Study on Return and Volatility Spillover Effects among Stock, CDS, and Foreign Exchange Markets in Korea

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(ProQuest: ... denotes formulae omitted.)I. INTRODUCTIONA number of studies have examined the effect of macroeconomic variables on financial asset returns. Since the work of Ross (1976), various macroeconomic variables such as GDP, inflation, and the trade balance as well as financial market variables such as interest rates and exchange rates have been tested to identify the influential factors for the expected return of a financial asset. However, few studies have been conducted about the relationships between macroeconomic volatility and asset market volatility. Schwert (1989) states that volatility in macroeconomic fundamentals and financial market factors are helpful in predicting stock return volatility, and vice versa.The key objective of this study is to investigate the return and volatility spillover effects between domestic and international financial and asset markets focused on the Korean economy. In particular, the presence of return and volatility spillover effects from country risk and advanced economy asset markets to Korean asset markets is the primary interest in this study.Before approaching the main subject, it is necessary to specify the concept of country risk. The Credit Default Swap (CDS) spread underlying government bonds is used as a measure of country risk in this paper.1 The CDS premium generally rises when credit risk of the underlying asset increases. Hence, the CDS premium is interpreted as a measure of credit rating of the authorities or the institutions which issue the underlying asset. For this reason, the CDS premium which is on the basis of bond in foreign money issued by the each country's government is used well as an indicator which reflects the country's credit rating.There have been considerable studies which show when external or internal economic and financial shocks affect the country's economy, the CDS market reacts sensitively and shows the current state through its index, called the CDS spread (see Remolona et al., 2008; Baum and Wan, 2010; Longstaff et al., 2011). However, compared with the substantial amount of empirical and theoretical studies on the foreign CDS market since 2000, most studies related to credit risk in Korea have focused on the credit premium in the bond market because of immature market conditions and deficiency of data for the Korean CDS market. Recently, several pioneering works for the Korean CDS spread are in progress. Nam and Byun (2006) conduct empirical analysis to find deterministic elements of the Korean CDS spread. They find that variations of the Korean CDS spread is affected by the variations of past value of CDS spread itself, domestic macroeconomic fundamentals, and financial variables such as yields on government bonds, stock prices, and the won/dollar exchange rate. They also find that the CDS market is more efficient in reflecting the change of credit status in the underlying asset to the change of credit risk spread than is the bond market. Considering the determinants of the CDS premium underlying Korean government bonds, Kim (2009) finds that typically well-known determinants of the CDS premium such as the short-term foreign debt ratio, exchange rate, and stock prices are ascertained to be statistically significant in the Korean CDS market. That is, he finds that the CDS premium decreases when stock prices increase and the exchange rate decreases.Early studies on the relationship between CDS spread and other macroeconomic or financial market variables usually focus on the link between the levels of the series without considering the link between the returns or volatilities of the series. However, examining the relationship between returns or volatilities of the series reflects the current trend of studies on the analysis for the relationship between financial markets. In a study on the relationship between CDS spread change and stock return, Norden and Weber (2009) analyse the relationship among CDS, bond and stock markets empirically. …