Return and Volatility Spillovers Between Large and Small Stocks in the UK

Abstract:  This paper investigates return and volatility spillover effects between the FTSE 100, FTSE 250 and FTSE Small Cap equity indices using the multivariate GARCH framework. We find that return and volatility transmission mechanisms between large and small stocks in the UK are asymmetric. In particular, there are significant spillover effects in both returns and volatility from the portfolios of larger stocks to the portfolios of smaller stocks. For volatility, there is also evidence of limited feedback from the portfolios of smaller stocks to the portfolios of larger stocks, although sub-period analysis suggests that this is to some extent period-specific. Simulation evidence shows that non-synchronous trading potentially explains some, but not all, of the spillover effects in returns, and that it explains none of the spillover effects in volatility. These results are consistent with a market in which information is first incorporated into the prices of large stocks before being impounded into the prices of small stocks.     

An investor sentiment barometer — Greek Implied Volatility Index (GRIV)

In this paper, we propose a new measure of Greek equity market volatility based on the prices of FTSE/ATHEX-20 index options. Greek Implied Volatility Index is calculated using the model-free methodology that involves option prices summations and is independent from the Black and Scholes pricing formula. The specific method is applied for the first time in a peripheral and illiquid market as the Athens Exchange.The empirical findings of this paper show that the proposed volatility index includes information about future realized volatility beyond that contained in past volatility. In addition, our analysis indicates that there is a statistically significant negative and asymmetric contemporaneous relationship between the returns of the implied volatility index and the underlying equity index. Finally, the volatility transmission effects on the Greek stock exchange from two leading markets, namely the New York Stock Exchange and the Deutsche Börse, are tested and documented.     

Nonparametric realized volatility estimation in the international equity markets

Using high-frequency intraday data, we construct, test and model seven new realized volatility estimators for six international equity indices. We detect jumps in these estimators, construct the jump components of volatility and perform various tests on their properties. Then we use the class of heterogeneous autoregressive (HAR) models for assessing the relevant effects of jumps on volatility. Our results expand and complement the previous literature on the nonparametric realized volatility estimation in terms of volatility jumps being examined and modeled for the international equity market, using such a variety of new realized volatility estimators. The selection of realized volatility estimator greatly affects jump detection, magnitude and modeling. The properties each volatility estimator tries to incorporate affect the detection, magnitude and properties of jumps. These volatility-estimation and jump properties are also evident in jump modeling based on statistical and economic terms.     

Volatility timing: How best to forecast portfolio exposures

This paper investigates how best to forecast optimal portfolio weights in the context of a volatility timing strategy. It measures the economic value of a number of methods for forming optimal portfolios on the basis of realized volatility. These include the traditional econometric approach of forming portfolios from forecasts of the covariance matrix. Both naïve forecasts using simple historical averages, and those generated from econometric models are considered. A novel method, where a time series of optimal portfolio weights are constructed from observed realized volatility and direct forecast is also proposed. A number of naïve forecasts and the approach of directly forecasting portfolio weights show a great deal of merit. Resulting portfolios are of similar economic benefit to a number of competing approaches and are more stable across time. These findings have obvious implications for the manner in which volatility timing is undertaken in a portfolio allocation context.     

Conditional risk and performance evaluation: Volatility timing, overconditioning, and new estimates of momentum alphas

Unconditional alphas are biased when conditional beta covaries with the market risk premium (market timing) or volatility (volatility timing). We demonstrate an additional bias (overconditioning) that can occur any time an empiricist estimates risk using information, such as a realized beta, that is not available to investors ex ante. Calibrating to U.S. equity returns, volatility timing and overconditioning can plausibly impact alphas more than market timing, which has been the focus of prior literature. To correct market- and volatility-timing biases without overconditioning, we show that incorporating realized betas into instrumental variables estimators is effective. Empirically, instrumentation reduces momentum alphas by 20-40%. Overconditioned alphas overstate performance by up to 2.5 times. We explain the sources of both the volatility-timing and overconditioning biases in momentum portfolios.     

The Lead‐Lag Relationship Between Cash and Stock Index Futures in a New Market

This paper investigates the lead‐lag relationship in daily returns and volatilities between price movements of the FTSE/ATHEX‐20 and FTSE/ATHEX Mid‐40 stock index futures and the underlying cash indices in the relatively new futures market of Greece. Empirical results show that there is a bi‐directional relationship between cash and futures prices. However, futures lead the cash index returns, by responding more rapidly to economic events than stock prices. This speed is much higher in the more liquid FTSE/ATHEX‐20 market. Moreover, results indicate that futures volatilities spill information over to the corresponding cash market volatilities in both investigated futures markets, but volatilities in the cash markets have no effect on the volatilities of futures markets. Overall, it seems that new market information is disseminated faster in the futures market compared to the stock market. This implies that the futures markets can be used as price discovery vehicles, providing further evidence that derivatives markets contribute to completing and stabilising capital markets in Greece. A further finding of this study is that futures volume and disequilibrium effects between cash and futures prices are important variables in the explanation of volatilities in cash and futures markets.     

Commonality in returns,order flows,and liquidity in the Greek stock market

Using a unique high-frequency data-set on a comprehensive sample of Greek blue-chip stocks, spanning from September 2003 through March 2006, this note assesses the extent and role of commonality in returns, order flows (OFs), and liquidity. It also formally models aggregate equity returns in terms of aggregate equity OF, in an effort to clarify OF's importance in explaining returns for the Athens Exchange market. Almost a quarter of the daily returns in the FTSE/ATHEX20 index is explained by aggregate own OF. In a second step, using principal components and canonical correlation analyses, we document substantial common movements in returns, OFs, and liquidity, both on a market-wide basis and on an individual security basis. These results emphasize that asset pricing and liquidity cannot be analyzed in isolation from each other.     

Targeting market neutrality

Neutralizing portfolios from overall market risk is an important part of investment management, particularly for hedge funds. In this paper we show an economically significant improvement in the accuracy of targeting market neutrality for equity portfolios. Key features of the approach are the relatively short forecast horizon of one week and forecasting with realized beta estimators computed using high quality, error corrected, intraday returns. We also find that too long and too short estimation windows result in poor beta forecasts and that the optimal length of estimation window depends on the frequency of return observations.     

Intraday volatility responses to monetary policy events

This paper explores the effects of US monetary policy events on intraday volatility in the US equity markets. We examine Federal Open Market Committee (FOMC) announcements as well as real-time changes in market expectations about future policy announcements and their impact on the intraday volatility dynamics of the S&P 500 index. The analysis shows elevated intraday volatility following FOMC announcements through the market close, with a spike at the time of the announcement. We then differentiate the volatility spike by modeling an asymmetric response based on the direction of the actual target rate change. Our results suggest that the size of the volatility spike is dependent on the direction of the rate change, with expansionary monetary policy actions having a larger spike than contractionary policy actions. The duration of these volatility spikes is relatively short-lived, with the spike dampening out within 15 minutes. A more lasting impact is, however, documented for real-time changes in market expectations where the volatility spike tends to persist for at least one hour.     

Intraday Empirical Regularities in Interest Rate and Equity Index Futures Markets, and the Effect of Macroeconomic Announcements

This paper focuses on the intraday behaviour of returns, volatility, volume and price reversals for the Short Sterling interest rate and FTSE100 stock index futures contracts traded on the London International Financial Futures and Options Exchange (LIFFE). It also examines the effect of scheduled macroeconomic announcements and interest rate changes on the intraday behaviour of the variables of interest. We find clear differences and similarities with US studies and between the interest rate and equity contracts, which have important theoretical implications. This new evidence helps discriminate between the theories seeking to explain these intraday patterns.     

Hedging effectiveness of the Athens stock index futures contracts

This paper examines the hedging effectiveness of the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 stock index futures contracts in the relatively new and fairly unresearched futures market of Greece. Both in-sample and out-of-sample hedging performances using weekly and daily data are examined, considering both constant and time-varying hedge ratios. Results indicate that time-varying hedging strategies provide incremental risk-reduction benefits in-sample, but under-perform simple constant hedging strategies out-of-sample. Moreover, futures contracts serve effectively their risk management role and compare favourably with results in other international stock index futures markets. Estimation of investor utility functions and corresponding optimal utility maximising hedge ratios yields similar results, in terms of model selection. For the FTSE/ATHEX Mid-40 contracts we identify the existence of speculative components, which lead to utility-maximising hedge ratios, that are different to the minimum variance hedge ratio solutions.     

Macroeconomic announcements, volatility, and interrelationships: An examination of the UK interest rate and equity markets

This study investigates the intraday and daily pricing behavior of UK interest rate and equity index futures contracts. The paper initially examines the response of Short Sterling, Long Gilt, and FTSE100 to the release of scheduled macroeconomic announcements before employing dynamic time series techniques in order to reveal the nature of causal transmission patterns between these variables. In brief, short-term interest rates were found to be highly sensitive to indicators of prevailing economic conditions. However, the release of data important in the formation of inflationary expectations had a relatively subdued impact on long-term rates. Announcement effects appear somewhat ambiguous for the stock market. The analysis also reveals the bid-ask bounce and swift mean reversion in volatility to be important behavioral features of the return-generating process. Whilst the three variables appear to be bound by two cointegrating relationships, the tests for lead/lag relationships produce mixed results.     

Hedging efficiency in the Greek options market before and after the financial crisis of 2008

This study examines the hedging effectiveness of the emerging Greek options market before and after the financial crisis of 2008. We test the hypothesis of market efficiency by analyzing violations of FTSE/ASE-20 index option returns with respect to standard option theory, estimating option risk-premia, and testing the statistical significance of the returns to delta and delta–vega neutral straddles. Our empirical results suggest that, despite a certain level of mispricing, the Athens Derivatives Exchange maintained a relative level of efficiency before 2008. However, the economic crisis has had a significant impact on the Greek options market, as evidenced by more pronounced violations of theoretical predictions observed in option returns and risk-premia. These findings have direct implications for the risk management of international portfolios, since the feasibility and effectiveness of hedging exposure in Greek investments is found to have declined precisely when it is needed the most.     

Estimating daily volatility in financial markets utilizing intraday data

This study proposes a new approach to the estimation of daily realised volatility in financial markets from intraday data. Initially, an examination of intraday returns on S&P 500 Index Futures reveals that returns can be characterised by heteroscedasticity and time-varying autocorrelation. After reviewing a number of daily realised volatility estimators cited in the literature, it is concluded that these estimators are based upon a number of restrictive assumptions in regard to the data generating process for intraday returns. We use a weak set of assumptions about the data generating process for intraday returns, including transaction returns, given in den Haan and Levin [den Haan, W.J., Levin, A., 1996. Inferences from parametric and non-parametric covariance matrix estimation procedures, Working paper, NBER, 195.], which allows for heteroscedasticity and time-varying autocorrelation in intraday returns. These assumptions allow the VARHAC estimator to be employed in the estimation of daily realised volatility. An empirical analysis of the VARHAC daily volatility estimator employing intraday transaction returns concludes that this estimator performs well in comparison to other estimators cited in the literature.     

An empirical examination of jump risk in asset pricing and volatility forecasting in China's equity and bond markets

Understanding jump risk is important in risk management and option pricing. This study examines the characteristics of jump risk and the volatility forecasting power of the jump component in a panel of high-frequency intraday stock returns and four index returns from Shanghai Stock Exchange. Across portfolio indexes, jump returns on average account for 45% to 64% of total returns when jumps occur. Market systematic jump risk is an important pricing factor for daily returns. The average jump beta is 62% of the average continuous beta for individual stocks. However, the contribution of jump risk to total risk is limited, indicating that statistically significant jumps in the stochastic process of asset price are rare events but have tremendous impacts on the prices of common stocks in China. We further document that accounting for jump components improves the performance of volatility forecasting for some equity and bond portfolios in China, which is confirmed by in-the-sample and out-of-sample forecasting performance analysis.     

Noise, equity prices, and hedging: A new approach

The existence of noise trading in equity markets has possible economic implications for arbitrage, and asset pricing. In terms of pricing, noise trading can lead to excess volatility which has been shown to influence the value of options and futures. Furthermore, option research shows that modeling volatility leads to improved hedging performance. To this end, we derive a general hedging model for equity index futures in the presence of noise trading. Our analysis shows how the level and dynamics of noise trading should influence a hedger's behavior. Finally, we empirically test our model using the NASDAQ-100 index futures and FTSE 100 index futures over the period of January 1998 to May 2003.     

Volatility‐Managed Portfolios

Managed portfolios that take less risk when volatility is high produce large alphas, increase Sharpe ratios, and produce large utility gains for mean‐variance investors. We document this for the market, value, momentum, profitability, return on equity, investment, and betting‐against‐beta factors, as well as the currency carry trade. Volatility timing increases Sharpe ratios because changes in volatility are not offset by proportional changes in expected returns. Our strategy is contrary to conventional wisdom because it takes relatively less risk in recessions. This rules out typical risk‐based explanations and is a challenge to structural models of time‐varying expected returns.     

In Defence of Capitalisation Weights: Evidence from the FTSE 100 and S&P 500 Indices

A simple method for decomposing the variance covariance matrix of portfolio returns at the level of individual stocks is applied to the FTSE 100 Index. During extreme negative shocks, the largest index constituents exhibit lower than average covariance, thereby reducing the volatility of the capitalisation‐weighted index. The risk‐adjusted returns of the capitalisation‐weighted FTSE 100 Index exceed those of an equally‐weighted version of the same index and the outperformance is robust to the method of risk adjustment applied. The equally‐weighted index also exhibits greater systematic (market) risk than the capitalisation‐weighted version.     

The influence of intraday seasonality on volatility transmission pattern

Using data on a five-minute interval basis, this article analyses the effects of intraday seasonality on volatility transmission between the spot and futures markets of the CAC40, DAX30 and FTSE100. Remarkable differences in the impulse response analysis and in the dynamic and directional measurement of volatility spillovers are encountered depending on whether the intraday periodic component is considered. Thus, the convenience of removing intraday seasonality seems to be critical to reduce the risk of spurious causality when employing high-frequency data in volatility transmission. Moreover, the impact of market microstructure noise seems negligible when using an optimal frequency of observations.