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How do normalization schemes affect net spillovers? A replication of the Diebold and Yilmaz (2012) study

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  • Caloia, Francesco Giuseppe
  • Cipollini, Andrea
  • Muzzioli, Silvia

Abstract

This paper replicates the Diebold and Yilmaz (2012) study on the connectedness of the commodity market and three other financial markets: the stock market, the bond market, and the FX market, based on the Generalized Forecast Error Variance Decomposition, GEFVD. We show that the net spillover indices (of directional connectedness), used to assess the net contribution of one market to overall risk in the system, are sensitive to the normalization scheme applied to the GEFVD. We show that, considering data generating processes characterized by different degrees of persistence and covariance, a scalar-based normalization of the Generalized Forecast Error Variance Decomposition is preferable to the row normalization suggested by Diebold and Yilmaz since it yields net spillovers free of sign and ranking errors.

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  • Caloia, Francesco Giuseppe & Cipollini, Andrea & Muzzioli, Silvia, 2019. "How do normalization schemes affect net spillovers? A replication of the Diebold and Yilmaz (2012) study," Energy Economics, Elsevier, vol. 84(C).
    • Handle: RePEc:eee:eneeco:v:84:y:2019:i:c:s0140988319303317
    DOI: 10.1016/j.eneco.2019.104536
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    15. Juncal Cunado & David Gabauer & Rangan Gupta & Chien-Chiang Lee, 2022. "On the Propagation Mechanism of International Real Interest Rate Spillovers: Evidence from More than 200 Years of Data," Working Papers 202212, University of Pretoria, Department of Economics.
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    More about this item

    Keywords

    Causality; Normalization schemes; Generalized forecast error variance decomposition; Spillover; Simulation; Vector autoregression models;
    All these keywords.

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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