Abstract
The interplay between currency risk pricing and market crashes has emerged as a multifaceted challenge that deeply concerns institutional investors and policy makers. These issues have garnered considerable attention in the existing literature due to their significance in shaping investment strategies, assessing systemic risks, and informing economic policies (Rehman et al. 2022; Al-Shboul & Anwar, 2014; Vohra and Fabozzi, 2019; and Bonga-Bonga, 2018). This thesis explores three vital dimensions that have far-reaching implications for the global financial sector: 1) the pricing of currency risk in both developed and emerging equity markets, 2) the complex relationships between foreign exchange rates (FX), crude oil prices, and stock markets, and 3) the impact of stock market crashes on cross-border spillovers. The three major contributions of this thesis carry substantial implications for institutional investors by helping them in optimizing portfolio strategies and risk management, and for policy makers by helping them to develop more effective economic policies to safeguard financial stability in an increasingly interconnected world.
The first contribution of this thesis is to explore whether currency risk is valued differently in developed markets, such as the United States, and emerging markets like Brazil, India, Poland, and South Africa. We investigate whether shocks stemming from floating currency risk exhibit variations across sectors in both developed and emerging economies and whether the effects of currency risk pricing on equities differ within sectorial markets. In this chapter, we empirically employ the ARFIMA-EGARCH Markov Switching-based C-Vine copulas approach. This method provides flexibility, numerical simulation for identifying risks associated with economic states, and ease of handling. Our findings reveal an asymmetric effect between equity markets and foreign exchange rates, suggesting a robust, heterogeneous, and positive relationship between the two. When using the US dollar (USD) exchange rates, we observe that higher equity prices correspond to local currency depreciation. Furthermore, we discern that the selected emerging economies actively price currency risks, and the impact of currency risk pricing varies according to the level of dependencies in both regimes.
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The second key contribution of this study involves investigating the empirical dependence structure and the time-frequency impact of foreign exchange rates (FX) on the correlation between crude oil prices and stock markets. We analyze a dataset spanning from 2005 to 2020, encompassing Crude Oil West Texas Intermediate (WTI), BRICS stock markets, and BRICS FX, using wavelet analysis and the Markov-Switching (MS) model. The results reveal that crude oil prices exhibit higher volatility than stock market returns and currency exchange rates. Wavelet analysis shows that both regimes follow a similar pattern with slight variations in co-movements concerning time and frequency domains. FX emerges as a significant factor driving market interdependence, especially in the medium and long term, during specific time-frequency and time-period intervals. In both scenarios, FX significantly influences the correlation between stock markets in emerging economies like Brazil, India, and China, and crude oil prices in the medium term. In contrast, for Russia and South Africa (SA), FX plays a less pivotal role in driving long-term co-movements. Furthermore, substantial co-movement is observed, particularly during the global financial crisis (GFC) and the European debt crisis (EDC), implying a higher degree of integration during these turbulent times.
The third major contribution of this thesis focuses on investigating the impact of the SP500 stock index crash on South African top sector indices during the GFC and the COVID-19 pandemic. Utilizing the Copula-based BEKK-GARCH approach, the results reveal the existence of price and volatility spillovers during stock market crash periods. Notably, price spillovers from the U.S. SP500 to South African top sector indices in the Johannesburg Stock Exchange (JSE) are more pronounced during stock crash episodes. However, there are no spillover effects from South African markets to US markets, indicating a lack of integration between the two economies. Furthermore, the findings highlight that Gumbel copulas exhibit higher dependence parameters, leading to extreme co-movements in the upper tails, signifying a substantial transmission of shocks from the SP500 to the JSE's eight top sector indices and indicating asymmetric dependence between the two markets.