During the period 1986-1996, Australian Capital Market, specially the stock and futures market has gone through revolutionary changes. The rapid changes in securitisation process, corporate law, system of trading and innovation of new financial derivatives have put Australian Stock Exchange and the Sydney Futures Exchange amongst the top ten stock and futures exchanges in the world.
With innovation and modernisation in the financial markets, the system of financial analysis and its application has gone through phases of modernisation. The literature of financial economics starting with the concept of Random Walk Hypothesis, Efficient Market Theory, reached the age of Modem Portfolio Theory within a short period of time. Simultaneous developments occurred with the introduction of index based futures in the financial derivatives market. Analysis of economic and financial variables went through their own phases of changes. Structural changes took place in the methodological aspect in the form of Nonlinear Dynamics, Neural Network, and Chaos Theory.
Econometric techniques till 1980s were largely based within the frame work of Classical Linear Regression Model. Two step Engle Granger Procedure, Vector Autoregression Autoregressive Moving Average with dummy variables were largely used to model jump volatility process of the financial markets.
Volatility, the key to portfolio insurance and investment management has been subjected to numerous empirical research. Nonlinear modelling technique in econometric method was introduced in the eighties. Since, late eighties and the early nineties, nonlinear tetchiness formed a parallel discipline with the classical econometric methods.
This thesis critically examines previous works in volatility and makes the important contribution of using nonlinear dynamics on top of classical econometrics. The joint application of two parallel methodologies demonstrates the superiority of nonlinear techniques for analysis of volatility in financial markets.
The period of analysis is from 1986-1996, which covers a decade of changes in the financial markets of Australia. The analysis concentrates on the volatility process of the Australian Stock Exchange and the Sydney Futures Exchange. Overall market volatility of those two markets are represented by the volatility process of the All Ordinaries Index movement and Share Price Index Futures Contract settlement price respectively. Share Price Index futures is the futures contract on the All Ordinaries Index.
Share Price Index Futures was introduced in the Sydney Futures Exchange in the year 1983. The introduction of index based futures brought a sea of change in the investment management techniques, as with an index based futures, fund mangers can insure a broad based market portfolio. The concept of portfolio insurance is largely dependent on index based futures. Amongst various strategies of portfolio insurance, hedging is the most effective and popular technique. Optimal hedge ratio is the key to hedging and therefore portfolio insurance and investment management.
Derivation of an optimal hedge ratio is dependent on the analysis of volatility. In the dissertation the application of classical technique has shown certain deficiencies which the nonlinear techniques can overcome. Therefore both the methodologies have been applied to empirically analyse volatility and derive optimal hedge ratio. The superiority of nonlinearity have found strong support through empirical evidence.
The work in this dissertation establishes the methods of non-linear dynamics as a superior method compared to classical statistics. This has been achieved through empirical analysis of volatility in the Australian Stock Exchange and the Sydney Futures Exchange. Analysis of overall market volatility process in both the cash and futures market has not been subjected to research with a combination of methodologies previously. Furthermore the combination of techniques have also been applied in the derivation of optimal hedge ratio, where also the superiority of nonlinear technique prevails.
The significant conclusion of the thesis is the establishment of the superiority of the nonlinear techniques; the parallel application of the classical statistical techniques must come to an end. The empirical evidence of the research suggests, financial analysis can solely be done with the nonlinear methodologies, for investment management in Australia.
A number of econometric software packages have been used, for calculation and methodological purposes. The main packages are EVIEW, TSP and SHAZAM.