Volatility spillover effect between Pakistan and Shanghai Stock Exchanges using copula and dynamic conditional correlation model

Fahim Afzal, Tonmoy Toufic Choudhury and Muhammad Kamran

International Journal of Islamic and Middle Eastern Finance and Management, 2022, vol. 16, issue 1, 59-80

Abstract: Purpose - Because of the growing financial market integration, China’s stock market’s volatility spillover effect has gradually increased. Traditional strategies do not capture stock volatility in dependence and dynamic conditions. Therefore, this study aims to find an effective stochastic model to predict the volatility spillover effect in the dynamic stock markets. Design/methodology/approach - To assess the time-varying dynamics and volatility spillover, this study has used an integrated approach of dynamic conditional correlation model, copula and extreme-value theory. A daily log-returns of three leading indices of Pakistan Stock Exchange (PSX) and Shanghai Stock Exchange (SSE) from the period of 2009 to 2019 is used in the modeling of value-at-risk (VaR) for volatility estimation. The Student’stcopula has been selected based on maximum likelihood estimation and Akaike’s information criteria values of all the copulas using the goodness-of-fit test. Findings - The model results show stronger dependency between all major portfolios of PSX and SSE, with the parametric value of 0.98. Subsequently, the results of dependence structure positively estimate the spillover effect of SSE over PSX. Furthermore, the back-testing results show that the VaR model performs well at 99% and 95% levels of confidence and gives more accurate estimates upon the maximum level of confidence. Practical implications - This study is helpful for the investment managers to manage the risk associated to portfolios under dependence conditions. Moreover, this study is also helpful for the researchers in the field of financial risk management who are trying to improve the returns by addressing the issues of volatility estimations. Originality/value - This study contributes to the body of knowledge by providing a practical model to manage the volatility spillover effect in dependence conditions between as well as across the financial markets.

Keywords: Value-at-risk; Copula; Financial risk; Volatility spillover (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:eme:imefmp:imefm-07-2021-0274

DOI: 10.1108/IMEFM-07-2021-0274

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