Academic journal article IUP Journal of Applied Finance

Asymmetric and Volatility Spillover between Stock Market and Foreign Exchange Market: Indian Experience

Academic journal article IUP Journal of Applied Finance

Asymmetric and Volatility Spillover between Stock Market and Foreign Exchange Market: Indian Experience

Article excerpt

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Introduction

At present the financial emergencies and liberalization have been felt by one and all in the global economy. The innovations in technology and new financial instruments instrumental for the quick integration of domestic market with international markets has quickened the transmission effect. The balance of payment crisis in 1991 gave rise to economic reforms in India. After liberalization of the economy, the prices were allowed to be determined by the market and the domestic financial markets got integrated with international financial markets. After that period, several crises took place in the global economy, e.g., 1994 Mexican currency crisis, 1997 Asian currency crisis, 1998 Russian crisis, 1999 Brazilian crisis, 2001 Argentine crisis, 2002 Turkish crisis, 2008 subprime financial crisis, and 2009 European debt crisis, resulting in a large number of negative asset returns and high volatility in financial markets. Financial crisis, by definition, refers to the problems associated with financial system like failure of banking policies, dysfunctioning of markets, collapse of stock market, declining asset prices, currency depreciation, sovereign defaults, etc. More specifically, each crisis is characterized by certain typical features and thus demands to be studied in a different manner. Financial crises have in general resulted in unexpected movements in the financial instruments; therefore there is a need to study the crises from the perspective of price movements or volatility.

The financial landscape has changed significantly after the collapse of Lehman Brothers in September 2008 (Mohanty, 2009). The losses from the financial crisis, a result of the volatility in financial asset price, undermined financial stability to a larger extent. Capital market is like an engine of growth which plays a major role in the capital formation of a country. However, the fluctuation in the foreign exchange market affects invariably the decisions of policy makers, foreign exchange traders, portfolio managers, investors, financial institutions, etc. Indian stock market is fully dominated by Foreign Institutional Investors (FIIs), and during the crisis period, there was a major fall in the Indian stock market because most of the FIIs withdrew their investment from the Indian stock market. In this context, the foreign exchange market also got affected in terms of volatile exchange rate. Of late, the interlinkages between the foreign exchange market and stock market have become more conspicuous attracting the attention and concerns of the policy makers, portfolio managers, investors as well as researchers. Two major markets of a vibrant economy, i.e., stock market and foreign exchange market, play a vital role in evaluating the growth and development of an economy. There exist two theories on the relationship between stock market and foreign exchange market. One is goods market approach (Dornbusch and Fisher, 1980) and the other is portfolio balance approach (Krueger, 1983). The goods market approach states that an exchange rate determines the stock market. On the other hand, portfolio balance approach shows that stock market determines the exchange rates. The results of empirical research on the effect of these two financial markets on one another are also mixed.

Information mechanism between stock and foreign exchange markets can be understood through the knowledge of volatility transmission. It is important for developing an effective hedging strategy for the investors, policy makers and for financial market prospective. For pricing of securities in the global market and for diversification of portfolio, it is necessary to know the transformation of information from stock market to foreign exchange market. The efficiency of the market can also be known through the volatility spillover across the markets. A study of volatility spillover will help to detect the persistence and the extent of the innovation in the financial market over time and to know the interlinkage between the markets, which would help develop an effective hedging strategy. …

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