Volatility Spillovers between New Zealand Stock Market Returns and Exchange Rate Changes before and after the 1997 Asian Financial Crisis

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1 Asian Journal of Finance & Accouning Volailiy Spillovers beween New ealand Sock Marke eurns and Excange ae Canges before and afer e 997 Asian Financial Crisis Daniel FS Coi (Corresponding auor Deparmen of Finance, Waikao Managemen Scool, Universiy of Waikao Privae Bag 305, Hamilon, New ealand Tel: dfscoi@waikao.ac.nz Vicor Fang Deparmen of Accouning and Finance, Monas Universiy 900 Dandenong oad, Caulfield Eas, Vic, 345, Ausralia Tel: Vicor.Fang@buseco.monas.edu.au Tian Yong Fu Porfolio isk Managemen, GE Money, 8 Tangiua Sree, Auckland 00, New ealand Tel: Tianyong.Fu@ge.com Absrac esearcers in e las decade ave been invesigaing e inerdependence of sock reurns and excange rae canges wiin e same economy. Kanas (2000 and Yang and Doong (2004 find a for e G-7 counries, in general, e volailiy of e sock marke spills over o e excange rae marke bu a volailiy spillovers from e excange rae marke o e sock marke are insignifican. Cen, Naylor, and Lu (2004 find a N individual firm reurns are significanly exposed o excange rae canges. Tis sudy complemens eir work by invesigaing e volailiy spillover beween e sock marke and e foreign excange marke wiin e N economy. Keywords: New ealand, EGACH model, volailiy spillover, Asian financial crisis JEL Classificaions: E44, G0 06

2 . Inroducion Asian Journal of Finance & Accouning Volailiy spillovers beween sock marke reurns and excange rae canges wiin e same economy ave been examined over ime and across differen counries. Kanas (2000 and Yang and Doong (2004 find unidirecional volailiy spillovers from sock marke reurns o excange rae canges in e G-7 markes. Te marke capializaion of eac of e G-7 counries is large and mulinaionals in e G-7 are fairly well-diversified. Cen, Naylor, and Lu (2004 poin ou a in a large marke wi well-diversified firms, domesic facors could be more imporan an inernaional facors. In conras, e New ealand marke is very small relaive o e US marke and firms in N are muc less diversified. Using a wo-facor model, Cen e al. find a N firm reurns (e firs momen are significanly explained by excange rae canges. However, Cen e al. do no examine e volailiy (e second momen spillover beween e sock marke reurns and excange rae canges wiin e N economy. In is paper, a mulivariae EGACH model is used o invesigae e volailiy spillover beween sock marke reurns and excange rae canges in N. Te EGACH model akes ino accoun New ealand s asymmeric, or down-marke effecs. Te sample period spans from 990 o Te 997 Asian financial crisis (AFC occurs in e middle of our sample period. I is us appropriae o examine e cange in volailiy spillover effecs before and afer e AFC. Our empirical evidence sows a in e full sample e volailiy of e N sock marke reurns spills over o all ree excange raes canges; only e ND/USD volailiy spills over o e sock marke reurns. Te sock marke reurns mainain unidirecional volailiy spillover o e ND/AUD in e full sample as well as eac subperiod. In e pre-afc period, ere are bidirecional volailiy spillovers beween e sock marke reurns and e ND/USD and e TWI index. However, ere are only unidirecional volailiy spillovers from e ND/USD and e TWI index o sock marke reurns in e pos-afc period. 2. Lieraure review Brailsford (996 is e firs o invesigae volailiy spillovers beween e N and Ausralian sock markes. He finds a, afer conrolling for e effecs of e US volailiy, e Ausralian marke volailiy spills over o e N marke bu no e reverse. However, Brailsford does no sudy e volailiy spillover beween excange rae canges and sock marke reurns wiin eier e N or Ausralian economy. Kanas (2000 sudies volailiy spillovers beween sock reurns and excange rae canges in six indusrialized counries, namely, e US, e UK, Japan, Germany, France, and Canada. He finds evidence of spillovers from sock marke reurns o excange rae canges for all counries excep Germany. On e oer and, e volailiy spillovers from excange rae canges o sock reurns are compleely insignifican. Yang and Doong (2004 expand Kanas sample o e G-7 by including Ialy. Teir empirical evidence sows sock price movemens will impac on fuure excange rae movemens, bu excange rae canges ave less direc effec on fuure sock reurns, wic is similar o Kanas findings. Cen, Naylor, and Lu (2004 observe a in large markes like e US, domesic facors are a maor concern over inernaional facors. Furermore, US mulinaional firms end o be fairly diversified. Tese wo poins may explain wy ere is unidirecional volailiy spillover from sock marke reurns o excange rae canges. In conras o e US marke, Cen e al. poin ou a e N marke is very 07

3 Asian Journal of Finance & Accouning small bu open o e inernaional economy. Moreover, mos N firms are no very well-diversified. Dungey (999 argues a i is e inernaional facor a mainly affecs e volailiy of N dollars. He poins ou a e N currency is mainly affeced by inernaional facors as more an 50% of e decomposiion of e N dollar volailiy in e foreign currency marke is due o overseas impacs. Moreover, e N sock marke is small, illiquid, limied in diversificaion, and exposed o excange rae volailiy. In oer words, volailiy socks in e local N sock marke can ave lile effec on e movemen of e N currency. I is us very likely a N sock reurns are impaced by excange rae canges. Te N currency as been floaing independenly on e inernaional excange marke since 985. Te N dollar akes price-aker posiions because of is relaively small capializaion in e foreign excange marke. Te eserve Bank of New ealand (BN as no inervening moneary policy o inervene for N dollar value wiin e sample period (Te N governmen amended e BN guidelines in 2006 o allow e Cenral Bank o acively rade o suppor or dampen e ND if i was appreciaing or falling oo rapidly. N is no a world leader in indusrial or commercial areas and e GDP figures sow a N is small and easily affeced by inernaional economical movemens. Local N firms are less diversified, aving eier expors and/or impors orienaions. Te close linkage among local N companies ensures none of e firms can be exemped from inernaional influences. Moreover, aloug e N sock marke is very small and less liquid an many overseas markes, e N sock excange is efficien wi ig marke awareness, especially o e excange rae uncerainy. All ese unique and imporan caracerisics of e N economy arac us o use is daa for invesigaing ow e N sock marke volailiy responds o e excange rae variabiliy. A recen sudy of Alaganar and Bar (2007 indicaes a e firs- and second-order effecs of excange rae canges impac significanly on diversified porfolios in e US sare marke. Tey use weekly reurns of 6 World Equiy Bencmark Series (WEBS in e sudy wile eac WEBS series represens a diversified porfolio of invesing in foreign sares in a counry ouside of e Unied Saes. Te diversificaion ecnique is efficienly applied in WEBS wile racking e performance of a foreign counry s Morgan Sanley Capial Inernaional (MSCI index oug WEBS are raded only in US Dollars. Alaganar and Bar employ e GJ and GACH-M models in esing e impac of excange rae volailiy on reurns of diversified counry index porfolios. Tey find a e excange rae uncerainy is priced as a facor in WEBS reurns. Tey poin ou a e second momen excange rae informaion is imporan for diversificaions in e sock marke. Te excange rae risk is priced in reurns and e excange rae volailiy is imporan o invesors. Te exen o wic similar findings will old for smaller economies remains open. Cen e al. use a wo-facor model wi e marke reurns and excange rae canges as facors o explain individual firm reurns. Teir empirical resuls sow a sample firm reurns are significanly impaced by excange rae exposure. Tis paper differs from Cen e al. s sudy in a e invesigaion focuses on e volailiy spillover beween sock marke reurns and excange rae canges in N. Pinfold e al. (200 poin ou a e N sock marke is caracerized by down marke condiions. As a resul, filering away e leverage effec in volailiy spillover ess is essenial. Te EGACH model andles e leverage effec very efficienly. In is paper, a mulivariae EGACH model is used o ake ino accoun New 08

4 Asian Journal of Finance & Accouning ealand s asymmeric, or down-marke effecs. 3. Daa and meodology 3. Daa and descripive saisics Daily N oal marke index prices were colleced from Daasream. Te USA and Ausralian markes are e wo larges expor markes for N firms. Te excange raes ND/AUD and ND/USD as well as e TWI index were colleced from e eserve Bank of New ealand. Te sample period spans 5 years from January 990 o December Tere are 3,866 daily observaions. Te 997 Asian financial crisis (AFC occurs rig in e middle of e sample period. Te full sample daa were spli ino wo approximaely equal sub-periods e pre-afc period (January 990 o June 997 and e pos-afc period (Augus 997 o December 2004, eac covering 7.5 years. In is sudy, e sock marke reurns and all excange rae canges are defined as log relaive reurns. Table sows summary saisics of sock and foreign excange marke reurns. Te Jarque-Bera es is performed for e sock marke reurns and excange rae reurns in order o es e normaliy of eac series. Te resuls sow a e disribuion of e sock marke reurns and excange rae reurns are no normal. Te EGACH model is used o examine e dynamic volailiy relaionsip beween N sock marke reurns and foreign excange rae canges. Table also conains e resuls of Augmened Dickey-Fuller (ADF uni roo ess. All sock and excange reurn series are inegraed wi I(0, i.e., saionary, as all -saisics are igly significan a e % level. Saisics Sock eurn Table. Summary saisics Excange ae eurn Toal Marke Index ND/AUD ND/USD TWI Index Observaions Mean Median Maximum Minimum Sd. Dev Skewness Kurosis Jarque-Bera ADF Tes Noe: Tis able presens basic descripive saisics of daily sock and foreign excange reurns of e New ealand marke. 3.2 Meodology Te relaionsips beween e movemens of e sock marke volailiy and excange rae flucuaions wiin an EGACH model, developed by Nelson (99, are examined. Te mulivariae EGACH 09

5 Asian Journal of Finance & Accouning models can effecively capure e asymmeric effecs of innovaions on volailiy in sock marke reurns wile e condiional volailiy of currency movemens can be included in e model a e same ime. Tis imporan feaure of e model gives direc and explici measuremen of e role of excange rae flucuaions in explaining e ime series beaviour of e sock marke volailiy. Similarly, EGACH models can es weer e excange rae volailiy effecs are asymmerical in e foreign excange marke, a is, weer appreciaions and depreciaions of e N dollar in e pas ave e same impacs on e fuure excange rae volailiy. Tis means a e EGACH model ess e leverage effec in e sock marke and also e asymmeric effecs in e foreign excange marke. Te model is specified by e following equaions: f ( f ( exp,0 exp 2,0 p,0 2,0 p, 2,, E f ( 2, E f ( p p,,2 2 2, f ( 2,2 f ( n( 2 n( ( (2 (3 (4 (5 (6,,, (7 were and denoe e sock marke reurns and excange rae canges. Te TWI index, ND/AUD and ND/USD, for respecively, are used o examine e excange rae effecs o sock marke reurns. Te number of lags, denoed by p in equaions ( and (2, is deermined by e Akaike Informaion Crieria (AIC. Te analysis searces for a dynamic relaionsip beween sock marke reurns and excange rae canges. Te coefficiens, and 2, in equaions ( and (2 sow e effecs of excange rae canges o sock marke reurns and e reverse effecs respecively. In equaions (3 o (7, and denoe e condiional variance of sock marke reurns and foreign excange rae canges. and and excange rae canges, respecively. Te coefficiens,2 and 2, denoe e sandardized innovaions of N sock marke reurns sow weer volailiy spillovers exis across e sock marke and e foreign excange marke. In paricular,,2 ( 2, indicaes volailiy spillover effecs sourced from e foreign excange (sock marke o e sock (foreign excange marke. Moreover, e coefficiens, and 2,2 sow e volailiy clusering in e sock marke reurns and excange rae canges. Aloug volailiy auocorrelaions are ofen idenified in inernaional sock markes, i is no clear if volailiies in e N currency are auocorrelaed. A saisically significan 2,2 provides evidence a volailiy in e foreign excange marke is significanly affeced by e isorical 0

6 Asian Journal of Finance & Accouning volailiy canges in e excange raes. Finally, e coefficiens and 2 indicae volailiy persisence in e sock marke and foreign excange marke, respecively. EGACH models faciliae an examinaion of e asymmeric effecs in volailiy impacs. As menioned above, e pas volailiy socks can ave asymmeric effecs on fuure volailiy canges in e marke. Te coefficiens and 2 in equaions (5 and (6 reveal asymmery effecs in e sock marke and foreign excange marke, respecively. A posiive (negaive and saisically significan indicaes good (bad news in e sock marke as greaer impac on e volailiy of e sock index. Likewise, e coefficien 2 sows if appreciaions in e N dollar ave e same impac on e excange rae volailiy as depreciaions. EGACH models are esimaed by using a maximum log likeliood funcion specified by e following equaion: were L 0.5 NT ln T ln H H is e parameer vecor o be esimaed. N is e number of equaions and as e volailiy spillover beween sock and foreign excange markes is analysed N=2. T is e number of observaions in e sample; H is a 2 2 ime-varying condiional variance-covariance marix wi diagonal elemens given ' by equaions (3 and (4. ' is e vecor of innovaions from e sock marke and e foreign excange marke a ime. 4. Empirical resuls 4.. Full sample period resuls Te analysis provides evidence of bidirecional volailiy spillovers beween e N sock marke reurns and excange rae canges wen e excange rae used is ND/USD. Te curren sudy finds a ere is significan volailiy clusering, persisence, and asymmery. Volailiy clusering (, and 2,2. Table 2 presens e condiional variances of e sock marke reurns and excange rae canges wic are significanly impaced by eir own sandardized innovaion in e pas. Te coefficiens, and 2,2 in Equaions (3 and (4 are saisically significan a e % level, in all cases, indicaing volailiy clusering in bo e N sock marke and e flucuaions of e N dollar in e inernaional foreign excange marke. Volailiy persisence ( and 2. Volailiy persisence in sock marke reurns and excange rae movemens is also eviden. Te coefficiens of volailiy persisence (measured by and 2 are saisically significan a e % level. Tese resuls are consisen wi ose of Naand and Yung (99.

7 Asian Journal of Finance & Accouning Table 2. Volailiy spillover beween sock reurns and excange rae canges (Full sample period: January 990 December 2004 Excange ae ND/AUD ND/USD TWI index Excange ae ND/AUD ND/USD TWI index Panel A: Sock volailiy,0,, *** *** *** -0.4 *** (-0.07 (28.24 (-0.0 ( ( *** 0.64 *** *** *** *** (-4.6 (30.28 (4.74 ( ( *** *** *** *** (-4.97 (5.02 (-0.2 (30.26 (-6.0 Panel B: Excange rae volailiy 2,0 2, 2, *** *** *** *** (-.93 (4.6 (4.64 (6.73 ( *** 0.09 *** 0.94 *** 0.99 *** *** (-5.5 (3.08 (22.36 ( ( *** 0.77 *** *** *** ( (5.54 (0.97 (33.27 (-0.20 Noe: Above are e resuls of EGACH models, were α, and α 2,2 indicae volailiy clusering in e sock reurns and excange rae canges, respecively; α,2 (α 2, is e volailiy spillover from e excange rae canges (sock reurns o sock reurns (excange rae canges; γ and γ 2 are volailiy persisence in e markes, δ and δ 2 are e asymmery in e volailiy effecs. -saisics in pareneses, *** denoes significance a e % level, wo-ailed Asymmery ( and 2. Te asymmery coefficiens are negaive and saisically significan a e % level in all cases, suggesing srongly significan leverage effecs in e N sock marke. Bad news a resuls in sock decline in e marke leads o a more volaile sock movemen. Tis finding is consisen wi e general leverage effec evidenced in e lieraure. A e same ime, e asymmery coefficien 2 is only saisically significan wen ND/USD is used in e model. Tis implies a currency depreciaions in N dollar agains e US currency resul in more volailiy in e inernaional foreign excange marke. Tis case, owever, is no applicable o oer excange rae variables for e N dollar. Volailiy spillover (, 2 and 2,. Looking a e volailiy spillover coefficiens, we noice significan volailiy spillover effecs from e sock marke o e foreign excange marke. Te coefficien 2, (Table 2, Panel B as ig saisical significance for all excange rae measuremens. Te resuls are consisen wi e findings of Kanas (2000 a volailiy canges in e sock reurns ave impacs on e movemens of foreign currency. 2

8 Asian Journal of Finance & Accouning Te volailiy of foreign excange rae canges also spill over o e sock marke reurns. Te coefficien,2 (Table 2, Panel A is saisically significan a e % level wen ND/USD is applied as e foreign excange rae in e model. Tis indicaes a e volailiy canges in ND/USD excange rae ave spillover effecs on e sock marke reurns. However, e spillover effecs are no significan wen e ND/AUD and e TWI index are used in e model Sub-periods resuls Te 997 Asian financial crisis (AFC occurred in e middle of e sample period. Te full sample period is us pariioned ino pre-afc and pos-afc sub-periods. Tere is consisen unidirecional volailiy spillover from N sock marke reurns o ND/AUD in e wo sub-periods. For bo ND/USD and TWI index, in e pre-afc period, e volailiy spillover beween N sock marke reurns and ese wo excange rae canges are bidirecional; in e pos-afc period, ere is only unidirecional volailiy spillover from e wo excange rae canges o e sock marke reurns. All EGACH models exibi significan volailiy clusering, persisence, and asymmery. In e following, we repor only e evidence of volailiy spillovers. ND/AUD and sock marke reurns. Tere is consisen unidirecional volailiy spillover from e sock marke reurns o ND/AUD in e full sample and bo e wo sub-periods. I can be seen a e coefficiens α 2, in Panel B of Tables 2, 3, and 4 are saisically significan, wile e coefficiens α,2 in Panel A of Tables 2, 3, and 4 are insignifican. ND/USD and sock marke reurns. In e full sample, e volailiy of sock index reurns spills over o e ree excange rae canges (Table 2, Panel B, α 2,. Tese spillover effecs are mainained in e pre-afc period (Table 3, Panel B, α 2, bu vanis in e pos-afc period. TWI index and sock marke reurns. In e full sample, e volailiy of sock index reurns spills over o excange rae canges (Table 2, Panel B, α 2,. In is insance, is spillover effec is only mainained in e pre-afc period (Table 3, Panel B, α 2, bu vanises in e pos-afc period (Table 4, Panel B, α 2,. 3

9 Asian Journal of Finance & Accouning Table 3. Volailiy spillover beween sock reurns and excange rae canges (pre-afc, 3 January June 997 Excange ae ND/AUD ND/USD TWI index Excange ae ND/AUD ND/USD TWI index Panel A: Sock volailiy,0,, *** 0.23 *** *** (-3.97 (8.54 (-.02 ( ( *** *** *** *** *** (-8.0 (9.96 (-3.59 ( ( *** 0.4 *** *** *** -0.0 ** (-4.49 (8.39 (-2.35 ( (-2.09 Panel B: Excange rae volailiy 2,0 2, 2, *** 0.2 *** *** 0.22 *** 0.8 *** (-9.24 (3.52 (.4 (2.65 ( *** *** 0.20 *** 0.99 *** *** (-0.67 (3.47 (.50 ( ( *** 0.09 *** *** *** ** (-9.99 (3.08 (2.89 (35.76 (-2.3 Noe: Please see Table 2 for variable definiions. -saisics in pareneses; ***(** denoe significance a e % (5% level, wo-ailed 4

10 Asian Journal of Finance & Accouning Table 4. Volailiy spillover beween sock reurns and excange rae canges (pos-afc, Augus December 2004 Excange ae ND/AUD ND/USD TWI index Excange ae ND/AUD ND/USD TWI index Panel A: Sock volailiy,0,, *** *** *** *** (-5.92 (8.63 (-.32 (06.23 ( *** *** *** *** * (-2.6 (5.42 (2.53 (4.79 ( *** *** *** *** ** (-9.42 (22.52 (3.74 (30.26 (-2.9 Panel B: Excange rae volailiy 2,0 2, 2, *** 0.08 *** 0.20 *** 0.92 *** (-3.23 (3.58 (4.68 (38.24 ( *** *** *** *** ( (3.9 (3.67 ( *** *** *** *** (-2.39 (-0.0 (5.9 (33.27 (-3.2 Noe: Please see Table 2 for variable definiions. -saisics in pareneses; ***(**,* denoe significance a e % (5%, 0% level, wo-ailed I is clear a e 997 Asian financial crisis is a criical even for e volailiy ransmission beween e foreign excange marke and e sock marke in N. Before e crisis, ere were bidirecional volailiy spillovers beween excange rae canges (ND/USD and TWI index and e sock marke reurns wiin e N economy (Table 3,,2 in Panel A and 2, in Panel B. Afer e crisis, only e volailiy of ND/USD and TWI index canges spill over o e sock marke reurns (Table 4,,2 in Panel A and 2, in Panel B. Tis is consisen wi e view a e N currency is driven by inernaional facors insead of domesic facors. 5. Summary and conclusions Tis paper examines volailiy spillovers beween sock marke reurns and excange rae canges wiin e New ealand economy. Down-marke effecs, in e N sock marke, are effecively conrolled by incorporaing e leverage effec in e EGACH framework. Te 997 Asian financial crisis (AFC occurs in e middle of our sample period encouraging us o pariion e full sample period ino pre-afc and pos-afc sub-periods. Tere is consisen unidirecional volailiy spillover from N sock marke reurns o ND/AUD canges in e full sample and eac of e wo sub-periods. For bo e ND/USD and e TWI index, Te volailiy of N sock marke reurns spills over o bo e ND/USD and e TWI in e pre-afc period bu no in e pos-afc period. However, e volailiy of ND/USD and TWI index canges spills over o 5

11 e sock marke reurns bo before and afer e AFC. Asian Journal of Finance & Accouning Our empirical evidence agrees wi Cen e al. (2004 a e small and open N sock marke is exposed o and impaced by foreign currency movemens. Acknowledgmen Te auors wis o ank Vincen Xiang, Monas Universiy, for is assisance in conducing empirical ess. We acknowledge elpful commens and suggesions from Associae Professor Suar Locke, Universiy of Waikao. 6

12 eferences Asian Journal of Finance & Accouning Alaganar, V.T., & Bar,. (2007. Empirical properies of currency risk in counry index porfolios. Quarerly eview of Economics and Finance, 47, Brailsford, T.J. (996. Volailiy spillover across e Tasman. Ausralian Journal of Managemen, 2 (, Cen, J., Naylor, M., & Lu, X. (2004. Some insigs ino e foreign excange pricing puzzle: Evidence from a small open economy. Pacific-Basin Finance Journal, 2, Dungey, M. (999. Decomposing excange rae volailiy around e Pacific im. Journal of Asian Economics, 0, Kanas, A. (2000. Volailiy spillover beween sock reurns and excange rae canges: Inernaional evidence. Journal of Business Finance & Accouning, 27 (3 & (4, Naand, M., & Yung, K. (99. A GACH examinaion of e relaionsip beween volume and price variabiliy in fuures markes. Journal of Fuures Markes, (5, Nelson, D. (99. Condiional eeroskedasiciy in asse reurns: A new approac. Economerica, 59, Pinfold, J.F., Wilson, W.., & Li, Q. (200. Book-o-marke and size as deerminans of reurns in small illiquid markes: Te New ealand case. Financial Services eview, 0, Yang, S., & Doong, S. (2004. Price and volailiy spillovers beween sock prices and excange raes: Empirical evidence from e G-7 counries. Inernaional Journal of Business and Economics, 3(2,

Volatility Spillovers between Stock Market Returns and Exchange Rate Changes: the New Zealand Case

Volatility Spillovers between Stock Market Returns and Exchange Rate Changes: the New Zealand Case Volailiy Spillovers beween Sock Marke eurns and Exchange ae Changes: he New Zealand Case Choi, D.F.S., V. Fang and T.Y. Fu Deparmen of Finance, Waikao Managemen School, Universiy of Waikao, Hamilon, New