Interrelations in market fears of U.S. and European equity markets

We examine interdependence between the implied volatilities of U.S. and five European markets in an integrated multivariate system that allows interactions in the first and second moments of volatility processes. Our results find significant interactions in the variance-covariance matrix of VIX and European volatilities which persist and facilitate risk transmission. Changes in U.S. and Eurozone volatilities are important drivers of risk shocks in European markets. VIX and European volatilities have predictive ability for each other. Further, VIX shocks contribute significantly to the prediction error of European risk shocks, but not vice versa. Risk transmission from U.K. markets to U.S. and European markets intensified around the Brexit vote. Also, VIX shocks added significantly more to European risks during the global financial crisis. Our results highlight the potential weakness of risk transmission models that ignore the second-moment risk transmission channel and have implications for volatility trades, portfolio diversification strategies, and hedging the cross-market risks.