Research in International Business and Finance 52 (2020) 101169

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Research in International Business and Finance

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Full length Article

Investors’ risk perceptions in the US and global stock market

T
integration☆
Hardik A. Marfatia
Department of Economics, Northeastern Illinois University, 5500 N St Louis Ave, BBH 344G, Chicago, IL 60625, USA

ARTICLE INFO ABSTRACT

JEL classification: Investors’ risk perceptions have significant implications for international stock markets. This
C22 paper estimates the time-varying impact of the VIX index – a widely used measure of investors
E44 risk perceptions – on the dynamic correlation across international stock markets. Results show
G11 that risk perceptions significantly impact the dynamic correlation between the U.S. market and
G15
the leading stock markets of the world. Further, in 17 out of 20 international stock markets, risk
perceptions Granger cause dynamic correlations. The impact of VIX is positive on the correlation
Keywords:
of the U.S. market with European and Latin American markets. In contrast, the relationship of the
Global stock markets
Dynamic correlations U.S. market with all the Asian markets weakens (strengthens) as the VIX index rises (falls). In all
Risks and uncertainty cases, the time-varying parameter model shows that the impact of VIX on these correlations
Time-varying parameter model varies significantly across time.

1. Introduction

Synchronization of the global stock market with the U.S. and the factors that drive this synchronization greatly interests financial
market participants, macroeconomists, and policymakers. The recent financial crisis highlighted how uncertainty in the U.S. influ-
enced the movement in global stock markets. Since global markets have become highly integrated, this meant unprecedented and
coordinated actions by policymakers across the world. This study explores how international stock market returns and their dynamic
correlation with the U.S. market respond to investors’ perceptions of risk.
The anecdotal and formal evidence suggests that the global stock markets exhibit time-varying integration patterns (Bekaert and
Harvey, 1995), but with an overall trend of increased comovement over time (Carrieri et al., 2007; Pukthuanthong and Roll, 2009). In
related literature, evidence of herding is found among the advanced stock markets (except the U.S.) and the Asian markets, but not
with Latin American markets (Chiang and Zheng, 2010). Based on basic portfolio management theory, this implies that the scope for
diversification of risk by investing across different countries is declining. The forces that drive the integration and herding process
include the bull and bear states of the financial markets (Yang et al., 2003; Demirer and Kutan, 2006; Chiang and Zheng, 2010) and
big macroeconomic events like the financial crisis or the information technology bubble (Brooks and Del Negro, 2004; Kim et al.,
2005; Dajcman et al., 2012). The evidence thus implies that the extent of market integration is non-constant and transitory.
In this paper, I argue that it is the investors’ perceptions of risk which drive the degree and nature of integration in global stock
markets. An indirect support for this argument is the superior power of the implied volatility (VIX) index, one of the principal

☆
There are no funds or grants to report. I acknowledge valuable inputs from the editor and anonymous referee(s).
E-mail address: h-marfatia@neiu.edu.

https://doi.org/10.1016/j.ribaf.2019.101169
Received 1 February 2019; Received in revised form 7 December 2019; Accepted 18 December 2019
Available online 07 January 2020
0275-5319/ © 2019 Elsevier B.V. All rights reserved.
H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

measures of investors risk perceptions, in explaining the U.S. stock market movements.1 This leads to two unanswered but important
and related questions. First, what is the degree and nature of the impact of investors risk perceptions on the global stock markets? If
the conditions in the U.S. market drive global returns and correlations, then it has major implications for international portfolio
management and economic policymaking, particularly during turbulent times. Second, given the large structural shifts in the global
markets, has the impact of risks on global market movements remained constant over time? Investigating this issue will provide
insights into the rationale for the transitory nature of the event's impact on the global stock market integration that is found in the
literature.
I use a holistic approach to model the role of U.S. financial market conditions in global markets. I first estimate the impact of the
VIX index on all the leading stock markets across the world by estimating a generalized autoregressive conditional heteroskedasticity
(GARCH) model.2 I estimate a multivariate GARCH model at the system level for three regions namely, Europe, Latin America, and
Asia-Pacific, with the U.S. market in each system. I estimate the impact of the VIX index on the dynamic correlation of the country's
stock market with the U.S. derived from the multivariate GARCH model. Since the global economy has seen large structural shifts, a
time-varying parameter model is estimated to assess the changing response of dynamic correlations to shifting perceptions of risk
among investors.
Evidence suggests that VIX has a statistically significant impact on the stock returns of the U.S. and leading markets across the
world. The impact of VIX on the U.S. market is consistent with the existing literature.3 However, I provide new findings that investors’
perceptions of risk drive the correlation between the U.S. and international stock markets. I further show that VIX Granger causes the
dynamic correlation of the U.S. with 17 out of 20 leading stock markets of the world.
Evidence also suggests that an increase (decrease) in VIX leads to a stronger (weaker) correlation of all the European and Latin
American stock markets with the U.S. market. In contrast, the correlation of all the Asia-Pacific markets with the U.S. responds negatively
to VIX. The time-varying parameter model shows that the impact of VIX on these correlations is not static. The time variation is particularly
pronounced in the case of Argentina, Austria, Belgium, Germany, the U.K., and most Asian markets, except Australia and Japan. These
findings provide useful insights for macroeconomic policymaking and in managing international portfolios.

2. Econometric methodology and data

The present study aims to understand the impact of investors’ risk perceptions on the global stock markets’ integration with the
United States. I use the VIX index to capture investors’ risk perceptions and study its impact within a univariate and a multivariate
systems GARCH model. The impact of VIX on the dynamic correlation obtained from the systems GARCH is estimated using a fixed-
coefficient and time-varying parameter approach. This modeling approach has several merits. First, it reveals the heterogeneous
response of global stock markets to the VIX index. This provides new evidence about the information content of VIX in explaining the
global stock market movements. Second, it allows me to take a holistic regional approach to model the dynamic correlation between
the U.S. and global stock markets. This is expected to provide superior estimates because it takes advantage of the hidden joint
dependence structure between the regional stock markets. Third, the strategy is flexible because it can explicitly estimate the time-
varying impact of risk perceptions on the dynamic correlation among global stock markets.

2.1. Baseline model: risk perceptions and global returns

One novelty of the paper is that it explicitly brings forth the role of investors’ risk perceptions in driving the global market returns
and their correlation. I estimate the response of world stock price returns to the VIX index. Since volatility of stock market returns
follows a clustering pattern, I specify a widely used GARCH model for each individual stock market.4 In particular, I estimate the
following benchmark GARCH (1,1) model:
Rt = 0 + 1 Rt 1 + VIXt + t where t |It N (0, 2
t ) (1)

t
2
= 0 + 2
1 t 1 + 2
2 t 1 (2)
where Rt represents the stock market returns of a country and VIXt captures the VIX index in period t . The parameter captures the
impact of investors’ risk perceptions on the individual stock market returns. Intuitively, the sign of is expected to be negative
implying that higher volatility lowers the stock market returns on average.

2.2. Time-varying model: risk perceptions and integration

To understand the sensitivity across time of the global stock market integration to the sentiments of risk among investors, I first
estimate a multivariate systems GARCH model. One of the advantages of this approach is that the covariance matrix is not constant

1
Superiority of the VIX index as a measure of investors risk perceptions and its ability to predict stock market movements is well-established in the
literature (Poon and Granger, 2003; Becker et al., 2006, 2007; Blair et al., 2010; Chung et al., 2011).
2
Stock market returns across the world largely exhibit volatility clustering. Hence, the most appropriate and widely used approach used to model
stock returns is through a GARCH process (Hamao et al., 1990; Longin and Solnik, 1995; Chiang and Doong, 2001; Beirne et al., 2010).
3
See, for example, Becker et al. (2006, 2007.
4
See, for example, Hamao et al. (1990), Longin and Solnik (1995), Chiang and Doong (2001), Beirne et al. (2010).

2
H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

over time. The following representation provides a natural extension of a univariate GARCH model as provided by Engle and Kroner
(1995), often known as the BEKK model5 :
Rt = c + t t N (0, Hit ) (3)
where c is the vector of constant, t is an n x 1 error vector, and Rt = [rit , ...,rnt ] is the vector of stock returns for n different markets in a
particular group/region. I separately consider the above system of equations for three different regional markets namely, Europe,
Latin America, and the Asia-Pacific region.6 In each system of equations, I include the stock market returns of the U.S. to extract the
dynamic correlation of the U.S. with every stock market in a particular region.
In Eq. (3), the error vector is t = Ht1/2 t , where Ht1/2 is a n × n positive definite matrix and t N (0, In) . The time-varying
conditional variance-covariance matrix Ht is then given by:
Ht = A + Bi t i t 1 Bi + Gi Ht 1 Gi (4)
where A , B , and G are each parameter matrix of dimension n × n . Matrix A is positive definite, whereas matrix Bi and Gi are diagonal
matrices. One the major advantage of this specification (BEKK) over other specifications (VECH, for example) is that positive-
definiteness is automatically ensured. Engle and Kroner (1995) discuss the merits of BEKK in detail. The conditional covariance
matrix in the multivariate GARCH model is estimated by the maximum likelihood method. Following this, I get the conditional
correlation as follows:
(h ij, t )
ij, t =
(h ii, t h jj, t ) (5)
where ij, t captures the time-varying conditional correlation and h ij, t are the elements of matrix H capturing the time-varying con-
ditional covariance.
Evidence in the literature suggests that the stock markets across the world have witnessed time-varying integration patterns
(Bekaert and Harvey, 1995; Carrieri et al., 2007; Pukthuanthong and Roll, 2009). In the present context, ij, t measures co-movement
of stock markets in the system across time. This measure is superior because it uses conditional information across different markets
present in the systems GARCH setup.
Given the central position of the U.S. financial markets, I study the dynamic correlation between the U.S. and leading stock
markets across the world. While the integration of the world stock markets with the U.S. potentially exhibits a time-varying pattern, it
is also important to understand the role of investors sentiments in driving these patterns. To study the sensitivity of these conditional
correlations to investors risk perceptions, I adopt both fixed and time-varying coefficient approaches. For the time-varying estimates,
I use a 60-month rolling window of the following regression equation:

ij, t = at + bt VIXt + ct ij, t 1 + vt (6)

where t is the conditional correlation from the multivariate GARCH model. The lagged value of the correlation is added as one of the
regressors given the basic setup of the multivariate GARCH model. In this equation, the coefficient of interest is bt . It measures the
extent to which changes in the investors’ sentiments impact the comovement of stock markets between the U.S. and other economies.
Notice that the coefficient bt has a time subscript denoting that the impact of sentiments on the comovement is not constant over time.
Naturally, the time subscript in bt coefficient is dropped in estimating the fixed coefficient model.
The coefficient bt can be positive or negative. It is likely that in more stressful times (rising VIX) the increased risks and un-
certainty in the global markets mean that the investors have little clarity about the future course of the economy. Consequently,
different stock markets across the world would follow the course of the U.S. stock market. This will result in a positive value of bt .
However, negative values of coefficient bt cannot be ruled out. For example, in less financially stressful times (falling VIX), the
increased risk appetite among international asset managers towards stock markets causes a stronger co-movement in stock market
returns across the world, particularly in the case of emerging markets.

2.3. Data

The sample period for this study spans from November 1992 to January 2017. The chosen sample period has the advantage of
capturing the effects of both the Asian crisis and the recent financial crisis. For all the countries, the stock price returns are expressed
as natural logarithmic difference and adjusted for dividends and stock splits.7 To measure investors risk perceptions, I use the level of
VIX index provided by the Chicago Board Options Exchange.8 Unlike other measures of volatility that are typically historical or

5
See Baba et al. (1990) for details.
6
The Europe (EU) group includes Austria (ATX), Belgium (BFX), France (CAC), Germany (DAX), Greece (ATH), Netherlands (AEX), Switzerland
(SSMI), UK (FTSE), and US (SNP); the Asia Pacific (Asia) group includes Australia (AORD), China (SSEC), Hong Kong (HSI), India (BSE), Indonesia
(JKSE), Japan (NIK), Korea (KOSP), Malaysia (KLSE), Singapore (STI), Taiwan (TWI), and US (SNP); and the Latin America (LA) group includes
Argentina (MERV), Brazil (BVSP), Mexico (MXX), and US (SNP).
7
The entire data set of closing stock price indices is sourced from the yahoo finance website.
8
I use the level of VIX index following the widely used approach in the literature that examines the impact of investors’ risk perceptions as
measured by the VIX index (Blair et al., 2010; Antonakakis et al., 2013; Bekaert and Hoerova, 2014; Marfatia, 2014, 2015; Liu and Zhang, 2015;
Choi, 2018; Adrangi et al., 2019; Sarwar and Khan, 2019; Smales, 2019, among others).

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

Table 1
Summary statistics.
Country Code Mean Median Max Min S.D. Obs

Europe and U.S.

Austria ATX 0.014 0.044 0.679 1.417 0.293 292
Belgium BFX 0.014 0.037 0.676 1.047 0.239 292
France CAC 0.006 0.046 0.628 0.821 0.269 292
Germany DAX 0.024 0.058 0.969 1.325 0.298 292
Netherlands AEX 0.011 0.026 0.643 1.037 0.275 292
Switzerland SSMI 0.015 0.049 0.540 0.970 0.230 292
U.K. FTSE 0.009 0.037 0.430 0.636 0.200 292
Canada TSE 0.018 0.044 0.691 0.920 0.211 292
USA SNP 0.028 0.054 0.459 0.807 0.207 292
USA VIX 19.66 17.690 62.640 10.820 7.567 325
Latin America
Argentina MERV 0.065 0.078 2.638 2.481 0.550 245
Brazil BVSP 0.047 0.077 1.039 2.440 0.442 245
Mexico MEX 0.050 0.081 0.778 1.678 0.328 245
Asia-Pacific
Australia AORD 0.015 0.031 1.403 0.900 0.237 236
China SSEC 0.049 0.042 3.410 1.558 0.476 236
Hong Kong HSI 0.002 0.042 1.732 2.436 0.439 236
India BSE 0.015 0.056 1.441 1.485 0.406 236
Indonesia JKSE 0.009 0.095 1.118 5.921 0.584 236
Japan NIK 0.001 0.013 0.846 1.109 0.330 236
Korea KOSP 0.038 0.020 3.847 2.438 0.523 236
Malaysia KLSE 0.015 0.020 1.500 2.107 0.365 236
Singapore STI 0.021 0.021 1.399 2.288 0.395 236
Taiwan TWI 0.002 0.012 2.120 1.350 0.393 236

The table provides summary statistics of the major stock market returns across the world.

statistical, the VIX index is a forward-looking measure of implied volatility. It is a weighted measure of the implied volatility on a
range of options (call and put) based on the S&P 500 index. The VIX index - popularly known as the investors fear gauge - is the
investors best prediction of near-term market volatility or risk. In times of financial stress, the VIX index rises, whereas it falls as
investors sentiments become complacent. The superior information content of the VIX index as one of the principal measures of
investors risk perceptions is well-established in the literature (Poon and Granger, 2003; Becker et al., 2006, 2007; Blair et al., 2010;
Chung et al., 2011).
Table 1 summarizes the global stock market behavior. The descriptive statistics reveal some interesting preliminary facts. The
average stock market returns of every country are positive, except for Japan, Malaysia, and Singapore. On average, the stock market
return in the three Latin American markets is higher than the average returns in other parts of the world. The mean return in
Argentina, Brazil, and Mexico is around 5%, as compared to the average of 1% in the Asia-Pacific region. Despite the effects of the
recent financial crisis, the average stock return in the advanced economies (Europe and the U.S.) is higher (1.6%) than in the
emerging economies. This is explained by the large swings in the stock market of the Asia-Pacific region. The standard deviation in
the Asian markets is higher than the markets of advanced economies. This is interesting because conventional financial wisdom of
high risk-high return does not hold for the Asia-Pacific region.

3. Empirical results

3.1. Risk perceptions and global returns

3.1.1. Static correlations

Table 2 presents the correlation between stock market returns of all the major stock markets of the world along with its corre-
lation with the VIX index. Results suggest that stock returns in every market are positively correlated with every other market in the
world. The correlation of the U.S. market with the U.K. is 0.78, whereas its correlation with Taiwan and Mexico is 0.45 and 0.61,
respectively. Basic portfolio management theory suggests that the gains from diversification are largest when there is a negative
correlation between assets with different risk profiles (that is across countries).
A positive correlation in the stock markets across the world suggests that the gains from diversification are limited, though not
eliminated. Take, for instance, a rather weak correlation of 0.14 between the U.S. and China, or the correlation between India and
China, which is 0.06. There is also an instance of a negative correlation (-0.19) between Indonesian and Chinese stock markets. The
Chinese and Indian stock markets have a rather weak correlation with global indices. This shows potential avenues for diversification
gains. At a regional level, European stock markets are more correlated compared to the Asia-Pacific region. The correlation between
the U.K. and Germany is 0.76, whereas the correlation between Indonesia and Malaysia is 0.37. Emerging markets, thus, offer a better
scope for diversifying portfolio risks.

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 H.A. Marfatia

Table 2
Global markets correlation.
AEX AORD ATX BFX BSE BVSP CAC DAX FTSE HSI JKSE KLSE KOSP MERV MEX NIK SNP SSEC SSMI STI TSE TWI VIX

AEX 1
AORD 0.49 1
ATX 0.68 0.52 1
BFX 0.83 0.52 0.71 1
BSE 0.33 0.35 0.38 0.37 1
BVSP 0.52 0.44 0.57 0.46 0.39 1
CAC 0.86 0.50 0.63 0.78 0.30 0.53 1
DAX 0.85 0.43 0.62 0.74 0.32 0.50 0.87 1
FTSE 0.81 0.53 0.65 0.74 0.30 0.55 0.80 0.76 1
HSI 0.43 0.66 0.43 0.38 0.38 0.50 0.42 0.38 0.47 1
JKSE 0.31 0.08 0.37 0.33 0.42 0.40 0.31 0.32 0.32 0.20 1
KLSE 0.29 0.35 0.30 0.23 0.28 0.37 0.25 0.27 0.26 0.47 0.37 1

5
KOSP 0.37 0.62 0.30 0.31 0.22 0.34 0.34 0.28 0.35 0.65 0.01 0.48 1
MERV 0.36 0.25 0.46 0.29 0.28 0.51 0.35 0.35 0.35 0.36 0.28 0.34 0.28 1
MEX 0.51 0.40 0.51 0.44 0.36 0.68 0.48 0.51 0.52 0.51 0.38 0.35 0.35 0.58 1
NIK 0.43 0.57 0.41 0.35 0.28 0.37 0.45 0.38 0.41 0.49 0.17 0.29 0.50 0.23 0.31 1
SNP 0.73 0.52 0.56 0.68 0.37 0.55 0.73 0.74 0.78 0.48 0.35 0.28 0.40 0.36 0.61 0.42 1
SSEC 0.11 0.33 0.22 0.14 0.06 0.21 0.10 0.10 0.09 0.28 0.19 0.17 0.38 0.14 0.13 0.28 0.14 1
SSMI 0.76 0.46 0.59 0.72 0.26 0.47 0.74 0.69 0.71 0.37 0.31 0.22 0.31 0.29 0.44 0.43 0.63 0.07 1
STI 0.45 0.62 0.44 0.41 0.45 0.52 0.40 0.41 0.42 0.78 0.32 0.65 0.64 0.44 0.56 0.49 0.50 0.29 0.39 1
TSE 0.65 0.50 0.59 0.55 0.38 0.63 0.64 0.62 0.69 0.48 0.37 0.36 0.36 0.45 0.62 0.43 0.74 0.16 0.53 0.51 1
TWI 0.37 0.45 0.39 0.32 0.39 0.42 0.37 0.40 0.38 0.52 0.23 0.38 0.49 0.42 0.40 0.39 0.45 0.20 0.29 0.46 0.46 1
VIX 0.34 0.33 0.35 0.38 0.22 0.15 0.26 0.31 0.27 0.20 0.21 0.16 0.17 0.15 0.16 0.33 0.31 0.06 0.31 0.27 0.34 0.17 1

The table presents the unconditional correlation matrix of stock market returns across the world. The table also presents the estimate of correlation of global stock returns with the VIX index. The bold and
italics face fonts indicate statistical significance at 1% and 5% level, respectively. The global markets considered include the U.S. (SNP), Canada (TSE), Austria (ATX), Belgium (BFX), France (CAC),
Germany (DAX), Greece (ATH), Netherlands (AEX), Switzerland (SSMI), UK (FTSE), Argentina (MERV), Brazil (BVSP), Mexico (MXX), Australia (AORD), China (SSEC), Hong Kong (HSI), India (BSE),
Indonesia (JKSE), Japan (NIK), Korea (KOSP), Malaysia (KLSE), Singapore (STI), Taiwan (TWI).
Research in International Business and Finance 52 (2020) 101169
H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

The relationship between VIX and stock returns is negative and statistically significant in almost all the cases (Table 2).9 What is
interesting is that there is a negative relationship of VIX with not just the U.S., but also with almost all the leading stock markets of
the world. In fact, seven stock markets in the world are more strongly correlated with VIX compared to the U.S. market.
Several channels support a strong correlation of VIX with other markets. First, the stock markets in the U.S. often anchor investors’
expectations in other parts of the world. Consequently, the risk perceptions of U.S. investors get strongly tied with the anchor
country's stock market returns, perhaps even more than the U.S. market returns. Smaller European economies could be a case in
point. Second, trade ties and the country's dependence on trade could be the other reason. Canada, for example, shares strong trade
ties with the U.S. However, the role of trade in the U.S. economy differs greatly compared to Canada. Trade (as a % of GDP) is around
65% for Canada, whereas it is less than half of that amount with the United States.10 A slowdown in the U.S. which induces
heightened risks in the financial markets, for example, can affect its major trading partners stock markets such as Canada more than
the U.S. market itself. This translates into a stronger correlation of VIX with stock returns in these markets compared to the U.S.
market returns.

3.1.2. Impact of risk perceptions on global returns

Given a positive correlation between global stock returns and a negative correlation with VIX, the next issue to explore how VIX
impacts global stock market returns. Table 3 presents the results of the country-level GARCH estimates. The evidence suggests that
the risks in financial markets, as measured by VIX, have a statistically significant negative impact on all the stock markets of the
world. There is clear evidence of ARCH and GARCH effects in the international stock markets. At a regional level, the European
markets have relatively strong ARCH effects, whereas the Asian markets have strong GARCH effects.
The statistically significant impact of VIX on almost all the stock markets across the world is noteworthy. Even though VIX
principally measures the implied volatility in the U.S. stock markets, its movement impacts the other parts of the world. Said
differently, financial market uncertainty in the U.S., measured by the VIX index, has a statistically significant impact on the world
stock markets.
In almost all markets, the coefficient is negative. An increase (decrease) in VIX pulls down (pushes up) the stock returns. This is
intuitive because a rising VIX, for example, shows that investors foresee increased uncertainty in the U.S. market. This dampens the
sentiments in the international stock markets. In terms of the magnitude, the impact is stronger for Germany and Netherlands relative
to the U.S. and the United Kingdom. In the Asia-Pacific region, the most significant impact is on Japan and Singapore, whereas the
Chinese and Malaysian stock markets are least impacted by the risks in the financial markets.
Note that the impact of VIX is stronger in the developed financial markets compared to the emerging economies. The portfolio
reshuffling effects could explain this regularity. As the financial market uncertainty in the developed markets rises, the portfolio
managers reshuffle their portfolios such that they can maximize the gains from diversification. Stressful times in the advanced
markets prompt diversifying the investments into the emerging markets, supporting stock returns in emerging economies. This gets
reflected in the relatively mild negative impact on emerging markets as compared to the markets in the advanced economies.

3.2. Risk perceptions and integration

In this section, I explore the dynamic correlation of the global markets with the U.S. market. I also study how these correlations
are related to risk perceptions.

3.2.1. Dynamic correlations

Fig. 1(a)–(c) shows the dynamic correlations from the multivariate GARCH systems. Clearly, there is a significant time variation in
the correlation of the U.S. market with all the leading stock markets of the world. The dynamic correlation of the U.S. with the
European markets is largely synchronous (Fig. 1(a)). This is in contrast to the movements and strength in the Asian markets’ cor-
relations with the U.S. (Fig. 1(c)). In Latin America, Mexico and Brazil reveal similar correlation patterns, unlike Argentina's market.
Also, the effects of the recent financial crisis on the dynamic correlation of the U.S. with Asia (Fig. 1(c)) and Latin America (Fig. 1(b))
is stronger than the European markets (Fig. 1(a)).

3.2.2. Direction of causation

I extend the analysis a step further and answer the question: Does investors risk perceptions cause the dynamic correlation or is it
the reverse? I test pairwise Granger causality between investors risk precipitations (VIX) and the dynamic correlation between the
U.S. and global stock markets. The Granger causality is tested for several lags of 2-, 6-, 12-, 18-, 24-, and 36-months. This will show
the direction of causation and how it evolves from the short run (2-months) to the long run (3-years).
Table 4 presents the test results. In 85% of the cases (17 out of 20), investors risk perceptions Granger cause the dynamic
correlation between the U.S. and global stock markets. I find evidence of bi-directional causation only for Malaysia and Mexico. The
predictive power of VIX holds for all lag specifications in most cases. Thus, investors risk perceptions drive dynamic correlations, both
in the short, and the long run. These findings motivate the need to further explore the time-varying impact of VIX on the dynamic
correlation of the U.S. with the global markets.

9
The bold and italics face fonts in the table show statistical significance at 1% and 5% level, respectively.
10
Source: World Bank national accounts data and OECD National Accounts data files.

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

Table 3
Impact of risk perceptions on the global stock market returns.
Country Code VIX t-stat ARCH t-stat GARCH t-stat

Europe and U.S.

Austria ATX 0.230 4.659 0.089 2.243 0.790 7.072
Belgium BFX 0.181 4.555 0.318 3.374 0.513 3.743
France CAC 0.161 3.902 0.214 2.433 0.731 7.000
Germany DAX 0.231 5.077 0.207 3.045 0.731 8.395
Netherlands AEX 0.208 5.026 0.228 2.932 0.678 6.385
Switzerland SSMI 0.191 5.269 0.152 2.914 0.785 12.894
U.K. FTSE 0.151 5.181 0.177 2.653 0.729 7.559
Canada TSE 0.167 4.372 0.161 3.844 0.793 19.219
U.S.A SNP 0.144 4.006 0.197 2.889 0.749 9.790
Latin America
Argentina MERV 0.178 1.846 0.215 2.586 0.689 7.886
Brazil BVSP 0.168 1.915 0.123 2.509 0.837 15.964
Mexico MEX 0.104 1.851 0.182 3.166 0.806 15.913
Asia-Pacific
Australia AORD 0.200 4.117 0.122 1.621 0.790 7.568
China SSEC 0.065 0.599 0.027 8.911 0.561 1.029
Hong Kong HSI 0.208 3.538 0.110 3.231 0.847 26.160
India BSE 0.237 3.612 0.073 2.538 0.917 23.683
Indonesia JKSE 0.213 2.542 1.410 13.319 0.007 0.366
Japan NIK 0.329 5.414 0.074 1.396 0.882 10.598
Korea KOSP 0.126 2.331 0.397 5.157 0.715 15.887
Malaysia KLSE 0.060 1.317 0.086 2.915 0.868 22.797
Singapore STI 0.263 4.616 0.084 3.318 0.878 34.283
Taiwan TWI 0.145 2.512 0.199 3.432 0.798 14.367

The table shows the estimation results of the GARCH(1,1) model with the impact of uncertainty as measured by the VIX index.

3.2.3. Fixed coefficient model

Table 5 presents the results of the fixed coefficient model. It measures the impact of risk perceptions on the dynamic correlation
between the U.S. and the country's stock market. Evidence suggests that the financial uncertainty measured by VIX significantly
impacts the dynamic correlations in all cases.
The impact of VIX on the correlation between the U.S. and European stock markets is positive. In contrast, the Asian stock markets
correlation with the U.S. responds negatively to the VIX index. As the risks and uncertainty rise, the correlation between the U.S. and
European stock markets gets stronger. In contrast, the correlation of the U.S. with the Asian markets becomes weaker. The behavior of
Latin American markets is comparable to European markets. Thus, in the more stressful times, it is difficult to achieve major gains by
diversifying in the European and Latin American markets, but that is not the case with Asia-Pacific markets.
The results can be explained intuitively. In a high-risk environment, heightened uncertainty causes information processing more
difficult. Hence, the market pricing of risk is more driven by investors herding behavior. This gets reflected in a stronger correlation
in global markets in financially stressful times. The forces of active international portfolio management could also drive these results.
When financial risk rises during the crisis, international investors flight to quality makes emerging markets less attractive. These
investors resort instead to more “safer” developed markets and/or Treasuries/safe-haven assets. The unwinding of positions from
emerging markets and investing in the U.S. likely cause the stock return correlations between these two markets to move in the
opposite direction. Admittedly, this may mitigate the effects of the herding process. Evidence from Table 5 suggests that the European
markets are more driven by the herding process, whereas, with Asian markets, active portfolio management forces drive the market
outcome.
Table 5 also shows that the positive impact of uncertainty on the correlation between the U.S. and the European markets is similar
in magnitude. But, the impact is much more diverse in Asia-Pacific markets. As the uncertainty increases, the correlation between the
U.S. and markets of Indonesia and Taiwan decreases far more than the decrease in the correlation between the U.S. and China, India,
and Malaysia. This implies that international portfolio reshuffling because of heightened financial market risks is most prevalent in
Indonesia and Taiwan. A relatively weak impact of uncertainty on the correlation of the U.S. with India, China, and Malaysia suggests
that diversification gains are possible when investors perceive heighten risks in the advanced economies financial markets.

3.2.4. Time-varying parameter (TVP) model

The results of the previous sections provide key insights into the behavior of global financial markets with risks and uncertainty.
However, the relationship between risks and the connections between global stock markets is unlikely to be not static. The Granger
causality test results and evidence in the existing literature both support this argument. Kim et al. (2005) find that the European
Monetary Union significantly influenced the process of European stock market integration. Similarly, Mensi et al. (2014) show that
the dependence structure of the stock markets of Brazil, Russia, India, China, and South Africa with the global forces varies across
different quantiles.
The fixed-coefficient model provides only partial insights into the impact of uncertainty on global market correlations. To gain

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

Fig. 1. Dynamic Correlation Between The U.S. and Stock Markets of Europe, Latin America, and Asia-Pacific region. The plots below show the time-
varying dynamic correlation between the U.S. and the individual stock market estimated from the system GARCH model.

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

Table 4
Granger causality test between risk perceptions and dynamic correlation.
Pairwise Granger Causality Tests lags = 2 lags = 6 lags = 12 lags = 18 lags = 24 lags = 36

VIX does not Granger Cause AEX 0.02 0.01 0.01 0.01 0.02 0.07
AEX does not Granger Cause VIX 0.42 0.66 0.40 0.52 0.58 0.56
VIX does not Granger Cause AORD 0.00 0.00 0.00 0.00 0.00 0.00
AORD does not Granger Cause VIX 0.04 0.78 0.17 0.11 0.32 0.72
VIX does not Granger Cause ATX 0.00 0.00 0.00 0.00 0.00 0.03
ATX does not Granger Cause VIX 0.22 0.98 0.47 0.61 0.45 0.91
VIX does not Granger Cause BFX 0.00 0.00 0.00 0.02 0.04 0.15
BFX does not Granger Cause VIX 0.72 0.65 0.33 0.30 0.36 0.54
VIX does not Granger Cause BSE 0.00 0.00 0.00 0.00 0.00 0.00
BSE does not Granger Cause VIX 0.20 0.81 0.72 0.62 0.71 0.57
VIX does not Granger Cause BVSP 0.00 0.01 0.00 0.05 0.07 0.46
BVSP does not Granger Cause VIX 0.44 0.26 0.34 0.53 0.45 0.17
VIX does not Granger Cause CAC 0.08 0.12 0.11 0.04 0.16 0.20
CAC does not Granger Cause VIX 0.23 0.76 0.85 0.82 0.84 0.71
VIX does not Granger Cause DAX 0.00 0.00 0.00 0.00 0.00 0.01
DAX does not Granger Cause VIX 0.55 0.92 0.84 0.94 0.93 0.91
VIX does not Granger Cause FTSE 0.14 0.20 0.06 0.14 0.20 0.50
FTSE does not Granger Cause VIX 0.85 0.36 0.22 0.48 0.53 0.15
VIX does not Granger Cause HSI 0.00 0.00 0.00 0.00 0.00 0.00
HSI does not Granger Cause VIX 0.05 0.68 0.31 0.35 0.30 0.47
VIX does not Granger Cause JKSE 0.00 0.00 0.00 0.00 0.00 0.00
JKSE does not Granger Cause VIX 0.74 0.63 0.71 0.52 0.62 0.68
VIX does not Granger Cause KLSE 0.00 0.00 0.00 0.00 0.00 0.00
KLSE does not Granger Cause VIX 0.00 0.07 0.02 0.03 0.04 0.11
VIX does not Granger Cause KOSP 0.00 0.00 0.00 0.00 0.00 0.00
KOSP does not Granger Cause VIX 0.03 0.67 0.21 0.30 0.21 0.21
VIX does not Granger Cause MERV 0.00 0.00 0.00 0.00 0.04 0.27
MERV does not Granger Cause VIX 0.14 0.37 0.60 0.34 0.56 0.28
VIX does not Granger Cause MEX 0.00 0.00 0.00 0.01 0.08 0.19
MEX does not Granger Cause VIX 0.05 0.00 0.00 0.00 0.00 0.00
VIX does not Granger Cause NIK 0.00 0.00 0.00 0.00 0.00 0.00
NIK does not Granger Cause VIX 0.36 0.96 0.71 0.76 0.81 0.85
VIX does not Granger Cause SSEC 0.81 0.00 0.00 0.00 0.00 0.03
SSEC does not Granger Cause VIX 0.48 0.61 0.21 0.38 0.52 0.30
VIX does not Granger Cause SSMI 0.71 0.10 0.20 0.20 0.34 0.25
SSMI does not Granger Cause VIX 0.40 0.67 0.67 0.69 0.74 0.84
VIX does not Granger Cause STI 0.00 0.00 0.00 0.00 0.00 0.00
STI does not Granger Cause VIX 0.02 0.53 0.18 0.18 0.04 0.07
VIX does not Granger Cause TWI 0.00 0.00 0.00 0.00 0.00 0.00
TWI does not Granger Cause VIX 0.02 0.43 0.09 0.27 0.68 0.55

The table shows the results of pair-wise Granger causality test for several alternative lags between risk perceptions and correlation of global stock
markets with the U.S. market. The reported values are the P-value of the test hypothesis in column one. In each case, the test is performed with each
of the 2-, 6-, 12-, 18-, 24-, and 36-period lag specifications in the test. The bold and italics face fonts indicate statistical significance at 1% and 5%
level, respectively.

further insights into the dynamic nature of the relationship, I estimate a TVP model of Eq. (6) using a rolling window approach.
Figs. 2, 3, and 4 plot the time-varying estimates along the confidence interval for the European, Latin American, and Asia-Pacific
markets, respectively.
Europe
Fig. 2(a)–(g) presents the time-varying impact of VIX on the correlation between the U.S. and the European stock markets.
Evidence suggests that there is a significant time variation in the impact of risk perceptions on the dynamic correlation. Most time-
variation in the case of Austria, Belgium, Germany, and the U.K. I find that the impact of VIX on the correlation of the U.S. with the
Dutch and Swiss markets is range-bound over the 2003-2016 period. In the case of Austria, France, and Germany, I find an increasing
impact of uncertainty over the sample period.
The time-varying responses exhibit interesting behavior. In the 1999-2001 period, the impact of uncertainty on the correlation is
negative in most cases. In the 2001-2005 period, in contrast, the level of risks and uncertainty had an increasingly strong and positive
impact on the correlation of the U.S. with the stock markets of Austria (Fig. 2(a)), Germany (Fig. 2(d)) and the U.K. (Fig. 2(g)).
Whereas, the impact of uncertainty was much weaker in the two years before the 2007–2008 crisis. In the post-crisis period, the
impact of VIX rose sharply and remained steady in the last five years. The average estimates of the fixed coefficient model did not
reveal the negative effects of VIX on the correlation in the interim periods. This highlights the importance of the TVP model.
The explanation for a time-varying positive impact of investors risk perceptions on the correlation could be the changing nature of
the underlying forces. When global markets are relatively calm (falling VIX), like in the early 2000s and the post-crisis period, the
impact of VIX on the European stock markets integration is rising. In these times, investors have a clearer foresight of the future

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

Table 5
Impact of risk perceptions on dynamic correlation.
Country Code VIX t-stat L.Corr. t-stat R-Sqr

Europe
Austria ATX 0.022 2.91 0.838 28.68 0.77
Belgium BFX 0.020 3.25 0.862 33.81 0.84
France CAC 0.016 3.13 0.913 63.67 0.95
Germany DAX 0.017 3.42 0.893 39.19 0.87
Netherlands AEX 0.018 3.50 0.824 33.15 0.84
Switzerland SSMI 0.007 1.74 0.876 45.28 0.89
U.K. FTSE 0.012 3.56 0.902 40.40 0.88
Latin America
Argentina MERV 0.042 2.43 0.837 24.26 0.72
Brazil BVSP 0.016 1.99 0.813 22.42 0.69
Mexico MEX 0.059 4.17 0.862 28.63 0.80
Asia-Pacific
Australia AORD 0.089 8.66 0.512 10.77 0.72
China SSEC 0.004 1.50 0.592 26.58 0.75
Hong Kong HSI 0.049 5.45 0.824 27.43 0.87
India BSE 0.037 9.67 0.423 9.37 0.67
Indonesia JKSE 0.214 7.13 0.499 9.70 0.59
Japan NIK 0.056 9.21 0.435 8.70 0.66
Korea KOSP 0.150 6.83 0.710 18.72 0.81
Malaysia KLSE 0.050 5.12 0.845 31.94 0.90
Singapore STI 0.135 7.85 0.681 18.17 0.84
Taiwan TWI 0.150 7.04 0.684 17.11 0.81

The table shows the impact of the VIX index on the dynamic correction of the U.S. with the country's stock market (derived from the multivariate
GARCH model). The regression model also includes the lagged value of correlation (L.Corr.).

course of the stock markets. Consequently, the movements in Europe stock markets vis-a-vis the U.S. market becomes less dependent.
This explains the falling correlation of the European markets with the U.S. when VIX is falling.
Latin America
Fig. 3(a)–(c) presents the time-varying impact of investors risk perceptions on the correlation of Latin American stock markets. I
find that, like with European markets, the impact of uncertainty on the correlation is positive. Brazilian (Fig. 3(b)) and Mexican
(Fig. 3(c)) markets response behave very similar, but significant variation is found in the case of Argentina's stock market (Fig. 3(a)).
In all the three markets, the impact of VIX on the correlation is declining in the 1998-2007 period, negative for a short period
thereafter, but bouncing back immediately to remain steady in the last five years. This implies that the positive correlation of the U.S.
with Brazil and Mexico is becoming increasingly decoupled with the level of uncertainty in the financial markets. In the 2003-2007
period, the impact of uncertainty on the correlation between the U.S. and Argentinean stock market is negative (Fig. 3(a)). This can
be because in this period the U.S. market was bullish with clam investors sentiments (lower VIX), whereas the sentiments in the
Argentinean market was bearish due economic crisis.
Asia-Pacific
Fig. 4(a)–(j) shows the time-varying impact of VIX on the dynamic correlation of the U.S. with the Asia-Pacific markets. In almost
all cases, VIX has a negative impact on the dynamic correlations. As uncertainty rises (falls), the correlation of Asian markets with the
U.S. decreases (increases). However, there is significant variation across time, except for Australia (Fig. 4(a)) and Japan (Fig. 4(b)).
Also, unlike European and Latin American markets, there is no uniform pattern in the response of the Asia-Pacific region's correlation
with the VIX index. For example, in the 2001-2008 period the impact of VIX on the correlation of Indonesia (Fig. 4(g)) was weak-
ening, whereas contrasting behavior is in the case of Hong Kong (Fig. 4(e)) and India (Fig. 4(f)) during the same period.
Several forces can explain the varied response of the Asian stock market integration to the VIX index. International investors view
the Asian markets, particularly those of the emerging economies, as avenues of diversification. For example, bearish sentiments in the
U.S. market because of increased uncertainty in the U.S. provides a positive impetus to the Asian markets. Thus, even while the U.S.
financial market uncertainty is higher, signaling bad news for global markets, Asian indices would not fall as much as S&P 500. This
results in the negative impact of VIX on the correlation of the Asian markets with the U.S.11
Despite the wide differences across countries, one thing is common in all cases. In the period following the 2007-2008 financial
crisis, the impact of VIX on the correlation is noticeably strong. The magnitude of the impact (absolute value) continuously rose and
reached a peak around mid-2013 in all the markets, except China. This highlights the powerful effects of the unconventional
monetary policy adopted by the Federal Reserve and other central banks. The unconventional policy actions across the globe, led by
the Federal Reserve, meant a huge surge in systemic liquidity. In the U.S., this infused confidence in the financial markets, leading to
a fall in the VIX index. The liquidity surge fueled not only the U.S. market but also led to large capital inflows into the emerging

11
Note that the portfolio reshuffling effects could also be in the reverse direction when investors’ flight-to-quality effects are strong. This channel
is more powerful in the times of wider systematic risks across the globe (rather than risks limited to developed markets like the U.S.).

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

Fig. 4. Time-Varying Impact of Risk Perceptions on the Correlation Between the U.S. and Asia-Pacific. The plots below show the 5-year rolling
estimate and confidence interval (CI Bands) of the impact of the VIX index on the dynamic correlation between the U.S. and the stock markets of the
Asia-Pacific region.

economies stock markets. The international investors search for positive returns in a zero interest rate environment in the U.S. also
played a role in the process. Thus, a falling VIX led to an increasingly strong correlation of stock returns between the U.S. and the
Asian stock markets.

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

Fig. 2. Time-Varying Impact of Risk Perceptions on the Correlation Between the U.S. and Europe. The plots below show the rolling estimate and
confidence interval (CI Bands) of the impact of the VIX index on the dynamic correlation between the U.S. and the stock markets of Europe.

Fig. 3. Time-Varying Impact of Risk Perceptions on the Correlation Between the U.S. and Latin America. The plots below show the rolling estimate
and confidence interval (CI Bands) of the impact of the VIX index on the dynamic correlation between the U.S. and the stock markets of Latin
America.

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H.A. Marfatia Research in International Business and Finance 52 (2020) 101169

4. Policy and portfolio implications

The evidence found in the present study holds important policy implications and provides insights into the management of
international portfolios. On the policy front, the results add to the ongoing debate on international monetary policy coordination and
its implications on the emerging market economies (Mohan and Kapur, 2014; Arteta et al., 2015; Bowman et al., 2015; Fratzscher
et al., 2016). Mohan and Kapur (2014) highlight that advanced economies’ unconventional monetary policies pose macroeconomic
challenges for the emerging market economies through volatile capital flows and exchange rates. The evidence found in the present
paper supports this point. I find a negative relationship between uncertainty and the correlation between the U.S. and Asian stock
markets. The actions of Federal Reserve to the restore of interest rates to normal levels is likely to have strong implications on the
future movement of Asian markets. The increasing trend over time in the impact of VIX on the dynamic correlation enforces this
point. Hence, policymakers in these economies need to be vigilant by undertaking preemptive steps to maintain a healthy and stable
financial system.
The findings also have implications for international portfolio management. Optimization of portfolio risks by diversifying across
countries may have become difficult. However, the results in the paper still support possibility of diversification gains by selectively
investing in certain markets. These gains vary significantly across countries and time. Hence, making a static assessment of a par-
ticular country's potential for diversification gains may not be an optimal strategy. This is in contrast to some studies that find
evidence against the existence of diversification gains in the past three decades (Hardouvelis et al., 2006; Morana and Beltratti,
2008). The findings in the paper support the main conclusions found in Chiang and Zheng (2010), Berger et al. (2011), and
Coeurdacier and Guibaud (2011) that diversification strategy based solely on constant correlations across markets can be misleading.
The findings of this study also support evidence in the broader literature on the time-varying impact of U.S. shocks on global
financial markets (Özatay et al., 2009; Dzielinski, 2012; Kishor and Marfatia, 2013; Mensi et al., 2014; Marfatia et al., 2017; Adrangi
et al., 2019; Smales, 2019). For example, Özatay et al. (2009) show that the magnitude and the sign of U.S. macroeconomic news
impact on global markets crucially depend on the state of the U.S. economy. In a related study, Dzielinski (2012) finds that the search-
based uncertainty measure has a significant relationship with aggregate stock returns and volatility. For BRICS economies, Mensi
et al. (2014) find that financial market uncertainty drives stock returns in a bear market but not in a bull market.

5. Conclusion

This paper explores the extent to which investors risk perceptions drive global stock returns and their integration of the U.S. Since
the stock markets possess the volatility clustering feature, univariate and multivariate GARCH models are estimated for the leading
stock markets of the world. I then estimate the impact of risks and uncertainty on the dynamic correlation derived from the mul-
tivariate GARCH systems. I estimate the impact both under a fixed coefficient and a time-varying parameter model.
Evidence suggests that investors risk perceptions – the VIX index – have a statistically significant impact on the global stock
market returns. Interestingly, VIX Granger causes dynamic correlation of the U.S. market with 17 (out of 20) leading international
markets. The regression estimates show that VIX has a statistically significant impact on the dynamic correlation of the U.S. with
every international stock market. An increase (decrease) in VIX leads to an increase (decrease) in the dynamic correlation of the U.S.
market with all European and Latin American markets. In contrast, the dynamic correlation of the U.S. market with all the Asian
markets increases (decreases) with a decrease (increase) in the VIX index. I also find a wide variation across time in the positive
impact of VIX on European markets correlation and the negative impact of VIX on Asian markets correlation.

Compliance with ethical standards

Ethical approval: This article does not contain any studies with human participants or animals performed by any of the authors.

Conflict of interest

Author declares that there is no conflict of interest.

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