Contagion effects on stock and FX markets : A DCC analysis among USA and EMU

Purpose – This paper aims to investigate the contagion effects of stock and FX markets for the USA and european monetary union (EMU) during the US subprime crisis of 2007-2009. Design/methodology/approach – The data sample is daily comprising a weighted Morgan Stanley Capital Index (MSCI) for US and EMU equity markets, as well as EUR/USD exchange rate and 3-month US and EMU interest rate indices. The authors model, simultaneously, the dynamic conditional correlations (DCC) for the triplet: US, EMU equity markets and euro – USD uncovered interest rate parity (UIP) via a multivariate GARCH(1,1)-DCC model. The authors also test for a level shift increase of DCCs during the crisis period by incorporating a dummy variable in a GARCH(1,1) model. Findings – Our results suggest the presence of contagion for the US stock market and UIP. These results indicate that possibilities for portfolio diversification exist even in periods of severe financial turmoil. This can be explained by the different monetary policies that followed during the crisis. While USA increased liquidity through stimulus packages in early 2009, EMU preferred a strict monetary policy and fiscal austerity measures. Consequently, the EUR/USD exchange rate was less volatile than the EMU equities, resulting in their weak co-movement. Originality/value – These findings confirm a specific pattern of contagion that provide important implications for international investors and policy-makers.