Dependence between stock market and foreign exchange market in South Asia: A Copula-Garch approach

Abstract

The paper studies the dependence pattern between stock market and foreign exchange market of three South Asian countries; namely Bangladesh, India and Sri Lanka by using five copula functions, to reveal asymmetric dependence structure. This paper focuses South Asia because of its promise as portfolio investment destination. The dependence structure between stock market and foreign exchange market assists MNCs, private equity firms, international portfolio managers and policy makers in international investment decision making. The paper also studies tail dependence (upper and lower). Markets crash together rather boom together, which can be traced by tail dependence parameter. Correlation, Kendall’s tau and Spearman’s rho reveal linear dependence. However, Copulas reveal non-linear dependence between non-normal distributions. In this paper, Copula functions are applied between marginal distributions of stationary uni-variate return series. Using daily return series for the period of July 31, 2009 to July 31, 2013, ARMA-GARCH type model are applied to obtain marginal distributions of return series. The results from marginal models indicate that volatility dies immediately after a crisis; meanwhile positive news creates more volatility than negatives. The results from copula models indicate existence of asymmetric dependence, with upper tail dependence for all pairs, implying dependence increases in bull market situation (price increase in financial instruments). Both Bangladeshi and Indian pairs provide some diversification possibility, against no diversification for investing in Sri Lankan market. Moreover, Bangladesh and India demonstrated as promising investment destination in terms of risk –return criteria. Foreign investors are recommended to employ proper risk and investment management strategy in order to earn capital gain, by following diversification strategy. Conversely, investment recipient countries are recommended to establish a stable, well regulated stock market, with high stock market capitalization to GDP. Besides, monetary policy should stabilize the exchange rate of currency to attract foreign investors. Copula based dependence measures assist foreign investors and investment recipient countries to change their related strategies and policies; subsequently they will be able to maximize their utility functions.