Volatility spillovers: Australasian futures and simulated options markets

Abstract

Some research is evolving which documents the strength of volatility spillovers from North American and European equity markets onto Pacific Basin equity markets. In this paper volatility spillovers from North American and European Index futures markets onto the Australian market for index futures are measured from two alternative frameworks:

1. A formal encompassing econometric model is specified in which 'overnight' volatility is allowed to enter. The encompassing model allows for three alternative volatility projections: (a) market volatility estimates (b) GARCH volatility estimates, and (c) volatility forecasts obtained from the futures equation of a system of simultaneous volatility equations. This encompassing model focuses on the variance process.

2. An artificial options market is specified in order to allow volatility projections (a) to (c) to compete in terms of trading performance. This market is artificial in the sense that actual prices and implied volatilities have been obtained for actual market trades directly from the Sydney Futures Exchange. This simulated options framework focuses on the returns process.

One important finding is that during periods of high volatility in the Australian market volatility spillovers from these overseas markets are very important explanatory variables in both frameworks. A second important finding is that the futures equation from the set of simultaneous volatility equations dominates the alternative volatility estimates in either framework. These results are important for traders, regulators and exchanges considering introduction of futures and options instruments on Asia Pacific exchanges.