Dynamic correlation between American Index and European Index

October 18, 2012

Universit Paris 1 Panthon-Sorbonne 2011/2012 Master 1 MoSEF Jasinski Alexandre Rousse Maxime

Supervised by: Philippe de Peretti

The goal of this work is to see how evoluate the stock exchange and how they are related. This topic is today in the spotlight with the development of nancial globalization and the subprime crisis. Indeed, the problem of correlation between stock exchange is challenging the risk market because all of the theory are based on the diversication to minimize the standard deviation. To estimate the correlation between market we use a Garch model because this model allow us to see the variance of each indexes and then we can describe the evolution of correlation between those indices. Finally, we will see that there is structural dierences between stock exchange.

Abstract

Keys words:

multivariate GARCH, systemic risk, stock exchange.

This project was inspired by one book:  The black swan 

If you lead a public company everything was wonderful with the shareholders when you and your partners were the only owners and you had to do with capitalist venture included the results jagged and the unstable nature of economic life. But now there's this nancial analyst of 30 years old in a company in the center of Manhantan with a slow mind who judge your results and sees a bunch of stu that doesn't exist. He likes regular nancial rewards and this is the last thing that you could give to him.
-

Nassim Nicholas Taleb -

Introduction
Since the deregulation, nancial crisis have been occurred on a recurring basis and for the last decade, there is no exception. Indeed, the industrialized and the emerging market have been both aected by major crisis. We can mention the best known examples: the crisis in Asia in 1997/1998, the crisis in Russia in 1998, the crisis in Argentina in 1999 or the subprime crisis in 2007 in all the industrialized countries. The problem with nancial crisis is that they are changing all the time and the structure of them isn't the same at each crisis so they are hard to predict and sometimes hard to explain too. If we go back in time, we can see that nancial crisis have always existed and have been affected by many macroeconomics or nancial variable but since the deregulation impulse by Margaret Thatcher or the banking law in France, we saw a new problem emerge: the contagion eect. In other words, a crisis in one country can spread through the international nancial markets and has an eect on neighbor countries. The contagion eects are commonly measured by a correlation coecient and we often speak of contagion when the correlation between two markets is higher during a period of crisis than normal. Why do we have a higher coecient of correlation during a period of crisis? This stronger correlation reects the transmission of a crisis through various ux as the trade or nancial which means that countries are exposed to a common creditor or are submitted to the same kinds of impact. The main problem of contagion eect is that if they are veried, the diversication to reduce the risk of a portfolio or the asset management cannot work. Our goal in this study is to demonstrate the contagion eect between France, the United States and the United Kingdom. For this, we take the standard deviation of the biggest stock exchange of this countries (CAC 40, S&P 500, FTSE 100) and try to explain with statistical method, if they are moving together...

Contents
I Theoritical Approach 5

1 Context and historic approach

1.1 How do we manage a portfolio? . . . . . . . . . . . . . . . . . . . 1.1.1 1.1.2 1.2 1.2.1 1.2.2 1.2.3 Financial Globalization: a global diversication? . . . . . . . . Contagion and diversication: what is the problem?

5
5 5 6 7 7 8 9

What are the measures of market risk? . . . . . . . . . . . . . . . Value at Risk (VaR) . . . . . . . . . . . . . . . . . . . . . The Garch model: modeling of uncertainty? . . . . . . . . Garch BEKK . . . . . . . . . . . . . . . . . . . . . . . . .

2 Correlation between stock exchange

2.1 Data Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 2.1.2 Why do we choose this data base? . . . . . . . . . . . . . Statistic Approach of our database . . . . . . . . . . . . .

10
10 10 12

II

Empirical Approach

13

3 Multivariate GARCH Modeling 4 BEKK Representation

4.1 Analysis of our model: roots of GARCH, minimization criteria, white noise analysis 4.1.1 4.1.2 4.1.3 4.2 4.2.1 4.2.2 4.2.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cac40 - S&P500 Model S&P500 - Ftse100 Model

13 14
14 14 15 17 18 18 18 20

Cac40 - Ftse100 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Time-Varying Correlation

Estimation of correlations . . . . . . . . . . . . . . . . . . Graphical representation Moving average representation

III

Annexe

25

Part I 1
1.1

Theoritical Approach
Context and historic approach
How do we manage a portfolio?
Nowadays, we distinguish three types of asset management with all their particularities. The rst is called the active portfolio management and it's a mode that aims to  outperform stock indexes by using analyzes and then establish a trend or determinate what values are undervalued which mean they will grow faster than the market. The second is called passive management and the portfolio manager will try to duplicate as closely as he can the performance of an equity index such as the CAC 40, S&P 500, . . . The last one is called alternative management and sought a complete target. The investors try to exploit ineciencies in nancial market through strategies arbitrages and by using nancial products such as short selling or derivate. These types of asset management have all the same goal: maximize the expected gain while minimize the risk. We use many methods to test our portfolio and to determine the best portfolio we can have under the constraint of minimizing the standard deviation and one the most famous method is the diversication and the second method is hedging. In nance, diversication means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversied portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors. Diversication relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation. So the technic to reduce the downside risk is to put in a portfolio asset from dierent activities because, in the theory, they aren't submitted to the same systemic risk and assets have low correlation between them.

1.1.1 Financial Globalization: a global diversication?

In the 80 all the industrialized countries had changed their approach of the nance and had encouraged the freedom of the market. This table shows the main stage of banking deregulation in France. The new rules allow the bank to establish itself internationally and therefore to practice the asset management through the world. Indeed, the diversication doesn't need to be only in France but in other country because all the country

Table 1: Deregulation key date in France Date 1983 1984 Key legislation Creation of a secondary market more accessible Banking Law - Financial institutions get bank status - New nancial products are available for all - End of paper for transferrable securities 1986 1987 1988 Creation MATIF (Financial Market specializes in Derivatives) Creation of MONEP (Protection against changes in stock) Removing the credit crunch Developing the role of markets Stockbrokers losing the monopoly of stock trading Creation of UCITS (Undertakings for Collective Investment in Transferable Securities) 1996 2000 2007 Creation of a new market for high-potential technology companies Euronext: merger of the three stock exchanges in Paris, Amsterdam and Brussels NYSE  Euronext

has a dierent risk prole which allows the investor to minimize the standard deviation of their portfolio. The development of the asset management through the world provides to all the specialist of nance a panel of risk which is a good opportunity to meet their entire customers. Indeed, during this period, we have seen many merger and acquisition (nationally or internationally) in order to have a biggest part of the market but also to minimize the downside risk. The problem of the globalization is that no economist or professional of nancial have seen the problem of the contagion between the markets. . .

1.1.2 Contagion and diversication: what is the problem?

The main idea of the diversication is to use a benchmark to diversify the portfolio: a benchmark is a reference with a low volatility and use to minimize the standard deviation. With the globalization, it has become harder to identify the benchmark because of the integration between the markets. Indeed, ve years ago,  Socit Gnrale was a reference in the banking community and France was noted AAA by all the rating agencies and now, the Socit Gnral meet some diculties to clean her balance sheet and France has been degraded by two of the rating agencies. Today, we don't have any market in a perfect security but only market in a partial security because the globalization has increased considerably the interdependences between nations. It's hard to nd countries with absolutely no correlation because China possess 80% of the treasure bill of the USA and nance almost the world. The Union European has no border and there is the freedom of capital, European

countries need Africa for raw materials and Africa need the industrialized for the liquidity. This lack of protection increases the probability of a shock in an economy and if a shock in a big economic such as the United States, the shock is spreading all over the world due to contagion eect. The diversication appears much more dicult with the introduction of the contagion eect in the economy and our goal will be to estimate the degree of integration between countries.

1.2

What are the measures of market risk?

In the rst part we saw the problem of the contagion for manage the diversication which means the problem of measure the market risk: is used to minimize the standard deviation and to minimize the systemic risk.

1.2.1 Value at Risk (VaR)

The Value at Risk is the best know method to measure and explain the systemic risk and we think in the context of nancial crisis that it was a good idea to show how it works and why do we use it. Value-at-Risk is dened as the maximum potential loss that should attainable only with a given probability over a time horizon (Engle and Manganelli, 2001). In other term, Value at Risk is the worst expected loss over a period of time for a condence level. This very simple denition is one of main attractions of the Value at Risk: it is indeed very easy to contact on VaR and propose a homogeneous measure and overall of risk exposure. So to calculate a VaR of a portfolio or an asset, we need three things: distributions of prots and losses for the portfolio holding period, the level of condence and the period of holding the period. The Value at Risk can be measured with many methods: the parametric method, the historic method, the Monte-Carlo simulation, the expected shortfall,. . . All of this methods allow any nancial expert to estimate the systemic risk but in our study we are not interested by the expected shortfall. We aren't going to talk about advantages and drawbacks of the VaR because it's out of the subject but the expected shortfall is one of the measure used with the Garch model and we use a Garch BEKK to estimate the correlation between the different market.

Rt

is the yield at time

and

fRt (r) r Rt

the distribution of prots and

losses for that date.

This density may be dierent from one date to another

and it's probably one of the major diculties when we use a value-at-Risk unconditionally. Then we can dene a conditional density with a set of information available on the date t, denoted fRt

t . This conditional density, denoted

(r | t ) r Rt .

This hypothesis is equivalent to assume that conditional

on an information set

returns are identically distributed and with this as-

sumption which allows a prediction of Value at Risk in the case of parametric models (for example a GARCH model). Value-at-Risk can be written:

1 V aRt () = FRt ( | t )
We can simply note simply that the Value at Risk is not a measure of risk coherent in the sense of Artzner et al. (1997), because most of the VaR aren't sub additive. We dene a sub additive, denoted A and B we have:

if and only if for two assets

(A + B) (A) + (B)
It is a fundamental problem because it implies that the Value at Risk cannot be considered as a "clean" measure.

1.2.2 The Garch model: modeling of uncertainty?

Engle (1982) noticed that for forecasting models from time series comes we need to use all the information included in the conditional expectation of the process. The general principle proposed by Engle is to assume that the variance depends on all the information we have. It oers a specication ARCH (q) or GARCH (p,q) where the square disturbances following an autoregressive process of order q. The ARCH/GARCH models are conditionally autoregressive Engle (1982) propose this new model to compensate models heteroscedastic.

the problem of the class ARMA representations. Indeed, ARMA doesn't seem to model nancial series which have extreme volatility and asymmetric adjustments. Thus, ARCH models are based on a parameterization of endogenous the conditional variance. We can write this model under the following form. Hypothesis of the model Garch(p,q):

E(t ) = 0 E(t s ) = 0 E(t | t1 ) = 0 i,i=1,...q 0 j,j=1,...p 0

We can write the model: by the form of a Arch(p):

Yt = E(Yt | Yt1 ) + t .

This model could be model

2 = V (Yt | Yt1 ) = zt t

ht where ht = 0 +
i=1

i 2 + i1
j=1

j htj

With a Garch model, the violation of the VaR appears less important than the other model. So when there is a default in prediction, the impact of insucient provisioning is smaller. Another advantage is the fact that capital can be

managed in a more dynamic and one part can be reinvested in more protable activities. This part was to introduce the problem of market risk and how it's dicult to model the variance of portfolio with the development the deregulation and nancial globalization. Our problematic is about the correlation between the markets by the approach of Bekk because if there is a high coecient of correlation the diversication isn't available anymore. . .

1.2.3 Garch BEKK

We see that the Garch model permit to estimate a conditionnal variance which is indispensable to estimable the correlation between nancial market. However, the Garch model failed to ensure positive conditional covariance matrix. The precedent work of Bollerslev & all (1988) and Engle created a model called Garch-Bekk which ensres positive denite conditional covariance matrix. Let

F(t 1)

be the sigma eld generated by the past values of

be the conditional covariance matrix of the

t and let H t k -dimensional random vector t . Let

then the multivariate Garch model

Ht

be measurable with respect toF(t

1);

can be written as

t |F(t 1) N (0, Ht ) Ht
where =

q i=1

Ai ti ti Ai +

p i=1

Gi Hti Gi

C , Ai and Gi are k k

parameter matrices.

For instance, consider a bivariate Garch(1,1) model as follows:

Ht =

c11 c12

c12 c22 a11 a21

a11 a12

a12 a22

2 1,t1 2,t1 1,t1

1,t1 2,t1 2 2,t1 g12 g22

a12 g + 11 a22 g21

g12 g . Ht1 . 11 g22 g21

or, representing the univariate model,

2 2 2 h11,t = c11 +a2 2 11 1,t1 +2a11 a21 1,t1 2,t1 +a21 2,t1 +g11 h11,t1 +2g11 g21 h12,t1 + 2 g21 h22,t1 2 h21,t = c12 +a11 a12 2 1,t1 +(a21 a12 +a11 a22 )1,t1 2,t1 +a21 a22 2,t1 +g11 g12 h11,t1 + (g21 g12 + g11 g22 )h12,t1 + g21 g22 h22,t1 2 2 2 h22,t = c22 +a2 2 12 1,t1 +2a12 a22 1,t1 2,t1 +a22 2,t1 +g12 h11,t1 +2g12 g21 h12,t1 + 2 g22 h22,t1

2
2.1

Correlation between stock exchange

Data Base

2.1.1 Why do we choose this data base?

By following methodology of earlier research we let S&P 500 be the best market because the US market is the largest in the world in term of market capitalization and it's generally accepted that what happens in the USA aects the rest of the world. Then we choose two of the biggest capitalization in Europe: FTSE 100 and CAC 40. This choice is motivate because we considered the FTSE 100 as the most powerful stock exchange in Europe and the CAC 40, in principle, reects the global trend of the economy of major French companies. Moreover, it was interesting for us to test the correlation between two countries structurally dierent. Indeed, France is still a country debt which means that French companies use the credit as nance chief whereas the United Kingdom is a market economy which appears with the fact that they have the largest and the most developed stock exchange in Europe. Our database is mensual and begins in March 1990 and nish the 2 May of 2012: we got almost 300 hundreds data for our analysis. At the beginning, we wanted to take daily data but the problem is that when we estimated the model and our result was uninterpretable. Indeed, we could only take 1000 data which means that our analysis began only in 2007 and therefore the correlation between the market was extremely high. Then, to model our database we take the return of the stock exchange:

S&P 500t RS&P 500 = log( S&P 500t1 ) 100 CAC40t RCAC40 = log( CAC40t1 ) 100 RF T SE100 = log( FF T SE100t ) 100 T SE100t1
And to represent the data we use a moving average 12 for a better visualisation of our data.

10

Figure 1: CAC 40

Figure 2: FTSE 100

11

Figure 3: S&P 500

We can see that there are two periods of crisis in the stock exchange: the internet bubble (2000) and the subprimes crisis (2007). However, when we study the return, the crisis bubble seems to have less impact of the market because variations are lower during this period (-5% to 5%) whereas the subprime is higher (-10% to 10%). Moreover, the evolution of FTSE 100 and S&P 500 it's may be because the two seems to be closer with than of the CAC 40:

countries tend to have a nancial structure practically similar.

2.1.2 Statistic Approach of our database

Table 2: Distributional characteristics (in percentage) S&P 500 N Mean Median Max. Min. Std. Dev. Skewness Kurtosis Shapiro Wilk p-value 214 0.66073103 1.07319 10.23066 -28.08173 5.12259602 -1.610417 6.11167361 0.905286 <0.0001 CAC 40 214 0.22808158 1.31235 19.78785 -31.67216 6.33284168 -0.9786269 3.45544023 0.950931 <0.0001 FTSE 100 214 0.43788758 0.915771 12.127392 -25.284895 4.87611435 -1.2339652 4.57618785 0.936118 <0.0001

All of our data are normaly represented because Shapiro Wilk test appears to be signicant at the level of 5%. The S&P 500 index has a mean a little higher than the other indices (0.66%) and the CAC 40 is the one with the biggest

12

volatility (6.33%). Then, we can see that the CAC 40 has a representation very close to the normale distribution with a skewness near to 0 and a kurtosis close to 3.

Table 3: Stationarity of our variable (Phillips Perron Test) S&P 500 t-stat p-value Stationarity=5% -14.16048 0.0000 Yes CAC 40 -13.15026 0.0000 Yes FTSE 100 -15.31611 0.0000 Yes

At the level of 5%, all of our variable are stationarity. In that context we can work with these variables without any problem. We didn't use the standard the Dickey Fuller test because it could give us a wrong information especially when the trend are very low and in that case we think that the Phillips Perron Test was more certain.

Part II 3

Empirical Approach
Multivariate GARCH Modeling
We applied the GARCH-BEKK method for each our data. The GARCH-BEKK ensures a positive denite conditional variance matrix in the process of optimization (Engle and Kroner 1995).It has shown to be successful in modelling variance, therefore good enough in our attempt to measure time-varying correlation. We use this process to measure time-varying correlations between the three International Stock Indices. We do three models :

Cac40 - S&P500 Cac40 - Ftse100 S&P500 - Ftse100

For the estimation of our models, the procedure GARCH - BEKK uses quasiNewton method to optimize the parameters. In optimization, quasi-Newton methods are algorithms for nding local maxima and minima of functions. Quasi-Newton methods are based on Newton's method to nd the stationary point of a function, where the gradient is 0. Newton's method assumes that the function can be locally approximated as a quadratic in the region around the optimum, and uses the rst and second derivatives to nd the stationary point.

13

In quasi-Newton methods the Hessian matrix of second derivatives of the function to be minimized does not need to be computed. The Hessian is updated by analyzing successive gradient vectors instead. Quasi-Newton methods are a generalization of the secant method to nd the root of the rst derivative for multidimensional problems. In multi-dimensions the secant equation is under-determined, and quasi-Newton methods dier in how they constrain the solution, typically by adding a simple low-rank update to the current estimate of the Hessian. In our case the Quasi-Newton method needs more than 200 iterations and more than 2000 functions.

4
4.1

BEKK Representation
Analysis of our model: roots of GARCH, minimization criteria, white noise analysis

4.1.1 Cac40 - S&P500 Model

The parameters are estimated with a Maximum Likelihood method. We use a Garch(1,3) Model. The parameters estimated for the variancecovariance matrix Ht are the following :

Ht =

h11,t h21,t

h12,t 6.74 1.64 0.14 = + h22,t 1.64 0.06 0.71 .Ht1 .

0.03 0.49

2 1,t1 2,t1 1,t1 .Ht2 .

1,t1 2,t1 0.14 . 2 0.71 2,t1 0.05 0.23 0.18 + 0.04

0.03 + 0.49

0.22 0.05 0.68 0.80

0.05 0.22 0.05 + 0.23 0.68 0.80 .Ht3 .

0.18 0.04

0.09 0.32 0.24 0.09

0.09 0.33 0.21 0.09

With the conditional random vector :

t | F(t 1) F(t 1)

N (0, Ht ) t .

is the sigma eld generated by the past values of past

The following results show the roots of the GARCH characteristic polynomials. The eigenvalues have a modulus less than one. It's the necessary and sucient condition for covariance stationarity of the multivariate GARCH process.

14

Index
1 2 3 4

Table 4: Roots of GARCH Characterictic Polynomial

Real

Imaginary Modulus Radian

0.00000 0.00000 0.08054 -0.08054 0.2332 0.2332 0.2332 0.2332 0.0000 0.0000 0.3526 -0.3526

Degree
0.0000 0.0000 20.2004

0.23324 0.23324 0.21889 0.21889

-20.2004

We have the following information criteria of the estimation :

Table 5: Information criteria 0.651844

AICC HQC AIC SBC FPEC

0.654394 0.651843 0.659152 1.919074

We have minimized the dierent criteria. The informations of the White-Noise of the Model are given by the following table :

Normality ARCH Variable Durbin Watson Khi-2 Pr > Khi-2 F value Pr > F
S&P500 Cac40 2.04428 2.00578 399.99 893.16 <.0001 <.0001 223.96 150.86 <.0001 <.0001

Table 6: White-Noise Diagnostic

These informations show that the White-Noise of estimated parameters are no auto-correlated and normal.

4.1.2 Cac40 - Ftse100 Model

We use a Garch(1,3) Model. The parameters estimated for the variance-covariance matrix

Ht

are the following :

Ht =

h11,t h21,t

h12,t 6.41 5.27 0.58 = + h22,t 5.27 3.98 0.16 .Ht1 .

0.19 0.31

2 1,t1 2,t1 1,t1 .Ht2 .

1,t1 2,t1 0.58 . 2 0.16 2,t1 0.07 + 0.11

0.19 + 0.31

0.57 0.15 0.83 0.21

0.57 0.15 0.15 + 0.83 0.21 0.28

0.07 0.11

0.15 0.28

15

0.47 0.36

0.03 0.14

.Ht3 .

0.477 0.365

0.038 0.145

With the conditional random vector :

t | F(t 1) F(t 1)

N (0, Ht ) t .

is the sigma eld generated by the past values of past

The following results show the roots of the GARCH characteristic polynomials. The eigenvalues have a modulus less than one. It's the necessary and sucient condition for covariance stationarity of the multivariate GARCH process.

Index
1 2 3 4

Table 7: Roots of GARCH Characteristic Polynomial

Real

Imaginary Modulus Radian

0.00000 0.00000 0.01942 -0.01942 0.0314 0.0314 0.0314 0.0314 0.0000 0.0000 2.4746 -2.4746

0.03139 0.03139 -0.02466 -0.02466

We have the following information criteria of the estimation :

Table 8: Information criteria -0.09786

AICC HQC AIC SBC FPEC

-0.09531 -0.09787 -0.09056 0.90677

We have minimized the dierent criteria. The informations of the White-Noise of the Model are given by the following table :

Normality Variable Durbin Watson Khi-2 Pr > Khi-2

Cac40 Ftse100 2.01996 2.03040 95.21 152.62 <.0001 <.0001

Table 9: White-Noise diagnostic

ARCH F value Pr > F

109.84 90.81 <.0001 <.0001

These informations show that the White-Noise of estimated parameters are non auto-correlated and normal.

16

4.1.3 S&P500 - Ftse100 Model

We use a Garch(1,3) Model. The parameters estimated for the variance-covariance matrix Ht are the following :

Ht =

h11,t h21,t

2 h12,t 0.02 0.52 0.38 0.55 1,t1 = + h22,t 2,t1 1,t1 0.52 1.45 0.09 0.25 .Ht1 . 0.79 0.32 0.29 0.22 + 0.23 0.21 0.15 0.16 0.39 0.07 .Ht3 . 0.6 0.6 0.39 0.07 .Ht2 .

1,t1 2,t1 0.38 2 0.09 2,t1

0.55 + 0.25

0.79 0.32 0.23 0.21

0.29 0.22 + 0.15 0.16

0.6 0.6

With the conditional random vector :

t | F(t 1) F(t 1)

N (0, Ht ) t .

is the sigma eld generated by the past values of past

The following results show the roots of the GARCH characteristic polynomials. The eigenvalues have a modulus less than one. It's the necessary and sucient condition for covariance stationarity of the multivariate GARCH process.

Index
1 2 3 4

Table 10: Roots of GARCH Characteristic Polynomial

Real

Imaginary Modulus Radian

0.00000 0.00000 0.08054 -0.08054 0.2332 0.2332 0.2332 0.2332 0.0000 0.0000 0.3526 -0.3526

Degree
0.0000 0.0000 20.2004

0.23324 0.23324 0.21889 0.21889

-20.2004

We have the following information criteria of the estimation :

Table 11: Information criteria 0.182357

AICC HQC AIC SBC FPEC

0.18439 0.182356 0.188258 1.200042

We have minimized the dierent criteria. The informations of the White-Noise of the Model are given by the following table :

17

Normality Variable Durbin Watson Khi-2 Pr > Khi-2

s&p500 Ftse100 1.97898 1.90508 85.21 69.62 <.0001 <.0001

Table 12: White-Noise diagnostic

ARCH F value Pr > F

95.02 87.21 <.0001 <.0001

These informations show that the White-Noise of estimated parameters are non auto-correlated and normal.

4.2

Time-Varying Correlation

4.2.1 Estimation of correlations

In this section we will present the time-varying correlation between indices. We use the parameters of the variance-covariance matrix

Ht

of GARCH-

BEKK Model. We calculate the correlation coecient for all periods :

XY,t =

cov(Xt , Yt ) = Xt .Yt

H12,t H11,t . H22,t

The following table show the mean of the correlations :

Indexes
S&P500 and CAC40 S&P500 and FTSE100 FTSE100 and CAC40

Mean Correlation BEKK Correlation of Pearson

0.79 0.82 0.69 0.74796 0.82683 0.79634

Table 13: Correlation

4.2.2 Graphical representation

We obtain the following graphs of Correlation between indices :

18

Figure 4: CAC40 and FTSE100

This graphic shows that there is a strong correlation between the CAC40 and the FTSE100.We can see that changes go downwardly.

Figure 5: CAC40 and S&P500

This graphic shows that there is a strong correlation between the CAC40 and the S&P500. Then the frequence of variation between those market is higher than between the European stock exhange.

19

Figure 6: FTSE100 and S&P500

This graphic shows that the correlation is high between the FTSE100 and the S&P500. Then we can see that the frequence of variation between those market is highest of all our graphics.

4.2.3 Moving average representation

Our rst three graphics allow us to think that we distinguish an European area where correlation is high and CAC40/TFSE100 are moving together and an American/European area where correlation is high and CAC40/S&P500 or FTSE100/S&P500 seem to overreact which can be explained by the high frequency of change. moving average 12: To conrm this result, we opted for a representation in

20

Figure 7: Moving Average CAC40/FTSE100

Figure 8: Moving Average CAC40/S&P500

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Figure 9: FTSE100/S&P500

This three graphics tend to shade our rst thought because the correlation in moving average between the S&P500 and the FTSE100 seems to be stationarity. This result prove to us that countries with the same structure (market economy) have a nancial market less volatile. On the other hand, the moving average representation shows that the correlation between countries structurally dierent are more subjected to volatility. However, the MA representation conrm that the correlation between our three markets is high and that the transmission channels exist and are behind the current debate on systemic risk management...

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Conclusion
This analysis give us a global vision of the economic situation in which we live today. On the one hand, there is a strong correlation between the three indexes and this correlation, according to our model, will continue in the future . Moving average tendency shows that the correlation between U.S. and European stock indexes shows that it exists two types of links. First, we have seen in this paper that in the past 20 years the correlation remained strong between the FTSE100 index and S&P500: they tend to be highly interrelated. The S&P500 is the exact reection of the FTSE100 and vice versa. The Cac40 index is more likely to have the role of follower. On average, the correlation between changes in the returns of the S&P500 and FTSE 100 is stronger than between European indices. There is a strong variation of the correlation between the U.S. index S&P500 and the French index Cac40 even if the trend stay positive. with them. Financial globalization has been in place for a long period and the dynamic correlation between indexes are always positive. This notion reinforces the effect of systemic shocks in nancial markets. This study indicates that a positive shock (respectively negative) on the S&P500 will impact positively (respectively negatively) the CAC40 or FTSE100. The impact will be higher in London than in Paris because the United Kingdom and the United States are subject to the same type of market risk. The development of the contagion eect are largely due to the development of new technologies which permit to the market for now twenty years to have all the information transmitted in real time through the world. This context allow to reduce the formation of asymetric information and despite of the geographical distances, we can see a drop in the S&P500 and FTSE100 and a decrease in the CAC40 in the same day. We can describe this transmission of shocks from a widespread stress on these three great nancial centers. So it's understadable that during the subprime crisis in United States we observed a strong recession in Europe. These strong correlations are combined with changes in short-term correlation over time which is a problem compared to the prediction of yields, particularly for CAC40 index due to his correlation with the two other indexes. This is an evidence that Anglo-Saxon indexes are more closely related than the CAC40

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References
[1] Sebastian Lohr, Olga Mursajew, Daniel Rosch and Harald Scheule, 15 August 2010, Dynamic Correlation Modeling in Structured Finance, Campus for Finance: Research Conference 2011. [2] Robert F. Engle and Kenneth F. Kroner, March 1995, Multivariate Simultaneous Generalized Arch, Econometric Theory, Vol. 11, No. 1, pp. 122-150. [3] Suleman Raq Maniya and Fredrik Magnusson, 14 May 2010, Bear periods amplify correlation: A GARCH BEKK Approach, University of Gothenburg. [4] Vanitha Ragunathan and Heather Mitchell, Modelling the Time-Varying Correlation Between National Stock Market Returns, Department of Economics and Finance Royal Melbourne Institute of Technology. [5] Eva Maria RIBARITS, 24 May 2006, Multivariate Modelling of Financial Time Series, Institut fur Wirtschaftsmathematik Forschungsgruppe Okonometrie und Systemtheorie (EOS). [6] Grard Cornujols and Reha Ttnc, Optimization Methods in Finance, Volume 13, Cambridge. [7] Robert Stelzer, 2008, On the Relation Between the vec and BEKK Multivariate GARCH Models, Econometric Theory 24, pp. 1131-1136, Cambridge University Press. [8] Christophe Urlin, Econometrie pour la Fiance, Master Economtrie et Statistique Applique, Universit d'Orleans. [9] Roberto Savona, Hedge Fund Systemic Risk Signals, 5th Financial Risks International Forum, Department of Business Studies, University of Brescia.

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Part III

Annexe
You can see in this annexe the forecasts of our three models Figure 10: CAC 40

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Figure 11: FTSE 100

Figure 12: S&P 500

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