Dynamic Connectedness among Forex Markets of Pakistan and Its Major Trading Partners

Abstract

Globalization and financial liberalization have made market participants and policymakers ponder over the importance of financial interconnectedness and shock spillovers. This discussion is in line with the International Portfolio Theory & Diversification. In this context, this study investigates the intensity and direction of return and volatility spillovers of foreign exchange (FX) markets of Pakistan and its major trading partners. Using an innovative research technique by Diebold and Yilmaz (2009, 2012), we separately compute measures of return and volatility spillovers. Furthermore, we also calculate total spillover, directional spillover, and net spillover indices using a daily data set over the period 1995 to 2019. To capture secular and cyclical movements in the trading partners’ FX markets, we rely upon a rolling window analysis. Our results, based on the spillovers indices, support the presence of dynamic connectedness among currency pairs of the major trading partners. We also note that among the sample economies, the USA, the EU, Singapore, and Malaysia are the main sources and originators of shocks spillover while Pakistan, India, Japan, Kuwait, Singapore, and UAE are net shock receivers. The rolling window analysis indicates that returns and volatility spillovers intensify during the phases of financial or economic anxiety. These results have some important implications for individuals working on risk management, portfolio diversification, and trading strategies.