Diversifying Investment Risk in India's Currency Derivative Market: Does Currency Equity Linkage Perform Better than Currency Bullion Linkage?

Abstract

This paper opens up the scope of risk diversification for investors active in Indian currency derivative market. It employs a DCC GARCH model to derive dynamic co variances and dynamic conditional correlations in currency-equity linkage (proxy as currency futures - Index Nifty futures) and currency-bullion linkage (proxy as currency futures - Gold futures, currency futures - Silver futures). The paper estimates the optimal weights of portfolio allocation, hedge effectiveness, risk adjusted return effectiveness for currency-equity and currency-bullion portfolios using two different diversification strategies. Findings suggest that currency-equity linkage provides better effectiveness of hedging and risk adjusted return. Moreover JPYINR (Japanese Yen futures) is most efficient diversifiable currency futures. Adding Index Nifty futures to JPYINR increases risk adjusted return effectiveness by 585 %. Our findings also indicate that there is no generic form of spillover dynamics in currency-bullion market, however there is a strong form of volatility spillover from equity to currency in currency-equity linkages. Dynamic conditional correlations derived from DCC GARCH suggest that currency-equity linkage have dynamic negative correlation while currency-bullion linkage has positive correlations.