Do Time-Varying Covariances, Volatility Comovement and Spillover Matter?

Financial markets and their respective assets are so intertwined; analyzing any single market in isolation ignores important information. We investigate whether time varying volatility comovement and spillover impact the true variance-covariance matrix under a time-varying correlation set up. Statistically significant volatility spillover and comovement between US, UK and Japan is found. To demonstrate the importance of modelling volatility comovement and spillover, we look at a simple portfolio optimization application. A utility based comparison is used to evaluate the economic performance of the portfolio which considers time varying correlation with volatility comovement and spillover. This paper shows that a portfolio strategy incorporating time-varying correlation with asymmetric volatility comovement and spillover outperforms the constant correlation model without comovement and spillover by yielding the highest level of wealth and utility difference of up to 250 basis points.