Doctoral thesis

Volatility and dependence transmission in Asian equity and bond markets

Asymmetric and extreme dependence in Asian equity and debt markets: Existing research on international equity and bond markets have shown little evidence of asymmetric dependence b ...

Author(s) :

Teng Hwee Neo, PhD

Chief Investment Officer; Head of Investment Products and Solutions at UOB Private Bank (Singapore)

Abstract :

Asymmetric and extreme dependence in Asian equity and debt markets: Existing research on international equity and bond markets have shown little evidence of asymmetric dependence between bonds and equities. Unlike stock markets, a priori, it is submitted that dependence structure between stocks and bonds is symmetric. This is because of the safe haven nature of bond markets where investors ‘flight to quality’ during episodes of market turmoil. Likewise, in an upswing, investors would switch back into risky assets and therefore, ‘flight from quality’. However, this study has found evidence of asymmetric dependence between foreign currency bonds and equities in Korea, Indonesia, and Philippines. For local currency bonds, foreign currency risk exacerbates asymmetric dependence with equities. As contrasting cases, Hong Kong and China, where exchange rates are stable have symmetric dependence between the two asset classes. Local currency bond markets in Indonesia and Philippines’ displayed asymmetric dependence with equity markets even when foreign exchange risk is completely removed through FX hedging. Tail dependence for foreign currency bonds and equities has been rising for some markets and this is partly due to increasing foreign participation and in some cases, such as China, changing composition of the bond market towards riskier issuers. In Korea, tail dependence has been declining reflecting the improvement in its credit fundamentals. In conclusion, outside of Indonesia and Philippines, the local currency market exhibits resilience against left tail risk for the domestic equity investor but not when currency risk is assumed for the foreign equity investor. For local currency markets, countries with tightly managed exchange rate regimes such as Hong Kong and China, have local currency bond markets that are relatively decoupled from the equity markets.

Volatility transmission, correlation dynamics and contagion study in Asian equity and bond markets:This paper studies volatility transmission between stocks and foreign (FCY) and local currency (LCY) bond markets in Asia. First, a univariate GARCH model is used to investigate the transmission of second moment effects between stocks and bonds for the two distinct segments of the bond market. This is done by using residual variance of one asset class in a GARCH model as an exogenous variable in the GARCH model of another asset class. We find that there is noticeable transmission of volatility especially in the foreign currency market. Volatility transmission is more pervasive from the direction of bonds to equities. By comparison, transmission effects are weaker between LCY bonds and equities. An asymmetric DCC model is then used to model dynamic conditional correlation between the two markets as well as within each market. There appears to be a rising correlation between the foreign currency debt market and equities. The LCY bond market is also highly correlated with the equity market with the exception of countries with controlled currencies (China and Hong Kong). As the correlation is driven largely by foreign exchange risk, correlation is low and stable between these two asset classes if foreign exchange risk of the local currency bonds is removed through hedging. Due to potential for liquidity shocks, there is more evidence of contagion than ‘flight to quality’ for bond markets in Asia during crisis periods.
Date : 14/06/2013
Thesis Committee :

Supervisor: René Garcia , EDHEC Business School

External reviewer: Peter Christoffersen, Rotman School of Management, University of Toronto

Other committee members: Ekkehart Boehmer and Stoyan Stoyanov, EDHEC Business School

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