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This paper proposes an empirical test of financial contagion in Europeanequity markets during the tumultuous period of 2008-2011. Our analysis showsthat traditional GARCH and Gaussian stochastic-volatility models are unable toexplain two key stylized features of global markets during presumptivecontagion periods: shocks to aggregate market volatility can be sudden andexplosive, and they are associated with specific directional biases in thecross-section of country-level returns. Our model repairs this deficit byassuming that the random shocks to volatility are heavy-tailed and correlatedcross-sectionally, both with each other and with returns. The fundamentalconclusion of our analysis is that great care is needed in modeling volatilityif one wishes to characterize the relationship between volatility and contagionthat is predicted by economic theory.  In analyzing daily data, we find evidence for significant contagion effectsduring the major EU crisis periods of May 2010 and August 2011, where contagionis defined as excess correlation in the residuals from a factor modelincorporating global and regional market risk factors. Some of this excesscorrelation can be explained by quantifying the impact of shocks to aggregatevolatility in the cross-section of expected returns - but only, it turns out,if one is extremely careful in accounting for the explosive nature of theseshocks. We show that global markets have time-varying cross-sectionalsensitivities to these shocks, and that high sensitivities strongly predictperiods of financial crisis. Moreover, the pattern of temporal changes incorrelation structure between volatility and returns is readily interpretablein terms of the major events of the periods in question.

An empirical test for Eurozone contagion using an asset-pricing model with heavy-tailed stochastic volatility