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Stock Price Dynamics in Overlapped Market

Segments: Intra and Inter-Industry Contagion Effects

Article  in  Journal of Business Finance & Accounting · December 2006

DOI: 10.1111/j.1468-5957.1994.tb00364.x

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 Joumal of Business Finance & Accounting, 21(7), October 1994, 0306-686X

STOCK PRICE DYNAMICS IN OVERLAPPED

MARKET SEGMENTS: INTRA AND INTER-
INDUSTRY CONTAGION EFFECTS
KASIM ALLI, SAMANTHA THAPA AND KENNETH YUNG*

INTRODUCTION

The worldwide stock market crash of 1987 has indicated the need for a better
understanding of the transmission mechanism of stock price formation. To meet
this need, a number of recent studies have conducted in-depth analysis of the
interdependence of stock prices, prices' volatility and its transmission across
nationad stock markets (see, for example. King and Wadhwani, 1990; Hamao,
Masulis and Ng, 1990; and Harvey and Huang, 1991). The generzil conclusion
of these studies is that there is a significant volatility spillover across national
stock markets with some delay in the adjustment process. That is, information
in one market is transmitted to other markets and affects the stock price
formation in these markets. The phenomenon is generally known as the
contagion effect.
The setting for most of these studies has been national or non overlapping
stock markets. To date, however, there does not exist an in-depth analysis of
the transmission mechanism of stock price formation of industrial firms within
a particular national market. The major exception in the literature is the study
on contagion effect of a bank failure. However, it has been argued that contagion
effects among financial institutions can be driven by the psychological panic
among depositors rather than by information in the stock market (Jacklin and
Bhattacharya, 1988). Hence, there is a need to further examine the transmission
process of stock price formation, namely, contagion effect, among industrial
firms within a nationad market. In this study, we provide such an analysis of
the stock price dynamics in overlapped market segments. Specifically, we
examine the stock price dynamics for the oil and oil-related industry in the US.
The choice of oil and oil-related industries (i.e.. Crude petroleum refining
and extraction industry, the oil and gas field services industry, and the gas
production and distribution industry) for our analysis stems from the con-
sideration that these industries represent an ideal setting for this kind of study
because they are highly interrelated and are affected by more or less the same

'The authors are respectively from Clark Atlanta University School of Business, Atlanta, GA;
Western Kentucky University School of Business, Bowling Green; and Old Dominion University
and College of Business and Public Administration, Norfolk, VA. They wish to thank the anonymous
referees for their useful comments. (Paper received September 1992, revised and accepted January
1993)

© Basil Blackwell Ltd. 1994, 108 Cowley Road. Oxford OX* !JF, UK 1059
and 238 Main Street, Cambridge, MA 02142, USA.
1060 ALLI, THAPA AND YUNG

set of fundamental factors. Chen and Sanger (1977) recognize this and analyze
the impact of partial deregulation of natural gas prices upon the stock prices
of firms engaged in the production and distribution of natural gas as well as
severzd closely related industries.
This paper is organized as follows: the next section describes the data,
methodological issues are described in the third section, the fourth section
presents the results, and the final section concludes the paper.

DATA

The sample of oil and oil-related companies used in this study is obtained from
the 1989 Center for Research in Security Prices (CRSP) tapes. The sample
consists of all firms (141 firms) on the CRSP tapes with selected SIC codes
that have daily stock return data between December 1, 1987 and April 28,
1989. The SIC groups examined are: 2911, 2992, and 2999 — Petroleum
Refining and extraction (79 firms); 1311, 1321, 1381, 1382 and 1389 — Oil
and Gas field Service (31 firms); 4922 to 4925 — Gas Production and Distribu-
tion (31 firms). For convenience, the above groups are referred to as the oil,
oil-service and gas industry respectively.
The return time series generated from the above sample is divided into two
time periods as follows: December 1, 1987 to March 23, 1989, and March 24,
1989 to April 28, 1989. The first period is used to model the return series while
the second period is used as a holdout sample. The data is partitioned on March
24, 1989, because of the occurrence on this date of a major oil spill (The Exxon
Valdez Incident) in the US. Hence, the holdout sample serves to evciluate if
there is any change in the stock price dynamics among the oil and oil-related
industries due to the Exxon Valdez event, as well as the robustness of the
model.'
For each group, value-weighted and equal-weighted time series of daily retum
are constructed. The inter-industry contagion effect is investigated using the
time series data of the three industries. In addition, three size based portfolios,
that is, large, medium, and small oil firms, are constructed from the oil industry
group in order to examine the intra-industry contagion effects within the oil
industry.

METHODOLOGY
The methodology chosen for this study is due to the recent empirical findings
about statistical properties of high frequency time series data. Several authors
have noted time varying volatility in stock return data and rejected a
homoskedastic error structure for condition3il distributions (for example, French,
Schwert, and Stambaugh, 1987; and Akgiray, 1989). This heteroskedasticity

© Basil Blackwell Ltd. 1994

 STOCK PRICE DYNAMICS OF CONTAGION EFFECTS 1061

has repercussions for time series modelling.

Stock exchange return data, like other financial price data, exhibits volatility
clustering as noted by BoUerslev et al. (1990) and Engle et al. (1990). Large
changes of either sign cluster together with intervening periods of relative
stability. This clustering could represent the arrived of information in clusters
or delays in the market adjustment process as traders try to gauge its content.
This is not an automatic negation of market efficiency. As noted by Engle et
al. (1990), if information arrives in clusters, asset returns or prices may exhibit
ARCH (Autoregressive Conditional Heteroskedasticity) behavior even when
markets are efficient. On the other hand, even if the market takes time to resolve
expectational differences, it is still informationally efficient in the sense of being
unbiased.
Another statistical property of stock return data that has a bearing on the
appropriateness of the modelling technique employed is the divergence of the
distribution from normal (e.g. Fama, 1965). The distribution of changes in
stock exchange returns has fatter tails than the normal distribution. This
leptokurtosis has been explained by some researchers by suggesting that the
data is generated from a fat tail distribution that is stationary over time.
Members of this distribution include the Paretian and the Student-i. Others
have suggested that the data comes from distributions that change over time.
A modeUing technique that particularly fits the distributional properties noted
above is the ARCH (Autoregressive Conditional Heteroskedastic) model. This
model allows the variance of returns to change over time. The variance in one
period can depend upon variables and disturbances from previous periods. Also
the conditional normality assumption in ARCH generates some degree of
unconditional excess kurtosis which, as BoUerslev et al. (1990) observe, make
ARCH models to partly account for the observed leptokurtosis in stock return
data. ARCH models have been used frequently to model stock return changes
by a number of researchers (for example, Akgiray, 1989; French et eil., 1987;
and Hamao et al., 1990, among others).
Engle's ARCH regression model is obtained by assuming that the mean of
yi (random variable) is given by x, (independent variables) which is a linear
combination of lagged endogenous and exogenous variables included in the
information set $(_, with /3 a vector of unknown parameters and h, the
variance of the errors.

A, = ao + 2 «,<?_! (1)
e, ^ y,- Xfi

BoUerslev (1986) extends the ARCH process to an ARCH-like process,

GARCH, by allowing for a more flexible lag structure in the equation of
conditional variance h,. However, as pointed out in Nelson (1991), conven-
tional ARCH and ARCH-like models impose the constraints that the coeffi-

© Basil Blackwell Ltd. 1994

1062 ALLI, THAPA AND YUNG

cients in the conditional variance equation be non-negative. This is inconsistent

with the evidence (Black, 1976) that stock returns are negatively correlated
with changes in returns volatility. Hence, in order to overcome the problems
caused by the non-negativity constraints imposed in conventional ARCH and
ARCH-like models, we followed Nelson (1991) and used the following
exponential-ARCH specification (model (2)).
y,\^,_i ~ N{Xfi,h,)
\n{h,) = ao + E,«,(e^,_^ + 7 [\z,_j\ - E\z,_j\]) (2)
where Zi_j is the standardized lagged residual ofj lags, ln(A() is the log of the
variance, and i stands for the ith industry among the oil, oil-service, and gas
industries. That is, for example, in model (2) the conditional variance equation
suggests that the volatility of returns of the oil industry is affected by its own
lagged residuals and the lagged residujils of the oil-service and the gas
industry. If the coefficient for the lagged residuals of the gas industry is
significant, then it is said that a contagion effect from the gas industry to the
oil industry exists in the return generating process of oil stocks. In this
exponential ARCH format, the term 7[|z,_^| — .E|z,_^|] represents a
magnitude effect found in conventional ARCH and ARCH-like models. For
example, if 7 > 0 and 0 = 0, the innovation in h, is then positive (negative)
when the magnitude of |Z(| is larger (smaller) than its expected value. If 7 =
0 and G < 0, then the innovation in conditional variance is now positive
(negative) when the standardized residucils (returns innovations) are negative
(positive). A priori, given the findings of Black (1976), we expect the 0 to be
negative. On the other hand, we expect the sign of 7 to be positive. Because
of the weU documented Monday effect on stock returns, we also tested the model
with and without a (0,1) dummy variable in the conditional mean and condi-
tional variance equations for the negative Monday effect. Model (2) is tested
using both the equal and value-weighted returns series.

EMPIRICAL RESULTS

The Data and its Distributional Properties

We first show that the returns distribution of the returns series of the oil and
oil-related industry's common stocks is non-normal and leptokurtic. Table 1
reports the results for the value-weighted return series (December 1,
1987 —March 23, 1989) and provides various descriptive statistics for the
samples.*
As shown in Table 1, the null hypothesis of normality is rejected at the one
percent level using Kolgomorov Z)-statistics. Further evidence on the nature
of deviation from normality is indicated in the sample skewness and kurtosis
measures. While skewness is relatively mild, the excess kurtosis is large with

© Basil Blackwell Ltd. 1994

 STOCK PRICE DYNAMICS OF CONTAGION EFFECTS 1063

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© Basil Blackwell Ltd. 1994

1064 ALLI, THAPA AND YUNG
all the returns series. This indicates that much of the non-normality is due to
leptokurtosis. Hence, a model with ARCH specification would be appropriate.
Additional justification for the use of an ARCH model is also provided in
the results of the Engle test on the residuals reported in Table 1. Engle's test
is a Lagrange multiplier test used to test for the presence of ARCH effect against
the null hypothesis of constant conditional variance. The Lagrange Multiplier
test statistics is computed as TR^, where 7^ denotes the sample size and R^
is the coefficient of determination from the regression of squared residuals on
the past squared residuals. Results in Table 1 show that the null hypothesis
is rejected at the five percent significance level with 10 lags. Results on other
lags are similar, and therefore not reported. Hence, the existence of a leptokurtic
distribution and a changing conditional variance provides justification for our
use of an ARCH model.
Results of the middle and lower panels of Table 1 also shows the presence
of strong heteroskedasticity in the returns series. For the raw returns data, the
Box-Pierce (^-statistic shows that the returns series of the gas industry and the
small-sized oil firms have insignificant autocorrelation. When the Box-Pierce
Q-test is performed on the squared raw returns, all returns series display
substantially higher autocorrelations. As suggested by Hsieh (1989), this is
evidence of the presence of strong conditional heteroskedasticity. The results
for the equally weighted return series are similar to those in Table 1 and hence
are not reported.

Evidence of Contagion Effects

Tables 2 and 3 report the test results of contagion effects among the oil, oil
service, and gas industries using the value-weighted returns series. (Results
for the equal weighted returns are similar and therefore not reported.) In these
tables, the subscripts 0, R and G stand for the oil industry, the oil-service
industry, and the gas industry respectively. In addition, the subscripts OL,
OM and OS stand for the large oil firms, medium sized oil firms, and small
oil firms of the oil industry. For all the model estimations, we have chosen
lag 1 (i.e. Z,_i) as the appropriate lag for the standardized lagged residuals
by inspecting the autocorrelation and partial autocorrelation functions. Evidence
for the adequacy of our model is further provided by the substantially reduced
skewness and kurtosis of the standardized residuals (described later). BoUerslev
(1986) and Akgiray (1989) have shown that a parsimonious ARCH/ARCH-
like model with 1 lag in the residuals describes financial time series data
adequately.
For examining the inter-industry contagion effect, the regression results of
the conditional variance equations of the exponential ARCH model (2) are
reported in Table 2. All the parameters are found by using maximum likelihood
estimations. Because we want to examine the inter industry contagion effect
only, the analysis is performed using the oil industry as a whole, the oil-service

© Basil Blackwell Ltd. 1994

 STOCK PRICE DYNAMICS OF CONTAGION EFFECTS 1065

Table 2
Estimation of Volatility Spillover Effects Among the Value-Weighted
Return Series of the Oil, Oil Service, and Gas Industries Between
December 1, 1987 and March 23, 1989
(Inter-Industry Contagion Effect Using an Exponential ARCH Model)

Oil Oil-Service Gas

Intercept -8.5597 -8.4981 -8.4980

(-369.98)* (-366.62)' (-336.61)*
Oo 0.0116 0.0158 0.0154
(0.21) (0.29) (0.30)
Jo 0.081 0.08558 0.08568
(1.25) (1.32) (1.31)
0.0064 0.0138 0.0139
(0.14) (0.30) (0.31)
JR (0.138) 0.1401 0.1400
(2.41)" (2.43)" (2.43)"
6c 0.0017 -0.0054 -0.0054
(0.04) (-0.12) (-0.13)
7c -0.036 -0.0371 -0.0371
(-0.68) (-0.69) (-0.69)
D 0.012 0.0105 0.0104
(0.22) (0.19) (0.19)
LR 88.72 98.43 136.45
Skewness -0.23 0.12 -0.10
(normalized residuals)
Kurtosis 1.01 0.78 1.35
(normalized residuals)
BP(12) 22.69 17.25 21.01
Notes:
* Significant at the 1 percent level.
*'Significant at the 5 percent level.

industry, and the gas industry. Since the results are estimated simultaneously,
the source of influence among the price dynamics can be readily observed. As
can be seen from the results, only the coefficient of 7 ^ is significant in all
situations. As stated earlier, the coefficient 7 measures the magnitude effect.
That is, the conditional variance of the stock returns is positively related to
the difference between the absolute value of the lagged residuals and their
expected value [\z,_j\—E\z,_j\]. A significant j ^ for all the three returns
series means that the variance of the returns of the oil industry, the oil-service
industry, and the gas industry is conditional on the magnitude (larger or smaller
than expected) of the lagged residuals of the oil-service industry.
In other words, a larger (smaller) than expected absolute price movement
in common stocks of the oil-service industry occurs before the volatility changes
in the stock returns of the three industries. To explain this, we examine the

© Basil Blackwell Ltd. 1994

1066 ALLI, THAPA AND YUNG

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 STOCK PRICE DYNAMICS OF CONTAGION EFFECTS 1067
firms included in the oil-service industry sample and find that they are mainly
engaged in servicing oil and gas wells and providing other exploratory services.
One possible reason for the contagion effect to have come from the oil-service
industry is that these oil-service firms are usually the first to be involved in
the chain of the production cycle, hence, any surprise in the stock price of the
oil-service industry gets transmitted to the other related industry sectors
immediately. In addition, the 0 and the 7 have the anticipated negative and
positive signs in general, though none is significant except the 7^. The only
other coefficient that is significant is the intercept for all the three industries.
This indicates that a large amount of information has not been accounted for
in these joint estimations. However, the significant log-likelihood ratios (see
Nelson, 1991, for details of estimation) reject the null that the returns are
normally distributed and simultaneously favor the specification of our model.
The insignificant Box-Pierce test statistic of the normalized residuads up to lag
12, BP(12), also supports the adequacy of the model. Moreover, the very small
kurtosis of the normalized residuals shows that heteroskedasticity has been
substantially removed from the data. Finally, the insignificant dummy, D, shows
that the negative Monday effect does not play an important role in the model.
Table 3 presents test results of inter and intra-industry contagion effects using
the exponential ARCH model (2). In this table, the oil industry is replaced
by its three sized based portfolios (large, medium and small) formed from the
firms of the oil industry. The results in Table 3 show that the coefficients of
lou loS' and fa are positive and significant. That is, after firms in the oil
industry are divided into large, medium, and small, volatility spillover from
large and small oil firms is observed. In sum, the results indicate that larger
(smaller) than expected absolute price movements in common stocks of large
oil firms, small oil firms, and the oil-service industry will cause higher (lower)
volatility in the stock returns of other oil and oil-related companies.
It is conceivable that surprises in the stock price of large oil firms and oil-
service companies would affect the volatility of the returns of others, however,
it is interesting to see that small oil firms also exert influence on the share price
of other firms on an intra-industry and inter-industry basis. One possible reason
is that the small oil firms are more easily affected by changes in the economic
fundamentals affecting the oil industry, hence any change in the share price
of small oil firms will transmit significant information content to other firms
in the oil and oil-related industries. Again, while the intercepts are significant,
the significant log likelihood ratios and the insignificant Box-Pierce test statistic
of the normalized residuals, BP(12), suggests the adequacy of the model.

The Holdout Sample Period

To evaluate the performance of the exponential ARCH model developed, the

model is applied to a holdout sample with time series data over a 30-day period
immediately following the Exxon Valdez oil spill. Following Akigray (1989),

© Basil Blackwell Ltd. 1994

1068 ALLI, THAPA AND YUNG

Table 4

Forecasts of Daily Variance of Returns on Value-Weighted Return Series

of the Oil, Oil-Serive and Gas Industries Between March 27, 1989 and
April 28th, 1989

Oil- Oil- Oil- Oil-

MSE Oil Service Gas Large Medium Small
Hist. Est. 0 .000352 0 .000421 0 .000373 0 .000714 0.000564 0 .000488
ARCH Est. 0 .000107 0 .000068 0 .000095 0 .000133 0.000089 0.000114
Notes:
MSE = m
Error (£,) forecast —actual.

the forecast errors using the developed exponential ARCH model are compared
to those using the historical average estimation. As can be seen in Table 4,
the mean square error (MSE) using the exponential ARCH is consistently
smaller than those using the historical average estimation method. The result
suggests that the exponential-ARCH specification is rather robust.^ It also
implies that the Exxon Valdez Incident has no significant impact on the stock
price dynamics among the oil and oil-related industries.

CONCLUSION
The worldwide stock markets crash of 1987 has indicated the need for a better
understanding of the transmission mechanism of stock price formation. This
study expands the knowledge on this subject studying the contagion effects
among common stock returns of industrial firms in overlapping markets rather
than the non-overlapping or partially overlapping stock exchanges across nations
using an exponential ARCH model. Specifically, the stock price dynamics
among the oil and oil-related industries of the US are examined to see how
stock price movements in one industry affect those of the related industries.
The results suggest that when the amount of price innovations is larger than
the expected amount, price volatility in returns will be affected. The results
further show that this influence comes from the oil-service industry and spreads
to the oil industry and the gas industry. That is, inter-industry contagion effects
do exist.
In addition when the firms of the oil industry are grouped into three size
categories: large, medium and small the results indicate that the source of
contagion is from the large and the small oil firms. The influence of their price
innovations spread to medium-size oil firms, the oil-service industry and the
gas industry. That is, the inter-industry and intra-industry contagion effects
exist simultaneously.

© Basil Blackwell Ltd. 1994

 STOCK PRICE DYNAMICS OF CONTAGION EFFECTS 1069

NOTES

The Exxoii Valdez oil spill occurred on March 24, 1989. Since the spill can be said to be totally
unanticipated, information contamination is likely to be very minor. In addition, because of
the significant size of the oil spill, it may be possible that this event has an effect on the return
dynamics of related industries. If the model remains robust for the post-Exxon Valdez holdout
sample period, it implies that the event has no significant impact on the stock price dynamics.
Please see Nelson (1991) for details on the deficiencies of conventional ARCH and ARCH-
like models due to the non-negativity constraint.
Using the oil industry as an illustration, the equation would be as follows:

(2)

where subscripts 0, R and G stand for the oil industry, the oil-service industry, and the gas
industry respectively.
There is one equation for each industry and the entire model is estimated simultaneously
using meiximum likelihood estimation.
Throughout the paper, analyses of the equal-weighted return series show qualitatively similar
results and are therefore not reported.
Analyses have also been performed by expanding the original time series to include the 30
days in the holdout sample period, results obtained are similar to those reported without the
holdout sample period.

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and Forecast', Journal of Business, Vol. 62 Qanuary 1989), pp. 55—80.
Barclay, M., R. Litzenberger and J.B. Warner (1990), 'Private Information, Trading Volume,
and Stock-Return Variances', Review of Financial Studies, Vol. 3 (1990), pp. 233-253.
Black, F. (1967), 'Studiesof Stock Market Volatility Changes', Proceedings for the American Statistical
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Bollerslev, T. (1986), 'Generalized Autoregressive Conditional Heteroscedasticity', Journal of
Econometrics, Vol. 31 (1986), pp. 307-327.
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_, R. Chou, N. Jayaraman and K. Kroner (1990), 'Arch Modeling in Finance: A Selective
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of Natural Gas Deregulation', Financial Review, Vol. 20 (1977), pp. 36-54.
Engle, R. (1982), 'Autoregressive Conditional Heteroscedasticity with Estimates of the Variance
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and D. Kraft (1986), 'Multiperiod Forecast Error Variances of Inflation Estimated from
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_, T. Ito and W.L. Lin (1990), 'Metro Showers or Heat Waves? Heteroskedastic Intra-
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1070 ALLI, THAPA AND YUNG

Harvey, C.R. and R.D. Huang (1991), 'Volatility in the Foreign Futures Market', Review of Financial
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© Basil Blackwell Ltd. 1994

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