Academic journal article IUP Journal of Applied Finance

Response Asymmetry in Return and Volatility Spillover from the US to Indian Stock Market

Academic journal article IUP Journal of Applied Finance

Response Asymmetry in Return and Volatility Spillover from the US to Indian Stock Market

Article excerpt

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The growing integration of international financial markets has prompted a vast amount of empirical research to examine the mechanism through which stock market movements are transmitted around the world. The studies have examined how stock returns and volatility in one national stock market influence those of another stock market and their implications for pricing of securities, management of portfolios, hedging and other trading strategies, and for regulatory policies that aim to curb the contagion. The earliest studies on international stock market linkage have focused on the identification of short-term benefits of international portfolio diversification. For example, Ripley (1973), Solnik (1974), and Hilliard (1979) examined the short run correlations of returns across national markets and pointed out the existence of substantial possibilities to diversify internationally taking benefit of low correlation among national stock markets. However, during the 1980s, strong financial linkages among the countries started evolving, particularly due to the process of financial liberalization adopted by most of the developing countries. Increasing level of integration has reduced the benefits of international diversification. Moreover, the empirical studies suggest that the correlation among national stock markets is not symmetric. It increases during the bear phase, further reducing the benefit of diversification when it is more required.

The US stock market plays a role of information leader in the world market. National stock markets world over respond to information signals coming from the US market; hence, there is considerable price and volatility spillovers from the US market to other markets (see for example, Eun and Shim, 1989; and Masih and Masih, 2001). Considering the asymmetric nature of this spillover, the small emerging markets are vulnerable to the contagion effect of the US market during a turbulent period. The knowledge of time-varying co-movements of emerging markets with the US market during different market conditions is of paramount importance both for portfolio managers and regulators in these markets.

The Indian stock market is also greatly influenced by the developments taking place in the US market (see for example, Kumar and Mukhopadyay, 2002; Nair and Ramanathan, 2003; and Mukherjee and Mishra, 2007). The object of this study is to examine whether the Indian stock market responds asymmetrically to the news coming from the US market. The results show that there is significant asymmetry in price and volatility spillover. The Indian stock market responds more strongly after negative returns than after positive returns in the US market. However, the study does not observe any significant difference in price and volatility spillover effects during the bull and bear phases.

Review of Literature

The neoclassical models of economics and econometrics are based on the belief that the economic agents have a symmetric utility function. The utility from one unit gain is equal to the disutility from one unit loss in absolute term. Therefore, the utility function is linear. It is mainly after the publication of the seminal work of Kahneman and Tversky (1979) on 'prospect theory' it was realized that economic agents react asymmetrically to positive and negative returns (profit and loss) of same magnitude. It is now increasingly realized that the asymmetry (of reaction) is a widespread phenomenon across the economic and social realism and the prospect theory can be used to explain the human behavior across the different disciplines.

The asymmetry is observed in the dynamics of asset prices in three different but interrelated aspects. The most robust evidence of asymmetry in the dynamics of asset prices is found in the response of volatility towards changes in price. Volatility increases more after a negative shock than after a positive shock of the same magnitude. …

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