Academic journal article Seoul Journal of Economics

Extreme Risk Spillover in Financial Markets: Evidence from the Recent Financial Crisis

Academic journal article Seoul Journal of Economics

Extreme Risk Spillover in Financial Markets: Evidence from the Recent Financial Crisis

Article excerpt

(ProQuest: ... denotes formulae omitted.)

I. Introduction

We often see that some negative shocks in a financial market have similar effects on other markets with lags of certain length. If markets were perfectly segregated, this kind of effect is not observed. In reality, however, international financial markets have become increasingly interdependent because of recent trends of capital liberalization and market integration, among other reasons. Kose, Otrok, and Whiteman (2010), for example, report the existence of a common world factor, which is an important source of business cycles in most countries. They also note that the influence of common factors tends to increase during this period of financial globalization.

The recent global financial crisis originated in the world's largest economy: the U.S. (Cheung et al. 2010). Recent studies, such as that of Longstaff (2010), examined the effects of the subprime asset-backed CDO (collateralized debt obligation) market on other financial markets. Cheung et al. (2010) noted that shocks from the U.S. market promptly spilled over into foreign markets, including both developed and emerging markets. These studies are based on the test of Granger causality in the mean. Engle et al. (1990), Ng (2000), and Hong et al. (2001), by contrast, used variance as a measure of financial risk for risk spillover analysis. However, analyses based on the mean and variance have clear limitations. That is, analyses based on the mean cannot adequately capture the riskiness of financial assets. In addition, analyses based on the variance cannot investigate asymmetric movements in risks nor the heavy tail properties of financial variables.

In this paper, we study risk spillover based on downside values at risk (VaR). VaR was originally proposed by J.P. Morgan (1994) and has become a standard measure for controlling and monitoring downside market risk. This measure indicates the degree to which the underlying financial asset can lose its profit within a certain period. In terms of statistics, VaR corresponds to the left-tail quantile of a distribution. Our approach to the investigation of risk spillover is to test Granger causality in VaR from one market to other markets. Grangercausality in VaR was introduced by Granger (1980) and further studied by Hong, Liu, and Wang (2009), among a few other researchers.

Our empirical work is based on daily observations from 1 July 2004 to 1 July 2010. We set July 2007 as the starting point of the crisis following Cheung et al. (2010). To test the extreme risk spillover effects of the crisis, the downside movement of S&P 500 is used as the benchmark risk. We also analyze the risk spillover effects between the stock market and the currency market of each country under consideration. In addition, we examine whether extreme movements in the value of riskier assets affect demand for safer assets by analyzing effects between the U.S. stock market and the international gold market.

Our result shows that the extreme risk spillover from the U.S. stock market to most Asian stock markets became significant after the global financial crisis. Specifically, downside movement in the U.S. stock market Granger-caused downside movement in Korean stock market at the 1% VaR level after the crisis and the stock markets of China, Hong Kong, Japan and Taiwan, at 5% level. Moreover, downside movement in a U.S. stock index significantly created a Granger-caused depreciation of all Asian currencies under study after the crisis. In addition, downside movement of a U.S. stock index created significant Granger-caused upside movements in international gold prices, which implies that extreme movements in riskier assets increased the demand for safer assets. In our analysis, it is not clear what the world common factor is that is related to the recent financial crisis, as noted in Kose, Otrok, and Whiteman (2010). Shocks in the U.S. market may contain world common factors. …

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