Abstract
In this article we take a recent generalized VAR-GARCH approach to examine the extent of volatility transmission between oil and stock markets in Europe and the United States at the sector-level. The empirical model is advantageous in that it typically allows simultaneous shock transmission in the conditional returns and volatilities. Insofar as volatility transmission across oil and stock sector markets is a crucial element for portfolio designs and risk management, we also analyze the optimal weights and hedge ratios for oil-stock portfolio holdings with respect to the results. Our findings point to the existence of significant volatility spillover between oil and sector stock returns. However, the spillover is usually unidirectional from oil markets to stock markets in Europe, but bidirectional in the United States. Our back-testing procedures, finally, suggest that taking the cross-market volatility spillovers estimated from the VAR-GARCH models often leads to diversification benefits and hedging effectiveness better than those of commonly used multivariate volatility models such as the CCC-GARCH of
Bollerslev (1990), the diagonal BEKK-GARCH of
Engle and Kroner (1995) and the DCC-GARCH of
Engle (2002).
► We study the volatility transmission between oil and sector stock markets. ► Optimal weights and hedge ratios for an oil-stock portfolio are also analyzed. ► Volatility spillover mechanism
Bollerslev (1990)s are not identical for European and the US markets. ► Oil risk exposures can be effectively hedged in portfolios of sector stocks. ► VAR-GARCH is the best model for portfolio designs and hedging effectiveness.