Volatility Transmission in Financial Markets: A New Approach ∗ Giampiero M. Gallo Dipartimento di Statistica “G. Parenti”, Universit` a di Firenze Via G. B. Morgagni, 59 - 50134 Firenze, Italy (gallog@ds.unifi.it) Edoardo Otranto Dipartimento di Economia, Impresa e Regolamentazione, Universit` a di Sassari, Via Torre Tonda - 07100 Sassari, Italy (eotranto@uniss.it) Abstract In this paper we suggest ways to characterize the transmission mecha- nisms of volatility between markets by making use of a new Markov Switch- ing bivariate model where the state of one variable feeds into the transition probability of the state of the other. The comparison between this model and other Markov Switching models allows us to derive statistical tests stressing the role of one market relative to another (contagion, interdependence, co- movement, independence, Granger causality). We estimate the model on the weekly high–low range of several Asian markets, with a specific interest in the role of Hong Kong. KEY WORDS: Markov Switching, multiple chains, volatility, transmission mechanisms, comovements JEL classification: C32 C52 C53 * We would like to thank participants in the JAE conference “Changing Structures in Interna- tional and Financial Markets and the Effects on Financial Decision Making” held in Venice on June 2-3, 2005 for many useful comments. Financial support from Italian MIUR under grants 2002134775 004 and 2004139322 007 is gratefully acknowledged. 1