Volatility co-movements: a time-scale decomposition analysis

In this paper we are interested in detecting contagion from US to European stock market volatilities in the period immediately after the Lehman Brothers collapse. The analysis is based on a factor decomposition of the covariance matrix, in the time and frequency domain, using wavelets. The analysis aims to disentangle two components of volatility contagion (anticipated and unanticipated by the market). Once we control for heteroskedasticity, the results show no evidence of contagion (from the US) in market expectations (coming from implied volatility) and evidence of unanticipated contagion (coming from the volatility risk premium) for almost any European country. Finally, the estimation of a three-factor model specification shows that a European common shock plays an important role in determining volatility co-movements mainly in the tranquil period, while in the period of financial turmoil the US common shock is the main driver of volatility co-movements.