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Spillover Volatility, Contagion and Information
Niël Oberholzer
Department of Finance and Investment Management
University of Johannesburg

esearch focus on international financial markets has shifted, in the last few years, to examine the inter-market relationship between markets with reference to the cause and effect of these inter-market relationships. More specifically referring to the inter-market volatility, and whether there are relationships and correlation or not, between market volatilities. This transmission of volatility is known as spillover volatility.

The motivation to examine and study spillover volatility, and the resulting contagion, is that it provides critical information regarding the increase or decrease in international cross border investment flow. It also acts as an indicator of increased demand and supply in foreign currency. This leads to some interdependency between stock market volatility returns and foreign exchange rate changes.

The study of spillover volatility provides useful insights into how information is transmitted between different asset class markets, both at a country to country level or at a local market level for example, from the underlying asset market to the derivative (market) created on the underlying asset. Spillovers can also exist between developed markets and emerging markets or trading time zone to trading time zone.

Literature and research into volatility spillover can be divided into two broad groups. The first group focus their studies on the return series or errors from modelling return series, and how returns correlate, across markets. For instance, Eun and Shim (1989) shows that 26% of the error variance of stock markets returns can be explained by innovations in other markets. They also note that the US market is the most influential market. The second group directly research and examines volatility. King and Wadhwani (1990) research the crash of October 1987, their study report evidence which supports the transmission of price information across markets through volatility innovation, even when information is market specific.

The transmission of volatility can be one way directional, for example from the foreign exchange market to the equity (stock) market or bi-directional, from the foreign exchange market to the equity (stock) market and from the equity (stock) market back to the foreign exchange market.

Internationalisation of equity (stock) markets and the liberalisation of capital flows, and the huge increase in foreign direct investment and international portfolio flows caused markets to become increasingly more interdependent. The understanding of inter-market volatility within and/or across markets is of critical importance when pricing and trading financial assets, constructing of financial hedges, especially across financial asset classes, and the formulating of financial policies and regulations across financial markets.

Several financial crises, over the last two decades and the introduction of floating exchange rates led to an increased trend in the correlation in movement between these two markets, resulting in market contagion. This forced academics and market participants to re-examine the nature and impact of spillover volatility between the foreign exchange market and the equity (stock) market. It must also be noted that international diversification and cross market return correlation lead to these markets becoming more interdependent.

Studies conclude that the importance of the volatility spillover effect between markets is influenced by the exchange rate regime and the direction of the exchange rate shock, in other words the appreciation or depreciation of the local currency.

The persistence of volatility in the foreign exchange market could result from an international process, such as speculation, bubbles or herd behaviour effects, but there also exist a perfectly compatible reason with the concept of efficient markets for the persistence of volatility.

The understanding of the inter-market relationship is critical in understanding the risk-return trade-off of international diversification. This understanding helps in the management of multi currency equity (stock) portfolios. With the significant increase in cross border investment flows especially into emerging markets, like South Africa, this has become a decisive issue for fund managers, especially when pricing financial investment assets and hedging strategies in the global financial markets. This implies that the expected equity (stock) market return is directly related to the predictability of equity (stock) market volatility and therefore the predictability of risk premiums.

The continuous global integration, liberalisation and the massive increase in the development and distribution of information technology in South African financial markets, led to an increase in volatility returns among financial market. The question to be answered is, how does local investors compare and price risk premiums namely country or sovereign risk and foreign exchange rate risk, to international investors ,when they invest, if at all.

The direction and timing, as well as the question of which market leads which market, is of critical importance in any study of spillover volatility and contagion. In simple terms, it is the time it takes for price formation to reflect the information, i.e. how long does it take for traders in one market to react to information in the opposite market. The concept of price formation, based on information flow, private or public, volume and size of trades, and order flows is an independent but critical study field, in understanding the concept of spillover volatility and contagion.

Information can be divided into two types, macro-economic news and data, and the other being non economic news and data. Considering the two markets, namely the foreign exchange market and equity (stock) market, is the impact of these two types of information on both markets similar or dissimilar?

The impact of information flow is consistent with the popular notation of a “flight-to-quality” and/or “flight-from-quality”, this result in market participants on frequent basis revising their risk assessment of financial assets.

In closing, I hope that this article invoke constructive debate and research in this fascinating field of financial markets. This study field is not all about the mathematics of markets, but also about the behaviour of markets and investors.

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