Wavelet coherence analysis of returns, volatility and interdependence of the US and the EU money markets: Pre & post crisis
Introduction
The liberalization of capital flows facilitated by recent developments in trading technologies and improved transmission of news has resulted in increased integration between international financial markets. Thus, the problem of intercorrelation and co-movement among world financial markets received much attention in the recent finance literature. Understanding the sources of international financial markets linkages is important for diversifying internationally, pricing securities, and making asset allocation decisions. Likewise, external shocks as a global financial crisis have a strong impact between markets resulting in a break in primary sources of capital or in depriving key liquidity flows. According to Kalaitzake (2020), this situation can transmit disastrous wave and contagion effects throughout markets. In such a case, often occur common tail behavior of extreme returns with the high nonlinearity and asymptotic dependency during the crisis (Wang and Zong, 2020, BenSaïda, 2018, Glasserman and Young, 2016, Grubisic et al., 2011). Some authors consider this to be the case of double-edged sword (Raddant & Kenett, 2021; Grubisic et al., 2011). From one side, markets interconnections may affect the absorption of shocks and greater robustness, and from other side, most likely, it will influence on greater fragility.
A large body of research are focused on stock market interdependence in terms of price and volatility spillovers (Lamedica and Reno, 2007, Vukovic et al., 2020, Wang and Zong, 2020, Raddant and Kenett, 2021). Mostly they study the connection between international equity markets through analysing the dynamics of stock market indices with a broad variety of methodologies (Lee and Rui, 2002, Wang and Zong, 2020). However, to our best knowledge, there is a lack in research devoted to the interdependence between global money markets. This particular issue is of great importance to investors for the diversification purposes and for the international asset allocation decisions. A minority of such studies analyse the relationships between world fixed income markets (Panchenko and Wu, 2009, Vukovic et al., 2019). The literature on the international co-movement across fixed income markets is concentrated on the government bond developed markets at the long end of the yield curve and were primarily motivated by concerns about diversification benefits. The broad findings related to the problem of interdependence between international bond yields still leave some place for further research. The objective of this research is the multilateral analysis of the US and the EU money markets interdependence from 2004 to 2018. We analyze these money markets with the core claim that bond returns, and monetary policy could be highly correlated and affected by each other not only in the long-term, but in the short-term as well. Extending the sample period to 2018 allows us to test how the money markets interdependence changed in different economic situation, particularly before, during and after the financial crisis in 2008 and in period of the European sovereign crisis in 2011. We contribute to the relevant literature considering the interconnections and dependence between returns and volatilities on different money markets are observed in only few studies. Secondly, our empirical results bring to light important aspects about the interdependence of interbank rates and bond returns between markets, especially in the cases of external shocks. The results can be useful for a wide range of financial players operating on the US and European financial markets. Thirdly, the implemented wavelet tools to money market coherence are also the novelty of our study. The analysis is motivated by concerns about diversification benefits. We intend to explain to what extent the returns and volatility of chosen money market instruments in the US and the EU are intercorrelated during different periods and to illustrate how investors can use this information to make international asset allocation decisions and optimize portfolio structure. Diversification benefits depend on the aim of an investor or a market actor. They can be measured as Markowitz (1952) proposed, but also can be qualitative. During different time periods (short, medium, long) such benefits may express in a) higher aggregate investment income by adding to a portfolio asset with higher expected return, b) lower investment risk by hedging and adding to a portfolio asset with low or negative correlation, c) lower financial costs by choosing an appropriate interest rate structure, d) higher liquidity rate by identifying an appropriate repo instruments and interest rates.
We suggest that the main reason for the unstable dependence and correlation between European and US money markets is different cycles in monetary policy. If cycles are symmetric or the pressure of monetary factors goes weak, the dependencies between markets could be explained by macroeconomic fundamentals in countries, the level of economic activity and the investors’ attitude toward risk assets. Based on this fact, investors could use the macroeconomic indicators to predict the future movements of money market instruments and to define the appropriate structure of portfolio and proportion of instruments. We observe that sometimes bond returns, and interbank rates deviate from the common rule of the financial market theory. Instead that longer maturity instruments have higher returns compared to instruments with a shorter maturity, sometimes is a paradoxical situation on the money and debt markets caused by some events (such as a crisis). For instance, returns on 1-week LIBOR may be higher than returns on government bills with much longer maturity. Practically, this situation offers to institutional players an opportunity to get extra returns in short period of investing.
In the remainder of this paper, in the second section, we review different arguments concerning relationship and dependence between money markets, with special reference to US and European markets. In the same section we provide a background discussion of the interdependence between markets and co-movement of financial asset returns and their volatilities, with the focus on the wavelet analysis. The third section explains the applied methodology in multilateral analysis of US and EU money markets. For the analysis of the historical dynamics of rates and bond returns and periods of extremely high volatility we use univariate GARCH model, and for measures time series in time–frequency domain we use wavelet coherence. The results and discussion are reported in sections four, with the focus on nonstable correlation between returns of analogous money market instruments in the EU and US, except in case of the same external shocks as global financial crisis. Section five concludes.
Section snippets
Literature review
The issue of intercorrelation and co-movement among world financial markets received much attention in the recent finance literature. Understanding the sources of international financial markets linkages is important for diversifying internationally, pricing securities, and making asset allocation decisions. A large body of research examined the connection between international equity markets through analysing the dynamics of stock market indices employing a broad variety of methodologies.
Data and methodology
In the research we analyse returns and volatility of the EU and US money market instruments from 2004 to 2018. The research questions concerning the correlation between US and EU government bond yields and interbank rates in different time periods are addressed with the statistic, correlation and wavelet coherence analysis. We also apply the econometric analysis and estimate univariate GARCH models to study the historical dynamics of rates and bond returns and periods of extremely high
Empirical results and discussion
Calculated statistical indicators for the US and EU series are presented in Table 1, Table 2.
For the US series we observe that distributions of bond returns and interbank rates are generally in line with the common rule of the financial market theory that assumes longer instruments have higher returns because of their exposure to higher risks in the future (Andersen & Hansen, 2006). However, there is still a contradiction between types of assets. For example, the mean return of 1-month LIBOR
Conclusion and implications
Firstly, our analysis demonstrates that correlation between returns of analogous money market instruments in the EU and US is not stable over time and there is not clear upward or downward trend. We found that correlation rises in periods when countries are exposed to the same external shocks as global financial crisis. In other years low or even negative correlation is explained by diverge monetary cycles, because monetary policy actions has direct influence on the bond returns and interbank
Data availability statement
The data that support the findings of this study are available from the corresponding author Darko B. Vukovic, PhD, Professor, upon reasonable request.
Declaration of Competing Interest
The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.
References (56)
- et al.
Financial connectedness of BRICS and global sovereign bond markets
Emerging Markets Review
(2018) - et al.
Co-movement of oil and stock prices in the GCC region: A wavelet analysis
The Quarterly Review of Economics and Finance
(2012) - et al.
Expected returns, risk and the integration of international bond markets
Journal of International Money and Finance
(2004) The contagion effect in European sovereign debt markets: A regime-switching vine copula approach
International Review of Financial Analysis
(2018)General autoregressive conditional heteroskedasticity
Journal of Econometrics
(1986)- et al.
What can wavelets unveil about the vulnerabilities of monetary integration? A tale of Eurozone stock markets
Economic Modelling
(2016) - et al.
Better to give than to receive: Predictive Directional measurement of volatility spillovers
International Journal of Forecasting
(2012) - et al.
A nonparametric test of serial independence for time series and residuals
Journal of Multivariate Analysis
(2001) - et al.
Evolution of international stock and bond market integration: Influence of the European monetary union
Journal of Banking and Finance
(2006) - et al.
Dynamics of international integration of government securities’ markets
Journal of Banking & Finance
(2011)