This study tests for non-linearities in the real interest differentials of four South East Asian economies with respect toThe extent to which real interest rates are equalized across countries has occupied researchers for a number of reasons. In an open economy, real interest rates play a key role in influencing real activity through saving and investment behavior. Confirmation or rejection of real interest parity (RIP) provides an indication of whether countries are financially integrated or autonomous. However, since RIP requires that ex ante purchasing power parity (PPP) holds, it can be viewed as a more general indicator of 3 macroeconomic integration or convergence. RIP is also important because it is a key working assumption in various models of exchange rate determination and the focus of many studies as early as Frenkel (1976), Mussa (1976) and Frankel (1979). The purpose of this paper is to examine how plausible such an assumption is and whether or not adjustments towards RIP between South East Asian economies and Japan and the U.S. can be characterized as non-linear. (2000), Sarno (2000aSarno ( , 2000b, Sarantis (1999) and Michael et al. (1997), provide strong argument and empirical evidence of nonlinearities mainly with respect to OECD real exchange rates. The importance of evidence on non-linearities in real exchange rates derives from the fact that it may be reflect the degree of heterogeneity of foreign exchange market participants in terms of the formulation of objective functions and formation of expectations.1 It is against the background of recent research trends and the importance of non-linearity in

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This paper examines asymmetries in the dynamic relationship between foreign exchange fluctuations and stock market volatility in Pacific basin countries. The methodology is based on a dynamic covariance modelling that accounts for leverage effects and the asymmetric impact of currency fluctuations. There is evidence that appreciations are more conducive to lower volatility in currency markets than depreciations of equal magnitude. Market volatility tends to be ceteris paribus, more sensitive to bad news about equity than good news and more responsive to currency depreciations than appreciations. The results also suggest that bad news about equity accompanied with currency depreciations are likely to generate higher volatility in currency markets and have the potential of affecting the significance of leverage effects in stock markets.

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We propose a new method for approximating the expected quadratic variation of an asset based on its option prices. The quadratic variation of an asset price is often regarded as a measure of its volatility, and its expected value under pricing measure can be understood as the market's expectation of future volatility. We utilize the relation between the asset variance and the Black-Scholes implied volatility surface, and discuss the merits of this new model-free approach compared to the CBOE procedure underlying the VIX index. The interpolation scheme for the volatility surface we introduce is designed to be consistent with arbitrage bounds. We show numerically under the Heston stochastic volatility model that this approach significantly reduces the approximation errors, and we further provide empirical evidence from the Nikkei 225 options that the new implied volatility index is more accurate in predicting future volatility. Keywords: Model-free implied volatility index; volatility forecasting; volatility surface; variance swaps. 433 Int. J. Theor. Appl. Finan. 2011.14:433-463. Downloaded from www.worldscientific.com by FLINDERS UNIVERSITY LIBRARY on 01/05/15. For personal use only. 434 M. Fukasawa et al.