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206 JOURNAL OF ECONOMICS AND FINANCE * Volume 25 * Number 2 9 Summer 2001

Asymmetric Volatility Spillover in the

Tokyo Stock Exchange
M a r i o G. R e y e s "


This paper examines volatility transfers between size-

based stock indexes from the Tokyo Stock Exchange. We use
a bivariate EGARCH model to test for volatility spillover
effects between large- and small-cap stock indexes. We find
an asymmetric volatility spillover from large-cap stock returns
to small-cap returns, but not vice versa. We also find a small-
firm January effect, but not a June seasonality, in either large-
and small-cap stock returns. Instead, we find that the
conditional correlation between large- and small-cap indexes
is time-varying, showing a tendency to increase during the
month of June. (JEL GI2, G15)


Several studies have documented the temporal dynamics between large- and small-cap stock
returns. Lo and MacKinlay (1990) report that price changes in large stocks tend to lead those of
small stocks, but small stocks do not lead large stocks. These results are supported by McQueen,
Pinegar, and Thorley (1996), who find asymmetry in the cross-autocorrelation of size-based
portfolios of U.S. stocks. Ross (1989) shows that volatility is directly linked to the rate of
information flow, and that information may be reflected in the returns of large firms first and then
small firms after a lag. Thus, the rate of information flow may be asymmetric between large and
small firms.
Conrad, Gultekin, and Kaul (1991) (CGK hereafter) investigate the transmission of
information between large and small U.S. stocks by analyzing the temporal relationship between
the volatility of size-based portfolios. Using a multivariate GARCH model, they find an
asymmetric effect in both price and volatility. More specifically, they find that both mean and
volatility shocks for large firms are transmitted to smaller firms, but not vice versa.
Our study seeks to extend the price and volatility spillover analysis between large and small
stocks to the stock market of Japan. Many studies have examined information Iransfers between
Japan and neighboring Asian-Pacific markets (Liu, Pan, and Shieh 1998; Liu and Pan 1997);
however, to the best of our knowledge, volatility spillover effects within the Japanese stock
market have not yet been reported in the literature. Yet such a study is intriguing because it

9 Mario G. Reyes, College of Business and Economics, University of Idaho, Moscow, ID 83844-3178,
J O U R N A L O F E C O N O M I C S A N D F I N A N C E * Volume 25 9 N u m b e r 2 9 S u m m e r 2001 207

provides some insights into information transmission, volatility estimation, and the pricing of
Japanese stocks. By confining our analysis to the stock market of Japan, we hold constant
important microstructure issues that may complicate inter-country volatility spillover analysis.
Our study differs from the multivariate GARCH methodology employed by CGK in that we
use a bivariate Exponential GARCH (EGARCH) model of price and volatility transfers.
EGARCH has several advantages over standard GARCH. First, the bivariate EGARCH model
allows the explicit testing of volatility spillover whereas testing within a multivariate GARCH
specification is complicated because additional restrictions on the variance must be imposed (see
Darbar and Deb 1997). Second, parameter restrictions are not necessary because EGARCH
models the log of the conditional variance, thereby guaranteeing that the variance will be positive.
Third, Kim and Kon (1994) show that EGARCH is the most appropriate model for stock indexes,
such as those used in our study. Finally, Engle and Ng (1993) report that asymmetric models such
as EGARCH provide the best forecasts of volatility.
The format of our paper is as follows. In the next section, we present our bivariate
autoregressive EGARCH model. Then, we discuss the empirical results. Our results reveal a
volatility spillover from large firms to small firms, but not vice versa. Our results also confirm a
small-firm January effect in stock returns similar to that documented by Kato and Schallheim
(1985), but we do not find abnormal returns during the month of June. The results reveal that the
correlation between large- and small-cap Japanese stocks is time varying, showing a tendency to
increase during the month of June.

Bivariate AR(1)-EGARCH(1,1)
Model Description

To study price and volatility spillovers on the Tokyo Stock Exchange, we employ a bivariate
EGARCH model. CGK note that a bivariate approach is more advantageous than the two-step
univariate technique because the simultaneous estimation involved in the former allows for the
utilization of the information in the entire variance-covariance matrix of the errors. As noted in the
introduction, EGARCH allows for an explicit testing of volatility spillover without imposing
additional restrictions.
Let rLt denote the monthly rate of return on the small-cap index, rzt denote the monthly rate
of return on the large-cap index, el, t represent the innovation term, (rE,a denote index i ' s
conditional variance, and a12.t denote the conditional covariance between small-cap and large-cap
returns. Then, the bivariate AR(1)-EGARCH(1,1) model may be written as follows:

r~,, =/3Lo +/~,:i,,-~ +/~L2r2,,-~ + el,~ (I)

rz, =/~zo + flzirl,t-n + f12,2r2,,-1+ez, (2)

,.2,.,: (3)

a~t = ex~O 'l-s 2 ]n(O'22,t_l)} (4)

s(z,,,) = Iz,,,-,I- e(Iz,,,-,I) + (5)

208 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 25 9 Number 2 9 Summer 2001

f ) = tz E(k,-ll) + ~2Z2,t-I (6)

Zl,t =ei,t[(Yl,t (7)

Z2,t = e2,t ItY2,t (8)

O'l~ t =Pl20"l,tO'2,t (9)

Equations (1) and (2) describe the monthly rate of return as a function of its own lagged return
and the lagged return of the other index. The coefficients fli, j s, i ~ j , capture the price spillover
effects between large- and small-cap stocks. A statistically significant ill.2 suggests a price
spillover from large-cap stocks to small-cap stocks, whereas a significant fl2,1 indicates a spillover
from small-cap to large-cap stocks. Bi-directional spillover exists if both coefficients are
statistically significant.
Equations (3) and (4) specify the conditional variance of each index as a function of its own
lagged standardized innovation (z,-,t) and the standardized innovation from the other index (zj,t).
Volatility spillover is present if the cti, j s, i ~ j , in equations (3) and (4) are significant. A
significant C~L2suggests a volatility spillover from large-cap stocks to small-cap stocks whereas a
significant a z l is indicative of a volatility spillover from small-cap to large-cap stocks. Since
volatility reflects the rate of information flow (Ross 1989), a statistically significant ai, j, i * j ,
suggests information transmission between indexes i andj.
The coefficient u in equations (5) and (6) captures the relationship between news and
volatility. Hamilton (1994, p. 668) notes that if -1< ~,~ < 0, then positive news increases volatility
less than negative news. If u < -1, then good news lowers volatility, whereas bad news increases
volatility) The coefficient 0~ in equations (3) and (4) represents volatility persistence. A high value
suggests that an information shock tends to persist for some time into the future. 2
The model described by the system of equations (1)-(9) has been employed by Koutmos
(1996) and Booth et al. (1997) in their analyses of the interdependence of foreign equity markets.
Unlike Koutmos or Booth et al., however, we model the conditional correlation to be time
varying) More specifically, we allow the conditional correlation to vary depending upon the
month of the year as follows:

Pl2 = Cl2 + d JANJ A N + d Jtme J U N E (10)

where JAN is an indicator variable taking on the value of 1 for the month of January and 0
otherwise, and JUNE is a second indicator variable taking on the value of 1 for the month of June
and 0 otherwise. Doing so allows us to investigate whether the correlation between large- and
small-cap stocks varies depending upon the month of year. We choose to add January and June
dummy variables in the conditional returns and the conditional correlation equations in light of the
January and June seasonality in Japanese stock returns reported by Kato and Schallheim (1985).

We would like to thank an anonymous referee for clarifying this point.

2 Persistence is often assessed using the half-life of an information shock. Half-life is calculated as ln(0.5)/ln(0), and is
a measure of the length of time it takes a shock to decay to one half.
3Longin and Solnik (1995) report that the correlations between equity stock market returns are time varying.
JOURNAL OF ECONOMICS AND FINANCE 9 Volume 25 9 Number 2 9 Summer 2001 209

D a t a D e s c r i p t i o n a n d P r e l i m i n a r y Statistics

The data examined in this study consist of continuously compounded monthly rates of return
over the period starting on January 1970 and ending on March 1996. We examine the
interdependence between two stock indexes from the Tokyo Stock Exchange (TSE), namely: (1)
Japanese Large Companies Index (JLG), which consists of the larger half of the First Section,
TSE, and (2) Japanese Smaller Companies Index (JSM), which consists of the smaller half of the
First Section, TSE. 4 From April 1986 to March 1996, the monthly returns for the JLG are the
returns on the Morgan Stanley Capital International Index for Japan, and the monthly returns for
the JSM are returns on the Dimensional Funds Advisors (DFA) Japanese Small Company
Portfolio. Although the DFA UK Small Companies Fund is constructed as a mimicking portfolio,
the DFA does not try to mimic exactly the JSM because of trading costs associated with
rebalancing the fund portfolio. 5


Small-Cap (JSM) Index Larse-Ca p (JLG) Index
Mean 0.013 0.010
Variance 0.003 0.003
Skewness -0.218 -0.162
(0.116) (0.242)
Kurtosis 2.256 1.450
(0.000) (0.000)
First-Order Autocorrelation 0.063 0.031
Ljung-Box Q(12) 17.165 6.178
(0.103) (0.861)
Ljung-Box Q2(I 2) 107.916 33.776
(0.000) (0.000)

Notes: p-valuesare inside the parentheses.

Descriptive statistics of the continuously compounded rates of returns on the two indexes are
reported in Table 1. During the sample period examined, the JSM index earned an average return
of 1.3 percent per month versus the 1 percent average return for the JLG index, although the
difference in the variance of returns between the two indexes is very small. The skewness and
excess kurtosis for both size-based indexes suggest that the return distributions are not normal.
Moreover, the Ljung-Box Q2(12) statistics indicate that the returns series exhibit linear
dependence and strong ARCH effects; thus, our EGARCH specification described above is

4We would like to thank the DimensionalFund Advisorsfor providingthe returns data.
5See Fama [1992] for an explanationof the characteristicsof the DFA mimickingpassivemutual funds.
210 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 25 9 Number 2 9 Summer 2001

Empirical Results

Diagnostic Checks

Estimation of the system of equations (1)-(10) is accomplished using the BHI-IH algorithm. 6 The
results are reported in Tables 2 and 3. We begin with Table 2, where we report several diagnostic
checks on the standardized residuals from the bivariate AR(1)-EGARCH(1,1) model. More
specifically, we report two sets of diagnostics checks, namely, Ljung-Box and the Engle-Ng (1993)
asymmetry tests. None of the Ljung-Box Q(12) and Q2(12) statistics are significant at the 5 percent
level. These tests reveal no significant departure from the null hypothesis of temporal independence.
The Engle-Ng diagnostic tests check for misspecifications induced by asymmetric effects. All four
asymmetry test statistics suggested by Engle and Ng, namely, sign bias, negative size bias, positive
size bias, and joint test, are not significantly different from zero at the usual levels. Taken together,
these tests indicate that the bivariate AR( 1)-EGARCH(1,1) model fits the data very well.


Small-Cap Index Large-Cap Index

Panel A: Descriptive Statistics

Skewness -0.385 -0.087
(0.006) (0.531)
Kurtosis 0.389 1.349
(0.165) (0.000)
Bera-Jarque Test for 9.734 24.041
Normality (0.008) (0.000)
Ljung-Box Q(12) 13.436 5.948
(0.266) (0.877)
Ljung-Box Q2(12) 9.001 8.854
(0.622) (0.635)

Panel B: Engle-Ng Diagnostics

Sign Bias Test 0.421 0.035
(0.674) (0.972)
Negative Sign Bias Test -1.544 -1.567
(0.123) (0.118)
Positive Size Bias Tests 0.048 0.193
(0.961) (0.847)
Joint Test 1.644 0.957
(0.179) (0.413)

Notes: p-valuesare inside the parentheses.

6 We would like to thank Greg Koutmos for sharing the EGARCH program. We do not include the asymmetry
coefficient, I , in the conditional variance because univariate estimation finds these coefficients to be statistically
insignificant. By excluding the asymmea'ycoefficient,we reduce the complexityof the maximumlikelihood estimation,
JOURNAL OF ECONOMICS AND FINANCE 9 Volume 25 9 Number 2 9 Summer 2001 211

The level of kurtosis in the standardized residuals is lower than the kurtosis of the raw returns.
However, excess kurtosis for the JLG index and the skewness of JSM index are statistically
significant. These contributed to the rejection of the hypothesis of normality of the standardized
residuals using the Bera-Jarque test. Departures from normality imply that the standard errors
estimated from the bivariate AR(1)-EGARCH(I, 1) specification may be understated. To minimize
this error, we use a 5 percent level of significance throughout the study.

Spillover E f f e c t s

Table 3 presents the maximum likelihood estimates of the bivariate AR(I)-EGARCH(I,I)

model. Panel A of Table 3 shows a significant autoregressive coefficient for the JSM index, but
not for the JLG index. The first-order autocorrelation in JSM index returns may be attributed to
nonsynchronous trading that characterizes small stocks. Panel A shows that both fll,2 and flzl are
not statistically significant. This suggests there is no price spillover between JLG and JSM stock
indexes during the sample period January 1970 and March 1996.


Small-Cap (i= 1) Lar[~e-Cap (i=2)
Panel A: Price Spillover Parameters
fli, l (small-cap) 0.147 -0,038
(2.221)* (-0.559)
/Ji,2 (large-cap) -0.005 0.030
(-0.708) (0.364)

Panel B: Volatility Spillover Parameters

ai, l (small-cap) 0.045 -0.065
(0.644) (I.053)
O~i,2 (large-cap) 0.276 0.258
(3.708)* (3.104)*
0 (volatility persistence) 0.912 0.882
(33.450)* (18.539)*

Panel C: Seasonality Parameters in the Conditional Mean Returns

dja N (January seasonality) 0.041 0.015
(4.382)* (1.562)
dju~/E (June seasonality) 0.006 -0.006
(0.554) (-0.056)

Panel D: Parameters in the Conditional Correlation

Cl2 0.689
d y:tN 0.048
d~UNE 0.147
Notes: t-statistics in parenthesis. * indicates significance at the 0.05 level,
212 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 25 *Number2 *Summer2001

From Panel B of Table 3, we find that the coefficient r is statistically significant, but a2,1 is
not. This suggests a volatility spillover from the JLG index to JSM index. This result is consistent
with that reported by CGK, who report shocks to large-cap stocks spillover to the conditional
variance of small-cap stocks, but shocks to small-cap stocks have no impact on the conditional
variance of larger stocks. Thus, the asymmetric volatility phenomenon found in the U.S. stock
market is also present in the Tokyo Stock Exchange. This suggests that estimation of the volatility
of small Japanese stocks must account for the impact of shocks from large-capitalization Japanese
Panel B also reports the estimated persistence coefficients, 0 i. Both coefficients are
statistically significant at the one-percent level. The estimate of 0.912 for the JSM index is higher
than the estimated persistence coefficient of 0.882 for the JLG index. This translates into a half-
life7 of 7.5 months and 5.5 months, respectively, and suggests that volatility is more persistent in
small-caps than in large-cap stock indexes.

Seasonality Effects on Returns and Correlation

Finally, Panels C and D of Table 3 present the estimates of the coefficients on the January and
June dummy variables in the conditional mean return equations (1) and (2) and the conditional
correlation in equation (10), respectively. Both January and June coefficients for the JLG index are
not significantly different from zero. On the other hand, the January coefficient (djAN) for the JSM
stock index is statistically significant at the 1 percent level, but not the June coefficient (djvNe).
This provides additional empirical support for the hypothesis that the January effect is mainly a
small-firm effect. Unlike Kato and Schailheim (1985), we do not find a June effect in Japanese
stock returns)
Interestingly, we find a June effect in the conditional correlation (see equation 10) between
large-cap and small-cap stocks in the Tokyo Stock Exchange. From Panel D, we find that the
average conditional correlation between large- and small-cap stocks during the other 10 months of
the year is 0.689. We also find that the January coefficient, D jAN, is not significantly different from
zero. Table 4 also shows that the June coefficient (D~vNe) is 0.147 and is statistically significant at
the 1 percent level. This suggests that the conditional correlation between large- and small-cap
stocks increases to 0.836 during the month of June. The June effect in the conditional correlation
may be related to the June bonuses that are peculiar to the Japanese business society (Kato and
Schallheim 1985).

Summary and Conclusion

This study provides some insights into the transmission of stock price movements between
small-cap and large-cap stocks on the Tokyo Stock Exchange. The results reveal an asymmetric
transmission of volatility from the large firm index to the small firm index. This result is
consistent with the asymmetric volatility spillover reported by Conrad et al. (1991) for U.S.
stocks. One possible explanation for the results is a differential rate of information flow between
small and large firms as postulated by Ross (1989).
Our results reveals a January effect in small-firm stock returns only, but not a June effect in
either small-cap or large-cap stock returns. Interestingly, our results show that the correlation
between large- and small-cap stocks tends to vary, depending upon the month of the year,

As noted in footnote2, half-lifeis calculatedas ln(0.5)/In(~.

s Differences in the sample period and the returns data may explain the difference between our results and those
reportedby Katoand Schallheim(1985).
JOURNAL OF ECONOMICSAND FINANCE 9 Volume25 9 *Summer2001 213

especially during the month of June. Taken together, our study suggests that volatility studies of
Japanese stock returns must account for the observed asymmetric volatility transfers between
large- and small-capitalization stock returns. Moreover, asset allocation studies must take into
account the tendency of the correlation between large- and small-cap stocks to increase during the
month of June.


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