The shifting dependence dynamics between the G7 stock markets

Abstract

The growing interdependence between financial markets has attracted special attention from academic researchers and finance practitioners for the purpose of optimal portfolio design and contagion analysis. This article develops a tractable regime-switching version of the copula functions to model the intermarkets linkages during turmoil and normal periods, while taking into account structural changes. More precisely, Markov regime-switching C-vine and D-vine decompositions of the Student’s t copula are proposed and applied to returns on diversified portfolios of stocks, represented by the G7 stock market indices. The empirical results show evidence of regime shifts in the dependence structure with high contagion risk during crisis periods. Moreover, both the C- and D-vines highly outperform the multivariate Student’s t copula, which suggests that the shock transmission path is as important as the dependence itself, and is better detected with a vine copula decomposition.

Keywords:

• Financial co-movement
• Regime-switching
• Vine copula
• Multivariate Student’s t

AMS Subject Classifications:

• G15
• C34
• C58

Notes

No potential conflict of interest was reported by the authors.

This paper was written while Sabri Boubaker was visiting professor in Finance at the International School, Vietnam National University, Hanoi, Vietnam.

1 In a related study, Bauer et al. (2012) propose a combination of pair copulas and directed acyclic graph (DAG-PCC) to model both the conditional dependence and directed interactions between variables. However, the selection of a suitable non-Gaussian DAG-PCC model is challenging as it requires assumptions about the Markov structure to derive directed interactions as well as the identification of appropriate pair copulas.

2 Patton (2012) provides a detailed survey on copula models for economic time series.

3 In a related study, BenSaïda (2017) designs a Markov-switching C-vine and D-vine under the symmetrized Joe-Clayton (SJC) copula to capture lower and upper tail dependencies separately among the European sovereign debt markets.

4 This does not mean that the contagion across Euro area countries has been controlled, a thorough investigation is needed.

5 There are six trees for each vine; for presentation’s purpose, we report only the first ones. The remaining trees are available from the corresponding author upon request.