Bond Volatility Transmissions Between United States and European Markets

Author(s)

Seth Kulman, University of Rhode IslandFollow

Major

Finance

Advisor

Dash, Gordon

Advisor Department

Finance and Insurance

Date

5-2011

Keywords

Neural Networks, Finance, Bond Market, WinORS

Abstract

Bond Volatility Transmissions Between United States and European Markets

Seth Kulman

Faculty Sponsor: Gordon Dash, Finance and Decision Sciences

Recent events have illustrated the degree of connection between the world’s economies. Economic events occurring in one country are felt in countless others, most vividly demonstrated by the onset of a worldwide recession following the financial collapse in the United States. Volatility no longer stays contained within one local economy.

The purpose of this study is to examine volatility spillovers between the United States and European bond markets. To identify volatility effects in a given country, we will be using a lag excess returns model representing an individual European country, given volatility spillovers from the broad based European government bond market, and that of the United States. This study will make use of a radial basis function (RBF) artificial neural network (ANN) to calculate correlations between the dependent and independent variables. The neural network essentially acts as an artificial brain, first learning the data set to identify a function that fits the bond volatility, then testing its proposed equation against the remaining data. After the equation is calculated, we observe the accuracy of the solution by examining various measures of error. We can then identify what factors most influence foreign bond volatility, and how substantial these effects are.

For example, to observe bond volatility spillovers in Germany, we set German excess returns as the dependent variable. We then used as independent variables one-period lag returns of Germany, the JP Morgan European bond index, and the Merrill Lynch U.S. government bond return index. We executed four tests with the neural network to identify the most precise function. The preliminary results suggest that the lag excess returns from the JP Morgan European bond index should be weighted three times as strongly as lag excess returns from Germany itself. The results also illustrate that United States’ returns play a rather insignificant role in transmitting volatility to Germany. These effects may be a result of Germany’s integral role in the European Union. Germany has the largest economy in Europe and is a strong advocate of the EU.

Volatility spillover effects for Germany, Spain, Sweden, and Slovenia will be explored and analyzed in this study. The results of this research will provide substantial insight into how individual economies interact in a global finacial system.