Volatility is a fascinating and important topic for financial markets in general, and probably the single most important issue in financial risk management. Although volatility itself is not synonymous with risk, it is closely associated with it in the realm of risk management. In this study, I focus on the volatility in the foreign exchange markets and investigate the spillover of volatility from this market to equity correlations and its impact on global equity markets’ bid-ask spreads as a proxy for market quality. I also explore the role that accounting earnings quality play in subsequent volatility in U.S. equity markets.
I provide a theoretical base and its associated empirics for the link between exchange rate volatilities and global equity correlations. I test this theory using multiple techniques that ends with the application of autoregressive error correction analysis, wherein, I demonstrate the predictive power of options implied exchange rate volatilities against ex-ante global equity correlations. My findings indicate that exchange rate implied volatilities, coupled with one-period ex-post correlations, are more predictive of subsequent equity market correlations than other models.
I then examine the impact of currency volatilities on the average monthly spreads in ADRs and their underlying local shares. I employ dynamic panel data estimation and principal component analysis to show that currency volatility explains a significant portion (16.6%) of the variation in spreads across markets, heretofore largely unexplored by extant finance literature.
Finally, I employ well established accrual measures to calculate aggregate accruals for the S&P 500 on a quarterly basis and examine the ability of this aggregate measure to forecast future trends in the volatility of the index. I find a statistically significant relation between subsequent twelve-month volatility in the S&P 500 index and aggregate accruals. This relation holds whether total or abnormal accruals measures are employed. My findings document a rare long-term indicator of volatility in the widely followed index. I also show that my aggregate accrual measure yields additional information about S&P 500 volatility when compared with simple historical volatility measures or option implied volatility.
