King 1990
King 1990
King 1990
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Transmission of Volatility
between Stock Markets
Mervyn A. King
Sushil Wadhwani
London School of Economics
This article was prepared for the NBER Conference on Stock Market Vola-
tility, March 16-19, 1989; an earlier version was presented to the LSE Finan-
cial Markets Group Conference on Stock Market Behavior in March 1988
and to the European Meeting of the Econometric Society at Bologna in
August 1988. Financial assistance was provided by the LSE Financial Markets
Group. The authors thank the International Stock Exchange, LIFFE, and
Nomura for their provision of data, and Victor Hung and Bertrand Kan for
excellent research assistance. They also thank Michael Brennan, the referee,
Fischer Black, John Campbell, Douglas Diamond, Rob Engle, Charles Good-
hart, Sandy Grossman, James Poterba, and Richard Roll for helpful comments
and suggestions. Address reprint requests to Prof. King, London School of
Economics, Houghton Street, London WC2A 2AE.
Index
110 .FT30
_- _ _Dow Jones
100 ......_.
Nkked
80
70
1 5 12 19 26
October
Figure 1
Stock market indexes, October 1987 (October 1, 1987 = 100)
national capital asset pricing model (ICAPM), would allow for such
a correlation. But to interpret the data solely within a Walrasian equi-
librium framework with fully informed agents seems inadequate for
two reasons. First, it is difficult to come up with a credible story that
links "fundamentals" to the crash; what could explain a fall of almost
23 percent, the largest one-day fall, on the NYSE? Moreover it is
extremely hard to imagine that any such explanation would be con-
sistent with the uniform decline in equity prices in different coun-
tries.' Second, the correlation coefficients between stock markets are
remarkably unstable over time [Brady Report (1988)].
In this article we examine a rational expectations price equilibrium
and model contagion between markets as the outcome of rational
attempts to use imperfect information about the events relevant to
equity values. Because investors (including market-makers) have
access to different sets of information they can infer valuable infor-
mation from price changes in other markets. Although published
news should affect all markets at the same time (albeit in different
ways because the significance of a piece of news may vary from country
to country), not all information, nor the ability to process it, is public.
ISome commentators saw the crash as the end of a speculative bubble. Although there may be some
truth to this story, there remains the puzzle of why the end of a bubble should have led to (1)
similar falls in markets that had behaved in very different ways prior to the crash and (2) subsequent
recoveries in markets, such as Tokyo, that had been most frequently cited as examples of speculative
bubbles.
6
Transmission of Volatility
7
The Review of Financial Studies/ v 3 n 1 1990
8
Transmission of Volatility
from changes in market prices than to incur the direct costs of pro-
cessing information. As a modeling strategy, therefore, we want to
analyze a non-fully-revealing equilibrium. Although this is perfectly
compatible with international trading in stocks, the greater com-
plexity involved in modeling the behavior of risk-averse investors,
especially with time zone trading, adds little to the implications of
empirical work.
The model is best illustrated by considering the case of two coun-
tries, both with their own stock market. The general case is examined
in Section 3. Assume first that both markets are open 'round the clock.
The change in the stock market index over an hourly period, say, is
a function of the news released between the beginning and the end
of that hour. Information is of two types, systematic and idiosyncratic.
The former, denoted by u, is information that affects market values
in both countries. The latter, denoted by v, is relevant only to a specific
country. Both u and v are assumed to comprise two components,
corresponding to information that is observed in one country or the
other. Consider, first, a fully revealing equilibrium. If information
from both countries were fully revealed, then the process that would
generate changes in stock prices is assumed to be
9
The Review of Financial Studies / v 3 n 1 1990
that the only information available to market 1 about the value of u(2)
is the contemporaneous price change in market 2. The unconditional
expectation of u(2) in market 1 is zero, but a nonzero realization of
ASt2)provides information to market 1 about the information that has
been observed in market 2. The message is contaminated by the fact
that some information which leads to price changes in market 2 is
idiosyncratic and irrelevant to market 1. Hence the equilibrium is not
fully revealing. In addition market 1 players realize that their coun-
terparts in market 2 are going through the same exercise in order to
infer information from price changes in market 1. We assume that the
distributions of the stochastic news processes and the parameters of
the model are common knowledge. Hence agents can solve the signal
extraction problem to find the minimum-variance estimator for the
value of the relevant news term that has been observed in the other
market. The solution to this problem is
i= 1, 2 (7)
c0-i) + t(o2
Substituting these expressions back into Equations (3) and (4) yields2
2
When u(I) and u(2) are correlated we obtain equations that are analogous to (8) and (9). These are
derived in the Appendix. We have also made the simplifying assumption that agents in one market
never learn subsequently about past realizations of the random variable u in other markets. When
agents learn in later periods about the currently unobservable news the mistakes in valuation are
corrected. This adds noise to the price changes but induces no serial correlation. The correlation
coefficient between markets is equal to its value in the fully revealing model. The implications for
price jumps as discussed below are unchanged. Details of this "catch-up" model are available on
request.
10
Transmission of Volatility
Table 1
Volatility in the two-market case
11
The Review of Financial Studies / v 3 n 1 1990
3 If u(I) and u(2)are correlated, then Equations (17) and (18) are no longer valid. The coefficient in
(18) is no longer equal to the corresponding coefficient in (8) when both markets are open. This
implies that the estimates of the contagion coefficients from overlapping trading hours and open-
to-close regressions need not coincide.
12
Transmission of Volatility
* Regime 3: Both markets are closed and the shadow price changes
are given by
s(tis) = nt i= 1, 2 (19)
* Regime 4: Market 2 is closed and market 1 is open. This situation
is obviously the mirror image of regime 2 and price changes are
described by Equations (17) and (18) with superscripts 1 and 2 inter-
changed.
It is necessary to examine also the jumps in price that take place
when switching from one regime to another. Such jumps occur when-
ever a market reopens and are a unique feature of the imperfectly
revealing equilibrium model. There are two cases to examine. First,
when market 1 reopens the shadow index in market 2 jumps to reflect
the information that is contained in the opening price in market 1.
Denote by to, and tc, the times at which market i opens and closes,
and by St3$and SQ)the logarithm of the stock price in market j at the
time when market i opens and closes, respectively.4 The change in
price between the close of trading on one day and the opening of
trading on the next day, the "close-to-open" (CO) price change, is
defined (for market j) by
CO (j)-=S( - S(p) (20)
CO(1) (
n1) + f12(S'c - S(2)) (22)
t-= tcI
4 To simplify notation we omit the day to which these values refer. This should be obvious from the
context.
13
The Review of Financial Studies/ v 3 n 1 1990
to2
Combining Equations (24) and (25), the jump in the price in mar-
ket 1 when market 2 reopens is
to2
J=
(1 (2) (26)
t= tc2
14
Transmission of Volatility
to2
CC(d =
NdJ) + 1(S c2 S02) + n(2)J (27)
L ~~~~~~~t--
4c2 J
Similarly
CC(2) = NAJ2 + fl1) (29)
Equations (28) and (29) are natural generalizations of Equations
(12) and (13). The lag in Equation (28) but not in Equation (29)
reflects the fact that market 1 opens and closes before market 2 trades.
These two equations may be solved to yield
CC(d1) =
f12CCd-1 + (1 12 021,L)N) (30)
CCd = f21CCdl + (1 -
012fl2,L)d) (31)
15
The Review of Financial Studies / v 3 n 1 1990
16
Transmission of Volatility
to'
J(!) = ij r(
2;
77i#] V i ?# j(5 (35)
t-tcj
3. Empirical Results
In this section we provide some empirical tests of the contagion
model using high-frequency data from the stock markets in London,
New York, and Tokyo for an eight-month period around the crash,
July 1987 to February 1988. Together these three markets account for
80 percent of total world market capitalization.
6
Local exchanges may choose their hours of trading in the light of experience of the price movements
determined endogenously within the model and, if this is the case, then the regimes become
endogenous to the model. The issue of the optimal length of the trading day is beyond the scope
of this article.
17
The Review of Financial Studies/ v 3 n 1 1990
7 The three subperiods were selected on the basis of differences in the average level of volatility.
The results are not sensitive to the precise dates that were used and, in particular, to the choice
of October 13 rather than October 16 for the end of the precrash subperiod.
8 We have excluded the observation for 11:30 A.M.-12 noon on August 20, as it represents by far the
largest single change in the subperiod (following an unexpected announcement of changes in
interest rates) and distorts the graph. Including this observation increases volatility by 50 percent
for that 30-minute period.
18
Transmission of Volatility
0.0022
i3 0.X2 A 01 3
3lxStd
* 0.002
0.0016
C 0.0014
0.0012
co
0.001
o '- r'2 >
'-4 '-4 '-4
~ 4 a
Local Time
Figure 2
Standard deviation of 30-minute returns using the FTSE-100 index, computed for 15-minute
intervals, July 1-October 13, 1987
19
The Review of Financial Studies / v 3 n 1 1990
0.003
1 .3lxStd
CC 0.0025- ......
E ~~~~~~~~~~~~~~~~
.3lxStd
0.002
0
o0.0015 ,
0.0005
O '-4 r'2 > N n
Local Time
Figure 3
Standard deviation of 30-minute returns using the FTSE-100 index, computed for 15-minute
intervals, December 1, 1987-February 26, 1988
period September to November 1987. For New York we use the Dow
Jones Index, for London the Financial Times 30 Share Index, and for
Tokyo the Nikkei-Dow Index.
One hypothesis to which we will pay particular attention is that
the contagion coefficients increased during and immediately after the
crash in response to the rise in volatility but then declined as volatility
decreased. Nothing in the model implies that the contagion coeffi-
cients are necessarily constant. The variances of the information vari-
ables may change over time. Suppose that investors do not know the
true variances of the information variables. With Bayesian updating
of beliefs about variances a common shock to all markets, such as
the crash, would result in an increase in the perceived variances of
the common news terms. In turn this would lead to a rise in the
contagion coefficients. Note that "common news" here refers to either
fundamentals in the conventional sense or other sources of changes
in equity values. If periods of high volatility exhibit little increase in
economic "news" (e.g., episodes like the crash), then in such periods
there is likely to have been a change in the underlying demand or
"taste" for equity. As in the Keynesian beauty contest parable, changes
in the average investor's taste for equity are important in determining
the demands of individual investors, who, therefore, in times of
increased volatility will rationally place greater weight on price
changes elsewhere. In our sample period, therefore, we might expect
that the contagion coefficients would be an increasing function of
volatility.
20
Transmission of Volatility
0.02
0.018
1..3lxStd
cc 0.016- - --
EG -1 .3lxStd
. . .
0.014 - - - - - - - -- - - - - - - - - - - - - - - -
o 0.012-
c
0.0
0.008
v.
0.006
0.004
co
0.002
Local Time
Figure 4
Standard deviation of 30-minute returns using the FTSE-100 index, computed for 15-minute
intervals, October 14-November 30, 1987
where
Aw= the percentage change in the world index
oi= the normalized covariance with the world index
Ei)=the idiosyncratic component of the return
21
The Review of Financial Studies / v 3 n 1 1990
(1) -
S= S(2) + a' (40a)
1-
2
, S(2) t L S()t + AZ + t
4b
(40b)
1 ~1 - 32w2
The difference between Equations (36) and (40) is that the IMM
implies a nonlinear restriction on the regression coefficients. (In the
two-market case the restriction is that the product of the coefficients
is unity.) This restriction is rejected in our data. In the remaining
empirical tests we focus on the change in the coefficients over time
and in particular on their relationship with volatility. Whether these
changes are more plausibly explained within a contagion model or
in the IMM framework is a judgment that we leave to the reader.
First, however, we examine the correlation between the markets
when both are open. Table 2 reports the correlation coefficient between
London and New York for hourly price changes during overlapping
trading hours (13:30 to 16:00 GMT), both before and after the crash.
The correlation coefficient is positive, which is consistent with the
idea of the contagion model. Using the published market index there
is some evidence of an increase in the correlation between the two
markets after the crash; the coefficient rises from 0.27 to 0.38. How-
ever, the published data for the United States may be misleading
because, during the week of the crash, the Dow Jones Index often
deviated from the "true" market-clearing price. For example, one
hour after the opening bell on October 19 more than one-third of
the stocks in the DowJones Index had failed to commence trading.
In contrast, the futures price is more likely to reflect market-clearing
levels (although the futures market itself shut down for a short period
on October 20). It seems highly plausible that the observation that
the futures price was often at a substantial discount to the cash price
reflects the presence of "stale quotes" in the cash index.10 In London
22
Transmission of Volatility
Table 2
Correlation between London and New York stock markets (hourly data for overlapping
trading hours)
Correlation Number of
Sample period coefficient observations
1
Uses data on the futures index for the United States during the crash week, as cash price data were
unreliable.
2
Uses data on the futures price index for both markets.
it has been argued by the International Stock Exchange that the official
index "moved closely in step" with actual transactions prices, although
there were occasions when the futures index traded at a discount."
For these reasons we recalculated the correlation coefficient using
the percentage change in (1) the S&P futures price (quoted on the
Chicago Mercantile Exchange) instead of the change in the Dow
Jones Index and (2) the FTSEfutures index (quoted on LIFFE) instead
of the FT-30 Index for observations in the week of the crash. As can
be seen from Table 2, this produces a significantly higher correlation
coefficient of 0.48 during the period October 16 to the end of Novem-
ber, implying a substantial rise relative to the period before the crash
and even higher values during the crash week itself. All the empirical
results reported below are based on use of the futures index rather
than the spot index for the United States during the crash week.12 It
is also striking that the correlation between the two markets had fallen
to approximately its precrash level by the beginning of 1988.
There was a significant increase in actual volatility during the week
of the crash (see Figure 5) in both London and New York. Measures
of implied (or expected) volatility derived from observed option
prices [using data from Franks and Schwartz (1988)] rose less than
actual volatility, although the time pattern is similar (see Figure 6,
which shows actual and implied standard deviations of hourly price
changes in London during each week of the sample period). After
the crash volatility fell, though it was not until February that it returned
to its precrash level.
11 Quality of Markets Quarterly, Winter 1987-1988, International Stock Exchange, London, p. 19.
12
The futures data used during the crash week refer to the S&P Index, whereas we use the Dow
Jones Index before and after the crash week. However, since the official Dow Jones Index during
the crash week was unreliable, we believe that the change in the price of an S&P futures contract
is likely to be a better proxy for the "true" change in the Dow Jones.
23
The Review of Financial Studies / v 3 n 1 1990
0.04 NowYork
London
0.03
>, 0.02
10
C
co
.... .~~~~~~~~~~~~~~~~~.......
0
)_ 0 H > H z
Z
-Y z Q >
Date
Figure 5
Standard deviation of hourly returns computed over the previous week using the Dow
Jones and FT-30 indexes, respectively
24
Transmission of Volatility
Actual volatility
\Implied volatility
I~~~ ,
Month
Figure 6
Alternative measures of volatility, London
and French (1986) and Poterba and Summers (1987)]. This may arise
through either variations in expected returns or the activities of "noise"
traders. With serially correlated returns, estimation of the following
augmented version of Equations (40) would provide a way of iden-
tifying the contagion coefficients:
= f21
AS( AS2+ '2 AS(2)1 + (1-(2) (41b)
25
The Review of Financial Studies/ v 3 n 1 1990
IV IV
takes OLS OLS OLS OLS
method between
the Estimation
form
t2) - - - - - - #12
London
= 0.41
(6.43) 0.36
(9.22) -0.07
(-0.68)
#21 and
AS," New
+
- - - - - -
42 -0.08 -0.09 0.01 York
(-0.98) (-1.25) (0.35)
5,2,
+ using
#1
- - - - 21
2.16
(6.35) 1.56
(9.14)
-0.46
(-1.82)
overlapping
#"(VOL,)(AS^,)
+ - - 0.16 - - 0.65 t2
0.09
(1.02) (2.05) (5.90) data
(2)
- - - - (t-values
3.54 VOL-#
0.94(7.86)
(4.05) in
- - - - -
-1.06 VOL.42
(-5.00)
parentheses)
60 60 60 60 316 316 of
obser-Number
vations
R2
0.630 0.568 0.628 0.644 0.516 0.588
26
Transmission of Volatility
Table 4
Estimates of the contagion coefficients between London and New York with time zone
trading (t-values in parentheses)
Number
of
obser-
Sample period 12 21 vations R2 D.W.
,0,
CO(l) = q(1) + #2 (Sli, - S2)
and
t?2
c02 = v (2) + #21 (S2 -
S())) -1221 (S(2-S)-
7
where 1 denotes the United Kingdom and 2 denotes the United States.
are significantly different from zero at the 5 percent level, as are the
IV estimates. This suggests that there is a true interrelationship between
the two markets and that the positive correlation coefficient is not
explicable in terms of the same news arriving in both markets simul-
taneously. It is somewhat surprising, however, that the estimated
contagion coefficients are slightly higher using IV than OLS estima-
tion, implying that the innovations in news in the two markets were
negatively correlated.
27
The Review of Financial Studies / v 3 n 1 1990
Table 5
Estimates of the contagion coefficients between Japan, United Kingdom, and United States
with time zone trading (t-values in parentheses)
Number of
observa-
Regression Sample iJfiji 3 tions
previous day from the close of London to the close of New York.
Rows 4, 5, and 6 show estimates of Equation (25) for the United States
for each of the subperiods. This second set of estimates involves
regressing the close-to-open price change in New York on the change
in the London price from its previous close and on the change in the
New York market on the previous day during the period when London
was closed.
The message from the results shown in Table 4 is clear. They
suggest a statistically significant association between the two markets,
and, moreover, one that increases during mid-October and then
declines after the end of November. The contagion coefficient mea-
suring the effect of New York on London rose from an average of
about 0.2 before the crash to about 0.4 after the crash. This is very
much in line with the estimates based on hourly changes during
contemporaneous trading, which show a rise from 0.20 to 0.38. As far
28
Transmission of Volatility
29
The Review of Financial Studies / v 3 n 1 1990
Table 6
Variances of daily returns In the United Kingdom
4. Conclusions
A world in which investors infer information from price changes in
other countries is also one in which a "mistake" in one market can
be transmitted to other markets. If, for example, a failure in the market
mechanism in the United States exacerbated the crash (and we remain
agnostic about that), then this would have transmitted itself to other
markets. Moreover, the empirical evidence suggests that an increase
in volatility leads in turn to an increase in the size of the contagion
effects. The rise in the correlation between markets just after the crash
is evidence of this. Were this result to prove robust, it would have
the important implication that volatility can, in part, be self-sustain-
ing.
The starting point of this article was the uniformity of the fall in
world stock markets during the October 1987 crash, despite important
differences in economic prospects, market mechanisms, and their
prior "degree of overvaluation." We believe that our story might
provide a part of the explanation. The evidence on price jumps with
time zone trading supports the contagion model and merits further
30
Transmission of Volatility
research with data from other markets. The evidence that volatility
in London was lower when the New York market was closed on some
Wednesdays in 1968 provides support for the contagion model. The
role of contagion should not be dismissed on the grounds that there
has been no historical trend increase in correlations between markets.
Nothing in our argument requires there to have been such an increase.
Rather, it is the volatility-related increase in contagion effects that is
the feature of the transmission mechanism.
The possibility of contagion means that one cannot assert that,
because markets without formal portfolio insurance fell as much as
the U.S. market, portfolio insurance could not have been responsible
for the crash."3It is possible-though we take no position on this-
that a U.S. price decline exacerbated by portfolio insurance could
have spread to other markets.
31
The Review of Financial Studies / v 3 n 1 1990
where
+ o4O)
Xi = 2o(t)/(Of22(,)
as before,
-= 4/(G2 + c7A(,)+ a_Vo)
and
(1 - XJ(1 - 6,)o + X16i?oJ1)- (1 - Xi)6i?oW()
=
(1 - ,)c42 + -2W,) + 62f2,) + 6P at,)
As(i) t = [a12X2
a22 t10 + (M1 + a 202)u(1) + Mlv(1)]
AS(2) (A7)
M + Ca12aX21X1
and
where
M2 = 1 - XX2a21Ia12 + X2a2181 > 0
where
where
32
Transmission of Volatility
K1 = 1/(1 + a21X2of),
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