VOLATILITY SPILLOVER BETWEEN TOCK AND FOREIGN EXCHANGE MARKETS: INDIAN EVIDENCE

ABSTRACT The study of volatility spillovers provides useful insights into how information is transmitted from stock market to foreign exchange market and vice versa. This paper explores volatility spillovers between the Indian stock and foreign exchange markets. The results indicate that there exists a bidirectional volatility spillover between the Indian stock market and the foreign exchange market with the exception of SP Foreign exchange market; Volatility spillovers; Information transmission; ARCH; GARCH; EGARCH I. INTRODUCTION The objective of this paper is to examine the relationship and volatility spillovers between Indian stock and foreign exchange markets. Internationalization of stock markets, liberalized capital flows, huge foreign investment in Indian equity markets have led stock and foreign exchange markets to be increasingly interdependent. An understanding of the intermarket volatility is important for the pricing of securities within and across the markets for trading and hedging strategies as well as for formulation of regulatory policies in an emerging market like India that is rapidly getting integrated into the global economy. Several financial as well as currency crises across emerging markets around the globe and the advent of floating exchange rate led the academicians as well as practitioners to have a re-look into the nature of volatility spillovers between stock and foreign exchange markets that have seen large correlated movements resulting in market contagion. It has been observed that exchange rate has been used to explain the behavior of stock prices on the assumption that corporate earnings tend to respond to fluctuations in exchange rate [Kim (2003)]. This issue attracted a plethora of regulatory implications as well, whereby institutional restrictions were set up to mitigate the volatility spillover [Roll (1989)]. Besides, international diversification and cross-market return correlations have led these markets to be increasingly interdependent. To understand the risk-return tradeoff of international diversification and, therefore, management of multi currency equity portfolios, it is important to analyze the interaction between the exchange rate risk and stock price. With significant rise in cross border equity investments and, in particular, investments in emerging markets like India, this has become a critical issue for fund managers, especially in the domain of pricing of securities in the global market, international portfolio diversification, and hedging strategies. Moreover, continuous economic globalization and integration of Indian financial Markets with world financial markets, especially fueled by the development of information technology, increases the international transmission of returns and volatilities among financial markets. A competent knowledge of the volatility spillover effect between the stock and foreign exchange markets, and consequently the degree of their integration, will potentially expand the information set available to international as well as domestic investors, multinational corporations, and policy makers for decision making. The existing research generally supports the existence of interdependence in return and volatility of stock and foreign exchange markets. …