Theoretical and empirical aspects of financial market volatility : herding, contagion and intervention
Creators: name: Wanaguru, D. Sumila Tharanga
Publisher: name: The Australian National University
Year: 2012
Subjects: subject: HB3722.W36 2012
subject: Foreign exchange rates
subject: Global Financial Crisis, 2008-2009
subject: Financial crises History 21st Century

description: This thesis examines the theoretical and empirical aspects of financial market volatility. Financial markets are essentially volatile. However, excess volatility may impair the smooth functioning of the financial system and economic performance. Volatility that was evident in financial markets during the recent financial crisis, and, even more recently, during the European debt crisis, has attracted renewed interest in studying volatility. The most prominent feature of this crisis was its widespread effects on the financial markets of developed countries, while leaving emerging markets as the success story. The main objectives of this thesis are twofold. The first is to quantify and investigate the nature of the factors behind the transmission of volatility on and among financial markets during the crisis of 2007-2011, with a special focus on developed countries. Both analytical and empirical modeling approaches are used. The analytical approach in Chapter 2 is built up on the herd behavior of international investors, using the role of carry traders' as a conduit. Particular attention is given to modeling the way in which private signals on margin requirements lead some investors to change their decisions, and how their strategic behavior transmits shocks across countries. Chapter 3 adopts an empirical approach using a latent factor methodology, and aims to explore the transmission mechanisms of the crisis through equity and bond markets over different phases of the crisis of 2007-2011. The factor model in particular specifies contagion channels through cross-country and cross-market contagion linkages, after controlling for other forms of fundamentals through the factor structure. The second objective of the thesis is to examine whether and how successfully emerging market central banks attempt to shield their domestic currency market from externally sourced financial market volatility through foreign exchange intervention. Two empirical approaches, the generalized autoregressive heteroskedasticity approach in Chapter 4 and the latent factor approach in Chapter 5, are used to explore the significance and effectiveness of foreign exchange intervention using a unique data set of daily intervention obtained from the Central Bank of Sri Lanka. Overall, this thesis finds strong evidence for the transmission of asset market volatility across developed countries during the crisis of 2007-2011. Through herd behavior and the feedback effects in asset prices and exchange rates, financial markets can be destabilized during crises. Financial market contagion is another significant channel through which the stability in the financial system can be compromised, and several channels of contagion are identified and estimated for different phases of the crisis. However, the relative importance of each contagion channel varies depending on the source asset market and the phase of the crisis. Turning to emerging market responses to periods of global volatility, foreign exchange intervention is found to be an effective policy instrument for shielding against external shocks, as is evident for Sri Lanka. Intervention is aimed to "lean against the wind" to reduce volatility and to accumulate international reserves. The central bank responds to global movements in currency markets when intervening, rather than movements specific to the domestic currency market.