Return and volatility spillover between stock price and exchange rate: Indian evidence

What is it about?

Return and volatility spillover between the stock market and the foreign exchange market have been studied for the Indian economy, over the period of April 2003 to September 2013. Bivariate EGARCH model has been used for this purpose, which can aptly capture the asymmetric responses to the shocks. Return and volatility spillover from the stock market to foreign exchange market has been found to be statistically significant. The paper further dissect the sample period between pre-crisis (2003–2007) and post-crisis (2008–2013) period and the analysis reveals that the strength of volatility spillover has become stronger in the post-crisis period. Policies pertaining to stock market stabilization can reduce the exchange rate volatility as well. However, managing exchange rate fluctuation is found to be an effective way of dampening stock market volatility at the time of stress only.

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Why is it important?

The literature on this issue in the Indian context is scanty. The paucity of previous research can be attributed to the presence of several barriers to capital flows, lack of liberalization measures, underdeveloped financial markets. However, the situation has begun to change quickly, with the rapid pace of financial reform undertaken by the Indian policymakers. Since the last decade, India has emerged as a preferred destination for foreign investors. Against this backdrop, understanding the interdependence between stock price and exchange rate is a much-needed agenda of research. Second, the recent global crisis has once again sparked the considerable interests in the stock price exchange rate linkages. However, it is very hard to find any study in Indian context which has analysed the issue in the trail of the global crisis. The study complements the previous researches by undertaking an in-depth analysis of the post-crisis situation vis-à-vis the pre-crisis period and thereby tries to identify that how this nexus has changed (if at all) in the wake of the global financial crisis. Third, examining the volatility spillover can help us to understand how the information is transmitted from one market to another. Presences of volatility spillover across the markets indicate that shocks in one market not only increase its own volatility but also amplifies the volatility of the others. On the contrary, the absence of volatility spillover indicates that the shocks are market specific and do not get transmitted to another market. Elucidation of volatility spillover across the different asset markets has always remained as an important agenda in financial economics. However, most of the prior studies have analysed the linkage by focusing on the first moment while paying less attention to their second moment. Fourth, Limiting exchange rate volatility is perceived to be an important objective of RBI. It often intervenes (mostly indirect interventions) in the foreign exchange market for this end. There remain some unsettled issues, which needs to be addressed properly. Is it more convenient way to moderate exchange rate volatility by focusing on stock market fluctuations? Or diminishing exchange rate volatility itself leads to stock market stabilization?