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IJOEM 8,2

Returns and volatility spillover between stock prices and exchange rates
Empirical evidence from IBSA countries
Manish Kumar
Global Research and Analytics, CRISIL, Chennai, India
Abstract
Purpose The purpose of this paper is to analyze the nature of returns and volatility spillovers between exchange rates and stock price in the IBSA nations (India, Brazil, South Africa). Design/methodology/approach The study uses VAR framework and the recently proposed Spillover measure of Diebold and Yilmaz to examine the returns and volatility spillover between exchange rates and stock prices of IBSA nations. In addition, multivariate GARCH with time varying variance-covariance BEKK model is used as a benchmark against the spillover methodology proposed by Diebold and Yilmaz. Findings The results of multivariate GARCH model suggests the integration between stock and foreign exchange markets and indicates the existence of bi-directional volatility spillover between stock and foreign exchange markets in the IBSA countries. Spillover results using the Diebold Yilmaz model suggest the bi-directional contribution between stock and foreign exchange market, in terms of both returns and volatility spillovers. Overall, results conrm the presence of returns and volatility spillovers within the IBSA nations and, in particular, the stock markets play a relatively more important role than foreign exchange markets in the rst and second moment interactions and spillovers. Practical implications The market participants may consider the relationship between the exchange rate and stock index to predict the future movement of each other effectively. Multinational companies interested in exchange rate forecasting may consider the stock market as an important attribute. There is an interesting implication for portfolio managers too because of the spillover stock and foreign exchange markets. This knowledge would help to create a fund which performs well. Moreover, the paper can help regulators and policy makers in IBSA nations to understand the structure of the market in a better way and then design their policies. Originality/value The study contributes to the literature by extending the existing studies on the spillover between stock price and exchange rate by investigating the issue for three emerging economies, India, Brazil and South Africa. Unlike most studies in the literature which focus on multivariate GARCH model, this is the rst study which explores the issue of returns and volatility spillover between the stock prices and the exchange rates using spillover measure of Diebold and Yilmaz and much longer and recent daily data. Moreover, multivariate GARCH with time varying variance-covariance BEKK model is used as a benchmark against the spillover methodology proposed by Diebold and Yilmaz. Keywords Stock prices, Exchange rates, Returns, Emerging markets, Spill over, Time series analysis, Multivariate GARCH, Variance decomposition, India, Brazil, South Africa Paper type Research paper

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International Journal of Emerging Markets Vol. 8 No. 2, 2013 pp. 108-128 q Emerald Group Publishing Limited 1746-8809 DOI 10.1108/17468801311306984

The author would like to thank the anonymous reviewers and Editor of the Journal for going through the manuscript patiently and critically and sharing their views in improving the article.

1. Introduction Studying the dynamic relationship between forex and stock market has attracted the attention from policy makers, market participants and the academicians for a long time and offers meaningful insights to them (Tabak, 2006; Aydemir and Demirhan, 2009; Kutty, 2010; Kumar, 2010; Zhao, 2010). For policymakers, analyzing the dynamic relationship between stock price and exchange rates is important because relationship between two markets may affect their decisions about monetary and scal policy. A booming stock market has a positive effect on aggregate demand. If this is large enough, expansionary monetary or contractionary scal policies that target the interest rate and the real exchange rate will be neutralized. Sometimes, policy makers advocate less expensive currency in order to boost export sector. They should be aware whether such a policy might depress the stock market (Dimitrova, 2005; Gavin, 1989). It would also be useful for regulator, as understanding of the stock price-exchange rate relationship may prove helpful to foresee a crisis. Until the 1980s, nancial crises were seen as events that happened in individual markets, without a systemic nature. Nonetheless, the incidence of numerous nancial crises such as the crisis of the European Mechanism of Exchange Rates (1992), the Mexican crisis (1994), the Asian crisis (1997), the Russian crisis (1998) and the Brazilian crisis (1999) were not restricted to the countries of origin, but they quickly spread all over the world to a number of international markets. These crisis gripped various economies due to signicant depreciation of exchange rates (in terms of US dollar) as well as drastic decline in the stock prices. Thus, it is important to study the transmission of shocks between exchange rates and stock price (Kumar, 2010; Dimitrova, 2005). Huge volume and value of currencies and stocks traded around the world have also led to speculation in these markets. Thus, for the market participants and investment community, who deal either or both in stock or foreign exchange markets, the dependence between the two markets may be used to protably exploit the relationship. Moreover, diversication in the portfolio (at nancial product, asset class, and country level) has made exchange rates an integral part of the portfolio held by mutual funds, foreign intuitional investors, hedge funds and other professionally managed funds. The mean-variance approach to portfolio analysis suggests that the expected return is implied by the variance of the portfolio. This requires an estimate of the correlation between stock prices and exchange rates (Kumar, 2010; Dimitrova, 2005). Thus, understanding of the relationship between exchange rates and stock prices may help the fund manager to manage and hedge the risk prociently. Multinational companies (MNCs) thrive on most of their sales coming from overseas. They have to dabble with many tasks such as decisions on hedging, short-term nancing, short-term investment, capital budgeting, earning assessment, and long-term nancing. This makes MNCs vulnerable to exchange rate movements. Thus, understanding the exchange rate movements can help MNCs take better decisions. This would also benet MNCs, in managing their short-term nancing, and investment, capital budgeting, earning assessment, exposure to foreign contracts and exchange rate risk stabilizing their earnings. Last but not the least, the empirical ndings helps strengthening the theoretical framework of the determinants of exchange rates or stock market movement, from the perspective of developing economies such as India, Brazil, South Africa (IBSA) countries, which may be useful for the academic community.

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Thus, the discussion on the dynamic relationship between exchange rate and stock market has been the subject of various studies (Mundell, 1963; Dornbusch and Fisher, 1980; Bahmani-Oskooee and Sohrabian, 1992; Mok, 1993; Ajayi and Mougoue, 1996; Abdalla and Murinde, 1997; Granger et al., 2000; Phylaktis and Ravazzolo, 2005; Yau and Nieh, 2006; Pan et al., 2001; Aydemir and Demirhan, 2009; Kumar, 2010; Zhao, 2010). Existing literature suggests two approaches to study this dynamic relationship. The microeconomic, or the goods market, or traditional, or ow oriented approach concentrate on the current account of the balance of payment. This approach hypothesizes that exchange rate changes inuence international competitiveness and trade balance, impacting real income and output. Thus, uctuations in exchange rate can signicantly affect the rm value. Exchange rate inuence the rms prots and value, depending on when it faces transaction, translation, and economic exposure. Over purely domestic ones, rms with foreign operations are more affected (Kumar, 2010). In summary, the microeconomic approach suggests that exchange rates lead the stock price (Dornbusch and Fisher, 1980; Ma and Kao, 1990; Ajayi and Mougoue, 1996; Yau and Nieh, 2006). The macroeconomic, or the portfolio, or asset market approach focuses on the capital account as a signicant determinant of exchange rate dynamics. This approach suggests that a rise in stock prices increases the domestic wealth of investors, helping increase the demand for money. Consequently, interest rates rise, capital ows into the domestic economy and the domestic-currency appreciates. This approach assumes there is a negative relationship between stock prices and exchange rates, with causality running from the stock market to the foreign exchange market (Kumar, 2010). Bahmani-Oskooee and Sohrabian (1992), Granger et al. (2000), Caporale et al. (2002), Vygodina (2006), Pan et al.(2001), Ai-Yee Ooi et al. (2009) and Lee and Lee (2009) stress the importance of the portfolio approach in analyzing the relationship. Reviewing the literature suggests that a large number of studies have examined the contemporaneous as well causal relationship in the returns of the two markets. Results of most of the studies support the contemporaneous as well as dynamic relationship between the two markets. Nevertheless, the direction and sign of the relationship between the foreign exchange and stock market relation is not ubiquitous in the developed, Asian as well as other emerging nation. Few studies (Bahmani-Oskooee and Sohrabian, 1992; Doong et al., 2005; Aydemir and Demirhan, 2009; Zhao, 2010; Kumar, 2010) concluded that there exists bi-directional causal relationship between the two markets. However, results of few studies (Bhattacharya and Mukherjee, 2003; Muhammad and Rasheed, rek, 2005; Rahman and Uddin, 2009) suggests that there is causal relationship 2003; Stava between stock price and exchange rates. Moreover, the review also suggests the mixed consensus about the existence of cointegration between exchange rates and stock prices. The earlier studies have used various linear and non-linear methodologies to examine the dynamic relationship between the two markets, such as, linear Granger causality, vector autoregression (VAR) and vector error correction model, Engle and Granger cointegration test and Johnson cointegration model, Hiemstra and Jones non-linear Granger causality, noisy Mackey-Glass non-linear causality model, etc. Variation in results among different economies may be because of the different degree of the capital mobility, trade volume and economic links; as well as omitted variable bias (for instance, interest rates may inuence stock and currency markets). Much of the available empirical evidence on the linkages between stock markets and exchange rates has concentrated on the rst moments, i.e. causal relationship in the

returns of the two markets; however, various studies have also investigated the volatility spillover between stock market returns and exchange rates within the same economy over time and across different countries. Kanas (2000), Yang and Doong (2004), Dark et al. (2005) and Francis et al. (2006) studied the volatility spillovers in developed countries between currency and stock markets. The results suggest that the exchange rate changes inuence on the stock market with the less direct impact then the stock market on the currency exchange market. Such spillover mechanism on developed economies is natural and expected, as there is no such signicant change on the foreign exchange markets of advance nations. There also exist volatility spillovers studies (Pyun et al., 2000; Choudhry, 2000, 2004; Caporale et al., 2002; Xu and Fung, 2002; Doong et al., 2005; Wu, 2005; Qayyum and Kemal, 2006; Morales, 2008; Yang and Chang, 2008; Choi et al., 2009; Lee and Lee, 2009; Zhao, 2010) on various emerging stock and foreign exchange markets as well. The results were similar to the results of the studies done on developed markets. Engle et al. (1990) proposed two hypotheses: heat wave and meteor shower on how volatility may manifest itself across trading centers. The heat wave hypothesis suggests that volatility has only location-specic autocorrelation, so that a volatile day in market A is likely to be followed by another such day in A, but not typically in market B. The meteor shower hypothesis suggests that intraday volatility spills over from one market to another, so that a volatile day in market A is likely to be followed by one in market B. The two hypotheses were further supported by Baillie and Bollerslev (1991) and Baillie et al. (1993). Forbes and Rigobon (2002) suggest that such spillovers can be seen as a consequence of greater nancial integration or contagion effects. The review suggests that, most of the studies agree that the extent to which the market evaluates and assimilates new information is reected in the volatility process. As a result, the investigation of volatility spillover can be of help is studying the nancial contagion between countries or different asset class. Moreover, examining the direction of volatility spillover would be important for identifying the nature of nancial contagion (Inagaki, 2007). Most studies use weekly, daily and intra-day data of the nancial time series from various developed nations and emerging markets, to analyze the returns and volatility spillovers. Empirical research has also documented volatility transmission from developed to emerging markets. In literature, univariate and multivariate GARCH/EGARCH models have been used as a standard method for investigating nancial spillovers. Literature review also reveals that most studies mainly focus on the investigation of rst and second moment interaction, among assets of developed countries, and the integration of developing with developed markets as well. However, in the existing literature, little attention has been paid to examine the nature of returns and volatility spillover between stock prices and exchange rates for three south-south nation namely India, Brazil and South Africa (IBSA nation). In light of these developments, in this study, an attempt is made to overcome the drawbacks identied in the earlier studies by examining the nancial spillover between stock prices and exchange rates for IBSA economies. The study selects IBSA nation because, in 2003, the tri-lateral cooperation of IBSA dialogue forum was launched with major objective of cooperation in trade and investment, agriculture, climate, culture, defense, education, energy, health, science, technology, poverty alleviations and social development. IBSA countries are emerging economies and in terms of economic power,

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the World Bank ranks Brazil 8th, India 11th and South Africa 31st by traditional gross domestic product (GDP) (Source: World Development Indicators database). The market capitalization in the stock exchanges for year 2010 of IBSA countries are 1,628,673, 1,457,790 and 532,890 (in millions of US dollar), respectively, (Source: Seeking Alpha). Moreover, according to Bank of International Settlements report, average daily turnover in April 2010 for IBSA countries as a percentage of global foreign exchange market turnover were 0.9, 0.7 and 0.7, respectively. However, their percentage share in 1998 was 0.1, 0.2 and 0.4, respectively. Government policy changes, including abolishment of capital inow obstructions, exible exchange rates system, economic restructuring, human and physical capital formation, foreign institutional and foreign direct investment, accumulation of foreign exchange reserves have contributed greatly to stronger economic fundamentals and thus have played a key role in IBSA countries. Moreover, an important contributor to growth in IBSA markets has been the massive rise in the size of middle class. Another area that is poised to support economic growth in IBSA markets is investment, particularly in infrastructure. Moreover, globalization and interdependent stock markets, abolishment of capital inow obstructions, have thrived in the past two decades. These factors have affected not only the exchange rates, but also stock prices, and thus, the risk of investment decisions and portfolio diversication. Thus, the collective size and relevance of IBSA countries in the global economy have widened the scope of studying the relationship between exchange rates and stock prices. A key issue in IBSA economies therefore refers to the questions, to what extent stock market dynamics would in turn affected by exchange rate developments or stock market dynamics would affect exchange rates. Given this background, the main objective of the study is to analyze the nature of returns and volatility spillovers between exchange rates and stock price in the IBSA nation. In literature, univariate and multivariate GARCH models have been used to model nancial spillovers. However, this is the rst study which uses VAR framework and the recently proposed spillover measure of Diebold and Yilmaz (2009) to examine the returns and volatility spillover between exchange rates and stock prices of IBSA nation. Variance decomposition analysis of the VAR model is used to identify spillovers of return and volatility shocks from the indigenous shocks. This methodology is simple and intuitive, yet rigorous and replicable to implement and can analyze causation pattern dynamics. To measure volatility, exponential GARCH (Nelson, 1991) model is used as it is capable of explicitly capturing asymmetries. In addition, multivariate GARCH with time varying variance-covariance BEKK model is used as benchmark against the spillover methodology proposed by Diebold and Yilmaz (2009). The BEKK-GARCH (1,1) model has been utilized to analyze the spillover in a bi-variate fashion. The BEKK-GARCH (1,1) has the attractive property which suggests that the conditional covariance matrices are positive denite by construction. Moreover, the model has the capability to analyze the returns and volatility linkages as well as across the market, i.e. returns and volatility spillover effect. Thus, the present study would complement the emerging body of literature by investigating how the behavior of spillover in the IBSA countries are similar or differ from those in the other emerging and developed markets. We believe that the results of this studys empirical analysis would enhance the understanding of spillover activities in the IBSA nations. The rest of the paper is set out as follows. In Section 2, we describe the data and briey review the unit root tests, cointegration tests and spillover index methodology.

In Section 3, we present our empirical results. Finally, Section 4 summarizes the ndings and brings out the implications. 2. Data and methodology The data set comprises the daily closing price for the benchmark stock market indices in India (S&P CNX Nifty), Brazil (Bovespa) and South Africa (FTSE/JSE Top 40 Index). Moreover, the study uses the daily exchange rate data of Indian rupee versus US dollar (INR/USD), Brazilian real versus US dollar (BRL/USD) and South African rand versus US dollar (ZAR/USD). The three stock indices and exchange rates data series spans 1 January 2000 to 17 January 2011. All the time series data has been obtained from Bloomberg. To overcome the problem of non-stationarity, the three indices and three exchange rate series are transformed into continuously compounded returns. Figure 1 shows the plots of daily returns of indices and exchange rate for each market. These plots show a clustering of larger returns volatility around the starting points of downward trends, both short-run and long-run downward trends, as in March 2005 or mid-2007, when was the start of the current downward trend on both markets. Table I describes the measure of central tendency (i.e. mean), a measure of statistical dispersion (i.e. standard deviation), measure of shape of distribution (i.e. skewness and kurtosis) and a goodness-of-t measure of departure from normality (i.e. Jarque-Bera (JB)).

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Figure 1. Daily returns of indices and exchange rates for IBSA nation

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A perusal of the standard deviation for the indices of IBSA nation suggests that Bovespa is more volatile than their counter parts. However, among the exchange rates, South African rand seems to be more volatile than Indian rupee and Brazilian real. The measure of skewness and kurtosis indicates that Nifty is more skewed and peaked than the indices of other IBSA nation. Moreover, all the indices are negatively skewed. The South African rand seems to be more skewed than the Indian rupee and Brazilian real, however, Indian rupee is more peaked than the other two currencies. It is interesting to observe that all the exchange rate returns are positively skewed. Thus, descriptive statistics suggests that all the time series exhibit skewness and high kurtosis which is common in nancial time series. The results of JB statistics indicates that the null hypothesis of normal distribution is rejected for each differenced series. 2.1 Unit root and cointegration test This study uses Augmented Dickey-Fuller (ADF) and Kwiatkowski, Philips, Schmidt and Shin (KPSS) tests (Gujarati, 1995; Brooks, 2002) to examine whether the time series of exchange rates and stock indices of IBSA nations are stationary or not. Afterwards, we examine the existence of long-run relationship between stock index and exchange rates of the IBSA countries using two steps Engle and Granger (1987) method. We preferred to use this method rather than the Johansen Cointegration test is because of the simplicity of the Engle and Granger test and moreover, there are two variables under investigation, and hence, there could be at most one cointegrating vector. Tables II and III show the result of unit root and cointegration test, respectively, for the stock index and exchange rate series of three IBSA economies.
India INR/USD Brazil BRL/USD South Africa FTSE/JSE ZAR/USD

Nifty

Bovespa

Table I. Returns descriptive statistics

Mean 0.00046 1.78 102 05 0.00052 2 2.47 102 05 0.00046 4.35 102 05 SD 0.01733 0.00377 0.01980 0.01115 0.01467 0.01132 Skewness 2 0.34754 0.01030 2 0.11606 0.04995 2 0.11899 0.66370 Kurtosis 10.3615 15.6814 6.62588 12.2840 6.16252 7.27607 Jarque-Bera 6,069.04 17,850.9 1,490.60 9,733.89 1,157.11 2,306.21 No of observations 2,664 2,664 2,710 2,710 2,761 2,761

Variable Panel A: India Nifty INR/USD Panel B: Brazil Bovespa BRL/USD Panel C: South Africa FTSE/JSE ZAR/USD

ADF test t-statistics 2 37.2744 2 52.5792 2 51.5844 2 52.7293 2 50.3820 2 51.3038

KPSS test t-statistics 0.20461 0.10105 0.15098 0.37793 0.08939 0.14606

Table II. Unit root test

Note: The critical values for ADF and KPSS test at 1 percent level are 2 3.4327 and 0.739, respectively

Dependent Panel A: India Ln Nifty Ln INR/USD Panel B: Brazil Ln Bovespa Ln BRL/USD Panel C: South Africa Ln FTSE/JSE Ln ZAR/USD

Tau-statistics

Probability

z-statistics

Probability

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Table III. Engle and Granger cointegration test

2 0.44367 2 1.95430 2 1.99042 2 2.249207 2 0.75603 2 2.08764

0.96650 0.55190 0.53310 0.39860 0.93770 0.48220

2 0.79149 2 7.27510 2 4.18859 2 6.70077 2 1.21221 2 7.61573

0.97260 0.55100 0.79570 0.59580 0.96090 0.52510

2.2 BEKK-GARCH (1, 1) model Extending the univariate GARCH model to a n-dimensional multivariate model requires the estimation of n different mean and corresponding variance equations and (n2-n)/2 covariance equations. As our interest is the time-varying covariance matrix, we dene the mean equation in the following way: r t m 1t ; 1t jVt21 , N 0; H t 1

where rt is a vector of appropriately dened returns and m a (N*1) vector of parameters that estimates the mean of returns series. The residuals vector is 1t with the corresponding conditional covariance matrix Ht given the available information set Ft2 1. The equivalent to a univariate GARCH (1,1) model is given as follows: vechH t V Avech1t21 10t21 BvechH t21 2

where Ht is the time-varying (N*N) covariance matrix, F denotes an (N*N)(N(N 1)/2*1) vector and A and B are (N(N 1)/2*N(N 1)/2) matrices. The VECH operator stacks the lower portion of an (N*N) symmetric matrix as an (N (N 1)/2*1) vector which can be done since the covariance matrix is symmetric by denitions. In the bi-variate VECH model, the matrices are all (3 3) matrices, thus, leading to 27 parameters to be estimated. The disadvantage of this model is that it has large number of parameters and to ensure Ht positively, restrictions are required to be imposed. The BEKK model is an improvement to the VECH model, as the number of parameters is reduced and the positive deniteness of the covariance matrix is guaranteed. Therefore, in this study, we have used the BEKK-GARCH model suggested by Engle and Kroner (1995). The covariance matrix of the unrestricted BEKK model in bi-variate case is represented as: H t B 0 B C 0 1t21 10t21 C G 0 H t21 G 3

where Ht is the conditional covariance matrix and B is the 2 2 upper triangular matrices. It is obvious from the above equation that the covariance matrix is guaranteed to be positive denite as long as BB is positive denite. The element Cij of the 2 2 matrix C indicates the impact of market i volatility on market j and reects ARCH effect of volatility. The element Gij of the 2 2 matrix G indicates the persistence of volatility transmission between market i and market j and reects GARCH effect of volatility.

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The total number of estimated parameter is 11. The bi-variate BEKK-GARCH (1,1) model can be written as: " # " #0 " # h11;t h12;t b11;t b12;t b11;t b12;t b h h b b b
21;t 22;t 21;t 22;t 21;t 22;t

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"

c 21;t " g 11;t

c11;t

#0 2 2 11;t21 4 c22;t 12;t21 ; 11;t21 c12;t g12;t g22;t #0 " g 11;t21 h21;t21

11;t21 ; 12;t21 12 2;t 21 #" g 11;t g 21;t

3" 5

c11;t c21;t #

c12;t c22;t

g 21;t

h12;t21 h22;t21

g12;t g22;t

where h11,t denotes the variance of the change rate of stock index returns, h12,t denotes the covariance of the change rate of exchange rate and stock index returns, h22,t denotes the variance of exchange rate returns. When we explore the volatility spillovers effect from stock market to foreign exchange market, we should test whether the coefcients c12 and g12 are statistically signicantly different from zero. When we explore the volatility spillovers effect from foreign exchange market to stock market, we need to test c21 and g21 are signicantly different from zero. If there is no volatility spillovers effect between foreign exchange and stock markets, the non-diagonal elements c21, g21, c12 and g12 of matrices c and g are not statistically signicantly different from zero. The study uses the UCSD GARCH Toolbox for MATLAB provided by Kevin Sheppard[1] in order to estimate the BEKK-GARCH (1, 1) model. The results are presented in Table IV. 2.3 Measuring returns and volatility spillovers The study uses the spillover index methodology introduced by Diebold and Yilmaz (2009) to measure the returns and volatility spillovers between foreign exchange and stock market of IBSA nation. Measurement of these spillovers is based on VAR models. The VAR model helps to analyze the decomposition of forecast error variance
Nifty INR/USD Coeff. t-stat. 0.34948 105.903 0.02014 118.470 2 0.01238 2 25.7917 0.37823 257.299 0.01261 217.413 2 0.05674 2 26.7642 0.38280 2 2,392.50 0.90419 2 837.213 2 0.00783 71.1818 2 0.03911 26.9724 0.92531 2 13,218.7 2 4,915.417 Bovespa BRL/USD Coeff. t-stat. 0.24978 130.774 2 0.04181 2 167.240 0.07811 2 2,2317.1 0.20180 388.076 2 0.02913 2 2,913.00 0.00664 2 47.4286 0.33040 2 1,573.33 0.97045 2 4,043.54 0.00861 430.500 2 0.00253 2 168.667 0.94261 11,931.7 2 9,007.836 FTSE/JSE ZAR/USD Coeff. t-stat. 0.17881 255.442 2 0.06516 91.7746 0.08653 2 786.636 0.28843 497.293 2 0.00320 22.8571 2 0.03056 152.800 0.22687 2 1,334.53 0.94891 2 3,953.79 0.00744 14.5882 0.00640 246.153 0.97025 119,784 2 8,522.799

Parameters m b11 b12 b22 c11 c12 c21 c22 g11 g12 g21 g22 Logliklihood

Table IV. Bivariate BEKK-GARCH (1, 1) parameter estimates

thereby providing a measure of the overall relative importance of an individual variable in generating variations in its own and on other variables. That is, the effect that each variable in the system has on itself and on other variables over different time horizons (say h-step ahead) can be measured by decomposing this forecast variance. This information is used in measuring interdependence and spillover effects across markets. Thus, it transforms wealth of information into a single quantitative measure called as spillover index (Diebold and Yilmaz, 2009). To illustrate the creation of a spillover index, consider a co-variance stationary rst order bi-variate VAR model represented as: yt Cyt21 1t
0

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where yt y1t ; y2t is a 2 1 matrix and Ci is a 2 2 coefcient matrix. If yt is covariance stationary, then according to Wold decomposition theorem, the above model can be written as innite moving average process of its innovation process. Formally: 1 X yt fi mt2i 6
i0

where fi is coefcient matrix and mt is vector of white noise. The h-step-ahead forecast of yt is given by: ^ th y
1 X ih

fi mth2i

The forecast error and its variance matrix can be calculated as: ^ th yth 2 y
h21 X i0

fi mth2i

^ th var yth 2 y Consider y1,t, the rst element of yt matrix. Its h-step-ahead forecast error is given by: ^ 1;th f0;11 m1;th f1;11 m1;th21 fh21;11 m1;t1 y1;th 2 y f0;12 m2;th f1;12 m2;th21 fh21;12 m2;t1 and the variance of its h-step-ahead forecast error is given by:     2 2 2 2 2 2 2 2 sy2 s f f f s f f f 0;11 1;11 h21;11 0;12 1;12 h21;12 y1 y2 1;h |{z} |{z} 9

10

Proportion of variance due to own shock Proportion of variance due to y2 shock

Thus, for a two-variable system, the total forecast variance of variable y1,t is equal to the sum of the variance in y1,t due to shocks in y1,t and the variance in y1,t due to shocks in y2,t. So the total spillover (TS1) is given by:
2 2 2 2 2 f2 0;11 f1;11 fh21;11 f0;12 f1;12 fh21;12

11

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Similarly, the total spillover (TS2) of variable y2,t is given by:


2 2 2 2 2 f2 0;21 f1;21 fh21;21 f0;22 f1;22 fh21;22

12

118

Hence, the variance decomposition allows us to split the forecast error variance of each variable into parts, attributable to the various system shocks. In the case of two-variable system, the total forecast error variation {trace (fi f0i )} would be given by:
2 2 2 2 2 f2 0;11 f1;11 fh21;11 f0;21 f1;21 fh21;21 2 2 2 2 2 f2 0;12 f1;12 fh21;12 f0;22 f1;22 fh21;22

13

This spillover can be converted into an easily interpretable index, by expressing it relative to total forecast error variation. The ratio can be expressed in percentage and spillover index can nally be represented as: S TSi *100 tracefi f 0i 14

In summary, by aggregating the variance decomposition into a single value, we get information about the degree of spillovers across markets. This study uses bi-variate VAR system, where the lag order is selected based on the Swartz Bayesian Information Criteria (SBIC). Following Nelson (1991), we estimate daily conditional variance of exchange rates and stock market index of IBSA nation represented by the following equation: 1t21 2 2 c1 1t21 j logst f1 w1 log st21 g1 15 st21 st21 The EGARCH model possess useful properties for estimating volatility dynamics in a unied framework and are consistent with the stylized facts in foreign exchange rate dynamics, such as volatility persistence and clustering. 3. Results 3.1 Unit root test Tables II shows the results of ADF and KPSS tests performed on the stock index and exchange rate returns of IBSA nations. Results of ADF test suggest that the absolute value of t-statistics is greater than the absolute critical value at 1 percent level for the index and exchange rate returns of the IBSA nations. This indicates that all the time series are stationary (i.e. the null hypothesis of a unit root is rejected for all the series in rst difference). Results of KPSS test are also in agreement with ADF results, as the t-statistics is smaller than the critical values at 1 percent level. 3.2 Cointegration test Table III, reports the results of the Engle and Granger (1987) cointegration test. The results of Engle and Granger cointegration test suggests that tau-statistics and normalized autocorrelation coefcient (i.e. z-statistics) both accept the null hypothesis

of no cointegration (unit root in the residuals) at the 1 percent level. This indicates that Nifty and INR/USD, Bovespa and BRL/USD and FTLSE/JSE and ZAR/USD are not cointegrated and thus, there is no long-run relationship between stock indices and exchange rates for India, Brazil and South Africa. Findings of Engle and Granger cointegration tests are consistent with the ndings of earlier studies for South African (Ocran, 2010), Brazil (Tabak, 2006), and Indian (Kumar, 2010) market. Moreover, ndings of Engle and Granger cointegration tests are consistent with the ndings Choudhry (2000), Yang and Doong (2004), Pan et al. (2001), Yang and Chang (2008), Morales (2008) Lee and Lee (2009), Zhao (2010) and Kutty (2010) for developed markets such as the USA, the UK, and Japan as well as for Asian and Latin American markets. 3.3 BEKK-GARCH (1, 1) model In this study, we attempt to examine the volatility transmission or spillover effect, therefore, using equation (4) we estimate three bi-variate BEKK-GARCH (1, 1) equations which are formed using the stock indices and exchange rates for each IBSA nations. This can be represented by the following univariate model:
2 2 2 2 2 h11;t b2 11 c11 11;t 21 2c11 c21 11;t 21 12;t 21 c21 12;t 21 g 11 h11;t 21

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2g 11 g 21 h12;t21 g 2 21 h22;t 21 ;
2 h12;t b11 b12 c11 c12 12 1;t 21 c21 c12 c11 c22 11;t 21 12;t 21 c21 c22 12;t 21

g11 g12 h11;t21 g 11 g 12 g 11 g22 h12;t21 g 21 g 22 h22;t21 ;


2 2 2 2 2 2 h22;t b2 21 b22 c12 11;t 21 2c12 c22 11;t 21 12;t 21 c22 12;t 21 g 12 h11;t 21

16

2g 12 g 22 h12;t21 g 2 21 h22;t 21 ; The equation (16) indicates that the variances and covariance of asset depend on 2 constants, lagged squared residual (12 1;t 21 , 12;t 21 ), products of the lagged cross residual (11,t2 112,t2 1), lagged variances (h11,t2 1, h22,t2 1) and lagged covariance (h12,t2 1) term. Thus, in order to discover volatility transmissions among or between different asset classes, it is essential to evaluate the impact of lagged squared and cross residuals, or the effect of the lagged variance and covariance terms. The results of BEKK-GARCH (1, 1) model are presented in Table IV along with respective t-statistics at 5 percent condence level. The results presented in Table IV indicate that the estimates of BEKK-GARCH models are consistent with the conditions of positive denite covariance matrices. In particular the determinants of the matrices B, C and G are positive, moreover, parameters b11, c11 and g11 are positive as well for the IBSA countries. The coefcient in matrix C represents ARCH effects, i.e. innovations in lagged squared error terms. However, the coefcient in matrix G indicates the GARCH effects, i.e. volatility spillover effects. The results suggest that the diagonal parameters (c11 and c22) of ARCH and (g11 and g22) of GARCH term are signicant at 5 percent level. The t-statistics are computed from robust standard errors. This indicates that in terms of magnitude, the stock indices of IBSA nations are affected by their own index new shocks and conditional volatility. The same is true for exchange rates too. Moreover, stock index and exchange rates of IBSA nations have been found to have cross ARCH and GARCH relationship and are

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bidirectional in nature, i.e. the off diagonal parameters (c12 and c21) of ARCH and (g12 and g21) of GARCH term are signicant at 5 percent level. The off diagonal elements of matrix C (c12 and c21) capture the cross-market shock effects. The results suggest that the off diagonal parameters (c12 and c21) of ARCH term are signicant at 5 percent level. This indicates the IBSA stock and foreign exchange market shows evidence of bidirectional interaction, meaning that news shock originating from the foreign exchange market effectively inuence the stock market and in the same way news shock originating from the stock market effectively inuences the currency market. In addition, the off diagonal elements of matrix G (g12 and g21) capture the cross-market volatility spillover among or between asset classes. The coefcient g12 and g21 is statistically signicant at 5 percent level for the IBSA nations. Thus, the overall result suggests the integration between stock and foreign exchange markets and indicates the existence of bi-directional volatility spillover between stock and foreign exchange markets in the IBSA countries. The presence of signicant volatility spillover coefcient indicates that the volatility of stock index returns is a determinant of the volatility of the exchange rate and that information contained in stock prices effects the behavior of exchange rates in the IBSA markets and vice-versa. Engle et al. (1990) in their study stated that market react to news originating in that market (the heat wave) and to news emanating from other markets (the meteor shower). Thus, our results conrm the presence of heat wave and meteor shower effects in the IBSA countries. The results of the study are consistent with the ndings of Mishra et al. (2007) for Indian, Morales (2008) for Brazil and Anoruo and Braha (2009) for South African market. Moreover, ndings of the study are consistent with the ndings of Francis et al. (2006), Aloui (2007), Zhao (2010) and Fu et al. (2011). In addition our results partially support the ndings of Kanas (2000), Yang and Doong (2004) and Choi et al. (2009) where the results indicates uni-directional volatility spillovers from stock returns to exchange rate. 3.4 Returns and volatility spillovers and spillover index This study uses bi-variate VAR model with the lag order selected, based on SBIC criteria. Following Diebold and Yilmaz (2009), the ten-step-ahead forecasts error variance decomposition associated with the two variables are analyzed. Tables V and VI provide the detailed calculation of the returns and volatility spillover, and spillover indices for the full sample. The cell (m, n) in Table V (returns spillover) and Table VI (volatility spillover) suggests that the estimated contribution, to the forecast error variance of time series m, originating from innovations of time series n. The sum total of the cells in the contribution to others row or that of the contribution from others column, gives the numerator of the spillover index. Similarly, sum total of cells in the contribution including own row gives the denominator of the spillover index. Results presented in panel A of Table V suggest that innovations to nifty returns explain 12.51 percent of the forecast error variance of INR/USD at the ten-day horizon. However, innovations to INR/USD returns explain 0.3305 percent of the forecast error variance of nifty at the ten-day horizon. In case of Brazil (panel B, Table V), innovations to bovespa returns explain 23.99 percent of the forecast error variance of BRL/USD at the ten-day horizon. However, innovations to BRL/USD returns explain 0.6436 percent of the forecast error variance of Bovespa at the ten-day horizon. The results in panel C of Table V suggest

Nifty INR/USD Contribution to others Contribution including own Bovespa BRL/USD Contribution to others Contribution including own FTSE/JSE ZAR/USD Contribution to others Contribution including own

Panel A: India Nifty INR/USD 99.7694 0.33056 12.5144 87.4856 12.5144 0.33056 112.183 87.8162 Panel B: Brazil Bovespa BRL/USD 99.3563 0.64363 23.9958 76.0042 23.9958 0.64360 123.352 76.6479 Panel C: South Africa FTSE/JSE ZAR/USD 99.74033 0.25967 0.441146 99.5588 0.441100 0.25970 100.1815 99.8185

Contribution from others 0.33056 12.5144 12.8449 6.4225 percent spillover index Contribution from others 0.6436 23.9958 24.6394 12.3197 percent spillover index Contribution from others 0.25970 0.44110 0.70080 0.3504 percent spillover index

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Table V. Returns spillover full sample

Nifty INR/USD Contribution to others Contribution including own Bovespa BRL/USD Contribution to others Contribution including own FTSE/JSE ZAR/USD Contribution to others Contribution including own

Panel A India Nifty INR/USD 97.1572 2.84280 5.15950 94.8405 5.15950 2.84280 102.316 97.6833 Panel B: Brazil Bovespa BRL/USD 94.3482 5.65180 18.6185 81.3815 18.6185 5.65180 112.966 87.0333 Panel C: South Africa FTSE/JSE ZAR/USD 98.7491 1.25084 4.09472 95.9052 4.09470 1.25080 102.843 97.1561

Contribution from others 2.84280 5.15950 8.00230 4.00110 percent spillover index Contribution from others 5.65180 18.6185 24.2703 12.135 percent spillover index Contribution from others 1.25080 4.09470 5.34560 2.6728 percent spillover index

Table VI. Volatility spillover full sample

that innovations to FTSE/JSE returns explain 0.2596 percent of the forecast error variance of ZAR/USD. However, innovations to ZAR/USD returns explain 0.4411 percent of the forecast error variance of FTSE/JSE at the ten-day horizon. Among the IBSA nations, Brazilian stock market explains the maximum forecast error variance in the exchange rates, followed by India and South Africa. Similarly Brazilian exchange rate explains the maximum forecast error variance in the stock market, followed by India and South Africa. Results reported in panels A-C if Table VI suggests that volatility spillover from stock market to foreign exchange market is 5.19, 18.61 and 4.09 percent for India, Brazil and South Africa, respectively. Moreover, volatility spillover from foreign exchange market to stock market is 2.84, 5.68 and 1.25 percent for India, Brazil and South Africa, respectively.

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While analyzing the returns and volatility spillover, we got some very interesting results. The results of returns spillover suggest that magnitude of innovations originating from stock market and explaining the forecast error variance of foreign exchange market is strongest in case of Brazil (23.99 percent) followed by India (12.51 percent) and South Africa (0.44 percent). Similarly, the magnitude of innovations originating from foreign exchange market and explaining the forecast error variance of stock market is strongest in case of Brazil (0.64 percent) followed by India (0.33 percent) and South Africa (0.25 percent). The results of volatility spillover are again inline with the results of returns spillover. These results provide the evidence that among the IBSA nations, the volatility spillover from stock market to foreign exchange market is highest for Brazil (18.61 percent) followed by India (5.19 percent) and South Africa (4.09 percent). Moreover, the volatility spillover from foreign exchange market to stock market is again highest for Brazil (5.68 percent) followed by India (2.84 percent) and South Africa (1.25 percent). The result is expected for South Africa. As in year 2000, South Africa changed the monetary policy regime to ination targeting. Under this regime, monetary policy intends to set interest rates with the aim of keeping ination at pre-announced goals. This has resulted in interest rates becoming stable by making them more predictable. Moreover, executing this policy requires the regulators to discard pre-commitment to any exchange rate parity, predominantly using exchange rate interventions. Thus, this has effectively made the exchange rate regime a free oat. The capital ows to South Africa have increased drastically in last one decade. These large capital inows were directed to purchases South African bonds rather than equities. The interest rate differential might be the main driver of these funs ows rather than growth expectations. In 2010, year-to-date foreign inows into the South African bond and equity markets are around a total of ZAR 100 billion, with ZAR 70 billion owing into the bond market. With the local bond market outperforming the local equity market, it is therefore no surprise that volatility spillover bi-directional volatility spillover between stock and foreign exchange market is lowest among the IBSA nation. On the other hand, Brazil which has adopted an ination targeting policy since 1999 experienced increase in foreign investment in its stock market. Participation of foreign participants in initial public offerings rose, from 48 percent of the total in 2005 to 76 percent in 2007. Brazilian stocks were one of the most aggressively traded stocks in emerging economies. However, such stock purchases resulted mainly from carry-trade processes, in which investors replaced deteriorating-dollar assets for short-term equities, whose real values were increasing in relative terms. In addition, participation of foreign institutional investors in derivatives market concentrated in very short-term maturities rose signicantly since 2000. Moreover, Brazils integration with various developed and developing international nancial markets had left it exposed to external shocks. Couple of months before the sub-prime crisis of 2008, Brazilian economy was ooded with short-term foreign capital which substantially appreciated its exchange rate. Immediately, after the fall out of Lehman Brothers and the global crisis, Brazils huge exposure to short-term foreign capital led to rapid depreciation of its currency and massive fund outow. After the nancial crisis, Brazilian real appreciated more than 35 percent against the dollar till October 2009, because of the various economic measures taken by the regulators and increasing investor enthusiasm for Brazilian assets. Learning from the past experience, regulators their in Brazil proposed to impose a 2 percent tax on foreign capital inows toward equities and xed-income investments. This policy

measure was introduced in order to slow the ongoing appreciation of the real against dollar and other measure currencies. Brazils stock market ended 2010 with a whimper, despite strong economic growth. Global concerns about European Government nances have buffeted the Bovespa stock exchange for much of the year. The strength of the Brazilian real against the dollar also played into the tepid performance, as investors hunted for bargain stocks in developed countries. The disappointing performance for Bovespa is a clear outlier among emerging markets, which have largely beneted from the condence among many investors to take more risks, as well as the rally in commodity prices. This corroborates our ndings of very high returns and volatility spillover between the stock and foreign exchange market in Brazil. The results presented in Tables V and VI also indicate that returns and volatility spillover effect from stock market to foreign exchange market is larger than returns and volatility spillover from foreign exchange market to stock market for IBSA nation. This may be due to positive exchange rate volatility on stock returns for some rms offsetting negative exchange rate volatility on stock returns for other rms to give a weak effect overall (Morales, 2008). In addition to this, domestic-currency invoicing and hedging with exchange rate derivatives may reduce the impact of exchange rate volatility on stock markets. Grant and Marshall (1997) and Bodnar et al. (1995) in their study also stated that the use of various nancial instruments to manage exchange rate risk is popular among larger and internationally active rm which are the main components of national stock market indices to reduce their exposure to exchange rate variations. A single spillover index is calculated for the returns and volatility separately for each IBSA nation. These indices are constructed using the information of the stock and foreign exchange rates spillovers for the full sample. The index in Tables V and VI suggests that approximately 5.21 percent of forecast variance comes from returns (6.42 percent) and volatility (4.00 percent) for India, 12.27 percent of forecast variance comes from returns (12.31 percent) and volatility (12.13 percent) for Brazil and 1.51 percent of forecast variance comes from returns (0.35 percent) and volatility (2.67 percent) for South Africa. This result conrms the ndings of Diebold and Yilmaz (2009). The overall results suggest the spillovers seem to be important in both returns and volatilities. 4. Conclusion This study examined the returns and volatility spillover between stock market and exchange rates for the IBSA countries. In order to explore the spillover between two important factors of an economy, rst, we applied unit root test to nd the stationarity of stock indices and exchange rates for the IBSA nation. The results show that all the data series of the variables are non stationary and integrated of order one. Next, we applied Engle and Granger (1987) methodology to test for the possibility of a cointegrating relationship. Result shows that there is no cointegrating relationship between stock prices and exchange rates. Then we employed multivariate BEKK GARCH to capture the volatility transmission between the stock and foreign exchange market for the period January 2001 to January 2011. In addition, we also used a new methodology known as spillover index developed by Diebold and Yilmaz (2009) to examine the returns and volatility spillover in the two markets for IBSA nations. The results of multivariate GARCH model suggests the integration between stock and foreign exchange markets and indicates the existence of bi-directional volatility spillover between stock and foreign exchange markets in the IBSA countries. The results

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of the study are consistent with the ndings of Mishra et al. (2007) for Indian, Morales (2008) for Brazil and Anoruo and Braha (2009) for South African market. Spillover results using the Diebold and Yilmaz (2009) model suggest the bi-directional contribution between stock and foreign exchange market, in terms of both returns and volatility spillovers. This nding corroborates the two hypothesis namely heat wave and meteor wave proposed by Engle et al. (1990). Overall, our results conrm the presence of returns and volatility spillovers within the IBSA nations and, in particular the stock markets play a relatively more important role than foreign exchange markets in the rst and second moment interactions and spillovers. The study contributes to the literature by extending the existing studies on the spillover between stock price and exchange rate by investigating the issue for three emerging economy, India, Brazil and South Africa. Unlike most studies in the literature which focus on multivariate GARCH model, this is the rst study which explores the issue of returns and volatility spillover between the stock prices and the exchange rates using spillover measure of Diebold and Yilmaz (2009) and much longer and recent daily data. Moreover, multivariate GARCH with time varying variance-covariance BEKK model is used as benchmark against the spillover methodology proposed by Diebold and Yilmaz (2009). Thus, we believe that reinvestigating the returns and volatility spillover between the two variables using powerful econometrics methodologies and recent data set, would contribute to the literature to the emergence of a consensus view on the underlying issue. Analysis of returns and volatility spillover is a key research area and so, has serious implications for market participants and policymakers. Understanding spillover sources and transmission mechanisms would help in pricing, optimal investment and decision making. The presence of returns and volatility spillover between stock prices and exchange rates implies the market inefciency and lends support to the technical analysis. The market participants may consider the relationship between the exchange rate and stock index to predict the future movement of each other effectively. MNCs interested in exchange rate forecasting may consider the stock market as an important attribute. There is an interesting implication for portfolio managers too because of the spillover stock and foreign exchange markets. This knowledge would help to create a fund which performs well. Moreover, the results of the two-way returns and volatility spillover between stock and foreign exchange market can also help the regulators and policy makers in IBSA nation to understand the structure of the market in a better way and then design the policy, because it may have impact on the development of the nancial markets. As rising (falling) stock market would attract capital ows from foreign investors, who sell the foreign (local) currency in substitute for local (foreign) currency. Thus, a rise (fall) in stock prices will appreciate (depreciate) the exchange rates. Moreover, an increase (decrease) in stock index causes an increment (reduction) in wealth of domestic investors thereby increasing (reducing) the demand for local currency and subsequently pushing up (pulling down) the local interest rates. The raising (lowering) of interest rates will encourage capital inows (outows), resulting in the appreciation (depreciation) of exchange rates. So, monetary scal policies that target the interest rates and exchange rates may get affected because of the booming (falling) stock market. Thus, regulators and policy makers can take cognizance of this fact while formulating and implementing the exchange rates and capital market policies as it can improve the effectiveness of

monetary policy in achieving its objective. In addition, any policies affecting foreign exchange markets should also account for the impact of shocks from stock market. Future research can be done by examining the cointegration between exchange rates and stock market index by including variables like US market data and interest rates. Additionally, we can compare the results on spillover in returns and volatility when global shocks from developed markets are controlled. As a robustness check, we can also analyze whether spillover in returns and in variance is present in different sub-samples.
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Wu, R. (2005), International transmission effect of volatility between the nancial markets during the Asian nancial crises, Transition Studies Review, Vol. 15, pp. 19-35. Xu, X. and Fung, H. (2002), Information ows across markets: evidence from China-backed stocks dual-listed in Hong Kong and New York, The Financial Review, Vol. 37, pp. 563-88. Yang, S. and Doong, S. (2004), Price and volatility spillovers between stock prices and exchange rates: empirical evidence from the G-7 countries, International Journal of Business and Economics, Vol. 3 No. 2, pp. 139-53. Yang, Y. and Chang, C. (2008), A double-threshold GARCH model of stock market and currency shocks on stock returns, Mathematics and Computers in Simulation, Vol. 79, pp. 458-74. Yau, H. and Nieh, C. (2006), Interrelationships among stock prices of Taiwan and Japan, and NTD/Yen exchange rate, Journal of Asian Economics, Vol. 17 No. 3, pp. 535-52. Zhao, H. (2010), Dynamic relationship between exchange rate and stock price: evidence from China, Research in International Business and Finance, Vol. 24, pp. 103-12. Further reading Caporale, G.M., Pittis, N. and Spagnolo, N. (2002), Testing for causality-invariance: an application to the East Asian markets, International Journal of Finance and Economics, Vol. 7 No. 3, pp. 235-45. About the author Manish Kumar received his BE degree in Mechanical Engineering from Pandit Ravi Shankar Shukla University Raipur, India and MS by Research and PhD in Finance from Indian Institute of Technology Madras, India. Currently, he is working at CRISIL Global Research and Analytics, Chennai, India. His areas of interest are nancial modelling, forecasting, nancial time series analysis and articial intelligence. Manish Kumar can be contacted at: manishkumar_iitm@yahoo.co.in

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