If volatility spillover exists between or among several markets, how it is related to market efficiency? In my understanding if spillover exists market is efficient. But on the other hand if spillover does not exist, than it is wrong to say market is inefficient. Because there are so many factors that determines stock price. It is not only the foreign market indices. Kindly reply me with relevant examples.
Dear Pradiptharathi,
Your thought of spillover effect and market efficiency are related is right. Market efficiency is a function of many factors and many channels through which information about the prices of assets traded in a market are influenced. The way market efficiency postulates are constructed indirectly include and presume the impact of spillover effects either in the past, present or future sub-sets of information influencing the prices of assets in a market. Spillover of Forex markets on Stock markets in open economies without restrictions on capital movements and market determined exchange rates is documented. In fact the international finance theory on parity relationships indirectly speaks about such relationships. When a level and mean of interest rate can influence the forward exchange rate then the volatility(second moment) should also have some influence on the forward rate and its volatility. Putting simply Market efficiency is related to the past and accuracy of absorption and reflection of ALL RELEVANT information which influence the price and value of assets. If volatility is an indicator of risk of an asset, then risk has to be priced into the asset returns present and future.
Market prices of financial assets can be interpreted as the sum of the "true" or "fundamental" value of the asset and noise (or pricing error, or mispricing). The fundamental value changes over time, which is a cause of volatility. If the fundamentel values of two assets are related, their changes in volatility should be related - we observe volatility spillover (or, more precisely, simultaneous changes in volatility), and this is entirely in line with efficiency. However, the noise component of asset prices can also cause volatility. If that volatility spills over, it moves prices away from fundamental values which harms efficiency. We thus cannot make a general statement on whether observed volatility spillover increases or decreases the level of efficiency.
I agree with Erik's answer above. My Mcom thesis was about volatility spillovers and interactions in financial markets and also commenting on the implications for market efficiency :) I do like the way Erik summarises the entire logic of it.
Thank you Kameswar Sir for your wonderful explanation. Thank you Erik and Hoveni for your valuable answer.
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