Assessment of stock market contagion during the subprime mortgage crisis using GARCH-in-VAR model

Abstract

In this paper, we provide an assessment of stock market contagionbased on the multivariate GARCH-in-VAR model, where the meanequation of VAR involves conditional volatility. Our specification ofGARCH-in-VAR can detect cross-market linkages by the risk-toreturnvolatility effect of the conditional volatility in VAR as well as thereturn-to-return interdependence effect of the structural shocks. Significant changes in interdependence and the volatility effectprovide important evidence for contagion caused by increases incross-market linkages through these two channels. Applying thisapproach to the subprime mortgage crisis, we examine whether thereexisted financial contagion between the stock markets of the U.S. andthose of the major countries in Asia, America, and Europe. Empiricalassessment confirms that most of the countries experienced contagionthrough either one of the two channels or through both channels, andthat through which channel the crisis is transmitted to a countrydepends on the country’s economic robustness and global financialmarket integration. The impact of a shock from the U.S. on othermarkets tends to be more pronounced and persistent when it ispropagated through the volatility effect than through interdependence.