How do Financial Markets Interact? A Vector Error Correction Model(VECM) Analysis of Commodity, Bond, Currency, and Stock Markets

AbstractPurposeThis paper investigates the interlinkages among major financial markets in India, aiming to analyze the dynamic relationships between different financial asset classes and evaluate their implications for portfolio construction and risk management.Design/MethodologyThe study employs a quantitative research design using daily time-series data spanning from 2018 to 2023 to analyze the interlinkages among four major financial markets in India: the stock market, bond market, commodity market, and currency market. The stock market is represented by the Nifty and Sensex indices, while the bond market includes indices for corporate bonds and green bonds. The commodity market is captured through the prices of Gold, Silver, Aluminium, Copper, and Cotton, and the currency market is represented by the INR/USD exchange rate. To examine the dynamic relationships among these diverse asset classes, the Vector Error Correction Model (VECM) is employed. This model is well-suited for analyzing co-integrated time series data, allowing for the identiation of both short-term adjustments and long-term equilibrium relationships among variables. The VECM framework helps uncover how shocks in one market transmit to others, thereby providing a comprehensive view of market interdependencies over time.FindingsThe analysis reveals significant interactions across the selected asset classes, highlighting both immediate and persistent influences. The study identifies how shocks in one market can transmit to others, influencing asset prices and volatility, which is crucial for multi-asset investment strategies.Practical ImplicationsInsights from the study can guide individual and institutional investors in portfolio diversiation, enhancing return potential while managing exposure to risk. The findings support the development of more balanced and efficient portfolios by leveraging cross-market dynamics.Originality/ValueBy integrating a wide array of asset classes and applying a robust econometric framework (VECM), this research contributes to a deeper understanding of market interdependencies in India. It offers practical tools for investors to refine their strategic asset allocation.