Does crude oil fire the emerging markets currencies contagion spillover? A systemic perspective

Abstract

The paper lays the empirical foundation for the significance of Crude in explaining the variation in implied volatilities (IVs) of emerging markets nations constituting the MSCI emerging market index. Guided by the significance of Crude as a significant regressor, the study aims to investigate the association of currency IVs with Crude using a connectedness-based approach by Diebold and Yilmaz (2012). The spillover pattern highlights the strong interconnectedness of Asian currencies, with the Taiwanese dollar and Thai Baht feeding the systemic risk, thus the currencies to watch out for the policymakers. An important finding is that the Polish zloty possesses a high spillover risk in the Eastern European economies due to improved economic conditions and a large flow of capital during quantitative easing. On the other hand, Russia is a huge exporter of Crude and shares a limited spillover relationship with Crude, implying domestic macroeconomic conditions and geopolitical risk contribute more to the ruble fall. Based on the spillover pattern of IVs, a portfolio universe selection and weight allocation with dynamic balancing have been devised for investors of the forex market for spillover risk minimization. Findings show that the Chinese Yuan and Chilean Peso are the most favorable currency alongside Crude. However, Indian Rupee serves as the most promising currency pair to be inducted with Crude. The study is particularly beneficial for investors and portfolio managers investing in the forex market to induct the assets in the portfolio to mitigate systemic risk fear, especially during times of distress.