The Dissimilar Market Volatility in Neighboring Financial Markets: An Empirical Study Using A Multivariate Garch Model

Abstract

ABSTRACT:Conventional knowledge of market volatility represents that two proximate financial markets operated in the same country would display a similar pattern in their time-varying volatility. In this paper, we propose that the heterogeneity in financial policy orientation of stock markets creates significant inter-market differences in terms of the volatility of stock returns, even if they are culturally and geographically linked to each other. For the empirical investigation of our proposition, the volatility data from two major stock exchanges in the Middle East, the Abu Dhabi Securities Exchange (ADX) and the Dubai Financial Market (DFM) are used. Both the ADX and DFM stock exchanges operate in the same country, the United Arab Emirates (UAE). The ADX is based in Abu Dhabi, the administrative capital, while the DFM is based in Dubai, the commercial and business hub of the UAE. They were both established in the year 2000, and their operational headquarters are located about 150 km from each other. This paper uses a multivariate GARCH model, in particular a diagonal VECH GARCH (1, 1) model to estimate volatility measures for stock returns between ADX-listed and DFM-listed stocks. The paper finds that the stock returns are significantly less volatile in the ADX compared to those in the DFM suggesting that the volatility transmission is incomplete between these two neighboring financial markets. This difference in volatility can potentially be attributed to the relatively conservative financial policies adopted by the oil-rich emirate of Abu Dhabi compared to the more market-oriented economic policies of Dubai, the country’s financial and commercial hub. Our findings have considerable implications for portfolio managers in ascertaining risk premiums when allocating investments across the two stock exchanges. For instance, this disparity in volatility should be taken into account by investors and policymakers when designing risk management strategies because it suggests that investors in the DFM may be exposed to higher levels of risk and uncertainty compared to their counterparts in the ADX. Investors operating in the DFM may require more robust risk management strategies, such as asset diversification and hedging, compared to their ASX counterparts.