Systemic risk in global volatility spillover networks: Evidence from option‐implied volatility indices

• Author: Yinggang Zhou,Zihui Yang,Xin Cheng
• Published date: 01 March 2020
• DOI: http://doi.org/10.1002/fut.22078
• Date: 01 March 2020

J Futures Markets. 2020;40:392–409.wileyonlinelibrary.com/journal/fut392

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© 2019 Wiley Periodicals, Inc.

Received: 2 November 2017

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Accepted: 7 November 2019

DOI: 10.1002/fut.22078

RESEARCH ARTICLE

Systemic risk in global volatility spillover networks:

Evidence from option‐implied volatility indices

Zihui Yang

1

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Yinggang Zhou

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Xin Cheng

3

1

Department of Finance, Lingnan College,

Sun Yat‐Sen University, Guangzhou, China

2

Center for Macroeconomic Research &

Department of Finance at School of

Economics, and Wang Yanan Institute for

Studies in Economics, Xiamen University,

Xiamen, China

3

Department of Finance, School of

Economics, Xiamen University, Xiamen,

China

Correspondence

Yinggang Zhou, Center for

Macroeconomic Research, Department of

Finance, School of Economics, and Wang

Yanan Institute for Studies in Economics,

A403 Economics Building, Xiamen

University, 361005 Xiamen, China.

Email: yinggang.zhou@gmail.com

Funding information

National Natural Science Foundation

of China, Grant/Award Numbers:

71571106, 71988101, 71721001, 71873152;

Humanities and Social Sciences grant of

the Chinese Ministry of Education, Grant/

Award Number: 18YJA790121; Major

National Social Science Project, Grant/

Award Numbers: 17ZDA073, 19ZDA060;

Key Program for the Guangdong Natural

Science Foundation, Grant/Award

Number: 2018B030311053

Abstract

With option‐implied volatility indices, we identify networks of global volatility

spillovers and examine time‐varying systemic risk across global financial

markets. The U.S. stock market is the center of the network and plays a

dominant role in the spread of volatility spillover to other markets. The

global systemic risks have intensified since the Federal Reserve exited from

quantitative easing, hiked interest rate, and shrank its balance sheet. We further

show that the U.S. monetary tightening is an important catalyst for the

intensifying global systemic risk. Our findings highlight the pernicious effects

of monetary tightening after an era of cheap money.

KEYWORDS

network, option‐implied volatility, spillover, systemic risk

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INTRODUCTION

The 2008 global financial crisis not only underscores the importance of global risk spillovers but also leads to recent

growth in the study of financial networks.

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Recent studies have linked systemic risk to financial networks, such as

Acemoglu, Carvalho, Ozdaglar, and Tahbaz‐Salehi (2012), Acemoglu, Ozdaglar, and Tahbaz‐Salehi (2015), and Elliott,

Golub, and Jackson (2014). A financial network describes a collection of nodes (financial markets or institutions) and

[Correction added on 7 Dec 2019, after first online publication: funder detail was modified]

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Financial Stability Board (2009) argues that systemic risk can arise through interlinkages between the components of the financial system so that individual failure or malfunction has repercussions

around the financial system.

the links between them (Allen & Babus, 2009). With the assistance of financial networks, we can investigate risk

spillovers systematically, measure the direction and intensity of spillovers at the micro‐level, understand the systemic

risk which arises through the structure and dynamics of network linkages, and so on.

To ease the cascade effects of the 2008 crisis, the U.S. Federal Reserve and other central banks have decreased

interest rates to zeros and engaged in quantitative easing in the previous decade. As the economy recovered, the Federal

Reserve had exited from quantitative easing in October 2014, raised interest rates since December 2015, and shrank its

balance sheet from October 2017. These monetary tightening policies coincided with some bouts of market turbulence.

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The coincidence of timing led many to blame the U.S. turbulence and the associated spillovers on the tightening.

To systematically investigate the global influence of monetary tightening, we identify networks of global volatility

spillovers with daily option‐implied volatility indices. Volatility is a representative measure of risk for asset valuation

and thus volatility spillover is essentially risk spillover. In contrast to ex post physical volatility measures, implied

volatility is better for studying volatility spillover because it contains ex ante risk‐neutral expectation of future volatility

and is readily available at daily or even intraday frequency. Moreover, we link global volatility spillovers to the systemic

risk across the global financial markets and examine the source of global systemic risk. Our study extends the literature

and makes contributions to the following aspects.

First, we extend the network modeling and construct time‐varying global systemic risk measures. Yang and Zhou

(2013) use a structural vector autoregressive (VAR) approach to uncover the network of contemporaneous causal

relations. Diebold and Yilmaz (2014) use generalized forecast error variance decompositions of a VAR model to form

time‐varying weighted and directed networks by estimating how much the innovation of a market contributes to the

variance of the forecast error for another market. However, the elements of variance decomposition matrix are not

additive and comparable directly because variation of different variables may be quite different. To deal with the

problem of additivity and comparability, we construct spillover networks with a more considerate weighting scheme

which takes the historical variation of spillover receivers’VIX changes into account.

Second, we find that the structure and dynamics of implied volatility spillover network are quite asymmetric.

Although asymmetric correlation (Solnik & Watewai, 2016) and asymmetric volatility transmission (Koutmos & Booth,

1995) have been documented in previous studies, they do not look at asymmetry in a network setting. In an asymmetric

network, the linkage structure is dominated by a small number of hubs affecting many different markets so that shocks

from an individual market might not cancel out through diversification but instead propagate throughout the network

and generate strong spillovers (Carvalho, 2014). In our study, the U.S. stock market is the center of the global volatility

spillover network and thus shocks from the United States generate intensifying volatility spillovers across markets,

supporting the role of the U.S. market as a leader among global financial markets (Bessler & Yang, 2003). Although

there is no surprise to see the asymmetric structure of the global volatility spillover network given the size of the U.S.

economy and financial markets, we find that the global systemic risk has intensified since the Federal Reserve exited

from quantitative easing, raised interest rates, and shrank its balance sheet. This evidence suggests that the United

States plays an increasingly dominant role as a volatility supplier to markets globally.

More important, we find that the U.S. monetary tightening is an important catalyst for the intensifying global

systemic risks as well as volatility spillovers from the U.S. stock market to the rest of the world. In addition, the

inclusion of additional controls, such as the business cycle and macroeconomic climate, does not diminish the

important role of monetary tightening in driving global systemic risk and volatility spillovers from the United States.

The U.S. short interest rates have increased substantially since quantitative easing came to an end and thus are used to

proxy for monetary condition and future policy stance (Fama, 2013; Hamilton & Jorda, 2002). Our findings extend the

recent literature which links conventional and unconventional monetary policies to systemic risk. Allen and Carletti

(2013) argue that systemic risk is endogenous and is related to central bank policies. Jiménez, Ongena, Peydró, and

Saurina (2014) and Yang and Zhou (2017) show that low‐interest rates and quantitative easing are potential sources of

systemic risk. We further document that the global systemic risk is intensifying with monetary tightening after an era of

cheap money. Our findings suggest that global investors and regulators should take a systemic perspective in

understanding the impact of the U.S. monetary tightening around the world.

The rest of this paper is organized as follows: Section 2 describes the data; Section 3 discusses the methodology;

Section 4 presents empirical findings, and Section 5 concludes.

2

For example, The S&P 500 index fell by 14% in the last quarter of 2018 and the yield on 10‐year U.S. Treasuries fell by 0.7%. This coincided with the Fed’s rate hike in September 2018 and shrinking

balance sheet by a faster pace of $50 billion a month from October 2018.

YANG ET AL.

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