Volatility transmission between stock and foreign exchange markets: a connectedness analysis

ABSTRACT

This paper empirically investigates volatility transmission among stock and foreign exchange markets in seven major world economies during the period July 1988 to May 2018. To this end, we first perform a static and dynamic analysis to measure the total volatility connectedness in the entire period (the system-wide approach). Second, we make use of a dynamic analysis to evaluate the net directional connectedness for each market. To gain further insights, we examine the time-varying behaviour of net pair-wise directional connectedness during the financial turmoil periods experienced in the sample period Our results suggest that slightly more than half of the total variance of the forecast errors is explained by shocks across markets rather than by idiosyncratic shocks. Furthermore, we find that volatility connectedness varies over time, with a surge during periods of increasing economic and financial instability.

KEYWORDS:

• Stock markets
• foreign exchange rates
• market linkages
• vector autoregression
• variance decomposition

JEL CLASSIFICATION:

• C53
• F31
• G15

Acknowledgments

The authors wish to thank an anonymous referee and the editor for their helpful comments and suggestions on a previous draft of this article, which have enabled us to introduce substantial improvements. The authors also thank Manish K. Singh for his excellent research assistance. One of the authors also thanks the hospitality provided by the Department of Economics during a research visit at the University of Bath. Responsibility for any remaining errors rests with the authors.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Hau and Rey (2006) show strong theoretical and empirical links between equity and exchange rate markets, while Doukas, Hall, and Lang (2003) explain why firms are affected by exchange rate exposure.

² The connectedness methodology has several advantages over the alternative approach of focusing on contemporaneous correlations (corrected or not for volatility). First, while correlation is a symmetrical measure, connectedness is an asymmetrical one, so the procedure provides information on the direction and magnitude of the volatility transmission (from country A to country B, from country B to country A, or both). Second, by investigating dynamic connectedness through a rolling window, we can evaluate how the strength of the connectedness evolves over time, allowing us to detect episodes of sudden and temporary increases in volatility transmission.

³ Awartania, Maghyerehb, and Al Shiabc (2013), Lee and Chang (2013), Chau and Deesomsak (2014) and Cronin (2014) apply this methodology to examine spillovers in the United States’ markets; Yilmaz (2010), Zhou, Zhang, and Zhang (2012) or Narayan, Narayan, and Prabheesh (2014) focus on Asian countries; Apostolakisa and Papadopoulos (2014) and Tsai (2014) examine G-7 economies, Duncan and Kabundi (2013) centre their analysis on South African markets, Antonakakisa and Floros (2016): study dynamic interdependencies among the housing market and stock market in the United Kingdom, Grosche and Heckelei (2016) investigate volatility spillovers between agricultural, crude oil, real estate, and other financial markets, Fernández-Rodríguez, Gómez-Puig, and Sosvilla-Rivero (2016) use connectedness analysis to assess financial stress transmission in EMU sovereign bond market volatility and Greenwood-Nimmo, Nguyen, and Rafferty (2016) study spillovers among daily returns and innovations in the option-implied risk-neutral volatility and skewness of the G10 currencies.

⁴ We use a trade-weighted exchange rate to account for each country’s diverse investment positions in foreign equities (see Tesar and Werner 1995; Kanas 2000).

⁵ Average of currency distribution of global foreign exchange market turnover over 2001, 2004, 2007, 2010, 2013 and 2016 Bank for International Settlements (2016). Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%.

⁶ This finding is in line with to those of Diebold and Yilmaz (2014) where the total connectedness of select companies in the financial services industry increased during the global financial crisis.

Additional information

Funding

This work was supported by the Bank of Spain [grant no. PR71/15-20229]; the Spanish Ministry of Education, Culture and Sport [grant PRX16/00261]; the Spanish Ministry of Economy and Competitiveness [grant ECO2016-76-203-C2-2-P]; and the ULPGC [grant CEi2017-025].