The predictive power of stock market's expectations volatility: A financial synchronization phenomenon

Abstract

We explore the use of implied volatility indices as a tool for estimate changes in the synchronization of stock markets. Specifically, we assess the implied stock market's volatility indices' predictive power on synchronizing global equity indices returns. We built the correlation network of 26 stock indices and implemented in-sample and out-of-sample tests to evaluate the predictive power of VIX, VSTOXX, and VXJ implied volatility indices. To measure markets' synchronization, we use the Minimum Spanning Tree length and the length of the Planar Maximally Filtered Graph. Our results indicate a high predictive power of all the volatility indices, both individually and together, though the VIX predominates over the evaluated options. We find that an increase in the markets' volatility expectations, captured by the implied volatility indices, is a good Granger predictor of an increase in the synchronization of returns in the following month. Estimating, monitoring, and predicting returns' synchronization is essential for investment decision-making, especially for diversification strategies and regulating financial systems.

Fig 1. VIX levels and time evolution.

Note: This figure depicts the time series evolution of the VIX between the years 2002–2019.

Fig 2. VIX autocorrelation graph.

Note: This figure depicts the autocorrelation graph for VIX levels with lags from 1 to 20.

Fig 3. Impulse response graphs.

Note: This figure depicts the impulse response exercise from a shock in VIX over the MSTLs of North-America (NAM), Europe (EUR), Asia-Oceania (ASIOC), All-shares (AS), Latin America (LAT), and America (AME, North and Latin America). This figure depicts the impulse response exercise from a shock in VSTOXX over the MSTLs of America (AME, North and Latin America), All-shares (AS), Asia-Oceania (ASIOC), Europe (EUR), Latin America (LAT), and North America (NAM). This figure depicts the impulse response exercise from a shock in VXJ over the MSTLs of America (AME, North and Latin America), All-shares (AS), Asia-Oceania (ASIOC), Europe (EUR), Latin America (LAT), and North America (North America).