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Market Connectedness: Spillovers, Information Flow, and Relative Market Entropy

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Author Info

  • Harald Schmidbauer

    ()
    (Istanbul Bilgi University)

  • Angi Roesch

    ()
    (FOM University of Applied Sciences, Munich)

  • Erhan Uluceviz

    ()
    (Istanbul Bilgi University; Koç University-TÜSİAD ERF)

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    Abstract

    The degree of connectedness of equity markets on a given day can be assessed by decomposing the forecast error variance resulting from a vector autoregressive model, applied to daily returns on stock indices. This well-known procedure leads, for each day, to a spillover matrix which can be readily interpreted as a network structure and summarized into the so-called spillover index, to which much recent research work has been devoted. Taking a sequence of spillover matrices as starting point, we show how the scope of this concept can be broadened in several ways. Firstly, we develop a concept to quantify a market's potential to spread information, which is related to the eigenvector structure of spillover matrices. Secondly, a Markov chain approach allows the definition of relative market entropy, quantifying the amount of information gained from day to day. A further entropy concept can be related to the speed of shock digestion and network stability. As an empirical example, we analyze a system of five markets represented by stock indices Dow Jones Industrial Average (USA), FTSE (UK), Euro Stoxx 50 (euro area), Nikkei 225 (Japan), and SSE Composite (China). It is demonstrated that increasing trends in the spillover index as well as in speed of information digestion are an empirical fact but no logical necessity theoretical examples show that there can be opposite trends in these series.

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    File URL: http://eaf.ku.edu.tr/sites/eaf.ku.edu.tr/files/erf_wp_1320.pdf
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    Bibliographic Info

    Paper provided by Koc University-TUSIAD Economic Research Forum in its series Koç University-TUSIAD Economic Research Forum Working Papers with number 1320.

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    Length: 25 pages
    Date of creation: Oct 2013
    Date of revision:
    Handle: RePEc:koc:wpaper:1320

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    Related research

    Keywords: Market connectedness; spillover matrix; propagation values; news spreader; informational divide; relative market entropy; network stability;

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    1. Francis X. Diebold & Kamil Yilmaz, 2007. "Measuring Financial Asset Return and Volatility Spillovers, With Application to Global Equity Markets," PIER Working Paper Archive 07-002, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
    2. Daron Acemoglu & Vasco Carvalho & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2011. "The Network Origins of Aggregate Fluctuations," Working Papers 587, Barcelona Graduate School of Economics.
    3. Robert Schoen & Young Kim, 1991. "Movement toward stability as a fundamental principle of population dynamics," Demography, Springer, vol. 28(3), pages 455-466, August.
    4. Karolyi, G Andrew, 2003. "Does International Financial Contagion Really Exist?," International Finance, Wiley Blackwell, vol. 6(2), pages 179-99, Summer.
    5. Pesaran, M. H. & Shin, Y., 1997. "Generalised Impulse Response Analysis in Linear Multivariate Models," Cambridge Working Papers in Economics 9710, Faculty of Economics, University of Cambridge.
    6. Mardi Dungey & Renee Fry & Brenda Gonzalez-Hermosillo & Vance Martin, 2005. "Empirical modelling of contagion: a review of methodologies," Quantitative Finance, Taylor & Francis Journals, vol. 5(1), pages 9-24.
    7. Francis X. Diebold & Kamil Yilmaz, 2011. "On the network topology of variance decompositions: Measuring the connectedness of financial firms," Working Papers 11-45, Federal Reserve Bank of Philadelphia.
    8. Didier, Tatiana & Mauro, Paolo & Schmukler, Sergio L., 2008. "Vanishing financial contagion?," Journal of Policy Modeling, Elsevier, vol. 30(5), pages 775-791.
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