Volatility and Foreign Equity Flows: Evidence from the Philippines

Abstract

Purpose: To dissect the dynamic linkages between foreign equity flows, exchange rates and equity returns in the Philippines.Design/Methodology/Approach: Using a parsimonious SVARX-GARCH model and unique daily equity flow data this research models the relationship between net equity flows, conditional variance of stock returns, and conditional variance of exchange rates.Findings: The authors find several noteworthy results, which are unique to this study and several results that confirm existing literature. Much of existing literature on foreign equity flows into emerging economies find that foreign equity investors are trend chasers and equity flows are auto correlated. We confirm these finding in the Philippines. We also document two new and important findings. First, we find that unexpected increases in foreign equity flows to the Philippines increases the conditional volatility of the Filipino stock market significantly over the next two weeks of trading. Our second major finding is that unexpected shocks to foreign equity flows sharply increases the conditional variance of the USD/PHP exchange rate over the next two to three weeks of trading. Implications: Taken together our results indicate that foreign equity investment, while providing many benefits for small open economies such as the Philippines, does in the short run increase the conditional variance of both the equity market and exchange rates. Policy makers must weigh the benefits of increased risk sharing and the potential for lower costs of capital with the short-run potential for increase swings in asset prices.Originality: This paper is one of the only studies of its kind to test the impact of foreign equity flows on the conditional volatility of returns and exchange rates.