Academic journal article Multinational Business Review

Is There a Link between Foreign Exchange Market Stability and Stock Market Correlations? Evidence from Canada

Academic journal article Multinational Business Review

Is There a Link between Foreign Exchange Market Stability and Stock Market Correlations? Evidence from Canada

Article excerpt

ABSTRACT:

The link between foreign exchange and stock markets has numerous practical business implications. If international diversification strategies are to be successful, these markets should display low levels of correlation. In addition, understanding the determinants of asset volatilities, as well as their international correlations, are important parameters for the day to day risk management of financial institutions, the risk management of firms operating internationally, and the pricing of contingent claims. This paper examines whether there is a link between exchange rate stability and stock market volatility and correlations. I find that the connection between exchange rates and stock market correlations and volatilities extends beyond periods of extreme crisis.

INTRODUCTION

The link between foreign exchange and stock markets has numerous practical business and economic implications. If international diversification strategies are to be successful, these markets should display low levels of correlation. In addition, understanding the determinants of asset volatilities, as well as their international correlations, are important parameters for the day to day risk management of financial institutions, the risk management of firms operating internationally, and the pricing of contingent claims. In this paper, I examine whether foreign exchange market structural stability is associated with changes in stock market volatility and correlation.

Previous literature on the interaction between exchange rates and stock markets includes causality (Abdalla and Murinde, 1997 and Bahmani-Oskooee and Sohrabian, 1992) and contagion effects between stock markets and exchange rates during times of currency crisis (Chhabra, 2002 and Forbes and Rigobon, 2001 and 2002). This literature has recently expanded to include the relationship between exchange rate volatility and stock market correlation and volatility. Bodart and Reding (1999) focus on the impact of the exchange rate regime - and the accompanying degree of exchange rate volatility - on the correlation between timevarying stock market volatilities. Their analysis shows that an increase in exchange rate volatility is accompanied by a decline in international correlations between stock markets. In addition, the authors find little evidence of a positive relationship between exchange rate and stock market volatilities'. Kanas (2002) investigates whether the volatility of exchange rates is affected by the volatility of stock market returns for the US, UK, and Japan. Evidence presented suggests that the volatility of the home countries' stock returns is a determinant of exchange rate volatility for all three countries.

I extend this developing literature and provide evidence of a link between structural instability in the foreign exchange market and stock market volatilities and correlations. I use structural change in the forward/ spot exchange rate relation as an indicator of structural instability in the foreign exchange market. Stability is examined using the test developed by Hansen (1992) based on the fully modified estimator of Phillips and Hansen (1990). I provide evidence of structural change in the long-run spot/forward exchange rate relation for both the US and UK currencies vis-a-vis the Canadian dollar.

This is an important finding in itself in regards to the usefulness of the forward exchange rate as a hedging device. Since the collapse of the Bretton Woods system of fixed parities in the early 1970s, the forward exchange rate has assumed a primary role in hedging against fluctuations in future spot exchange rates. The effectiveness of hedging currency risk, however, depends in part on the relation between spot and forward exchange rates. If, for example, the forward rate is used to predict future spot exchange rates, then instability in the spot/forward exchange rate relation produces larger forecast errors. Tong (1996) and Briys and Solnick (1992) show that in the context of a dynamic hedging model, larger forecast errors reduce the benefits of hedging currency risk. …

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