RDP 9609: Australian Financial Market Volatility: An Exploration of Cross-Country and Cross-Market Linkages 1. Introduction

Several episodes of quite severe market turbulence have occurred in financial markets over the last decade. The sharp and widespread fall in international bond prices witnessed in 1994 is one of the more recent episodes. Other prominent events include the stock-market crash of 1987, the ERM crises of 1992 and 1993, and the 1994–95 Mexican peso crisis and subsequent ‘Tequila’ effect. Such episodes have been interpreted by some observers as evidence of a change in the behaviour of present-day financial markets. In particular, assertions that financial markets are now characterised by higher levels of volatility than in the past, and display greater susceptibility to ‘contagion’ and ‘spillover’ effects, have acquired considerable prominence in recent years.

In this paper we examine the behaviour of daily asset price movements in Australian bond, share and foreign exchange markets over the period since 1987 and address several key questions. First, is there evidence of a trend increase in Australian financial market volatility over the period? Second, what are the predominant foreign influences on Australia's financial markets, and have these influences become more important over time? If so, what are the predominant foreign influences? Third, have international influences been more or less important than domestic cross-market influences? Fourth, is there evidence of directionality and other asymmetries in Australian financial market volatility?

The paper is organised in the following manner.

Section 2 documents the volatility of daily price changes in the bond, share and foreign exchange markets in Australia, the United States, Japan, Germany and the United Kingdom over the period 1987–1996. This section also undertakes preliminary investigations into the extent of international linkages between markets.

Correlations of both daily volatility and daily price changes in the different country markets are presented, and their variations over the sample period examined.

Section 3 presents results from some simple econometric analysis further investigating the importance of cross-country linkages. It assesses the extent to which developments in foreign bond and equity markets influence the size and direction of daily price changes in the Australian counterpart markets.

Section 4 extends the empirical examination undertaken in the previous section by exploring cross-market as well cross-country linkages between Australian and US financial markets.

Section 5 examines issues relating to the directionality of volatility and other asymmetries in Australian financial market volatility. Specifically, it addresses questions such as: is volatility higher in ‘bear’ markets than in ‘bull’ markets; do market falls cause greater volatility than market rises; and do the cross-country and cross-market correlations between volatility vary during periods of market turbulence?

A summary of the paper's main findings and concluding comments is presented in Section 6.