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.