Does Volatility Transmission Between Stock and Foreign Exchange Markets in Pakistan Reveal Asymmetry?

Abstract

Foreign exchange and stock markets are closely interlinked and affect each other in different ways; volatility of each market is transferred to the other market due to many reasons. This study examines the direction and nature of volatility transmission between the stock market and foreign exchange market of Pakistan.Volatility transmission between the two markets is examined using bivariate diagonal BEKK-GARCH and bivariate E-GARCH models. Stock market returns are measured using the KSE-100 index and daily Pakistan Rupee-PKR to the United States Dollar-USD exchange rate is used for the foreign exchange market. Normality is examined through Skewness and Kurtosis, Autocorrelation through Correlogram Q-statistics, and ARCH effect through ARCH-LM test. Results of the study indicate that bi-directional volatility transmission exists between the stock market and foreign exchange market of Pakistan and E-GARCH model further indicated asymmetric volatility transmission between these two markets, which means bad news of one market have a greater impact on the volatility of another market than good news. Findings of the study are helpful for investors and policy makers both. Knowledge of market response to changes in the other market can assist them to devise hedging strategies and for diversification decisions. Policy makers can use findings of this study in making policies for currency markets. The literature lack consensus regarding relationship of FORX and stock market in general and more precisely in the context of developing economies. Considering the fact that limited literature on the topic for developing economy like Pakistan, where variation in results exist hence dynamics of relationship between these two markets need to be explored.