The Dynamics of International Asset Price Linkages and Their Effects on German Stock and Bond Markets

Abstract

The financial market turbulence in 1998, as other crises previously, produced strong price movements in the securities markets worldwide. This reflected, first, a general reassessment of credit risk, and, second, a drying-up of liquidity even in some of the largest mature securities markets. As a result, cross-market return correlations temporarily underwent dramatic changes, challenging portfolio allocation and risk management strategies which rely on constant historical comovements of asset prices. Against this background, the immediate question arises of how asset price linkages can be properly measured when they are subject to periodic changes as observed in times of market stress. The main purpose of the present paper is to address this question more thoroughly. In order to measure the dynamics of international asset price linkages, we first employ bivariate GARCH models to analyse the comovements between weekly stock and bond market returns across the G3 countries. GARCH models take account of the specific time-series properties of short-term asset returns, which is needed to obtain reliable estimates of the cross-country linkages. Next, switching-regime ARCH or 'SWARCH' models are applied which can identify different volatility regimes for short-term asset prices endogenously. We use this methodology to address two issues: first, 'Are international short-term return linkages state-dependent?,' and second, 'Do volatility spillovers affect individual segments of the domestic bond or stock market differently (i.e. are they market-segment-dependent)?' The first question may also be referred to as the 'contagion hypothesis.' This states that contagion leads to a significant increase in the cross-market correlation during states of financial market turmoil. Hence, contagion differs from mere 'interdependence' in that it demands a stronger-than-normal market linkage during periods of stress.

Keywords: asset price linkages, volatility regimes, contagion, SWARCH, GARCH

JEL Classification: F30, G01, G12, G15