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This study examines the volatility and persistence of volatility between oil, gold, and the CNX Nifty stock index in India from 2008-2014 using integrated ICSS and GARCH models. The objective is to identify the strength of volatility persistence among these markets and determine their correlation. Literature on volatility modeling, structural breaks, and relationships between commodity and stock markets is reviewed to provide context and motivation. The analysis will use weekly price data in Stata and R/Matlab to calculate ICSS and model volatility. The expected outcome is to determine the correlation between oil, gold, and the Nifty index.
This study examines the volatility and persistence of volatility between oil, gold, and the CNX Nifty stock index in India from 2008-2014 using integrated ICSS and GARCH models. The objective is to identify the strength of volatility persistence among these markets and determine their correlation. Literature on volatility modeling, structural breaks, and relationships between commodity and stock markets is reviewed to provide context and motivation. The analysis will use weekly price data in Stata and R/Matlab to calculate ICSS and model volatility. The expected outcome is to determine the correlation between oil, gold, and the Nifty index.
This study examines the volatility and persistence of volatility between oil, gold, and the CNX Nifty stock index in India from 2008-2014 using integrated ICSS and GARCH models. The objective is to identify the strength of volatility persistence among these markets and determine their correlation. Literature on volatility modeling, structural breaks, and relationships between commodity and stock markets is reviewed to provide context and motivation. The analysis will use weekly price data in Stata and R/Matlab to calculate ICSS and model volatility. The expected outcome is to determine the correlation between oil, gold, and the Nifty index.
Analyzing the relationship and volatility persistence
across various market segments using integrated ICSS
and GARCH Approach.
Introduction
This study examines volatility effect of Oil on Gold and Indias major stock index CNX Nifty using daily data over sample period 1st January 2008 to 30th June 2014.
Crude oil like every commodity is traded in Multi Commodity Exchange (MCX) and has its own contract value and margin requirements. Commodities are traded based on margin, and the margin changes based on market volatility and the current face value of the contract.
GOLD is an integral part of Indian culture and heritage. India is considered as a largest consumer of Gold across the world. Historically, Indians consider Gold as a SYMBOL OF STATUS, also as a highly secured investment option. As an investment option gold is treated as a safe bet. In the past, Gold prices tend to be stable. However, of late the gold is witnessing an unprecedented volatility in its price. This may be because of pegging Indian Bullion market with Global Bullion markets. Another reason may be a median between Supply and Demand. Because of these two reasons and few other reasons, volatility in Gold has increased drastically and predicting Gold price has become a great challenge.
Volatility is the amount of uncertainty or risk about the size of changes in a securitys value. Higher volatility implies that the securitys value can potentially spread out over large values. And lower volatility means that the securitys value does not fluctuate dramatically; but change at a steady pace.
Volatility persistence is the tendency of a securitys volatility that will move in its present direction i.e., large changes in the price of an asset are often followed by other large changes, and small changes are often followed by small changes.
In recent literature, there has been a investigation of the extent to which the rate of information flow is correlated across markets. The increasing integration throughout the world has generated interest in studying the transmission of financial market shocks across markets. Hence it has become necessary for financial market participants to understand the volatility transmission mechanism across time and sector in order to facilitate optimal portfolio decisions. Thus there is growing concern about how volatility persist across markets.
Problem Statement
The analysis of relationship between Oil, Nifty and Gold is of high importance for financial markets participants, if our analysis does not find existence of relationships between these variables this will imply that there are possibilities of diversification in between these markets. The level of volatility in financial markets influence the corporate sectors investment decisions and banks willingness and ability to extend credit facilities. Therefore it is important to know what changes in volatility level might have on financial stability.
Objective
The objective of this study is to examine the effects of volatility in oil markets on volatility in Gold markets, including CNX Nifty, Crude Oil and Gold to identify the strength of the volatility persistence among these markets.
Scope
This study has being carried out by taking weekly closing prices from 1st January 2007 to June 2014 in the three market segments- Nifty, Oil and Gold. We are going to make the use of statistical software called Stata. In addition to that,we will also make use of programming languages like R and matlab to calculate the ICSS algorithm.
Literature review
1. Engle (1982) developed the autoregressive conditional heteroskedasticity (ARCH) process which was an improvement over the traditional constant one period forecast variance model. The ARCH processes are mean zero, series uncorrelated process with non-constant variances conditional on the past. This paper estimated the mean and variances of the inflation in United Kingdom, and the ARCH effect was found to be significant and estimated variances increased during the 1970s.
2. Hamilton J.D (1983), studied the US recessions since World War 2 and observed that 7 out of the 8 post war recessions in the US have been preceded by a dramatic increase in the price of crude oil. This study provides evidence that increases in oil prices are responsible for decline in macro-variables like real Gross National Product (GNP).
3. Bollerslev (1986) proposed the generalization of ARCH (Autoregressive Conditional Heteroskedastic) process to allow for past conditional variances in the current conditional variance equation.
4. Haun et al. (1996) examined the relationship of oil returns with stock returns during 1980s using vector autoregressive (VAR) to study the lead lag relationship by controlling interest rate effects, seasonality and other effects. They concluded that oil returns and stock returns are not correlated and this suggests that oil futures can be used to diversify the portfolio.
5. Robert et. al. (2000) studied various volatility models and proposed that pronounced persistence mean reversion should also be incorporated in a model and concluded that GARCH type models are best to capture these models.
6. Inclan et al. (1994) studied the problem of multiple change points in the variance of the sequence and proposed Iterative cumulative sum of squares (ICSS).The algorithm doesnt have much heavy computational burden and the results are comparable with Bayesian approach or the likelihood ratio tests.
7. Aggarwal, et al (1999) examined what type of events cause the shifts in the volatility of emerging stock markts, using the ICSS algorithm to identify the points of sudden changes in the variance of the returns in each market and also tried to examine whether the events were social, political or economic.They concluded that Oct 1987 crash is the only global event in the lasr decade that caused the significant jump in the volatility of several markets since the data covered a 10 year period -May1985 to April 1995.Other events such as the Gulf War had a little impact comparably.
8. Fernandez (2004) examined the presence of structural breaks using two approaches namely ICSS and Wavelet analysis and found out that number of shifts detected by the two methods when filtering out the data for conditional heteroskedastic and serial correlation.
9. Wang et al.(2007) analyzed sudden changes in stock markets of the EU members using weekly data over the period 1994-2006. They used the ICSS algorithm and found that the results obtained were consistent with that of the Aggarwal et al.(1999).
10. Agren (2006) studied the volatility spillovers from oil prices to stock markets within an asymmetric Baba-Engle-Kraft-Koner ( BEKK) model by using weekly data of the stock market.He concluded that the stock market shocks are more prominent than the transmission of oil shocks. 11. Ricardo Alberola (2007) estimated volatility returns using the ARCH models by analyzing the common regularities of daily stock returns time series in the Spanish Energy markets. He concluded that the electric market had been the most volatile market during the period under analysis.
12. Long, T.L (2008) using the ARCH/GARCH model, stated that stock return volatility of the Vietnam stock market (VSM) is highly persistent. This high persistence of VSM return volatility is reduced when structural breaks are included in the ARCH/GARCH models ( by using dummy variables).
Expected Outcome To determine the correlation between Oil, Gold and Nifty.
References:
Bernadette Andreosso-OCallaghan and Lucia Morales, Volatility Analysis on Precious Metals Returns and Oil Returns: An ICSS Approach, University of Limerick, Dublin Institute of Technology
Long, T.L., (2008) Empirical Analysis of Stock Return Volatility with Regime Change Using GARCH model: The case of Vietnam Stock Market. Vietnam Development Forum. Working Paper 084.
Wang, P., Moore, T., (2007) Sudden changes in volatility: The case of five central European Stock Markets.
Alberola, R., (2007) Estimating Volatility Returns Using ARCH Models. An Empirical Case: The Spanish Energy Market, Lecturas de Economia 66, 251- 276.
Agren, M., (2006) Does Oil Price Uncertainty Transmit to Stock Markets? Uppsala Universitet, Working Paper No.23.
Fernandez, V., (2004) Dectection of Breakpoints in Volatility. Estudios de Administracion, vol 11. No.1.
Malik, F., (2003) Sudden changes in variance and volatility persistence in foreign exchange markets. Journal of Multinational Financial Management 13, 217-230.
Aggarwal, R., Inclan, C. and Leal, R. (1999) Volatility in emerging stock markets, Journal of Financial and Quantitative Analysis 34, 33-55.
Huan, R., Masulis, R., and Stoll, H., (1996) Energy Shocks and Financial Markets, Journal of Futures Markets 16(1).
Inclan, C. and Tiao, G.C. (1994) Use of cumulative sums of squares for retrospective detection of changes of variance, Journal of the American Statistical Association, 89, 913-923 . Bollerslev. T. (1986) Generalized Autoregressive Conditional Heteroscedasticity, Journal of Econometrics 31, 307-327.
Hamilton, J.D. (1983) Oil and the Macroeconomy since World War II. Journal of Political Economy 91, pp. 228-248.
Engle, R. F. (1982) Autorregresive Conditional Heteroskedasticity with estimates of the variance of UK inflation, Econometrica, 50, 987-1008.
An Empirical Study of Price-Volume Relation: Contemporaneous Correlation and Dynamics Between Price Volatility and Trading Volume in the Hong Kong Stock Market.