Volatility Spillover in Foreign Exchange Markets

The recent financial crisis in US and then debt crisis in Europe have impacted the economical performance of world in general and financial performance in particular. With increase in globalization and cross-border trade, dependency of one economy increases on other economies. Portfolio diversification theory proposed by Markowitz (1952) suggests that if two markets are not significantly correlated, taking positions in that market helps in reducing risk of the portfolio. The recent turmoil in these two markets (US & Europe) has affected entire world and a lot of volatility has been observed in all financial markets around the world. Hence, it becomes imperative to identify the volatility spillover effect from one market to other at this moment. This paper examines the volatility spillover of one market on other by taking five exchange rate markets: Great Britain Pound (GBP), Euro (EUR), Canadian Dollar (CAD) and Australian Dollar (AUD) and Japanese Yen (JPY) against US Dollar. Data from June 2008 to December 2012 were taken for consideration. Unit-root test was used to identify the stationarity of data. Variance decomposition method was applied to identify the degree of influence of one market to other.Volatility spillover index as suggested by Diebold and Yilmaz (2009) was created to identify the return spillover effect. Outcomes suggest that volatility on JPY and CAD follows the concept “better to give than receive” while GBP as the net receiver goes along with the findings of Nikolaos (2012). Volatility spillover index of 11.11% indicates low possibility of volatility transmission among considered currency pairs. This paper will help traders, portfolio managers, policy makers and other market participants to identify the source of volatility in considered currency markets and take corrective measures