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