Review of Financial Economics 11 (2002) 109 118

The temporal relationship between large- and

small-capitalization stock returns:
Evidence from the UK
Terrance Grieb1, Mario G. Reyes*
College of Business and Economics, University of Idaho, P.O. Box 443178, Moscow, ID 83844-3178, USA
Received 29 April 2001; received in revised form 10 August 2001; accepted 18 January 2002

Abstract

In this study, we provide some evidence of Granger-causal transmission of information to the

correlation between large- and small-cap stock indexes in the UK. We employ the bivariate Logistic
Exponential Generalized Autoregressive Conditional Heteroscedasticity (LEGARCH) specification
proposed by Darbar and Deb [Darbar, S. M., & Deb, P. (1999). Linkages among asset markets in the
United States tests in a bivariate GARCH framework. IMF Working Paper WP/99/158; Darbar,
S. M., & Deb, P. (2000). Transmission of information and cross-market correlations. Indiana
University Purdue University Indianapolis Working Paper.] and document correlation persistence,
and a two-way information flow. More specifically, information to the large-cap stock index positively
affects its next period correlation with the small-cap index, whereas information to the small-cap index
negatively affects its next period correlation with the large-cap index. We also find evidence
supporting the presence of both a January effect and an April effect in both small-cap and large-cap
returns. D 2002 Elsevier Science Inc. All rights reserved.

JEL classification: G12; G15

Keywords: Information transmission; Correlation; Bivariate Logistic EGARCH

* Corresponding author. Tel.: +1-208-885-7146; fax: +1-208-885-5347.

E-mail addresses: tgrieb@uidaho.edu (T. Grieb), mreyes@uidaho.edu (M.G. Reyes).
1
Tel.: +1-208-885-7140.

1059-0560/02/$ see front matter D 2002 Elsevier Science Inc. All rights reserved.
PII: S 1 0 5 9 - 0 5 6 0 ( 0 2 ) 0 0 1 0 4 - 1
110 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118

1. Introduction

Stock market interdependence has attracted the attention of many researchers because of its
implications for portfolio construction, asset pricing, and information transmission. Research-
ers often analyze information transmission within a Generalized Autoregressive Conditional
Heteroscedasticity (GARCH) framework. Hamao, Masulis, and Ng (1990) were the first to
examine information spillovers using a univariate GARCH framework. Subsequent studies
have examined this issue within a multivariate framework. For instance, Booth, Martikainen,
and Tse (1997), using a multivariate Exponential GARCH (EGARCH) model proposed by
Koutmos (1996), find multidirectional information transmission between four Scandinavian
markets. Kanas (1998) also finds interdependencies between the markets in London,
Frankfurt, and Paris. However, Koutmos reports that the UK is the dominant market in
terms of price spillovers from its stock market to the markets of France, Germany, and Italy.
He also reports that accounting for heteroscedasticity and interactions among markets
substantially reduces the pairwise correlation coefficients between these markets. This result
suggests that the potential for diversification among these markets is better than that
suggested by assuming constant correlation.
Darbar and Deb (1997), using a generalized positive definite multivariate GARCH
model, find evidence of time-varying conditional correlation between developed markets.
Longin and Solnik (1995) argue that return correlation could be dependent upon factors
such as market volatility or business cycles, which would cause intertemporal fluctuations
in the conditional correlation. Using a bivariate GARCH technique, they document the
existence of a positive time trend in conditional correlation, as well as a positive
relationship between conditional correlation and the degree of volatility in the respective
markets. King, Sentana, and Wadhwani (1994) provide confirming evidence of the
relationship between volatility and conditional correlations for 16 national stock markets.
They did not investigate whether there is a causal relation between volatility and cross-
market correlation.
Darbar and Deb (1999, 2000) consider a Granger-causal transmission of information to
cross-market correlation. They develop a bivariate Logistic EGARCH (LEGARCH)
model that accounts for information spillover to the conditional correlation between dif-
ferent financial markets. Their proposed model allows for the explicit testing of infor-
mation transfers without having to impose additional restrictions on the variance. Darbar
and Deb (2000) finds that the stock market dominates information transmission in that
information in the stock market affects its correlation with money and currency markets
in the US.
Our study seeks to extend the Darbar and Deb (1999, 2000) analysis to the UK stock
market. Whereas many studies have reported evidence of information transfers between the
UK and neighboring European markets (see, e.g., Kanas, 1998; Koutmos, 1996), there is a
paucity of evidence on the impact of information on the correlation between size-based UK
stock indexes. Yet such evidence is important because it provides some insights into the
temporal relationship between large- and small-cap stocks and its implication for portfolio
allocation. By confining our analysis to the UK stock market, we hold constant important
 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118 111

microstructure issues (e.g., nonsynchronous trading, trading days, etc.) that complicate
intercountry information transmission and correlational analysis. Our bivariate LEGARCH
analysis reveals a two-way information flow from large- and small-cap indexes to their next
period correlation. The analysis also confirms a small-firm January effect and an April effect
in both size-based indexes. This study, therefore, extends the empirical evidence on UK stock
returns recently summarized by Dimson and Marsh (2001). In the next section, we describe
the sample data and present the results of our bivariate logistic EGARCH(1,1) estimation.
Section 3 concludes.

2. Empirical analysis

2.1. Data description and preliminary statistics

The data examined in this study consist of continuously compounded monthly rates of
return (in pounds) over the period starting on March 1955 and ending on March 1996. We
examine the interdependence between two stock indexes from the London Stock
Exchange, namely: (1) Financial Times Actuaries (FTA)All Share Stock Index, repre-
senting large capitalization stocks in the UK, and (2) Smaller Companies Stock Index
(UKSM), as an index of small-capitalization stocks. From March 1955 through March
1986, monthly returns on the UKSM are represented by the rates of return on the Hoare
Govett Smaller Company Stock Index compiled by the London School of Business. From
April 1986 to March 1996, the monthly returns are from the Dimensional Funds Advisors
(DFA) UK Small Companies Fund. Although the DFA UK Small Companies Fund is
constructed as a mimicking portfolio, the DFA does not try to mimic exactly the Hoare
Govett Smaller Company Index because of trading costs associated with rebalancing the
fund portfolio.2
Descriptive statistics of the continuously compounded rates of return on the two indexes
are reported in Table 1. The skewness and excess kurtosis for both indexes indicate that the
return distributions are not normal. Formal tests conducted using the BeraJarque test reject
the null hypothesis of normality of the return distributions. Moreover, the LjungBox Q and
Q2 statistics indicate that the returns series exhibit linear dependence and strong ARCH
effects, respectively.

2.2. The bivariate LEGARCH(1,1) model

Let r1,t denote the monthly rate of return on the large-cap index, r2,t denote the monthly
rate of return on the small-cap index, ei,t represent the innovation term (i.e., the unexpected
2
return), si,t denote index is conditional variance, and s12,t denote the conditional covariance

2
See Fama (1992, p. 1588) for an explanation of the characteristics of the DFA mimicking passive
mutual funds.
112 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118

between small-cap and large-cap returns. Then the bivariate EGARCH(1,1) model may be
written as follows:
r1,t b10 b11 r1,t1 j11 JANt a11 APRt e1,t 1

r2,t b20 b22 r2,t1 j22 JANt a22 APRt e2,t 2

lns211,t c11 a11 jz1,t1 j  Ejz1,t1 j g11 z1,t1 q11 lns21,t1 3

lns222,t c22 a22 jz2,t1 j  Ejz2,t1 j g22 z2,t1 q22 lns22,t1 4

zi,t ei,t =si,t , for i 1,2 5

s12,t r12 s1,t s2,t 6

where JANt is a dummy variable taking on the value of 1 for the month of January and 0
otherwise, and APRt is a dummy variable taking on the value of 1 for the month of April and
0 otherwise. We include an autoregressive term in Eqs. (1) and (2) in order to account for the
observed autocorrelation in UK stock returns (see, e.g., Chelley-Steeley & Steeley, 1995). We
also include January and April dummy variables in light of the January and April seasonality
in UK stock returns reported by Clare, Psaradakis, and Thomas (1995), Menyah (1999), and
Reinganum and Shapiro (1987). Dimson and Marsh (2001) note that the tax year for
individuals ends on April 5th, and that UK firms tend to have fiscal year-ends in December or
March; hence, the turn-of-the-year effect could show up in January or April. They find
evidence that January and April have higher mean returns than the other months of the year.
We employ an EGARCH specification of the conditional variance in Eqs. (3) and (4) for
several reasons. First, EGARCH models the (natural) logarithm of the conditional variance,
thereby ensuring that the variance will be positive. Second, Kim and Kon (1994) show that
EGARCH is the most appropriate model for stock indexes, such as those used in our study.
EGARCH specifies the conditional variance of each index as a function of its own lagged

Table 1
Descriptive statistics of returns on size-based UK stock indexes: 1955.03 1996.03
Large-cap Small-cap
Mean 1.1029 1.3519
Standard Deviation 5.7344 4.9077
Skewness 0.1449 [.1902]  0.4396 [.0000]
Kurtosis 8.0858 [.0000] 4.8702 [.0000]
Bera Jarque test for normality 1309.3441 [.0000] 490.2595 [.0000]
First-order autocorrelation 0.1026 0.2993
Ljung Box Q(12) statistics 19.2929 [.0560] 54.8656 [.0000]
Ljung Box Q2(12) statistics 53.7898 [.0000] 64.5342 [.0000]
P values in brackets.
 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118 113

2
standardized innovation (zi,t  1) and own lagged conditional variance (lnsi,t  1). The
coefficient a represents the effect of the lagged standardized innovation on future volatility
(i.e., the ARCH effect). The coefficient q is the GARCH parameter, and it represents volatility
persistence in that a high value suggests that an information shock tends to persist for some
time into the future. Volatility persistence is often measured using the half-life of a shock.
Half-life is calculated as ln(0.5)/ln(q), and is a measure of the length of time it takes a shock to
decay to one-half. Stylized facts from studies of UK stock returns show that the ARCH effect
is dramatically lower than the GARCH effects (see, e.g., Chelley-Steeley & Steeley, 1995;
Koutmos, 1996).
The coefficient g in Eqs. (3) and (4) captures the relationship between news and volatility.
For instance, Koutmos (1996) reports a g-estimate of  0.2930 for the Financial Times 500
Share Index. Since  1 < g < 0, Hamilton (1994) notes that positive news increases volatility
less than negative news. If g had been less than  1, then good news lowers volatility,
whereas bad news increases volatility (Hamilton, 1994, p. 688).
A version of the system of equations given by Eqs. (1)(6) was employed by Booth et al.
(1997) and Koutmos (1996) in their analysis of the interdependence of foreign equity
markets. Unlike Booth et al. and Koutmos, however, we model the conditional correlation to
be time varying. The model we use is the logistic transformation proposed by Darbar and Deb
(1999, 2000):

!
1
r12,t 2 1 7
1 expx12,t

where

x12,t c12 a12 z1,t1 z2,t1 q12 x12,t1 d1 e21,t1 d2 e22,t1 8

The conditional correlation is a function of an index function x12,t, which in turn is a function
of it own past values (x12,t  1) and the past values of the cross-products of the standardized
innovations. The logistic transformation ensures that the conditional correlation is the (  1,1)
range. We follow Darbar and Deb (2000) and specify the conditional correlation to be a
function of the lagged large- and small-cap unexpected returns, namely, the squared residuals,
2 2
e1,t  1 and e2,t  1, respectively. Squared residuals are added to the index function because they
are commonly used as proxies for volatility, and to the extent that volatility reflects the rate of
information flow (Ross, 1989) such an addition allows us to investigate whether the arrival of
new information to the large- and small-cap indexes at t  1 significantly affects their
correlation at time t. If di = 0, then there is no link between information to index i and its
conditional correlation with index j. On the other hand, if di 6 0, then there is a transfer of
information from index i to the conditional correlation.
114 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118

2.3. Results

Estimation of the system of Eqs. (1)(8) is estimated using the Broyden, Fletcher,
Goldfarb, and Shanno (BFGS) algorithm.3 The results are reported in Tables 2 and 3. We
begin with Table 2 where two sets of diagnostics checks, namely, LjungBox and asymmetry
tests, are presented. LjungBox Q tests on the standardized residuals from the bivariate
LEGARCH(1,1) model reveal no significant departure from the null hypothesis of temporal
independence. In addition to the LjungBox Q test, we also ran the diagnostic tests suggested
by Engle and Ng (1993) as a way to check for misspecifications induced by asymmetric
effects. All four asymmetry test statistics (sign bias, negative size bias, positive size bias, and
joint test) are not significantly different from zero. Taken together, these tests indicate that the
bivariate LEGARCH(1,1) model fits the data very well. However, excess kurtosis in the
standardized residuals is statistically significant, contributing to the rejection of the hypo-
thesis of normality when using the BeraJarque test. In this regard, we employ robust
standard errors of the parameter estimates.4
Panel A of Table 3 presents the estimates of the coefficients in the conditional mean and
variance equations. Panel A reveals that the autoregressive term in both the large- and small-
cap return equations is statistically significant. This finding is consistent with those reported
by Chelley-Steeley and Steeley (1995) for size-based portfolios of UK stocks. Unlike Chelly-
Steeley and Steeley, however, we find that both the January effect coefficients, j11 and j22, are
statistically significant. Chelley-Steeley and Steeley and Menyah (1999) report a January
effect for UK small-cap portfolios but not for the large-cap portfolio. Differences in the
sample period, returns data, and methodology employed may be responsible for the results.
Panel A of Table 3 also reveals that both the April effect coefficients, a11 and a22, are
statistically significant. This finding is consistent with the April effect reported by Dimson
and Marsh (2001).
The ARCH parameters (a11 and a22) and the GARCH parameters (q11 and q22) are all
statistically significant. Consistent with the results reported by other researchers, the ARCH
estimates of 0.1767 and 0.1592 are smaller than the GARCH estimates of 0.9614 and 0.9751.
The GARCH estimates suggest a high volatility persistence, with volatility shocks to small-
caps persisting longer than shocks to the large-caps. The estimate of 0.9614 for the large-cap
index suggests a half-life of approximately 17 months whereas the estimate of 0.9751 for the
small-cap index indicates a half-life of approximately 27 months. Another way of looking at
the volatility persistence is to consider that for the large-cap index, 88% ( = 0.961433) of a
shock remains after 3 months compared to 92% ( = 0.975133) for the small-cap index.

3
We do not include the asymmetry coefficient (g) in the final estimation of the conditional variance because
we find the coefficient to be statistically insignificant in univariate estimations. Poon and Taylor (1992) also report
no significant asymmetric effects in their analysis of the Financial Times (FT) All-Share Index during the period
1965.01 1989.12.
4
In RATS, this is achieved using the BFGS algorithm with the ROBUSTERRORS option. For details, see the
description by Rob Trevor in the May 1994 RATS Letter.
 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118 115

Table 2
Diagnostic tests of the bivariate LEGARCH(1,1) model of size-based UK stock indexes
Large-cap Small-cap
Panel A: Bera Jarque and Ljung Box statistics
Skewness  0.6068 [.0000]  0.6321 [.0000]
Kurtosis 3.5830 [.0000] 2.9586 [.0000]
Bera Jarque test for normality 286.9577 [.0000] 207.8326 [.0000]
Ljung Box Q(12) statistics 17.2689 [.1002] 10.9210 [.4499]
Ljung Box Q2(12) statistics 8.7499 [.6449] 2.3972 [.9965]

Panel B: Engle Ng (1993) diagnostic test statistics

Sign bias test 0.5160 [.6061]  0.0763 [.9392]
Negative size bias test 0.5279 [.5977]  0.9813 [.3269]
Positive size bias test 0.2291 [.8189]  0.4210 [.6739]
Joint test 0.1218 [.9472] 0.5518 [.6472]
P values in brackets.

Panel B presents the parameter estimates for the index function in the logistic transforma-
tion of the conditional correlation between large- and small-cap indexes. The estimates reveal
a pattern very similar to the one we find for the conditional variance. The ARCH parameter
(a12) in the conditional correlation is very small when compared to the GARCH parameter
(q12); however, only the GARCH parameter is statistically significant. This suggests that the
correlation between large- and small-cap indexes in the UK exhibits considerable persistence,

Table 3
Bivariate LEGARCH(1,1) model of size-based UK stock indexes
Large-cap (i = 1) Small-cap (i = 2)
Panel A: Conditional mean and variance parameters
bi0 0.0104 (5.7809)** 0.0084 (6.0177)**
bii  0.0917 (  3.7285)** 0.2412 (17.3448)**
jii 0.0135 (2.3687)* 0.0229 (5.9417)**
aii 0.0243 (6.9386)** 0.0202 (5.9157)**
cii  0.2178 (  1.3899)  0.1467 (  1.2329)
aii 0.1767 (4.1025)** 0.1592 (3.5764)**
qii 0.9614 (36.5645)** 0.9751 (51.6927)**

Panel B: Parameters in the conditional correlation

c12 0.2399 (4.0478)**
a12 0.0152 (0.4939)
q12 0.9214 (36.0935)**
d1 6.0415 (2.5318)*
d2  18.9350 (  3.3269)**
t statistics in parentheses.
* Denotes significance at the .05 level.
** Denotes significance at the .01 level.
116 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118

with a half-life of a little more than 8 months. The constant term, c12, is estimated to be
0.2399, and is statistically significant. This estimate corresponds to a base correlation of 0.12,
and is significantly lower than the 0.86 unconditional correlation estimated for the entire
sample period. These results suggest that ignoring the time variation and GARCH effects in
the conditional correlation leads one to overestimate the correlation between large- and small-
cap stocks in the UK and thus, understate the diversification benefits.
Panel B reveals that both d1 and d2 are statistically significant information parameters in
the conditional correlation. This finding suggests a two-way information transmission from
large- and small-cap to their next period correlation. The significance of d1 indicates a link
between the information to large-cap index in time t  1 and its conditional correlation with
the small-cap index in time t. This finding is compatible with the information transmission
from large-cap stocks reported by Lo and MacKinlay (1990) and others.5 Since the estimated
d1 coefficient is positive, information to the large-cap stock index increases its next period
correlation with the small-cap stock index. This increase in cross-market correlation may
indicate the arrival of information common to both indexes (King et al., 1994).
The significance of d2 indicates a link between the information to the small-cap index and
its next period conditional correlation with the large-cap index. Information transmission
from small-caps is suggested by Chelley-Steeley and Pentecost (1994, p. 410), whose
cointegration analyses indicate that small firm returns can also be used to predict large firm
returns. Because the estimated d2 coefficient is negative, information to the small-cap index
negatively affects its next period correlation with the large-cap index. In other words,
information that is generally good news for small-caps is generally bad news for the large-
cap index.

3. Summary and conclusion

This study provides some evidence of Granger-causal transmission of information to the

correlation between large- and small-cap stock indexes in the UK. We employ the Darbar and
Deb (1999, 2000) LEGARCH specification, and find correlation persistence and a two-way
information flow from large- and small-cap stock indexes to their next period correlation.
Information to large-cap stocks positively affects their next period correlation with small-cap
stocks. This increase in cross-market correlation may reflect the arrival of information that is
common to both stock indexes, or indicate periods when a rise in the volatility of
nonfundamental factors lead investors to examine other markets, thereby exhibiting increased
cross-market correlations (King & Wadhwani, 1990).
On the other hand, information to the small-cap index negatively affects its next period
correlation with the large-cap index. Thus, information that is generally good news for small-

5
See, for example, McQueen, Pinegar, and Thorley (1996) who find asymmetry in the cross-autocorrelation of
size-based portfolios of US stocks. In the case of the Tokyo Stock Exchange, Reyes (2001) observes an
asymmetric volatility spillover from large-cap to small-cap stocks.
 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118 117

caps is generally bad news for large-caps. These changes in correlations may reflect
differences in the sensitivity of large-cap and small-cap stock returns to movements in
exchange rates (King et al., 1994). For instance, small firms, who may be net importers, gain
when the pound appreciates whereas large companies, who may be net exporters, are
adversely affected. These results suggest that studies of UK stock returns must account for
the time variation in the conditional correlation between large- and small-cap stocks indexes
and the impact of information spillovers on their correlation.

Acknowledgments

The authors would like to thank the Dimensional Fund Advisors for providing the returns
data and an anonymous referee for several helpful suggestions that improved our study.
Errors are solely the responsibility of the authors.

References

Booth, G. G., Martikainen, T., & Tse, Y. (1997). Price and volatility spillovers in Scandinavian stock markets.
Journal of Banking and Finance, 21, 811 823.
Chelley-Steeley, P. L., & Pentecost, E. J. (1994). Stock market efficiency, the small firm effect and cointegration.
Applied Financial Economics, 4, 405 411.
Chelley-Steeley, P. L., & Steeley, J. M. (1995). Conditional volatility and firm size: an empirical analysis of UK
equity portfolios. Applied Financial Economics, 5, 433 440.
Clare, A. D., Psaradakis, Z., & Thomas, S. H. (1995). The analysis of seasonality in the UK equity market.
Economic Journal, 105, 398 409.
Darbar, S. M., & Deb, P. (1997). Co-movements in international equity markets. Journal of Financial Research,
20, 305 322.
Darbar, S. M., & Deb, P. (1999). Linkages among asset markets in the United States tests in a bivariate GARCH
framework. IMF Working Paper WP/99/158.
Darbar, S. M., & Deb, P. (2000). Transmission of information and cross-market correlations. Indiana University
Purdue University Indianapolis Working Paper.
Dimson, E., & Marsh, P. (2001). U.K. financial market returns, 1955 2000. Journal of Business, 74, 1 31.
Engle, R. F., & Ng, V. K. (1993). Measuring and testing the impact of news on volatility. Journal of Finance, 48,
1749 1778.
Fama, E. F. (1992). Efficient capital markets: II. Journal of Finance, 46, 1575 1617.
Hamao, Y., Masulis, R., & Ng, V. (1990). The effects of the stock market crash on financial integration. Review of
Financial Studies, 3, 281 307.
Hamilton, J. D. (1994). Time series analysis. New Jersey: Princeton University Press.
Kanas, A. (1998). Volatility spillovers across equity markets: European evidence. Applied Financial Economics, 8,
245 256.
Kim, D., & Kon, S. J. (1994). Alternative models for the conditional heteroscedasticity of stock returns. Journal of
Business, 67, 563 598.
King, M. A., Sentana, E., & Wadhwani, S. (1994). Volatility and links between national stock markets. Econo-
metrica, 52, 901 933.
King, M. A., & Wadhwani, S. (1990). Transmission of volatility between stock markets. Review of Financial
Studies, 3, 5 33.
118 T. Grieb, M.G. Reyes / Review of Financial Economics 11 (2002) 109118

Koutmos, G. (1996). Modeling the dynamic interdependence of major European stock markets. Journal of Busi-
ness Finance and Accounting, 23, 975 988.
Lo, A., & MacKinlay, C. (1990). When are contrarian profits due to stock market over-reaction? Review of
Financial Studies, 3, 175 205.
Longin, F., & Solnik, B. (1995). Is the correlation in international equity returns constant: 1960 1990? Journal of
International Money and Finance, 14, 3 26.
McQueen, G., Pinegar, M., & Thorley, S. (1996). Delayed reaction to good news and the cross-autocorrelation of
portfolio returns. Journal of Finance, 51, 889 919.
Menyah, K. (1999). New evidence on the impact of size and taxation on the seasonality of UK equity returns.
Review of Financial Economics, 8, 11 24.
Poon, S. H., & Taylor, S. J. (1992). Stock returns and volatility: an empirical study of the UK stock market.
Journal of Banking and Finance, 16, 37 60.
Reinganum, M. R., & Shapiro, A. C. (1987). Taxes and stock return seasonality: evidence from the London stock
exchange. Journal of Business, 60, 281 295.
Reyes, M. G. (2001). Asymmetric volatility spillover in the Tokyo stock exchange. Journal of Economics and
Finance, 25, 206 213.
Ross, S. A. (1989). Information and volatility: the no-arbitrate martingale approach to timing and resolution
irrelevancy. Journal of Finance, 44, 1 17.