Extreme returns and the contagion effect between the foreign exchange and the stock market: evidence from Cyprus

Abstract

In this article we apply the Extreme Value Theory (EVT) in order to estimate the Value-at-Risk (VaR) and the correlation of extreme returns for two inherently unstable markets; the foreign exchange and the stock market. We also derive the corresponding VaR estimates from more ‘traditional’ methods of estimation on daily returns of the US dollar/Cyprus pound exchange rate and the Cyprus stock exchange general index. The main conclusion we reach is that the more heavy-tailed distributed a series is the more accurate the loss predictions are from the application of the EVT. We also show that the conditional correlation index of the extreme returns of those two markets remained almost constant throughout the backtesting period that was characterized by ‘bear’ market conditions.