Capturing the Spillover Effect with Multiplicative Error Models

Recent statistical models for the analysis of volatility in financial markets serve
the purpose of incorporating the effect of other markets in their structure, in order
to study the spillover or the contagion phenomena. Extending the Multiplicative Error
Model we are able to capture these characteristics, under the assumption that the
conditional mean of the volatility can be decomposed into the sum of one component
representing the proper volatility of the time series analyzed, and other components,
each representing the volatility transmitted from one other market. Each component
follows a proper dynamics with elements that can be usefully interpreted. This
particular decomposition allows to establish, each time, the contribution brought by
each individual market to the global volatility of the market object of the analysis.
We experiment this model with four stock indices.