Indonesia's Rupiah and Capital Market Correlation Risk Study for Macroprudential Policy to Prevent Systemic Risk

Abstract

On the last 3 months, there have been some concerns over the weakening of Indonesian Rupiah currency that mostly driven by bearish trend in Indonesia’s equity market. Though the explanation of this correlation is known mostly due to foreign capital flow in the equity market (hot money), it appears that correlation risk between currency rates, with mostly impacted USD/IDR rate, and capital market is not well-studied and modeled in Indonesian market. The difficulty of the investigation would be to build model that would fit to the observed dynamics of both time-series and computational difficulties. This study will show how the cross-asset correlation between Indonesia’s Rupiah strength and capital market behaves along time. In this paper, auto-correlation was filtered out from USD/IDR rate and JCI (Jakarta Composite Index) daily returns from 2003-2013 data using ARMA-GARCH type modeling and the filtered “white noise” of the fitted data will be used to check indication of the correlated “innovation” existence that will be used in the proposed model. In addition, an empirical study will evidence an indication of global crisis spillover effect to Indonesian Rupiah currency due to JCI correlations with major world market indices, to express indirect effect of the cross-asset correlation risk. The cross-asset correlation is proposed to be modeled using a multi-factor Dupire model with correlated two Brownian Motions of the equity (JCI) and currency (USD/IDR) components for derivative pricing activity. Lastly, several important points are proposed to note regarding macroprudential measures to be taken in accordance to the shown correlation risk.