Extreme Returns in the European financial crisis

• DOI: http://doi.org/10.1111/eufm.12112
• Published date: 01 September 2017
• Date: 01 September 2017
• Author: Andreas Chouliaras,Theoharry Grammatikos

Extreme Returns in the European

financial crisis

Andreas Chouliaras

ICMA Centre, Henley Business School, University of Reading, Henley Business School, Whiteknights,

Reading RG6 6BA

E-mail: a.chouliaras@icmacentre.ac.uk

Theoharry Grammatikos

Luxembourg School of Finance, University of Luxembourg, 4, rue Albert Borschette L-1246

Luxembourg

E-mail: theoharry.grammatikos@uni.lu

Abstract

We examine the transmission of financial shocks among the euro-periphery

(Portugal, Ireland, Italy, Greece, Spain), the euro-core (Germany, France, the

Netherlands, Finland, Belgium), and the major European Union (but not euro)

countries (Sweden, the United Kingdom, Poland, the Czech Republic, Denmark).

Using extreme returns on daily stock market data from 2004 until 2013, we find

transmission effects for the tails of the returns distributions for the pre-crisis, US

crisis and euro crisis periods from the euro-periphery to the non-euro and

euro-core groups. During the crises, the shocks transmitted were more substantial,

indicating significantly higher losses on extreme return days.

Keywords: financial crisis, financial contagion, spillover, euro crisis, stock markets

JEL classification: G01,G15

The authors are especially grateful to John Doukas (the Editor) and three anonymous

referees for very helpful suggestions. The authors also thank Gerard Hoberg, Tim

Loughran, Bill McDonald, Thorsten Lehnert, Dimitrios Gounopoulos, Chris Brooks,

Adrian Bell, George Alexandridis, Charles Sutcliffe, Chardin Wese Simen, Konstantinos

Tsiveriotis, Christoph Schommer, Themistoclis (Themis) Pantos, Theologos Homer

Bonitsis, Timothy (Tim) Alexander Carle, Gautam Tripathi, Roman Kraussl, Matti

Suominen, Kalle Rinne, Aigli Siouti, Andreas Sioutis, Cleopatra Sioutis, Alexandros

Chouliaras, Sara Goumalatsou, Eleni (Lilo) Theochari, Apostolos Christopoulos, as well as

seminar participants at the Luxembourg School of Finance and the ICMA Centre, Henley

Business School, University of Reading for helpful comments. Any remaining errors are

those of the authors alone.

European Financial Management, Vol. 23, No. 4, 2017, 728–760

doi: 10.1111/eufm.12112

© 2017 John Wiley & Sons, Ltd.

1. Introduction

The recent global financial crisis began as a crisis in the subprime mortgage loan business

in the United States of America (USA) in 2007 and continued with multiple waves of

financial distress that hit the global financial markets. Since the beginning of 2010, the

eurozone has been facing a severe financial crisis (Doukas, 2012). What started as a

sovereign debt crisis in Greece soon transmitted to Portugal, Ireland, Cyprus and, at least

partially, to Spain and Italy. It soon became clear for Europe that, beneath the sovereign

debt crisis surface, there also existed a severe banking crisis (Caselli et al., 2016). The

propagation of financial distress from one country to another, with stock markets, bond

yields and credit default swaps (CDS) spreads being affected, makes the studying of the

transmission of extreme returns more pertinent than ever.

1

A number of researchers investigate the recent eurozone financial crisis and its

transmission effects, particularly emphasising the sovereign debt and CDS markets.

Missio and Watzka (2011) report the existence of contagion effects using dynamic

conditional correlation (DCC) models. Metiu (2012) employs a simultaneous equations

model and examines the tails of bond yield distributions, an approach derived from

extreme value theory and Value-at-Risk, and finds structural shift contagion effects for

the crisis periods. Other papers, however, do not find contagion effects for the sovereign

bond and CDS markets (e.g., Caporin et al., 2013 and Bhanot et al., 2012).

The study of stock markets during financial crises has not been sufficiently examined

in the previous literature, despite their being the most liquid markets. We investigate the

stock market financial transmission effects of the European financial crisis (and the US

crisis) for three groups of countries: two groups of eurozone countries, the euro-core

eurozone countries (Germany, France, the Netherlands, Belgium, Finland) and the euro-

periphery eurozone countries (Portugal, Ireland, Italy, Greece, Spain), and a group for

European Union (EU) but non-euro countries (Sweden, the UK, Poland, the Czech

Republic, Denmark). The creation of these three groups is justified mainly by the

existence of the EU and the eurozone. The EU is primarily a free trade union, in which the

free movement of capital, labour and tradeable goods takes place. This has resulted in

strong ties that go well beyond these trade relationships, also taking the form of a primary

political union (with the existence of EU legislation that applies to all member countries,

the European Parliament, and various political and administrative authorities such as the

European Commission). The non-euro group is heterogeneous, but these countries’

participation in the EU justifies grouping them together. A subset of the EU countries has

formed the eurozone, which, as well as being a free trade area, is a monetary union,

sharing the euro as a common currency. The heads of state of the member countries of the

eurozone meet regularly to coordinate policy and make decisions. The agreed-upon

measures affect all eurozone countries. This justifies the inclusion of the euro-core in our

sample, which consists of the five countries with the highest market capitalisations

among all eurozone countries. Finally, the five countries that were most badly hit by the

1

The shock transmission literature is extensive, e.g. Allen and Gale (2000), Forbes and

Rigobon (2001), Rigobon(2001), Kaminsky, Reinhart, and Vegh (2003), Pericoli and Sbracia

(2003), Bekaert, Harvey, and Ng (2005), Dungey, Fry, Gonzalez-Hermosillo, and Martin

(2005), Corsetti, Pericoli and Sbracia (2005), A

€

ıt-Sahalia, Cacho-Diaz, and Laeven (2015),

Haß, Koziol, and Schweizer (2014).

© 2017 John Wiley & Sons, Ltd.

Extreme Returns in the European financial crisis 729

recent crisis are Portugal, Ireland, Italy, Greece and Spain (Doukas, 2013). These five

countries are part of the EU and the eurozone, which is why we group them together in

the euro-periphery group. The transmission of shocks between the euro-core and the

euro-periphery is interesting, because, since the two groups are part of the same trading

union and the same monetary union, financial problems in one group could affect the

other groups. The euro-core countries were called upon to provide financial aid (along

with the other eurozone countries, the European Central Bank and the International

Monetary Fund) to the euro-periphery countries that were in need. Since hundreds of

billions of euros were provided in assistance, it is worth examining the effect of extreme

stock market shocks to the three country groups for one more reason: The provision of

financial assistance may not only have been an act of solidarity, but also an act of

self-interest for the euro-core and the non-euro groups, if this financial assistance is able

to mitigate the transmitted shocks.

2

The correlations framework has been widely used by previous authors in related

studies, but there is no consensus as to how to best define contagion when using that

framework. Forbes and Rigobon (2001) claim that heteroskedasticity biases correlation

tests for contagion.

3

To avoid this problem we follow the extreme returns approach

proposed mainly in two papers, those of Bae et al. (2003) and Boyson et al. (2010).

Bae et al. (2003) examine the coincidence of extreme return shocks across countries

within and across groups, while Boyson et al. (2010) study hedge funds contagion. A

number of other studies have also used this methodology.

4

In a related paper,

Christiansen (2014) uses a sample of 14 EU countries and proposes two classification

approaches for extreme returns: One that calculates extreme returns separately for every

country and one that pools stock returns (‘multivariate classification scheme’), and

calculates extreme returns on the overall sample. As far as extreme stock returns

are concerned, Christiansen (2014) finds that one cannot reject that the two approaches

are identical for the financial crisis period (2008 until 2012).

What is this paper’s incremental contribution to the literature? First, we study for

effects that existed in the equity markets during the European financial crisis, which were

(quite surprisingly) not sufficiently examined in the previous literature, which typically

studies for ‘contagion’effects on sovereign bonds and CDS markets (Missio and

Watzka, 2011; Missio and Watzka, 2011; Metiu, 2012; Abad et al., 2014; G€

und€

uz and

Kaya, 2014; Fabozzi et al., 2016; Banerjee et al., 2016). The study of equity markets is

significant, since they are the most liquid markets and have the highest trading volume.

Another reason to study the effects on stock markets is the fact that during the European

2

Although the non-euro countries did not directly contribute to the financial assistance

packages, they are indirectly affected through the International Monetary Fund (IMF)

contributions. On top of that, decisions to create the European Financial Stability Facility

(EFSF) and the European Stability Mechanism (ESM) in order to deal with the euro-crisis

were taken by all the EU Member States.

3

By applying a correction, the authors find no contagion for the 1997 Asian crisis. On the

other hand, Corsetti et al. (2005) claim that the variance restrictions imposed by Forbes and

Rigobon (2001) are ‘arbitrary and unrealistic’. They find evidence for at least five countries

facing contagion effects during the Hong Kong stock market crisis of 1997.

4

See, for example, Markwat et al. (2009), Christiansen and Ronaldo (2009), Gropp et al.

(2009), Lucey and Sevic (2010), Chouliaras and Grammatikos (2015).

© 2017 John Wiley & Sons, Ltd.

730 Andreas Chouliaras and Theoharry Grammatikos