An examination of causality and predictability between Australian domestic and offshore interest rates

Abstract

This paper studies the causality and predictability between Australian domestic and offshore short term interest rates in both the first and second moments during the period 1987 to 1996. Causality flow is observed to be stronger from the domestic to the offshore market in the earlier sub periods but characterised by significant two-way causality flow in the latter sub-periods. Volatility tests show that the volatility in one market spills over to the other market simultaneously, which is consistent with Australian markets being well integrated with global markets. The predictability across the two markets in the first moments is examined through an error correction model, whose forecasting performance is assessed relative to a benchmark random walk model. To test the predictability of volatility, four different models are compared: A GARCH model, A GARCH model incorporating contemporaneous spillover effects, a GARCH model with lagged spillover effects, and a benchmark random walk model. Results indicate that the error correction model and the GARCH model with contemporaneous volatility spillover are the superior models for forecasting changes in interest rates and for forecasting volatility, respectively.