Undergraduate Honors Theses

Thesis Defended

Spring 2016

Document Type

Thesis

Type of Thesis

Departmental Honors

Department

Economics

First Advisor

Robert McNown

Second Advisor

Martin Boileau

Third Advisor

Tony Cookson

Fourth Advisor

Michael Stutzer

Abstract

This paper implements a VAR-EGARCH model (Nelson, 1991; Koutmos, 1996) to explore the linkage between both the returns and volatility transmissions between the U.S. stock market, the world gold market, and the Chinese stock market over the period from January 15, 1996, through August 31, 2015. The exponential component of the model allows us to capture significant asymmetric effects across financial markets and confirms the necessity of a VAR-EGARCH model over a VAR-GARCH model. Also, we find that reciprocal volatility transmission existed between the U.S. stock market and the Chinese stock market over the period, while the transmissions from the U.S. stock market to the Chinese stock market are more significant. Moreover, the past U.S. stock market returns can be used to predict current returns of the Chinese stock market and the world gold market. This suggests the predominant status of the U.S. stock market in the world. This paper further analyzes the model's results by comparing dynamic hedging to portfolio diversification strategy. We show that diversification is far more effective in reducing risks than the dynamic hedging strategy. Moreover, the results of portfolio diversification suggest that passive investors should hold an equal weight portfolio that contain indices or commodities from these three markets, while active investors should re-balance their minimum variance line portfolio and hold more gold future contracts.

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