS model.  Testing on residuals from regime-switching models gives the same conclusion of no contagion at both individual market levels and to the CEE as a group.  The panel test of contagion indicates excess exposure to the US effects for the CEE equity markets when structural ‘beta’ model is employed.

Conclusions Shock-spillover from the global level are larger than those from the regional level to the group of CEE equity markets. The US market volatility is the dominating influence on CEE equity market variation. Higher risk of local CEE sovereign default, higher currency volatility and worsening financial conditions in the world economy (US) lead to higher CEE stock market volatility. Contagion tests results depend upon the model of volatility spillovers. I find no contagion when using the best-fitted models. The results of the study come in line with the findings in the literature on contagion which employs similar methodologies.

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