The Relationship between Exchange Rates and Stock Prices: Studied in a Multivariate Model

In the period November 2003 to February 2004, there was an unambiguous upward trend in the U.S. stock market. Over the same period, the U.S. dollar kept depreciating against all major currencies. Analysts kept trying to predict when this downward trend would come to an end based on the U.S. trade deficit. Was not the exchange rate affected by the stock market instead? In this paper, I study if there is a link between the stock market and exchange rates that might explain fluctuations in either market. I make the case that, in the short run, an upward trend in the stock market may cause currency depreciation, whereas weak currency may cause decline in the stock market. To test these assertions, I will use a multivariate, open-economy, short-run model that allows for simultaneous equilibrium in the goods, money, foreign exchange and stock markets in two-countries. Specifically, I focus on the United States and the United Kingdom over the period January 1990 through August 2004. Establishing the relationship between stock prices and exchange rates is important for a few reasons. First, it may affect decisions about monetary and fiscal policy. Gavin (1989) shows that a booming stock market has a positive effect on aggregate demand. If this is large enough, expansionary monetary or contractionary fiscal policies that target the interest rate and the real exchange rate will be neutralized. Sometimes policy-makers advocate less expensive currency in order to boost the export sector. They should be aware whether such a policy might depress the stock market. Second, the link between the two markets may be used to predict the path of the exchange rate. This will benefit multinational corporations in managing their exposure to foreign contracts and exchange rate risk stabilizing their earnings. Third, currency is more often being included as an asset in investment funds’ portfolios. Knowledge about the link between currency rates and other assets in a portfolio is vital for the performance of the fund. The Mean-Variance approach to portfolio analysis suggests that the expected return is implied by the variance of the portfolio. Therefore, an accurate estimate of the variability of a given portfolio is needed. This requires an estimate of the correlation between stock prices and exchange rates. Is the magnitude of this correlation different when the stock prices are the trigger variable or when the exchange rates are the trigger variable? Last, the understanding of the stock price-exchange rate relationship may prove helpful to foresee a crisis. Khalid and Kawai (2003) as well as Ito and Yuko (2004) among others, claim that the link between the stock and currency markets helped propagate the Asian Financial Crisis in 1997. It is believed that the sharp depreciation of the Thai baht triggered depreciation of other currencies in the region, which led to the collapse of the stock markets as well. Awareness about such a relationship between the two markets would trigger preventive action before the spread of a crisis. Next I review literature related to the hypothesis and modeling approach of this paper. In Section II, I outline the theoretical background which yields the model presented in Section III. The data and results are analyzed in section IV.