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markets to trading volume

Richard Gerlacha, Cathy W.S. Chenb,,

Doris S.Y. Linb, Ming-Hsiang Huangc

a

School of Mathematical and Physical Sciences, University of Newcastle, Australia

b

Graduate Institute of Statistics and Actuarial Science, Feng Chia University, Taichung 407, Taiwan

c

Department of Business Administration, National Changhua University of Education, Taiwan

Received 28 February 2005; received in revised form 30 May 2005

Available online 18 July 2005

Abstract

The major goal of this paper is to examine the hypothesis that stock returns and return

volatility are asymmetric, threshold nonlinear, functions of change in trading volume. A minor

goal is to examine whether return spillover effects also display such asymmetry. Employing a

double-threshold GARCH model with trading volume as a threshold variable, we ﬁnd strong

evidence supporting this hypothesis in ﬁve international market return series. Asymmetric

causality tests lend further support to our trading volume threshold model and conclusions.

Speciﬁcally, an increase in volume is positively associated, while decreasing volume is

negatively associated, with the major price index in four of the ﬁve markets. The volatility of

each series also displays an asymmetric reaction, four of the markets display higher volatility

following increases in trading volume. Using posterior odds ratio, the proposed threshold

model is strongly favored in three of the ﬁve markets, compared to a US news double

threshold GARCH model and a symmetric GARCH model. We also ﬁnd signiﬁcant nonlinear

asymmetric return spillover effects from the US market.

r 2005 Elsevier B.V. All rights reserved.

Keywords: Asymmetry; Double threshold GARCH; MCMC methods; Model selection; Trading volume

change

E-mail address: chenws@fcu.edu.tw (C.W.S. Chen).

0378-4371/$ - see front matter r 2005 Elsevier B.V. All rights reserved.

doi:10.1016/j.physa.2005.06.045

ARTICLE IN PRESS

R. Gerlach et al. / Physica A 360 (2006) 422–444 423

1. Introduction

technology, the modern theory of international markets has switched from the

traditional view of market segmentation to the concept of market integration. A

substantial amount of research emphasizes the co-movements of international stock

markets and explores the dynamics of return co-variances and spillover effects

between markets. For example, Jaffe and Westerﬁeld [1] provide empirical evidence

of a signiﬁcant direct spillover effect among some national stock markets, while Eun

and Shim [2] ﬁnd return spillover effects among national markets and an inﬂuential

role of the US market on the cross-country market index series. Ross [3] argues

further that information from one stock market can be incorporated into the

volatility process of other stock markets. Hamao et al. [4], Theodossiou and Lee [5],

Chiang and Chiang [6] and Martens and Poon [7] subsequently ﬁnd supporting

evidence for volatility spillover among major stock markets.

There is also substantial evidence in the literature that stock markets react

asymmetrically to market news results. This phenomenon was ﬁrst discovered by

Black [8] and Christie [9] who discuss the leverage effect as the cause of higher

volatility following negative stock returns; similar to the market over-reaction

hypothesis discussed in Ref. [10]. There is also the volatility feedback hypothesis

which says that higher volatility causes stock prices to fall. Many models have been

developed to capture types of asymmetric behavior, most ﬁt into the threshold

GARCH framework. Glosten et al. (1993) employ a threshold GJR-GARCH model

and ﬁnd evidence that local negative market news causes increased market volatility

[47]. This ﬁnding is conﬁrmed in studies by Koutmos [11], Nam et al. [10] and Brooks

[12], using double threshold models. These papers also ﬁnd evidence of faster mean

reversion dynamics following local market bad news. More recently, Chen et al. [13]

employ a double-threshold GARCH model with a US market threshold variable, to

explore the dynamics of daily stock-index returns for six international markets from

1985 to 2001. Their results provide strong evidence supporting an asymmetric

nonlinear spillover effect from the US market to other markets in Europe and Asia.

The US market news transmits asymmetrically, around a threshold value, to each of

the national stock markets considered with average volatility in each national market

much higher following bad US news. Further, Chen and So [14] explore a range of

international markets to use as exogenous threshold values in a double threshold

GARCH model. They ﬁnd that the Japanese market has little spillover or threshold

nonlinear effect on mean returns in Asian markets, in comparison with the US

market. These results are supported by Wang and Firth [15], who ﬁnd the emerging

market of China does not exhibit signiﬁcant spillover effects to other markets

worldwide, including those in Asia. The US return has thus evolved as the preferred

threshold variable in the examination of return spillover and nonlinear asymmetric

effects.

However, this previous work ignores the possible correlation between the stock

price or return and trading volume. Numerous ﬁnancial studies have documented

this important relationship. Clark [16] and Epps and Epps [17] suggested that trading

ARTICLE IN PRESS

424 R. Gerlach et al. / Physica A 360 (2006) 422–444

volume is a good proxy for information arrival from the capital market. The

hypothesis has been further supported by empirical evidence; Lamoureux and

Lastrapes [18], Kim and Kon [19], Andersen [20], Gallo and Pacini [21] found the

same effect for the US stock market; Omran and McKenzie [22] observed this effect

for the UK stock market; Bohl and Henke [23] reported similar evidence for the

Polish stock market.

Ying [24] was the ﬁrst to provide strong empirical evidence supporting an

asymmetric relation between trading volume and price-change. By investigating six

series of daily data from NYSE, Ying made the following conclusions: a small

trading volume is usually accompanied by a fall in price; a large volume is usually

accompanied by a rise in price; and a large increase in volume is usually

accompanied by either a large rise in price or a large fall in price. These

propositions lay an important foundation for our nonlinear asymmetric

hypothesis and illustrate that a linear relationship between price return and

volume, and/or volatility and trading volume, may not be sufﬁcient to capture the

true relationship. This hypothesis is also documented by Karpoff [25] in an

extensive survey of research into the relationship between stock–price change and

trading volume. Karpoff suggests several reasons why the volume–price change

relationship is important and provides evidence to support the asymmetric

volume–price change hypothesis. His asymmetric hypothesis implies that the

correlation between volume and price change is positive when the market trend is

going up, but that this correlation is negative when the market trend is

downwards. This is again important and highlights that we should not simply

add a linear exogenous volume term to the mean equation in a GARCH model for

stock returns. To capture the possible nonlinearity we will consider an asymmetric

piecewise linear relationship between price (return) and volume, as can be captured

by threshold models [26].

Departing from traditional work that focused on the contemporaneous relation

between return and trading volume, Chordia and Swaminathan [27] examine the

causal relationship and the predictive power of trading volume on the short-term

stock return. Their empirical evidence suggests that volume plays a substantial role

in the dissemination of national market-wide information. In a dynamic context, Lee

and Rui [28] utilize the GARCH(1,1) model to investigate the relationship between

stock returns and trading volume using the New York, Tokyo and London stock

markets. Their empirical results suggest that US ﬁnancial market variables, in

particular US trading volume, have extensive predictive power in both the domestic

and cross-country markets, after the 1987 market crash. Moosa et al. [29] employ a

bivariate VAR model and ﬁnd signiﬁcant mean level asymmetry in the price–volume

relationship for the future market in crude oil prices; they did not consider a

heteroscedastic model and they enforced the threshold variable to be zero. The above

ﬁndings further enforce our belief that a consideration of trading volume as a

threshold variable might add to the understanding of capital market behavior in

general. The major objective of this study is thus to investigate whether stock

returns, volatility and international return spillover effects react in a threshold

nonlinear fashion to changes in trading volume, in ﬁve international markets. As far

ARTICLE IN PRESS

R. Gerlach et al. / Physica A 360 (2006) 422–444 425

as the authors are aware, this is the ﬁrst time that trading volume has been employed

as a threshold variable in a dynamic heteroscedastic model of stock returns.

To address the above issue, we follow Chen et al. [13] and employ a double-

threshold autoregressive GARCH model, using a Bayesian estimation approach

through Markov chain Monte Carlo (MCMC) methods. This new model allows

threshold nonlinearity in both the mean and volatility processes to be driven by

lagged changes in trading volume. We compare this model to the US news threshold

model in Ref. [13] and a symmetric GARCH model. We utilize the posterior odds

ratio, the standard Bayesian model comparison technique, as in Ref. [30], to

determine which is the most favored model in each market. We also employ the

causality tests of Ref. [29] to motivate and validate our models. Building on the work

of Ying [24], Karpoff [25] and Moosa et al. [29], our empirical results provide strong

evidence supporting the return-volume nonlinear threshold relation. The stock

return, volatility and international return spillover do react asymmetrically, around

a threshold value of change in trading volume, in the ﬁve markets considered. Our

ﬁndings shed new light on the application of trading volume in the market

integration literature and develop a new avenue for asset pricing in a multi-market

framework.

The remainder of this study proceeds as follows. Section 2 describes the data used

in this study and presents some statistical properties of the stock returns in a

standard GARCH(1,1) speciﬁcation. Section 3 discusses the Bayesian methods for

estimation and present the double threshold models considered. Section 4 discusses

the estimated results for each model, and compares the ﬁndings with the existing

literature. Section 5 discusses the Bayesian model comparison methods and discusses

the ﬁndings for each market. Section 6 contains concluding remarks.

The analysis undertaken in this article is based on daily closing prices and trading

volume of ﬁve stock market indexes: the Korean Composite Price Index (South

Korea), Thailand SET index (Thailand), the Taiwan Stock Exchange Weighted

Stock Index (Taiwan), the CAC 40 (France), and the FTSE 100 (UK). We also

employ the US Dow Jones Industrial Average as a benchmark. The data, obtained

from Datastream International, run from January 1, 1994 to November 26, 2003.

The market return at time t is deﬁned by Rt ¼ ðlnðpt Þ lnðpt1 ÞÞ 100%, where pt is

the price index at time t. Time series plots for each market return series are given in

Fig. 1. We also consider the series of logarithm of trading volume over the same time

period in each market. The variable change in volume at time t is deﬁned as

V t ¼ c ðlnðvt Þ lnðvt1 ÞÞ 100%, where vt is the trading volume at time t. The

multiple c is used here because the scales of the market return and percentage change

in volume series are very different. We thus scale the change in volume series by a

constant c, chosen to allow the series V to have a similar scale to the return series R.

In order to form a statistically adequate model, the variables should ﬁrst be

checked as to what extent they can be considered stationary. The results of applying

ARTICLE IN PRESS

426 R. Gerlach et al. / Physica A 360 (2006) 422–444

TWSI SETI

10

5

5

0

0

-5 -5

-10 -10

0 500 1000 1500 2000 2500 0 500 1000 1500 2000 2500

KSll CAC

10

5

5

0 0

-5

-5

-10

0 500 1000 1500 2000 2500 0 500 1000 1500 2000 2500

FTSE DJIA

6 6

4 4

2 2

0 0

-2 -2

-4 -4

-6 -6

0 500 1000 1500 2000 2500 0 500 1000 1500 2000 2500

Fig. 1. Time series plots for the ﬁve market returns and the returns of US Dow Jones Industrial Average

as a benchmark.

an augmented Dickey–Fuller (ADF) test to the logs of the price, returns, log-volume

and volume changes are shown in Table 1. We conclude from the p-values in this

table that the log-price and log-volume series contain unit roots, while the returns

and volume change series appear stationary in mean. To provide a general

understanding of the nature of each market’s returns, we summarize the daily return

and scaled volume change statistics in Table 2. Perhaps due to the Asian ﬁnancial

crisis within this time period, all three Asian markets exhibit negative mean returns,

while the UK, France and the US have positive mean returns over this period. All six

return series exhibit the standard property of asset return data: they have fat-tailed

distributions, as indicated by the positive coefﬁcient of excess kurtosis. This

characteristic is also shown by the highly signiﬁcant Jarque–Bera normality test

statistics, a joint test for the absence of skewness and kurtosis. All series are

negatively skewed, except Thailand.

ARTICLE IN PRESS

R. Gerlach et al. / Physica A 360 (2006) 422–444 427

Table 1

ADF tests for a unit root on log-prices, return, log-volume, and log-volume changes

weighted SET SE composite CAC 40 FTSE 100

(log-price)

ADF statistic 32.6736 32.5623 35.5427 35.9939 37.3928

(return) ðo0:01Þ ðo0:01Þ ðo0:01Þ ðo0:01Þ ðo0:01Þ

ADF statistic 3.1763 2.4134 1.6049 2.2453 2.1092

(log-volume)

ADF statistic 49.3402 23.3543 21.4808 43.8022 31.6039

(volume changea) ðo0:01Þ ðo0:01Þ ðo0:01Þ ðo0:01Þ ðo0:01Þ

a

V t ¼ c ðlnðvt Þ lnðvt1 ÞÞ 100%, where vt is the trading volume at time t and c ¼ 0:1.

Table 2

Summary statistics: Stock Index Returns and volume change

weighted SET SE composite CAC 40 FTSE 100 DJI

Std. 1.7156 1.8673 2.1918 1.4830 1.1549 1.1220

Skewness 0.0824 0.4619 0.0647 0.0658 0.1574 0.2648

Kurtosis 1.9856 3.7963 3.0240 2.1205 2.3953 4.0236

Minimum 9.9360 10.0280 12.8047 7.6780 5.8853 7.4549

Maximum 8.5198 11.3495 10.0238 7.0023 5.9026 6.1547

Observations 2408 2421 2401 2491 2498 2491

J–B testa 398.3084 2039.7620 1298.5400 453.2870 714.1045 1957.0780

(o0.01) (o0.01) (o0.01) (o0.01) (o0.01) (o0.01)

Volume changeb

Mean 0.0015 0.00093 0.0133 0.0109 0.0078 0.0045

Std. 2.3952 3.7479 2.1108 3.8009 2.9139 2.4186

Skewness 0.1414 0.2297 0.3449 0.0234 0.0523 0.0889

Kurtosis 1.1420 1.3255 3.4734 2.7646 4.7098 5.6539

Minimum 12.8846 24.6453 9.7940 25.9523 20.0322 15.0145

Maximum 12.7297 18.1687 14.7527 23.5100 19.7815 18.3530

Observations 2408 2421 2401 2491 2498 2491

J–B testa 137.7552 197.0956 1247.7470 788.9356 2298.3250 3301.8310

(o0.01) (o0.01) (o0.01) (o0.01) (o0.01) (o0.01)

a

The Jarque–Bera normality test statistic and p-value are listed. The lower p-value indicates the null

hypothesis of normality can be rejected.

b

V t ¼ c ðlnðvt Þ lnðvt1 ÞÞ 100%, where vt is the trading volume at time t and c ¼ 0:1.

interest to examine whether the stock returns on price indexes in the advanced

markets are affected by international market return spillover. Possible choices of

exogenous factor here include the US, Japan and the emerging market in China.

ARTICLE IN PRESS

428 R. Gerlach et al. / Physica A 360 (2006) 422–444

However, Chen and So [14] illustrate that the US market dominates Japan in terms

of return spillover effects in Asian markets. China’s stock market has recently

become more correlated with major international ﬁnancial markets, but it is still

an emerging market in nature. Previous literature suggests that return spillover

effects are unidirectional, transmitted from advanced ﬁnancial markets to less-

developed ﬁnancial markets. This argument was further conﬁrmed in recent work by

Wang and Firth [15]. Their ﬁndings suggest the existence of only unidirectional

return spillover effect from the US to China. Thus, for the time being it seems

inappropriate to consider China as an exogenous factor. We thus consider only the

US stock market for return spillover effects. It is important when doing this to note

that stock markets in different countries operate in different time zones with

subsequently different opening and closing times. To compare the realized returns

for international markets in a given calendar day in different real-time periods is

difﬁcult. However, the stock trading at New York City (the Dow Jones Index in the

US market) is the last one to close among the international stock exchanges under

investigation. So the closing news in the US market at day ðt 1Þ will have sufﬁcient

time to transmit to the Southeast Asian markets and various European markets,

see Ref. [13].

We employ standard Granger bi-directional causality tests to examine, using

a bivariate VAR model between the US and each market separately and

employing a regression F-statistic, whether each domestic market is signiﬁ-

cantly affecting the US (in mean) and/or vice versa. The results from these tests

are presented in Tables 3. Clearly, the US is signiﬁcantly affecting each

market’s return in the mean, while each market has a much weaker and mostly

insigniﬁcant effect on the US market return. For this reason, we restrict ourselves to

a univariate, as opposed to a bivariate, model and include a 1-day lagged cross-asset

return in the mean equation. We also assume the conditional variance is a

Table 3

Causality tests for stock returns in global markets

F test F test

US ! UK 228.45 0.0000 122.18 0.0000

US ! SK 142.99 0.0000 71.47 0.0000

US ! THAI 76.72 0.0000 38.48 0.0000

US ! TWN 112.36 0.0000 56.85 0.0000

FR ! US 3.70 0.054 3.134 0.044

UK ! US 2.712 0.100 2.561 0.077

SK ! US 0.037 0.847 2.945 0.053

THAI ! US 0.187 0.666 0.212 0.809

TWN ! US 0.309 0.578 0.517 0.596

ARTICLE IN PRESS

R. Gerlach et al. / Physica A 360 (2006) 422–444 429

GARCH(1,1) process

Model 1 Rit ¼ f0 þ f1 Rit1 þ c1 Rjtþm1 þ at ,

pﬃﬃﬃﬃ

at ¼ ht e t ,

ht ¼ a0 þ a1 a2t1 þ b1 ht1 ; et tðnÞ , ð1Þ

where m is the time difference between i and j markets, Rit and Rjt are stock returns

from countries i (i ¼ Taiwan, Thailand, South Korea, France and the UK) and j

(the US), respectively; ht is the conditional variance; f0 , f1 , c1 , a0 , a1 and b1 are

unknown parameters; and at is a random error term following a standardized t-

distribution with n degrees of freedom, mean 0 and variance 1. As in Ref. [13] we

estimate the degrees of freedom parameter n as part of the Bayesian estimation, see

details in Appendix.

Ref. [13]; details are given in an Appendix. Brieﬂy, MCMC is an iterative sampling

scheme that, in turn, samples parameter values as follows:

parameter values.

Sample a0 ; a1 ; b1 jointly conditional on the data R and the other current

parameter values.

Sample n conditional on the data R and the other current parameter values.

The Bayesian approach has the advantages over classical statistical methods of

simultaneous inference, and incorporation of any prior information, on all model

parameters. The priors used are described in Appendix, but are mostly chosen to be

uninformative over the standard region ensuring stationarity and ﬁnite, positive

variance in the model.

Estimates of Model 1, for each of the ﬁve series, are presented in Table 4. This

table contains the posterior means, together with standard errors, for the unknown

parameters (f0 , f1 , c1 , a0 , a1 , b1 ). Here we see that, as expected, indeed there are

signiﬁcant spillover effects from the US market to each national stock index, as

measured by the signiﬁcantly positive estimates of c1 . We note the standard

empirical result, high level of persistence in volatility in each market, with estimates

of a1 þ b1 between 0.96 and 0.99 for each market. There is signiﬁcant negative ﬁrst-

order persistence in mean in the UK and French markets, but signiﬁcant positive

persistence in mean in the Thailand and South Korea markets, after accounting for

the exogenous US mean effect. Finally, the degree of freedom parameter is especially

low in the three Asian markets, indicating a higher level of kurtosis in the error

distribution compared to the UK and France. This justiﬁes the use of the t-

distribution and indicates the tails of the conditional error distribution are

signiﬁcantly fatter than a normal distribution.

ARTICLE IN PRESS

430 R. Gerlach et al. / Physica A 360 (2006) 422–444

Table 4

Bayesian estimates for Model 1

(0.0303) (0.0301) (0.0325) (0.0244) (0.0171)

f1 0.0108 0.1056 0.0675 0.0928 0.0910

(0.0207) (0.0214) (0.0204) (0.0224) (0.0213)

c1 0.3035 0.2234 0.3169 0.3416 0.2780

(0.0290) (0.0276) (0.0351) (0.0274) (0.0206)

(0.0463) (0.0365) (0.0125) (0.0078) (0.0037)

a1 0.0961 0.1164 0.0691 0.0636 0.0792

(0.0190) (0.0214) (0.0142) (0.0092) (0.0116)

b1 0.8659 0.8588 0.9253 0.9260 0.9124

(0.0304) (0.0284) (0.0152) (0.0108) (0.0125)

n 6.5699 7.1010 9.6063 20.4054 20.7016

(0.9262) (1.0312) (1.6805) (8.4478) (8.7777)

In forming our models, we are motivated by the causality tests of Moosa et al. [29],

useful for vector autoregressive models in order to determine directions of causality

or dependence. While these tests make strict assumptions: the threshold variable is

exactly zero, volatility is constant and errors are Gaussian; they do allow asymmetric

relationships in the mean equation. They are thus useful as an initial guide in

asymmetric model choice, while being much less general than the results in this

paper. The results of these tests are presented in Table 5. Clearly, the results indi-

cate that both positive and negative US market returns signiﬁcantly affect returns

in all ﬁve domestic markets. This motivates the choice of the US as both an

exogenous variable in the mean equation and a threshold variable. The model we

employ is a Double TAR-GARCH model, which generalizes the DT-ARCH model

of Li and Li [31] and Chen [32]. This model is motivated by several nonlinear

characteristics commonly observed in practice, such as asymmetry in declining and

rising patterns of a process. It uses piecewise linear models to obtain a better

approximation of the conditional mean and conditional volatility equations based

on a threshold variable.

We specify the ﬁrst two-regime asymmetric heteroscedastic model as

8 ð1Þ ð1Þ j

< f0 þ fð1Þ i

1 Rt1 þ c1 Rtþm1 þ at ; Rjtþmd pr1 ;

i

Model 2 Rt ¼

: fð2Þ þ fð2Þ Ri þ cð2Þ Rj Rjtþmd 4r1 ;

0 1 t1 1 tþm1 þ at ;

ARTICLE IN PRESS

R. Gerlach et al. / Physica A 360 (2006) 422–444 431

Table 5

Causality tests without assuming symmetry for stock returns in global markets

F test F test

US ! FR 76.530 0.0000 41.704 0.0000

USþ ! UK 64.191 0.0000 35.989 0.0000

US ! UK 106.240 0.0000 56.563 0.0000

USþ ! SK 35.217 0.0000 14.397 0.0000

US ! SK 60.712 0.0000 35.548 0.0000

USþ ! THAI 19.508 0.0000 6.333 0.002

US ! THAI 63.147 0.0000 32.180 0.0000

USþ ! TWN 23.527 0.0000 12.634 0.0000

US ! TWN 55.225 0.0000 26.672 0.0000

t is the return on the US market, are deﬁned as

( (

þ

RUS

t if RUS

t X0; RUS

t t p0 ;

if RUS

USt ¼ USt ¼

0 otherwise; 0 otherwise :

pﬃﬃﬃﬃ

at ¼ ht et ; et tðnÞ ,

8 ð1Þ

< a0 þ að1Þ 2 ð1Þ

1 at1 þ b1 ht1 ; Rjtþmd pr1 ;

ht ¼ ð2Þ

: að2Þ þ að2Þ a2 þ bð2Þ Rjtþmd 4r1 ;

0 1 t1 1 ht1 ;

where m is the time different between i and j markets. The deﬁnition of Rit and Rjt is

the same as Model 1. This is the model considered in Ref. [13] where the mean and

volatility equations can react asymmetrically to good or bad return news from the

US market. This model has the advantage that the threshold parameter, usually ﬁxed

at r1 ¼ 0, and the delay parameter, usually ﬁxed at d ¼ 1, are not speciﬁed but can be

estimated from the data simultaneously with the other model parameters, in a

Bayesian framework.

Model 2 above ignores any potential relationship between trading volume and

price movements on the stock market. Financial theory suggests that volume and

stock return are strongly associated and many authors have found empirical results

to back this up, see Refs. [27,28] among others. To motivate our model, we again

employ the Moosa et al. [29] causality tests, without assuming symmetry, applied to

each market’s volume-change and return series together in a bivariate VAR model.

Results are presented in Table 6. Here we see, assuming a zero threshold, constant

volatility and Gaussian errors (these assumptions are violated for these markets, see

Table 8) that results are somewhat mixed, however, this test is meant as an initial

guide only. Both positive and negative changes in trading volume signiﬁcantly affect

ARTICLE IN PRESS

432 R. Gerlach et al. / Physica A 360 (2006) 422–444

returns in South Korea (5% level), while Taiwan is affected strongly by only positive

volume-change at 5% level. Also, at the 10% level, decreasing volume affects returns

on the French and Taiwanese markets. However, the UK and Thailand seem not be

signiﬁcantly affected in the mean equation by trading volume-change. We also

observed the standard causality tests, not presented here to save space, which

illustrated that volume was not a signiﬁcant exogenous factor in these markets.

These results suggest that volume may potentially affect market returns asymme-

trically and motivates the choice of volume as a threshold variable, but not as an

exogenous variable in the mean equation.

We thus develop a new model in this paper, motivated by the work of Ying [24]

and Karpoff [25], attempting to capture the potentially asymmetric reaction of

stock prices to changes in trading volume. We introduce a Double TAR-GARCH

model using change in trading volume as the threshold variable. This is the ﬁrst

time that trading volume has been employed as a threshold variable in an

asymmetric heteroscedastic dynamic model of stock returns. The model is posited

as follows:

8 ð1Þ ð1Þ j

< f0 þ fð1Þ i

1 Rt1 þ c1 Rtþm1 þ at ; V itd pr2 ;

i

Model 3 Rt ¼

: fð2Þ þ fð2Þ Ri þ cð2Þ Rj V itd 4r2 ;

0 1 t1 1 tþm1 þ at ;

pﬃﬃﬃﬃ

at ¼ ht et ; et tðnÞ ,

8 ð1Þ

< a0 þ að1Þ 2 ð1Þ

1 at1 þ b1 ht1 ; V itd pr2 ;

ht ¼ ð3Þ

: að2Þ þ að2Þ a2 þ bð2Þ ht1 ; V i 4r2 ;

0 1 t1 1 td

lnðvit1 ÞÞ 100% is the change in trading volume, where vit is the trading volume of

market i at time t and c ¼ 0:1. This model will allow us to test the major hypothesis

about asymmetries between mean and volatility of returns in reaction to changes in

trading volume, and will allow us to empirically conﬁrm the ﬁndings and theories of

Ying [24] and Karpoff [25] in a GARCH-type dynamic volatility setting. The model

allows trading volume to drive or inﬂuence stock returns in a piecewise linear

fashion, allowing different return behavior following increasing or decreasing

volume. Again, the threshold change in volume level and delay lag parameter are

estimated simultaneously with the unknown model parameters, a signiﬁcant

advantage of the Bayesian approach to estimation.

We employ a similar MCMC method to that for Model 1, as in Ref. [13], to

estimate both Models 2 and 3. See Appendix for some details of this approach.

Brieﬂy, this involves the same iterative sampling scheme as for Model 1 (the two

steps above are performed separately for each regime) with the addition of the steps:

Sample rk conditional on the data R and the other current parameter values.

Sample d from it’s discrete posterior distribution conditional on the data R and

the other current parameter values.

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The prior distributions on model parameters here are described in Appendix, but are

mostly chosen to be uninformative over the region ensuring stationarity and ﬁnite

variance in each model.

Table 7. These illustrate a clear nonlinear asymmetric reaction to US return news in

each of the ﬁve markets, similar to results found in Ref. [13]. Firstly in each market,

the mean reversion is faster in the negative regime, following bad news from the US

market, i.e., fð1Þ ð2Þ

1 of1 , with these parameters being signiﬁcantly different to zero in

all ﬁve markets following good or positive US return news. Again, this local

persistence in return is positive in the three Asian markets, but negative in UK and

France. In addition, the spillover effect from the US market is signiﬁcantly greater

following bad US news, i.e., cð1Þ ð2Þ

1 4c1 in each market. We note that the spillover

effect from the US market is signiﬁcantly stronger than the local return persistence in

each of the ﬁve markets, as indicated by jc1 j4jf1 j and jc1 j4jf0 j in each regime.

Also, the persistence in volatility, as measured by a1ðjÞ þ bðjÞ

1 is higher following bad

news in each market.

Table 9 highlights the asymmetric reactions in the ﬁve markets. Here, we see

that volatility level increases by as little as 7.5 times and as much as 68 times

following bad US news compared to that following good US news. Thailand is the

exception, with volatility level appearing stable regardless of the news from the US.

In fact, the asymmetric reaction in volatility appears to be much stronger in the UK

and France, compared to the three Asian markets. We also see that the mean return

estimate in each market has decreased from the positive to negative threshold, i.e.,

following bad news from the US. This mean return decrease is from positive return

following good US news to negative return following bad US news, in three of

the markets.

We note that the threshold parameters in Table 7 are estimated to be negative and

signiﬁcant in four of the ﬁve markets. This illustrates that small negative US returns

do not induce an asymmetric reaction and are not perceived as ‘bad news’ by these

ﬁve national markets. However, signiﬁcant negative US returns, that is below each

threshold estimate, are needed to induce the asymmetric reaction in each market.

Thailand is the exception to this rule, although the positive estimated threshold

parameter is not signiﬁcantly different to 0 in this case. We also note in Table 9 that

the posterior mode for the delay parameter d is 1 in four of the ﬁve markets, but is

two days for the Taiwan market. The degrees of freedom estimates are similar to

those obtained for Model 1.

Results for Model 3 are presented in Tables 8 and 9. Results here illustrate a clear

nonlinear asymmetric reaction to change in trading volume in each of the ﬁve

markets. Firstly in each market, the mean reversion is faster following negative

changes or decreases in trading volume, i.e., fð1Þ ð2Þ

1 of1 in four of the ﬁve markets,

excepting Taiwan. The international spillover effect from the US market is greater in

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434 R. Gerlach et al. / Physica A 360 (2006) 422–444

the positive regime, following increases in trading volume, i.e., cð2Þ ð1Þ

1 4c1 in each

market, except Thailand. We note that the spillover effect from the US market is

again signiﬁcantly stronger than the local return persistence in each of the ﬁve

markets, as indicated by jc1 j4jf1 j and jc1 j4jf0 j in each regime. In this case, the

persistence in volatility (a1 þ b1 ) is mostly higher following positive trading volume

changes.

Table 9 again highlights the asymmetric nonlinear reactions to trading volume

change in the ﬁve markets. Here, we see that average volatility increases by as little as

1.5 times (South Korea) up to 100 times (UK, France) following increases in trading

volume, compared to that following declining trading volume. This is consistent with

the hypothesis of Ying [24] who suggested that large increases in volume lead to large

increases or decreases in price and hence to volatility. Taiwan is the notable

exception to this rule, with volatility level signiﬁcantly decreasing as trading volume

increases. This distinctive empirical result in the Taiwanese market is interesting in

light of the under and over reaction hypothesis, in the modern theory of behavior

ﬁnance, proposed by Daniel et al. [33] and Barberis et al. [34]. Their hypothesis states

that individual investors tend to be over-conﬁdent and over-reliant on their own

private information, in general, resulting in over-reaction to public information, on

the basis that they perceive this to conﬁrm their individual beliefs. Proposition 3 in

Ref. [33] states that ‘overconﬁdence can increase or decrease volatility’ around public

information events. The result for Taiwan thus agrees with this theory, as indeed the

volatility has changed following news on trading volume, it just changes in a

different way to that in the other four markets. The particular Taiwan market

behavior has been well documented in previous studies of price–volume relationships

with the most plausible explanation falling in the realm of market imperfection and

investor irrationality [35,36]. The Taiwanese stock market’s prolonged behavioral

characteristic is very short-run speculation, which may also contribute to the

inherent political jitters in Taiwan, due to the Chinese Missiles incident, and

economic crisis in 1997–1998. In addition, the majority (approximately over 92%) of

investors are uninformed traders and individual investors. Thus, we suspect that this

speculative behavior, incorporated with investor irrationality, caused the particular

information ﬂow pattern and price–volume relationship in the Taiwan stock market.

On close examination of the mean and volatility of returns under Model 3 in Table 6,

the evidence suggests that in regime 1 investors over-react, proxied by the relatively

high volatility and lower mean return, to the negative volume change. On the other

hand, the result in regime 2 suggests an under-reaction, with lower volatility, but in a

bullish fashion, with increasing volume of trade.

The estimates of average return in each market have increased following increases

in trading volume, excepting Thailand. The greatest increases in mean return are in

South Korea and Taiwan. The particular ﬁnding in the Thailand stock market is also

of interest. The turmoil of the Asian currency crisis in July 1997 led the economy of

Thailand into a well-documented seven-year stagnation, falling into a long sluggish

bear market until June of 2003, except for a short rebound between August 1998 and

June 1999. This phenomenon is reﬂected by the largest, in magnitude, negative mean

return ð0:0422Þ among our ﬁve sample markets in Table 2 and also a large negative

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R. Gerlach et al. / Physica A 360 (2006) 422–444 435

Table 6

Causality tests without assuming symmetry for domestic returns and volume changes

F test F test

V ! FR 3.375 0.066 0.432 0.239

Vþ ! UK 0.247 0.619 0.103 0.902

V ! UK 1.263 0.261 0.732 0.481

Vþ ! SK 4.743 0.029 3.152 0.043

V ! SK 4.712 0.030 1.296 0.274

Vþ ! THAI 1.752 0.186 0.914 0.401

V ! THAI 0.538 0.463 0.422 0.656

Vþ ! TWN 6.607 0.010 5.453 0.004

V ! TWN 2.925 0.087 3.372 0.034

(

V t if V t X0; V t if V t p0 ;

Vþt ¼ V

t ¼

0 otherwise; 0 otherwise :

volume threshold value of 1:5375 in Table 7. Financial theory suggests that trading

volume tends to expand in the direction of the major market trend. If the observed

stock market is up in trend, the volume should increase with price increase, and the

volume should diminish as price decreases. Conversely, if the major trend of the

stock market is down, the volume should diminish as price rallies up but expand as

price dips down. The relatively large magnitude of negative mean return ð0:0385Þ of

regime 2 under Model 3 in Table 6 is consistent with these ﬁndings in the literature, a

large increase in volume is usually accompanied by either a large rise in price or a

large dip in price, the dip here associated with a period of poor market return

performance in Thailand.

These results suggest very clear and signiﬁcant asymmetric and nonlinear reactions

in each market to changes in trading volume and support the original work by Ying

[24] and Karpoff [25]. The results suggest that the mean return in each market is

higher (except Thailand) and the volatility level is much higher (except Taiwan) when

trading volume increases:

We note that the threshold parameters in Table 8 are estimated to be positive and

signiﬁcant in three of the ﬁve markets. This illustrates that small increases in trading

volume do not induce an asymmetric reaction and are not perceived as signiﬁcant by

these ﬁve national markets. However, signiﬁcant positive changes in volume, that is

above each positive threshold estimate, are needed to induce the asymmetric reaction

in Taiwan, South Korea and France. Thailand is again the exception to this rule, as

explained above. We also note in Table 9 that the posterior mode for the delay

parameter d is 1 day in all ﬁve markets. The degrees of freedom estimates are similar

to those obtained for Model 2.

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Table 7

Bayesian estimates for Model 2

(0.0697) (0.0621) (0.1372) (0.0756) (0.0570)

f1ð1Þ 0.0780 0.0981 0.0153 0.1119 0.1198

(0.0377) (0.0298) (0.0418) (0.0394) (0.0367)

c1ð1Þ 0.3030 0.2497 0.5464 0.404 0.3827

(0.0502) (0.0537) (0.1027) (0.0691) (0.0497)

(0.0410) (0.1075) (0.0455) (0.0400) (0.0302)

f1ð2Þ 0.1429 0.1034 0.0895 0.0814 0.0824

(0.0257) (0.0366) (0.0244) (0.0269) (0.0279)

c1ð2Þ 0.0890 0.1808 0.3224 0.2855 0.2623

(0.0392) (0.0751) (0.0550) (0.0502) (0.0365)

(0.0965) (0.0568) (0.0734) (0.0315) (0.0152)

a1ð1Þ 0.1134 0.1129 0.1036 0.0939 0.1066

(0.0284) (0.0282) (0.0248) (0.0197) (0.0231)

b1ð1Þ 0.8608 0.8639 0.8811 0.8985 0.8871

(0.0400) (0.0364) (0.0296) (0.0213) (0.0240)

(0.0524) (0.1027) (0.0133) (0.0117) (0.0040)

a1ð2Þ 0.1424 0.1464 0.0734 0.043 0.0542

(0.0234) (0.0342) (0.0197) (0.0121) (0.0159)

b1ð2Þ 0.8129 0.801 0.9149 0.9114 0.9117

(0.0374) (0.0481) (0.0219) (0.0161) (0.0192)

(0.1332) (0.3178) (0.1197) (0.0697) (0.0722)

n 6.6773 7.2158 9.8639 21.9762 25.3133

(0.9553) (1.0223) (1.8114) (13.9071) (18.6993)

Figures in brackets represent posterior standard errors for each parameter. r1 : threshold value for US

returns.

5. Model comparison

model, Model 3, adds any value over the simple and DTAR-GARCH

models, Models 1 and 2. To compare models pairwise we use the posterior

odds ratio which is the ratio of integrated likelihoods for each model, multi-

plied by the prior odds ratio. This is a Bayesian decision rule where for any

two models A and B the posterior odds ratio, showing evidence in favor of A

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R. Gerlach et al. / Physica A 360 (2006) 422–444 437

Table 8

Bayesian estimates for Model 3

(0.0380) (0.0549) (0.0432) (0.0303) (0.0247)

f1ð1Þ 0.0027 0.0160 0.0275 0.1293 0.1447

(0.0290) (0.0560) (0.0242) (0.0288) (0.0316)

c1ð1Þ 0.2988 0.2537 0.2642 0.2722 0.2286

(0.0344) (0.0481) (0.0396) (0.0360) (0.0340)

(0.0667) (0.0367) (0.0786) (0.0411) (0.0245)

f1ð2Þ 0.0431 0.1309 0.0910 0.0207 0.0266

(0.0335) (0.0248) (0.0375) (0.0436) (0.0372)

c1ð2Þ 0.3147 0.2103 0.3338 0.4280 0.3058

(0.0546) (0.0343) (0.0657) (0.0529) (0.0278)

(0.0562) (0.1169) (0.0153) (0.0085) (0.0069)

a1ð1Þ 0.1348 0.0905 0.0785 0.0633 0.0938

(0.0284) (0.0508) (0.0169) (0.0158) (0.0194)

b1ð1Þ 0.8438 0.8344 0.9150 0.8982 0.8703

(0.0353) (0.0539) (0.0179) (0.0186) (0.0258)

(0.0941) (0.0416) (0.0452) (0.0385) (0.0109)

a1ð2Þ 0.0534 0.1171 0.0806 0.1020 0.0825

(0.0223) (0.0218) (0.0230) (0.0238) (0.0193)

b1ð2Þ 0.8714 0.8686 0.9075 0.8868 0.9119

(0.0522) (0.0253) (0.0263) (0.0270) (0.0203)

(0.3979) (0.9330) (0.1962) (0.6038) (0.4197)

n 6.6030 7.2002 8.5599 22.3516 21.4837

(0.9211) (1.0382) (1.3779) (12.9051) (10.0179)

Figures in brackets represent posterior standard errors for each parameter. r2 : threshold value for volume-

change.

over B is

pðAjRÞ pðRjAÞPrðAÞ

ORA;B ¼ ¼ .

pðBjRÞ pðRjBÞPrðBÞ

The decision rule is to choose Model A if ORA;B 41, otherwise choose model B. See

Ref. [37] for a complete discussion of Bayesian decision rules. We use the integrated

or marginal likelihood function pðRjAÞ here, so that we may integrate over the

possible values of unknown parameters based on the observed sample data, and thus

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438 R. Gerlach et al. / Physica A 360 (2006) 422–444

Table 9

The estimates of means and unconditional variance for each regime

Model 1

m 0.0243 0.0402 0.0024 0.0380 0.0337

a0 3.1627 3.9258 5.6165 2.0900 1.3417

1 a1 b1

Model 2

mð1Þ 0.0768 0.2108 0.3954 0.2939 0.2101

mð2Þ 0.0777 0.1824 0.1484 0.1985 0.1601

a0ð1Þ 9.5368 3.2780 13.4063 19.0026 11.1588

1 a1ð1Þ b1ð1Þ

a0ð2Þ 1.3355 4.2612 1.4863 0.2911 0.1235

1 a1ð2Þ b1ð2Þ

d1 2 1 1 1 1

Model 3

mð1Þ 0.0614 0.0318 0.2629 0.0223 0.0088

mð2Þ 0.2279 0.0385 0.6763 0.0721 0.0568

a0ð1Þ 7.6983 2.3874 4.1567 0.1696 0.1010

1 a1ð1Þ b1ð1Þ

a0ð2Þ 1.4935 5.7459 6.0943 14.7160 8.0672

1 a1ð2Þ b1ð2Þ

d1 1 1 1 1 1

account for parameter uncertainty. We assume prior model ignorance so that the

prior ratio is 1, equivalently PrðAÞ ¼ PrðBÞ ¼ 0:5. To estimate the integrated

likelihood for each model can be quite difﬁcult, with many Bayesian approaches

suggested in the literature, see Refs. [38–40] for examples. We employ the method

suggested in Ref. [30], employing importance sampling techniques. These methods

are implemented in Ref. [14], who give a detailed exposition of this work applied to

extended threshold GARCH models. See Appendix for details.

Table 10 contains the logarithm of the odds ratio comparing each pair of Models

1, 2 and 3. The ﬁrst listed model is preferred over the second listed model if the

number in the table is positive (and hence the corresponding odds ratio is 41),

otherwise the second model is preferred. The boxed number is for the most preferred

model in each market, conﬁrmed by the ﬁnal line of the table. It is interesting to note

that the model with trading volume as a threshold variable, Model 3, is strongly

preferred over both Models 2 and 1 in the three Asian markets: Taiwan, Thailand

and South Korea. Using the Bayesian odds ratio interpretation in Ref. [39], this is

‘very strong’ to ‘decisive’ evidence in favor of the volume threshold asymmetric

model. In contrast, however, for the European markets of the UK and France, the

asymmetric model with lagged US news as the threshold variable is preferred over

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R. Gerlach et al. / Physica A 360 (2006) 422–444 439

Table 10

Logarithm of the posterior odds ratio

Model 3 vs Model 1 6:3943 8:9871 3:6360 0.4313 5.8874

Model 3 vs Model 2 8:5306 5:5011 12:1109 2.2026 7.4607

Preferred model Model 3 Model 3 Model 3 Model 2 Model 2

Models 1 and 3. This represents ‘substantial’ evidence in favor of this model for these

two markets. Clearly, the asymmetric effect from trading volume is comparatively

strongest in the Asian markets considered, while the US trading news dominates

trading volume news in the UK and France markets. Table 10 also shows that the

symmetric GARCH model with leptokurtic innovations, Model 1, ranked second in

four of the ﬁve markets. This result is not surprising, and conﬁrms previous ﬁndings,

such as those in Ref. [41], that a simple GARCH formulation with t-errors can

sometimes outperform more complex models for real market returns.

It is hard to make the usual good news–bad news ﬁnancial argument with this

trading volume threshold model, as asymmetric increases in volatility also coincide

with increases in mean return in each market; following an increase in trading

volume. However, this is a common ﬁnding in many ﬁnancial studies; an increased

level of return is associated with, and often caused by, an increased level of risk

(volatility) [42]. The traditional bad news argument can only be applied in Taiwan,

where investors seem to perceive decreases in trading volume as bad news, as this

result is associated with lower negative mean returns and higher return volatility.

6. Conclusions

between stock return, return volatility, international return spillover and change in

trading volume for ﬁve international stock markets. Conforming to well-established

empirical results, stock returns and return volatility display a certain degree of

persistence and consistent with a meteor-shower hypothesis, our empirical results

suggest that the stock-return news developed from US is transmitted signiﬁcantly to

each of the ﬁve national stock markets. In particular, the US return-news is

positively correlated with the stock price of each national market but this correlation

is asymmetric around a threshold US return value and/or a value of trading volume

change. This conﬁrms the minor goal of this paper. The major issue of this study has

been whether stock returns and return volatility react asymmetrically, in a threshold

nonlinear fashion, to trading volume change. By employing a double-threshold

GARCH model to capture the nature of market reaction to trading volume change,

we ﬁnd that a large increase in volume is accompanied by a large rise in average

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440 R. Gerlach et al. / Physica A 360 (2006) 422–444

stock price, while a decrease in volume is associated with lower average returns, with

the exception of Thailand. Moreover, the return volatility of all the stock-markets

also displayed an asymmetric reaction to volume change, around a threshold level.

With the exception of Taiwan, the average magnitude of return volatility following

an increase in trading volume was much larger than that following decreases in

volume. Our model comparison results revealed that the asymmetric nonlinear

model, with change in volume as a threshold, was decisively favored in the three

Asian markets: Taiwan, Thailand and South Korea. However, the DT-GARCH

model of Chen et al. [13], with US return news as threshold variable, was favored in

UK and France.

In summary, our ﬁndings are consistent with, and add to, the arguments of Ying

[24], Karpoff [25] and Gallant et al. [43]: that the joint study of stock price and

trading volume, as an asymmetric nonlinear relationship, leads to a better

understanding of capital market behavior. These ﬁndings shed new light on the

application of trading volume in the market integration literature and develop a new

avenue for asset pricing in a multi-market framework.

Acknowledgements

The authors thank two anonymous referees and the Editor, H. Eugene Stanley,

whose comments improved the paper. C.W.S. Chen is supported by National Science

Council (NSC) of Taiwan grants NSC93-2118-M-035-003. R. Gerlach was

supported by the Mathematical Research Promotion Center of the NSC of Taiwan,

Feng Chia University and the University of Newcastle, via an ECA networking

grant and the School of MAPS.

Appendix A

This appendix gives some details for the Bayesian MCMC sampling scheme used

to estimate the GARCH models in this paper and of the method used to estimate the

marginal likelihood required in the posterior odds ratio used for model comparison.

For further details of MCMC sampling see Ref. [44] or [14].

Firstly, let

0 ; f1 ; c1 Þ;

ðjÞ

j ¼ 1; 2,

aðjÞ ¼ ða0ðjÞ ; aðjÞ

1 ; bðjÞ

1 Þ; j ¼ 1; 2,

ð1Þ ð2Þ ð1Þ ð2Þ

H ¼ ð/ ; / ; a ; a ; rk ; dÞ.

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R. Gerlach et al. / Physica A 360 (2006) 422–444 441

( ðnþ1Þ=2 )

Yn X2

Gððn þ 1Þ=2Þ 1 ðRt mt Þ2

2;n

pðR jHÞ ¼ pﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃ pﬃﬃﬃﬃ 1 þ I jt ,

t¼2 j¼1 Gðn=2Þ ðn 2Þp

ht ðn 2Þht

where I jt is the indicator variable IðRjtþmd pr1 Þ, Gð:Þ is the Gamma function and n is

the degrees of freedom. For Bayesian inference, we need to set prior distributions on

all model parameters. We use the prior pðHÞ / Iðað1Þ ð1Þ ð1Þ ð2Þ

0 40; a1 þ b1 o1ÞIða0 40;

ð2Þ ð2Þ

a1 þ b1 o1ÞIðq1 ork oq3 ÞIðd 2 1; 2; 3ÞIðt 2 ½0; 0:25Þ, where IðÞ is an indicator

function, t ¼ 1=n and q1 and q3 are the ﬁrst and third quantiles, respectively, of

the required threshold variable. In threshold modelling, it is important to set a

minimum amount of observations in each regime, so there is sufﬁcient sample size to

generate meaningful inference results, driving our prior choice for rk here. We

restrict n44 so that the variance of t is ﬁnite, while ensuring that the kurtosis is

greater than 3. Finally, for the mean equation parameters we assume the normal

prior /j Nð/j0 ; V j Þ, where usually we set /j0 ¼ 0 and V 1 j to be a large number,

such as 1, to ensure a reasonably ﬂat prior.

Incorporating the likelihood above and the priors, using Bayes rule, leads to the

conditional posterior distributions for the parameter groupings we use in the

MCMC sampling scheme. We use the following iterative sampling scheme to

construct the desired posterior sample:

1. Draw the vector /ðjÞ jR; Hfj for j ¼ 1; 2, using the random walk MH algorithm.

2. Draw the vector aðjÞ jR; Haj for j ¼ 1; 2 using the random walk MH algorithm.

3. Draw the parameter rk jR; Hr using the random walk MH algorithm.

4. Draw djR; Hd by noting that d is discrete valued and using it’s discrete posterior.

5. Draw t using the random walk MH algorithm.

These posterior distributions are in general not of a standard form and require us to

employ techniques such as the Metropolis random walk method [45,46] to achieve

the desired sample, as detailed now. Consider a general parameter vector q, a subset

of H. The posterior distribution for this parameter vector is evaluated by

pðqjR2;n ; Hq Þ / pðR2;n jHÞpðqÞ .

Details of the random walk MH algorithm are:

Step 1: Generate initial values q½0 from the prior distribution for this parameter

vector

Step 2: At iteration i, generate a point q from the kernel density,

q Nðq½i1 ; aOÞ ,

where q½i1 is the ði 1Þth iterate of q.

Step 3: Accept q as q½i with the probability p ¼ minf1; pðq jR2;n ; Hr Þ=

pðq½i1 jR2;n ; Hr Þg. Otherwise, set q½i ¼ q½i1 .

To yield good convergence properties, the choices of O and a for each parameter

vector are important. These choices can be made to ensure good coverage for each

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442 R. Gerlach et al. / Physica A 360 (2006) 422–444

diagonal terms, while the coverage and sampling efﬁciency can also be tuned using

the acceptance rate, in the burn-in period of the MCMC sample; see Ref. [14] for

details. A suitable value of a, with good convergence properties, can usually be

selected by having an acceptance probability of between 25% and 50% in the burn-

in period.

Parameter estimates of any functions of parameters are obtained as posterior

means by averaging the function over all sample iterates after the burn-in period.

We follow Gerlach

Q et al. [30] in estimating the marginal likelihood term for each

model pðRi Þ ¼ nt¼1 pðRit jR1;t1 Þ by estimating the respective marginal term at each

time t using

PD

pðRi jR1;t1 ; Yk½i Þ=pðRt;k jR1;t1 ; Y½i

kÞ

pðR i

^ t jR 1;t1

Þ ¼ i¼1 PtD t;k 1;t1 ½i

,

i¼1 1=pðR jR ; Yk Þ

Y n

^ iÞ ¼

pðR ^ it jR1;t1 Þ ,

pðR

t¼1

where Y½i

k is the ith MCMC iterate from the posterior distribution of the unknown

parameter vector YjR1;k , conditional on the ﬁrst k observations only. Following

Gerlach et al. [30], we choose a maximum value for k t ¼ 300 and allow

^ it jR1;t1 Þ for t ¼ k

k ¼ 300; 600; . . . ; n. For each k, we simultaneously compute pðR

300; . . . ; k. This means we need to run the MCMC sampling scheme multiple times

(in fact n=300 integer rounded times) for each model. While this process can be more

time consuming than 1 single MCMC run, we consider the gain from including

parameter uncertainty in model comparison is sufﬁcient, from a Bayesian viewpoint,

to justify this procedure.

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