Exchange rates, stock prices and volatility

Published: Wednesday | December 18, 2013 Comments 0
Dr Andre Haughton
Dr Andre Haughton

THE WORLD Finance and Banking Symposium 2014 concluded yesterday at the Central University of Finance and Economics in Beijing, China.

The conference provided a high-quality discussion forum for all aspects of finance and financial economics for academics, professionals, and practitioners.

It is held in a different country each year, and gives researchers the opportunity to present their work and engage in meaningful discussions about global financial issues.

This year, I was invited to present a research paper - just as I did in Brazil last year. My presentation was well received and the overall experience to discuss ideas with other excellent finance and financial economics researchers from around the word was very good.

What was the focus of my research paper?

My research, titled 'Exchange rate movements, stock prices and volatility (risk) in the Caribbean and Latin America', analyses the interrelationship between the stock market and exchange rates in two Caribbean countries - Jamaica, and Trinidad and Tobago - as well as four Latin American countries - Argentina, Brazil, Chile and Mexico.

Data on exchange rates, stock prices, net international reserves (NIR) and interest rates from 2002 to 2012 for all countries are regressed in appropriate econometric models to provide useful results.

This research analyses the relationships between the exchange rate market and the equity market before and after the global financial crisis of 2008; first, during the tranquil period from 2002 to 2008, and then during crisis period from 2008 to 2012.

What does the existing literature say?

Research on the interaction between exchange rate and stock prices has received more attention since the recent global financial crisis. Researchers in the United States and Asia, mainly, have been trying to estimate the direction of causality between both variables.

There are two main theories surrounding their interaction:

1. The 'flow-oriented model', proposed by Dornbusch and Fisher (1980), looks specifically at the balance of trade between countries. Theoretically, exchange rate fluctuations influence the output and hence competiveness of firms. If firms are more competitive, this has a direct positive effect on their stock prices, since stock prices represent future cash flow streaming for a company.

2. The 'stock-oriented model', proposed by Frankel (1983) and Branson (1993), states that advances in the stock market affect exchange rate through the liquidity and the wealth effects. A decrease in stock prices reduces the wealth of local investors, which lowers their demand for money. Then banks react by lowering interest rates which dampen capital inflows, reducing the demand for local currency and, therefore, depreciates the local currency. Since domestic and foreign assets are not perfect substitutes in the portfolio balancing effect, as investors adjust their portfolio ratio of domestic to foreign assets in response to changes in economic conditions, the exchange rate responds accordingly.

Evidence of either theory is not uniform across countries as various studies employing a range of different techniques reveal different results.

What about risk?

The relationship between exchange rate and stock prices has a tendency to be greater during crisis periods as returns in asset markets are lower and volatility (risk) is higher. Therefore, after the initial analysis, we extend the models to account for the impact of risk.

Like in Asia, North America and Europe, the global financial crisis in 2008 resulted in an immediate decline in the stock prices in the Caribbean and Latin American countries, after which they gradually reverted to growth and have been increasing since.

Exchange rates in our Caribbean and Latin America countries depreciated as a result of the financial crisis. The shift for Jamaica, in particular, is more obvious, given that exchange rates are higher and appear to be less stable than the other countries.

What are the results?

In the initial stage, the results provide more evidence to support the stock-oriented models rather than the flow-oriented models in Jamaica, Argentina and Brazil.

This suggests that governments in these countries should try to prevent a currency crisis by stimulating economic growth and expanding the stock market to attract capital inflow. There was no evidence to support either theory in Trinidad and Tobago, Mexico and Chile.

Subsequently, when the volatility factor was added to the models, it was statistically significant in all six countries, and the results from the stock-oriented models improved significantly.

Now stock prices significantly impacted the exchange rates; in the tranquil period for Jamaica, Argentina, Mexico and Chile, and in both crisis and tranquil periods for Trinidad and Tobago. Overall, the results demonstrate the importance of taking volatility into account when attempting to analyse stock market and exchange rate data.

Dr André Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on twitter @DrAndreHaughton; or email editorial@gleanerjm.com.

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