Executive Summary
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International financial markets transmit signals to each other through direct and indirect channels. Those processes can be analyzed for volatility of prices as well as for returns.
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Transmission channels exist across different geographical regions and various asset classes.
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The “meteor shower” effect is the transmission of signals across markets in different regions, usually in sequences in which they trade. The “heat wave” effect is the transmission of return or volatility signals within the same market over time.
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Information about the existence of meteor showers and heat waves, such as their sign, strength, direction, stability, and statistical and economic significance, can lead to better and more profitable designs of investment strategies on stock, currency, and other financial markets.
Introduction
The interdependence of national and international financial markets, both in returns and volatility, is well documented in the finance literature. Twenty-four-hour markets, such as the currency market, and less-continuous ones, such as stock markets, are known to exhibit correlation in returns and volatility both over time and across countries or regions. In many cases, such correlation has been increasing in recent decades. This apparent integration has been rationalized by increasing globalization, intensified international capital flows and investments, faster information transfer, harmonization of international regulations, increasing trade and market order flow, as well as enhanced alignment of economic scope, scale, and policy.
Engle, Ito, and Lin, in 1990, introduced the financial equivalent to the astronomical and meteorological phenomena of meteor showers and heat waves, as the interregional and region-specific persistence in volatility. The “meteor shower” (MS) effect refers to the transmission of information, as captured by volatility, across markets (when they trade in different regions and time zones). The “heat wave” (HW) effect is the transmission of information internally within the same market. The MS and HW effects are not mutually exclusive and, hence, during any period of time both of them can co-exist, even though one may dominate.
The MS persistence, or clustering, of volatility has been initially documented between only a few pairs of international stock markets, and for major foreign exchange rates in the currency market. Recently, however, evidence from the currency market has been extended, and innovative new methodology enabled wider and more thorough analyses of stock markets.
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