On the linkages between stock prices and exchange rates: Evidence from the

Transcription

1 On he lnkages beween sock prces and exchange raes: Evdence from he bankng crss of Guglelmo Mara Caporale, John Huner, Faek Menla Al Deparmen of Economcs and Fnance, School of Socal Scences, Brunel Unversy, Uxbrdge, Mddlesex, UB8 3PH, UK Absrac Ths sudy examnes he naure of he lnkages beween sock marke prces and exchange raes n sx advanced economes, namely he US, he UK, Canada, Japan, he euro area, and Swzerland, usng daa on he bankng crss beween 2007 and Bvarae UE-GARCH models are esmaed producng evdence of undreconal Granger causaly from sock reurns o exchange rae changes n he US and he UK, n he oppose drecon n Canada, and bdreconal causaly n he euro area and Swzerland. Furhermore, causaly-n-varance from sock reurns o exchange rae changes s found n he US and n he oppose drecon n he euro area and Japan, whls here s evdence of bdreconal feedback n Swzerland and Canada. The resuls of he me-varyng correlaons also show ha he dependence beween he wo varables has ncreased durng he recen fnancal crss. These fndngs mply lmed opporunes for nvesors o dversfy her asses durng hs perod. Keywords: Causaly-n-varance; Conegraon; Exchange raes; Sock prces JEL Classfcaon: C32; F31; G15 We are graeful for her useful commens o Menelaos Karanasos, James Lohan and parcpans n he BMRC-QASS conference on Macro and Fnancal Economcs, May 24 h, 2012, Brunel Unversy, London, UK and he Inernaonal Conference on he Global Fnancal Crss, Aprl 25-26, 2013, Unversy of Souhampon, UK. Correspondng auhor: Deparmen of Economcs and Fnance, School of Socal Scences, Brunel Unversy, Uxbrdge, Mddlesex, UB8 3PH, UK. Tel:+44(0) Emal addresses: Guglelmo-Mara.Caporale@brunel.ac.uk (G.M. Caporale), John.Huner@brunel.ac.uk (J. Huner), Faek.Menlaal@brunel.ac.uk (F. Menla Al).

2 1. Inroducon The collapse on Sepember 15 h 2008 of Lehman Brohers (LB, unl ha pon he fourh larges nvesmen bank n he US) sen a wave of global panc across fnancal markes. Followng global bank falures and he resulng collapse n lqudy and ner-bank lendng, sock marke ndces n mos developed economes experenced sgnfcan declnes. 1 Hgher uncerany also generaed urbulence n he foregn exchange markes, wh he major currences beng h by a reducon n nernaonal ransacons and a flgh o value. 2 An neresng ssue s wheher fnancal markes have become more dependen as a resul of he uncerany creaed by he crss. Alou, Ben Assa, and Nguyen (2011), Kenourgos, Samas, and Palalds (2011), Samarakoon (2011), and Dufréno, Mgnon, and Pégun- Fessolle (2011) among ohers fnd ndeed an ncrease n dependence beween nernaonal sock markes, and smlar fndngs are repored by Couder, Couharde, and Mgnon (2011) and Bubak, Kočenda, and Žkeš (2011) for foregn exchange markes. Surprsngly, very few sudes have nvesgaed he lnkages beween sock marke prces and exchange raes durng he recen crss. A mes of fnancal urmol, he hgh volaly of sock markes generaes speculave acons by nvesors and capal flgh o value and hs may lead o consderable nsably n oher markes such as foregn exchange markes. Ths has been shown n he case of he Asan fnancal crss when sock markes led he foregn exchange markes (see, e.g., Granger, Huang, & Yang, 2000; Caporale, Ps, & Spagnolo, 2002). However, n urbulen mes, decouplng may also occur: when sock markes experence severe downurns, nvesors may only focus on markes where 1 From early Ocober 2007 unl he second week of March 2009, he S&P 500 (US), FTSE 350 (UK), and Soxx 50 Euro (euro area) ndces declned by approxmaely 56%, 48%, and 59%, respecvely. Smlar sock marke falls occurred n Swzerland and Japan, where he lowes pons were reached n he second week of March 2009 followng peaks on June 1 s and July 10 h, 2007, respecvely. The Swss marke ndex declned by approxmaely 54%, whereas he Japanese Nkke 225 ndex dropped by roughly 61% durng hs perod. 2 Pound Serlng and he Canadan dollar deprecaed agans he currences of her radng parners by approxmaely 30% (from Sepember 3, 2007 o January 22, 2009) and 28% (from November 7, 2007 o March 9, 2009), respecvely. By conras, he Japanese yen and Swss franc apprecaed seadly by approxmaely 38% and 61% unl lae

3 her asses can be seen as safe havens rrespecve of foregn exchange movemens; consequenly, here mgh no be neracons beween dfferen markes (see, for example, Haem-J & Roca, 2005). To he bes of our knowledge, he sudy by Wong and L (2010) s he only one o dae o have examned he neracons beween sock prces and exchange raes durng he recen crss; however, has some lmaons. The frs s he use of monhly daa whch canno capure he mng of evens such as he balous of AIG n he US and RBS and HBOS n he UK. The second s he fac ha her analyss ends n 2008, hereby gnorng he urbulen perod followng he collapse of LB. The hrd s her economerc mehodology, namely he dynamc condonal correlaon () model of Engle (2002) ha was no desgned o es for causaly-n-varance beween he wo varables. The presen sudy ams o address he neracons beween sock and exchange rae reurns as well as her volales and correlaons n a comprehensve manner by analysng weekly daa for sx advanced economes, namely he US, he UK, Canada, Japan, he euro area and Swzerland. Specfcally, wo sub-perods are examned: he pre-crss (Augus 6, 2003-Augus 8, 2007) and he crss perod (Augus 15, 2007-December 28, 2011). These are seleced o enable us o analyse lnkages n boh normal and urbulen mes, whch can provde mporan nsghs o nvesors n erms of porfolo managemen sraeges by focusng her aenon on he rgh segmens of he marke durng such mes wh he am of mnmsng rsk and maxmsng reurns n hghly negraed fnancal markes. The chosen economerc framework s a bvarae VAR-GARCH model, specfcally a dynamc verson of he unresrced exended CCC-GARCH developed by Conrad and Karanasos (2010), where each varable s condonal varance s deermned by lagged squared shocks and lagged condonal varances of boh varables. Ths approach s flexble enough o capure me-varyng correlaons and volaly spllovers beween sock reurns and exchange rae changes. Furhermore, o crcumven poenal mssng varable errors n he condonal mean, he model s exended o ncorporae he underlyng shor-run devaons beween sock prces and exchange raes n he condonal mean n case boh varables are conegraed; he parwse Engle and Granger (1987), Johansen (1995), and Gregory 2

4 and Hansen (1996) conegraon ess are employed. Therefore, a horough economerc analyss s conduced of he dependence beween sock prces and exchange raes durng he perod under examnaon. The paper s organsed as follows. Secon 2 provdes a bref revew of he heorecal and emprcal leraure on he relaonshp beween sock prces and exchange raes. Secon 3 descrbes he daa. Secon 4 oulnes he economerc mehodology. Secon 5 dscusses he emprcal resuls and Secon 6 concludes. 2. A revew of he leraure There are wo man ypes of heorecal models analysng he lnkages beween exchange raes and sock prces. The radonal approach based on flow-orened models (Dornbusch & Fscher, 1980) poss ha causaly runs from he former o he laer, whereas he porfolo approach based on sock-orened models (Branson, 1983; Frankel, 1983) suggess he oppose. In he frs case a more compeve exchange rae, assumng ha he Marshall-Lerner condons hold, wll mprove he rade poson of an economy and smulae he real economy hrough frm profably and sock marke prces. 3 However, domesc frms ulsng mpored npus wll experence an ncrease n producon coss, leadng o a reducon n he frms sales and her earnngs, whch n urn wll lead o a declne n her sock prces. Hence, he mpac of exchange raes on sock prces can be eher posve or negave. In he second case, he exchange rae s hough o respond o ncreases n he demand for fnancal asses such as bonds and socks. Hence, a bullsh domesc sock marke wll sgnal favourable domesc economc prospecs, hereby nducng capal nflows and an apprecaon of he exchange rae (Kollas, Mylonds, & Paleologou, 2012). Anoher channel for hs ype of causaly sems from he 3 Ths approach has been gven some emprcal suppor n he leraure on asse prcng models based on consumpon and ncome (Gregorou, Huner, & Wu, 2009), as well as oupu (Sousa, 2010). 3

5 demand for money (Gavn, 1989). If, however, boh radonal and porfolo approaches are emprcally relevan, a bdreconal relaon beween he wo varables wll be found wh an arbrary correlaon (Granger e al., 2000). The emprcal leraure also provdes mxed resuls. For example, Aggarwal (1981) found a sgnfcan posve correlaon beween US sock prces and he srengh of he US dollar usng monhly daa beween 1974 and 1978, alhough Soenen and Henngar (1988) repored ha he sgn depends on he sample used. Subsequen sudes used he wo-sep conegraon procedure of Engle and Granger (1987) and he maxmum lkelhood echnque of Johansen (1995) o examne he me seres properes of boh sock prces and exchange raes n he long run. Usng monhly daa on he US economy for he perod , Bahman-Oskooee and Sohraban (1992) found ha hese wo varables are no conegraed, ye here s a bdreconal feedback n he shor run. Smlar fndngs were repored by Neh and Lee (2001), who nvesgaed sock prces and exchange raes for he G7 counres and found one-day sgnfcan lnkages n some counres. Conegraon may no be deeced as a resul of model msspecfcaon, and n parcular he omsson of varables. Phylaks and Ravazzolo (2005) found ha US sock prces were a key channel lnkng he exchange raes of fve Pacfc basn counres o her sock ndces. On he oher hand, Ülkü and Demrc (2012) showed ha global developed and emergng sock marke reurns explan a large poron of he permanen comovemen beween sock and foregn exchange markes for egh European emergng economes. The semnal arcle of Engle (1982) showed ha he ARCH famly of models can capure volaly cluserng and ARCH effecs n fnancal reurns. Kanas (2000) found posve volaly spllover effecs from sock reurns o exchange rae changes for all he G7 excep Germany. Nng (2010), nsead, used copulas o show ha here s sgnfcan symmerc upper and lower al dependence beween sock and foregn exchange markes for he G5 counres (US, UK, Germany, France and Japan). Kaechos (2011) found ha he sgn of he lnk beween global sock marke reurns and exchange raes depends on wheher he currency n queson s a hgh yeldng (posve) or a low 4

6 yeldng one (negave). Furhermore, he recen sudy by Chkl, Alou, and Nguyen (2012) esmaes a bvarae CCC-FIAPARCH specfcaon o capure asymmery and long memory n daly daa from January 1999 o December 2010 for hree major European counres (namely France, Germany, and he UK). The auhors repor a srong correlaon beween he wo varables and more accurae n-sample esmaes as well as beer ou-of-sample performance han n he case of GARCH specfcaons. 3. Daa descrpon We employ weekly daa (Wednesday o Wednesday) o analyse he lnkages beween sock marke prces and exchange raes, because daly or nra-daly daa are affeced by nose and anomales such as day-of-he-week effecs, whle monhly daa may be nadequae o race he shor-run evoluon of capal across nernaonal fnancal markes. We consder sx advanced economes: Canada, he euro area, Japan, Swzerland, he UK, and he US from Augus 6, 2003 o December 28, 2011, a sample of 441 observaons. The exchange raes used are rade-weghed (as calculaed by he Bank of England), hus provdng a beer measure of he compeveness for hese economes (Kanas, 2000), whle he sock prces are he man local sock exchange ndces. The currences of hese economes are he mos acvely raded n he foregn exchange markes, whle her sock markes are he larges among he developed economes n erms of marke capalsaon. The daa have been obaned from Thomson DaaSream. We consder wo sub-perods: a ranqul or pre-crss perod from Augus 6, 2003 o Augus 8, 2007, and a crss perod from Augus 15, 2007 o December 28, I s well known ha he former corresponds o he so-called Grea Moderaon (see Sock & Wason, 2002), whch was characersed by sable and low nflaon and a declne n he volaly of oher macroeconomc fundamenals. The subsequen global fnancal crss (and he assocaed Grea Recesson ) clearly represens a new regme. 5

7 The sar dae of he pre-crss sample s chosen o avod he mpac of major global evens such as he 9/11 errors aacks and her annversary n 2002 (see Gregorou e al., 2009), and he ensung conflcs n Afghansan and Iraq as well as he docom bubble ha burs n lae On he oher hand, he crss perod s defned as sarng wh he frs sgns of he subprme morgage crss n he US n he summer of 2007, ahead of he falure of Fanne Mae and Fredde Mac and he collapse of LB and AIG. Ths s also conssen wh he sudy of Melvn and Taylor (2009), who consder Augus 16 h 2007 as he begnnng of he crss n he foregn exchange markes. The varables n levels are denoed by s and e, respecvely he log sock prces and log exchange raes, whle her frs dfferences (R S, and R E, ) are connuously compounded reurns; he daa are n percenages and are mulpled by 100. A wde range of descrpve sascs are dsplayed n Table A1 (see Appendx A). Fg.1a and Fg. 1b show he weekly evoluon of he rade-weghed exchange raes and sock prces wh her correspondng changes for he perod under nvesgaon. Sock reurns and exchange rae changes exhb volaly cluserng, especally n he crss perod, whch ndcaes an ARCH model mgh be approprae. The Fgures also sugges ha he log of exchange raes and sock prces mgh be non-saonary and follow a sochasc rend, whle her frs dfference s co-varance saonary or has a fne varance. 4 [Inser Fg. 1a-Fg. 1b abou here] 4. The economerc mehodology In hs sudy, we employ a bvarae VAR-GARCH model o examne he jon processes governng weekly changes n sock marke prces and exchange raes for he wo sub-perods. Ths enables us o explan he dependence beween boh he frs and he second momens of sock reurns and exchange rae changes n a dynamc framework. Specfcally, n he frs sep, we specfy he 4 Ths s confrmed by a baery of un roo ess, ncludng he augmened Dckey Fuller (1981) es, he Phllps and Perron (1988) es and he mnmum LM es of Lee and Srazcch (2004) wh one srucural break n he nercep and he rend. 6

8 condonal mean equaon by adopng a dfferenced VAR (Sms, 1980) n case boh sock prces and exchange raes are no conegraed and a vecor error correcon form (Johansen, 1995) when he varables are conegraed. Furhermore, he model also ncludes some exogenous varables o capure he effecs of domesc moneary polcy shocks as well as global shocks such as hose of world sock marke and ol prces. The model s hen esmaed usng he dynamc verson of he unresrced exended consan condonal correlaon GARCH (UECCC-GARCH) specfcaon developed by Conrad and Karanasos (2010) o capure he jon volaly dynamcs beween he wo varables Modellng he condonal mean Le R = [R S,, R E, ] be he vecor conanng sock reurns R S, and exchange rae changes R E,. The condonal mean equaon s specfed as follows: R 1 S, E p R R SS ES w, SE EE R rf, P S, E,, ol,. (1) The nnovaon vecor 1~ N(0, H ) s normally dsrbued wh H beng he correspondng condonal covarance marx, and 1 s he nformaon se avalable a me -1. () ψss and () ψ EE 5 We hank an anonymous referee for suggesng o use a specfcaon whch allows for a more meanngful nerpreaon of he volaly ransmsson beween he wo varables (sock reurns and exchange rae changes). Whle he VECH, n comparson o he BEKK, allows for hs, esmaon of s parameers s compuaonally demandng as poned ou by Slvennonen and Teräsvra (2009). Tweny-one parameers n he varance-covarance equaon have o be esmaed n he case of wo varables n he VECH model and he problem was ll-condoned as convergence was no acheved n any of he cases consdered n our sudy even when daly daa were used. 7

9 ndcae respecvely he response of sock marke reurns and exchange rae changes o her own lags, whereas () ψ ES and () ψ SE measure respecvely any causaly from sock marke reurns o exchange rae changes, and vce versa. The exogenous varables nclude R w, (reurns of he world sock ndex), R rf, (he hree-monh domesc neres rae), and p ol, (he logarhm of he world ol prce). 6 Reurns on he world sock marke capure shocks from oher fnancal markes around he globe. Ineres raes reflec domesc moneary polcy and he avalably of cred, gven ha he moneary auhores of he economes consdered n hs sudy were operang neres rae rules respondng o nflaon and an oupu gap. The ol prce can be seen as represenng supply shocks; for example Amano and van Norden (1998) showed ha world ol prce movemens can capure he underlyng shocks o he erms of rade. Gven he naure of he daa, n mos cases a lag lengh p=1 s suffcen o capure he dynamcs assocaed wh fnancal reurns. If necessary, furher lags are added o elmnae any seral correlaon on he bass of he mulvarae Q-sasc of Hoskng (1981) appled o he sandardsed resduals z / h for = S, E. Noe ha n he even of deecng conegraon beween sock marke prces and exchange raes, (1) s also augmened by a lagged error correcon erm (ec -1 ) as n L, Lng, and Wong (2001). The excluson of an error correcon erm n he dfferenced VAR gves rse o a vecor movng average erm ha s generally non-nverble (see Burke & Huner, 2005). Conegraon s esed usng he parwse Engle and Granger (1987) es, he Johansen (1995) race es, and he Gregory and Hansen (1996) mehod ha allows for a sngle unknown endogenous srucural break. Furhermore, f a srucural shf n he long-run relaonshp beween sock prces and exchange raes s deeced and n order o examne he mpac of hs shf on he dynamc lnkages beween he wo varables and he shor-run adjusmen owards he long-run equlbrum, we use a dummy varable and allow he parameers relaed o Granger 6 Reurns on he world sock ndex for all counres n he sample excep he US are represened by reurns on he S&P 500 ndex. In he case of he US, he world sock ndex s represened by he MSCI world (excludng he US) ndex. The world ol prce s represened by he Wes Texas Inermedae Cushng crude ol spo ndex, US dollars per barrel. The daa have been obaned from DaaSream. 8

10 causaly beween boh varables, denoed by ES and SE, as well as he error correcon erm, denoed by, o shf as follows: R p 1 R R w, R rf, P ol, ec 1 ec 1, SS ES ES SE EE SE. (2) Fnally, as Granger causaly ess do no provde nformaon on he sgns and mng of he relaon beween sock reurns and exchange rae changes, we compue he generalsed mpulse response funcons (GIRFs) of Pesaran and Shn (1998) based on (1) and (2) n order o explore he drecon of spllovers beween he wo varables and her evoluon over me Modellng volaly spllovers Havng specfed he condonal mean equaon, a dfferenced VAR s esmaed n he case of no conegraon beween he wo fnancal asses, whereas a vecor error correcon form s adoped when he varables are conegraed, as saed earler. The model s hen esmaed condonal on he mulvarae GARCH model o capure he jon volaly dynamcs beween he wo varables. Of he varous mulvarae GARCH specfcaons ha can be found n he leraure, we employ he dynamc condonal correlaon model of Engle (2002) allowng for volaly ransmsson beween he wo varables n a lead-lag framework by mposng he UECCC-GARCH specfcaon of Conrad and Karanasos (2010). Ths s gven by: H D R D, (3) 9

11 where D s a 2 2 marx of he condonal volales along he man dagonal, dag D h,. The common pracce n esmang he model s o assume ha he condonal volales are unvarae GARCH processes. In hs paper, o allow for he volaly ransmsson beween he wo varables, elemens of D are obaned from he mulvarae GARCH model nsead. Engle (2002) and Caporn and McAleer (2012) argue ha conssen esmaes of such condonal volales can be compued from he mulvarae GARCH model. More specfcally, we mpose he followng srucure on he condonal varances: h A Bh, (4) where s a vecor of consans, and A and B are ARCH and GARCH parameer marces: S ass ase bss bse, A, B. E aes aee bes bee (4) s he UECCC-GARCH model developed by Conrad and Karanasos (2010). 7 Conrad and Karanasos (2010) derved he necessary and suffcen condons o ensure h 0, allowng for volaly spllovers of eher posve or negave sgn. I follows from (4) ha each varable s condonal varance s modelled as a funcon of lagged condonal varances and lagged squared nnovaons of boh varables. Noe ha (4) s no exended o ake no accoun asymmerc responses, because sgn and sze bas ess (as n Engle & Ng, 1993) produced no evdence of asymmery for hese wo varables. 8 7 See also Rler (2012) for an asymmerc unresrced exended -GARCH model used o examne he relaonshp beween European Unon Allowance spo- and fuure-prces whn he second commmen perod of he European Unon emssons radng scheme. 8 These resuls are avalable upon reques from he auhors. 10

12 Volaly s ransmed beween sock reurns and exchange rae changes hrough wo channels represened by he off-dagonal parameers n he ARCH and GARCH marces: a symmerc shock and he condonal varance h j,-1 = h j,-1. j, 1 j, 1 Havng specfed he condonal varances, he correlaon n he model s gven: Q 1 ) Q Q, (5) ( where Q ( q j, ) s he me-varyng covarance marx of, Q s he uncondonal covarance marx of, and and are non-negave scalar coeffcens. The saonary condon s sasfed as long as 1. For 0, he model reduces o he UECCC-GARCH (1,1) specfcaon of Conrad and Karanasos (2010). Furhermore, snce Q does no have un values on he man dagonal, s hen rescaled o derve he correlaon marx R : 1/ 2 1/ 2 R dag{ Q } Q dag{ Q }, (6) where dag { Q } s a marx conanng he man dagonal of Q and all he off-dagonal elemens are zero. A ypcal elemen of R akes he form for, j S, E and j. j, q j, / q, q jj, We use he quas-maxmum lkelhood esmaor of Bollerslev and Wooldrdge (1992) for all specfcaons as he correspondng compued sandard errors are robus o non-normaly n he error process. 9 We also employ he mulvarae Q-sasc (Hoskng, 1981) for he squared sandardsed 9 The procedure was mplemened wh a convergence creron of , usng he quas-newon mehod of Broyden, Flecher, Goldfarb, and Shanno, whch does no requre exac esmaes of he marx of second dervaves n conras o he approach of Bernd, Hall, Hall, and Hausman (see Sargan, 1988). 11

13 resduals o deermne he adequacy of he esmaed model of he condonal varances o capure he mulvarae ARCH and GARCH dynamcs. 5. Emprcal resuls 5.1. Conegraon es resuls The frs sep s o examne he me seres properes of he sock prce and exchange rae seres. Then, conegraon s esed usng he Gregory and Hansen (1996) procedure whch allows for a sngle unknown srucural break. Ths es s lkely o be nformave: Campos, Ercsson, and Hendry (1996) and Gregory and Hansen (1996) provded Mone Carlo evdence ha he power of a consan parameer conegraon es deeroraes n he presence of a srucural break. No usng such ess may lead o he erroneous concluson ha conegraon does no exs when s presen bu governed by a srucural break. Allowng for a srucural change s lkely o be nformave for he wo sub-perods, pre-crss and crss. In he pre-crss perod, economes such as Japan and he euro area have been subjeced o sgnfcan change. For example, Japan afer a decade of deep recesson sared o recover n he mddle of 2005 before beng h by he fnancal crss. The euro also underwen sgnfcan changes rvallng he US dollar durng he pre-crss perod. Durng he crss perod fnancal markes were h by he collapse of LB, he European deb crss, he downgrade of US governmen deb, ec. - a regme change mgh have occurred, wh nvesors reacng dfferenly o he new suaons n he markes. 10 However, snce he Gregory and Hansen (1996) es can also deec conegraon wh no srucural shf, rejecon of he null hypohess of no conegraon may no be due o changes n he 10 The Gregory and Hansen (1996) es s parcularly suable as allows for a regme change a an unknown dae and wll lkely capure any regme change no deeced by he sample spl. Usng pre-specfed break pons nsead wll requre pror observaon of he daa for each counry and could nroduce pre-esng problems as hghlghed by Zvo and Andrews (1992). Furhermore, as poned ou by Cashn, Cespedes, and Sahay (2004) here s no necessarly a one-o-one correspondence beween possble causes of a srucural shf and s occurrence n he daa. 12

14 conegrang relaon. Therefore, we also provde esmaes of he me-nvaran conegraon ess of he parwse Engle and Granger (1987) es and he Johansen (1995) race es. If Gregory and Hansen (1996) es provdes evdence of conegraon, bu he consan parameer conegraon ess of Engle and Granger (1987) and Johansen (1995) do no, hen here s evdence of conegraon wh a srucural shf (see Gregory and Hansen, 1996). On he oher hand, f Gregory and Hansen (1996) as well as he convenonal conegraon ess of Johansen (1995) and Engle and Granger (1987) provde evdence of conegraon, hen followng Gregory and Hansen (1996) we use he Hansen (1992) nsably es, whch s appled o he resduals of a Fully Modfed Ordnary Leas Squares regresson, o deermne wheher he conegrang relaonshp exhbs a srucural shf. The resuls of he Gregory and Hansen (1996) ess, dsplayed n Table 1, sugges ha he null hypohess of no conegraon beween sock prces and exchange raes s rejeced n hree cases, n parcular for he euro area and Japan n he pre-crss perod, and for he UK n he crss perod. 11 On he oher hand, he resuls of boh Engle and Granger (1987) and Johansen (1995) race ess, dsplayed n Table A2 and A3, respecvely (see Appendx A), ndcae he exsence of conegraon only n he case of Japan n he pre-crss perod. [Inser Table 1 abou here] Whle n he euro area n he pre-crss perod and n he UK n he crss perod he conegrang relaon appears o have been subjeced o srucural change, here s no clear evdence ha hs was also he case n Japan n he pre-crss perod. However, he Hansen (1992) nsably es for hs case 11 Noe ha he long-run relaon s perse mul-causal beween varables ha are prmarly endogenous. As long as all seres are I(1), neher he regresson nor error correcon esmaes are affeced by endogeney as hey are super conssen; he neresed reader s dreced o he dscusson n Davdson and MacKnnon (2004). However, here wll be some varaon beween he esmaons and he resulng ess for conegraon n a fne sample (.e., even hough our sample exceeds 100 weekly observaons). From he algebra of he problem (Engle and Granger, 1987), n he case of a sngle conegrang relaon he regresson and VAR esmaons should gve rse o smlar parameer esmaes rrespecve of he way n whch he regresson s run. In all of he cases where was possble o observe conegraon we found no evdence for furher relaons enerng he sysems esmaon and hs s suppored by he fndng of no furher seral correlaon (see Gregorou e al., 2009). 13

15 mples a rejecon of he null hypohess of conegraon wh consan parameers agans he alernave of no conegraon due o parameer nsably. 12 Ths suggess ha he conegrang relaon n he case of Japan n he pre-crss perod has also been subjeced o a srucural shf. Nex, we nclude he breaks denfed by he Gregory and Hansen (1996) ess for he hree cases n he VECM models, (2), n order o furher capure he srucural change n he relaon beween sock prces and exchange raes. The denfed break pons are May 25, 2005, for he euro area; Ocober 5, 2005, for Japan; and Sepember 2, 2009, for he UK. Overall, he resuls of he conegraon ess sugges ha he comovemen beween sock prces and exchange raes n he euro area and Japan had broken down by he onse of he fnancal crss. A possble explanaon n he case of Japan s he overvaluaon of he yen snce Specfcally, he yen h a record hgh agans he US dollar n lae 2011 wh he crss leadng o a decouplng of he Japanese sock and foregn exchange markes n he long run relaon. For he euro area, he deprecaon of he euro and he uncerany surroundng he sngle currency snce he onse of he crss mgh be he reason for he breakdown of he long-run relaon. By conras, seems ha he long-run relaon beween fnancal markes n he UK was srenghened by he fnancal crss, whch led o boh seres beng nfluenced by smlar underlyng facors and as a resul sharng a sngle common sochasc rend. Noe ha he lack of conegrang relaons may also be he resul of msspecfcaon as oher fundamenal economc varables may work as channels hrough whch he wo ypes of fnancal markes (sock and foregn exchange markes) are lnked n he long run. However, our fndngs of lmed conegraon beween sock prces and exchange raes are n lne wh much of he exsng emprcal leraure (see, e.g., Bahman-Oskooee & Sohraban, 1992; Granger e al., 2000; Neh & Lee, 2001; Alagdede, Panagods, & Zhang, 2011). 12 We use he Lc es o check he sably of he regresson parameers. The p-value of he es sasc s

16 5.2. Condonal mean resuls The esmaes of he condonal mean equaon of he bvarae VAR (VECM) UE GARCH model along wh assocaed mulvarae Q-sascs (Hoskng, 1981) are dsplayed n Tables 2 7 for Japan, he US, he euro area, Canada, Swzerland, and he UK n urn. Panels A and B concern he pre-crss and crss perods, respecvely. On he bass of he conegraon ess of subsecon 5.1, he lagged error correcon erms are ncluded n he condonal mean equaons for he cases for whch conegraon was deeced. Furhermore, snce he deeced conegrang relaons have been subjec o srucural change, he shor-run Granger causaly parameers as well as he lagged error correcon erms n he VECM models are allowed o shf a he break pons. The Hoskng mulvarae Q- sascs for he sandardsed resduals ndcae no seral correlaon a he 5% level. In all cases, a lag lengh of 1 capures he dynamcs, excep for he UK n he pre-crss sample where p = 3 and he US and Swzerland n he crss sample where p = 3 and p = 5 are requred, respecvely (noe ha he nsgnfcan parameers n he mean equaons are excluded). Overall, he esmaed models appear o be well specfed. [Inser Tables 2 7 abou here] The dynamc neracons beween he frs momens of sock reurns and exchange rae changes, capured by ψ and ψ (), sugges ha here are lmed dynamc lnkages beween he wo varables n () ES SE he pre-crss compared wh he crss perod. The resuls for he pre-crss perod mply he exsence of undreconal shor-run Granger causaly from sock reurns o exchange rae changes n he case of Japan, whle here s shor-run causaly n he oppose drecon n he UK. Snce lagged error correcon erms are ncluded n he cases of conegraon, he VECM model wll allow one o dfferenae beween he shor-run and long-run Granger causaly. Specfcally, long-run causaly beween he wo varables wll be hrough he error correcon erm f hs s negave and sgnfcan as, for example, n Japan n he equaons for boh sock reurns and exchange rae changes. Ths mples 15

17 ha boh varables adjus o he seady-sae equlbrum n Japan, and here s bdreconal long-run feedback. However, he speed of adjusmen of exchange rae changes owards equlbrum becomes slower afer he break on Ocober 5, 2005 as E s posve and sgnfcan. 13 By conras, he lagged error correcon erm n he euro area s negave and sgnfcan only n he equaon for exchange rae changes, suggesng ha he adjusmen owards equlbrum akes place hrough hs varable. In he crss perod, nsead, he resuls ndcae he exsence of shor-run Granger causaly from sock reurns o exchange rae changes n he US and he UK, n he oppose drecon n Canada, and bdreconal shor-run causaly n he euro area and Swzerland. Wh regard o he UK, he lagged error correcon erm compued from he esmaon of a conegrang relaon of he exchange rae on he sock prce s found o be negave and sgnfcan n he equaon for exchange rae changes, mplyng an adjusmen mechansm hrough he exchange rae and ensurng he evdence of causaly from sock reurns o exchange rae changes n he long run. In conras o he case of Japan (n he pre-crss perod), he mpac of he breaks, denfed by he Gregory and Hansen (1996) ess n he prevous subsecon, on he lnkages beween sock reurns and exchange rae changes n he euro area (n he pre-crss perod) and he UK (n he crss perod) seem o be lmed, hence he causal srucure beween he wo varables as well as he speed of adjusmen owards he equlbrum are sable n hese wo cases. The sgnfcan change n he speed of adjusmen of he exchange rae owards equlbrum n he case of Japan (n he pre-crss perod) may be due o he acceleraon n he deprecaon of he yen as a resul of he declne n he Japanese longerm real neres raes compared o hose for he US over he perod Aprl 2005 o June 2006 (Obsfeld, 2009). To analyse furher he dynamc lnkages beween sock reurns and exchange rae changes, we esmae he GIRFs of Pesaran and Shn (1998) for he cases where Granger causaly s no rejeced. Overall, he resuls of he GIRFs (8 perods) from one sandard error shock of he varable n queson, 13 Noe ha he error correcon erm s calculaed from he esmaon of a conegrang relaon of he sock prce on he exchange rae. 16

18 dsplayed respecvely n Fg. 2a and Fg. 2b for he pre-crss and crss perods, are n lne wh he fndngs for Granger causaly. In he pre-crss perod (see Fg. 2a), a one sandard error shock o sock reurns n Japan leads o an apprecaon of he yen n he frs week. Ths s lne wh he porfolo approach on he lnkage beween sock prces and exchange raes, suggesng ha sock prces lead exchange raes wh a posve correlaon. In he UK, he response of sock reurns o a one sandard error shock o exchange rae changes s sgnfcan and posve n he hrd week. Ths s conssen wh he radonal approach on he lnkage beween he wo varables, suggesng ha exchange raes lead sock prces. However, he sgn of he correlaon can go eher way dependng on wheher he domesc frm s an exporer or an mporer. The ne effec on he aggregae sock ndex canno be deermned a pror and hence he sgn can be eher posve or negave (Granger e al., 2000). Wh regard o he crss perod (see Fg. 2b), s found ha a one sandard devaon shock o sock reurns resuls n a deprecaon of he exchange rae n he UK, whch s no conssen wh he porfolo approach, unlke n he US, where he posve sgn suppors emprcally hs approach. In Canada a shock o exchange raes decreases sock reurns, n lne wh he radonal approach. In Swzerland a shock o sock reurns has a posve mpac on correspondng exchange raes n he frs week, whls he response of sock reurns o a shock o exchange raes s negave and sgnfcan n he hrd week. Fnally, exchange rae changes (sock reurns) n he euro area respond negavely (posvely) o a shock o sock reurns (exchange rae changes). [Inser Fg. 2a-2b abou here] Granger e al. (2000) concluded ha capal flows played a major role n he neracons beween sock prces and exchange raes durng he Asan flu perod. Fg. 3 shows he evoluon of porfolo nvesmen lables and curren accouns as a percenage of GDP for all counres over he sample perod consdered here. The emprcal suppor for he porfolo approach found for he US could be he resul of capal flows. Gven ha he US was he cenre of he crss, he declne n s sock marke a he onse of he crss n lae 2007, along wh he collapse of LB and he downgrade of s deb saus, nduced capal ouflows (see Fg. 3) and a deprecaon of s currency. Wh regard o he UK, he 17

19 collapse of LB n he US and he shudown of her offces n London sen a wave of panc rgh hrough he UK sock marke followed by a severe downurn 14 and major changes n he Brsh pound over he crss perod. Noneheless, he causal effec as measured from he mpulse responses seems o be more complex han mpled by he porfolo approach as he sgn does no valdae such an approach, as saed earler. [Inser Fg. 3 abou here] By conras, Canada experenced capal nflows as opposed o ouflows durng he crss (see Fg. 3) and s currency srenghened afer 2009 (see Fg. 1a) leadng s sock marke. The lack of any neracons beween sock reurns and exchange rae changes n Japan, on he oher hand, can be arbued o counry-specfc facors. The fac ha Japan has amassed huge foregn exchange reserves and had a srenghenng real economy played a sgnfcan role n he apprecaon of s currency and makng mmune o he crss (Wong & L, 2010). The fndng also reflecs he overall sae of he Asan and Ausralasan counres whose banks and economes appeared no o be conamnaed by he crss ha has been lnked o he falure of he valuaon of complex dervaves. As far as he exogenous varables n he condonal mean equaons are concerned, he reurn on he world sock ndex exers srong nfluence on sock reurns and exchange rae changes n mos cases, especally n he crss perod, suggesng s domnance n he ransmsson of shocks and nformaon o oher markes around he globe. The mpac of he domesc neres rae, by conras, appears o be lmed. Ths renforces he noon ha he quanave easng polces adoped by he moneary auhores hroughou he crss perod were neffecve. One possble explanaon s ha he economc cycle dd no respond because of he breakdown of boh he fnancal sysem and he moneary ransmsson mechansm va he banks. Wh regard o he nfluence of world ol prce changes, hs ncreased n he crss perod compared wh he pre-crss one n mos counres, excep Swzerland. The effecs on sock reurns n 14 Accordng o Alsar Darlng, he hen Chancellor of he Exchequer, lqudy was compromsed so ha here was a fear ha he cash machnes would be empy. 18

20 he case of Swzerland, n he pre-crss perod, and Canada and he UK, n he crss perod, are conssen wh he fndngs of Fls, Degannaks, and Floros (2011), who argued ha sock markes reac posvely o demand-sde ol prce shocks. The wo perods n hs sudy are characersed by such shocks. The pre-crss perod was accompaned by an ncrease n ol prces because of an ncrease n demand, prmarly n Chna, whereas n he crss perod here was a declne n ol prces as a consequence of he global recesson nduced by he fnancal crss. The ncreased mpac of ol prce changes on exchange rae changes n he crss perod compared wh he pre-crss one, on he oher hand, s n lne wh he fndngs of Roboredo (2011). Durng he crss, he mpac on he US dollar and Japanese yen s negave, whereas for he Brsh pound, he Canadan dollar, and he euro s posve, conssenly wh he fndngs of Lzardo and Mollck (2010) Volaly spllovers resuls In he prevous subsecon, we provde an analyss of he dynamc lnkages beween sock reurns and exchange rae changes n erms of he frs momen across he wo sub-perods examned. Now we analyse he esmaed jon volaly dynamcs beween he wo varables across he wo sub-perods. The esmaes of he condonal varance equaons as well as he dynamc correlaons n he UE-GARCH models are repored n Tables 8 13 for Japan, he US, he euro area, Canada, Swzerland, and he UK, respecvely. Panels A and B concern he pre-crss and crss perods, respecvely. The repored Hoskng mulvarae Q-sascs of order (6) and (12) for he squared sandardsed resduals suggess a he 5% sgnfcance level ha he mulvarae GARCH (1,1) srucure adequaely capures volaly, and hence no furher varance dynamcs are requred. The resuls also sugges ha he saonary condon of Engle (2002) and he non-negavy condons of Conrad and Karanasos (2010) are fulflled. Furhermore, n each panel, we es four hypoheses. The frs s ha he condonal varances follow unvarae GARCH models by resrcng b b 0. The second and he hrd es for causaly-n-varance from sock reurns o exchange rae changes by seng 19 SE ES SE ES

21 b 0 and n he reverse drecon by seng b 0. Fnally, we es for no me-varyng ES ES SE SE correlaon beween sock reurns and exchange rae changes by resrcng 0. These ess are conduced usng a lkelhood rao es sasc LR = -2(L r - L ur ) 2 df, where L r and L ur denoe he resrced and unresrced log-lkelhood funcon values and he LR sasc follows he ch-squared dsrbuon wh degrees of freedom equal o he number of resrced parameers. [Inser Tables 8 13 abou here] The resuls sugges ha he sock prce exchange rae process n he wo sub-perods dsplays srong condonal heeroscedascy: he dagonal elemens of he ARCH marces are posve and sgnfcan n 75% of he cases n he pre-crss perod and 91.6% of he cases n he crss perod. The condonal varances, on he oher hand, exhb perssence n all cases wh only one excepon,.e., UK exchange rae changes n he pre-crss perod. More specfcally, he esmaed condonal varances of sock reurns range from 0.72 (he lowes) for Swzerland o 0.91 (he hghes) for Japan n he pre-crss perod, whls hey range from 0.75 (he lowes) for he UK o 0.92 (he hghes) for Japan n he crss perod. The correspondng esmaes of exchange rae changes range from 0.64 (Japan) o 0.95 (euro area) n he pre-crss perod and from 0.77 (Swzerland) o 0.93 (Japan) n he crss perod. Furhermore, he off-dagonal elemens of he ARCH and GARCH marces ndcae ha shocks o exchange rae changes (sock reurns) affec he condonal varance of sock reurns (exchange rae changes) n he euro area and Canada across he wo sub-perods, he UK n he pre-crss perod, and Japan, Swzerland and he US n he crss perod. More specfcally, n he pre-crss perod, we observe volaly spllovers from exchange rae changes o sock reurns ( b SE ) n all counres, shock spllovers from exchange rae changes o sock reurns ( spllovers n he reverse drecon ( ES SE ) n he UK and Canada, and shock ) n he US. In he crss perod, lagged shocks and volales of boh varables affec boh varables volales n Canada and Swzerland. In Japan, whle here s bdreconal volaly spllovers beween he wo varables, lagged shocks of exchange rae changes 20

22 affec he volaly of sock reurns. The fndngs also ndcae ha he volaly of exchange rae changes n he US reacs sgnfcanly o he lagged volaly of sock reurns, whls he volaly of sock reurns n he euro area s affeced sgnfcanly by lagged shocks o exchange rae changes. Overall, he resuls of he lkelhood rao ess sugges he exsence of causaly-n-varance operang as a flow of nformaon from exchange rae changes o sock reurns for he UK, Swzerland, Canada and he euro area n he pre-crss perod. These fndngs mply ha durng normal mes s he volaly of exchange raes ha leads ha of sock prces. In he crss perod, here s evdence of causaly-n-varance from sock reurns o exchange rae changes n he US and n he oppose drecon n he euro area and Japan. Furhermore, here s a bdreconal feedback for Swzerland and Canada, whls here s no evdence of causaly-n-varance for he UK. Fnally, he resuls sugges ha he wo seres exhb me-varyng correlaon n he wo subperods n mos cases. Specfcally, a he 10% level, he null hypohess H : 0 s 0 rejeced n all cases, excep for Canada n he pre-crss perod. Fg. 4a and 4b show he evoluon of he dynamc condonal correlaon beween he wo seres respecvely for he pre-crss and crss perods o provde furher nsghs no he dependence beween he wo varables. I s evden ha he correlaon beween sock reurns and exchange rae changes s me-varyng n he wo sub-perods n mos cases. Furhermore, he average correlaons beween he wo varables n he pre-crss (crss) perod are found o be 0.16 (0.58), 0.03 (0.34), (-0.62), (-0.40), (0.02), and (- 0.26) for Canada, he euro area, Japan, Swzerland, he UK, and he US, respecvely. These fndngs are conssen wh he causaly-n-varance ess. Therefore hese wo ypes of fnancal markes appear o have become more dependen n all counres, excep he UK, durng he recen fnancal crss. [Inser Fg. 4a and 4b here] 21

23 6. Conclusons In hs sudy, we have analysed he naure of he lnkages beween sock marke reurns and exchange rae changes n sx advanced economes, namely he US, he UK, Canada, Japan, he euro area, and Swzerland. Specfcally, we have examned he exen o whch hey have been affeced by he bankng crss of employng weekly daa from Augus 2003 o December The esmaon of bvarae UE-GARCH models provdes evdence of undreconal shor-run Granger causaly from sock reurns o exchange rae changes n he US and he UK, n he oppose drecon n Canada, and of bdreconal feedback n he euro area and Swzerland durng he recen fnancal crss. Furhermore, causaly-n-varance ess for he crss perod lend suppor o he exsence of causalyn-varance from sock reurns o exchange rae changes n he US, n he oppose drecon n he euro area and Japan, and of bdreconal feedback n Swzerland and Canada. Our fndngs are conssen wh hose of Granger e al. (2000) and Caporale e al. (2002), who examned he 1997 Asan fnancal crss. The resuls reflec cross-counry dfferences n erms of polces, cycle phases, expecaons, he degree of lberalsaon, and capal conrols (Neh & Lee, 2001). Furhermore, gven he fac ha he currences under nvesgaon are he mos acvely raded and he correspondng economes are he op radng parners, her heerogeneous srengh hroughou he fnancal crss may have played an mporan role n generang capal flows no and ou of hese counres. Ths mgh be one of he reasons for he dfferen resuls when analysng he neracons beween sock reurns and exchange rae changes n hese economes. Fnally, our fndngs also mply he exsence of lmed dversfcaon opporunes on a domesc bass durng fnancal crses. Snce sock prces and exchange raes have been shown o be nerlnked srongly whn naonal economes, follows ha nvesors canno use hem as effecve nsrumens for porfolo hedgng and dversfcaon sraeges. Ths apples o all counres examned excep he UK. 22

24 Appendx A [Inser Tables A1-A3 abou here] References Aggarwal, R. (1981). Exchange raes and sock prces: A sudy of he U.S. capal markes under floang exchange raes. Akron Busness and Economc Revew, 12, Alagdede, P., Panagods, T., & Zhang, X. (2011). Causal relaonshp beween sock prces and exchange raes. The Journal of Inernaonal Trade & Economc Developmen, 20, Alou, R., Ben Assa, M. S., & Nguyen, D. K. (2011). Global fnancal crss, exreme nerdependences, and conagon effecs: The role of economc srucure? Journal of Bankng and Fnance, 35, Amano, R. A., & van Norden, S. (1998). Ol prces and he rse and fall of he US real exchange rae. Journal of Inernaonal Money and Fnance, 17, Bahman-Oskooee, M., & Sohraban, A. (1992). Sock prces and he effecve exchange of he dollar. Appled Economcs, 24, Bollerslev, T. P., & Wooldrdge, J. M. (1992). Quas-maxmum lkelhood esmaon and nference n dynamc models wh me-varyng covarances. Economerc Revews, 11, Branson, W. H. (1983). Macroeconomc deermnans of real exchange rae rsk. In R. J. Herrng, (Ed.), Managng foregn exchange rae rsk. Cambrdge, MA: Cambrdge Unversy Press, Bubák, V., Kočenda, E., & Žkeš, F. (2011). Volaly ransmsson n emergng European foregn exchange markes. Journal of Bankng and Fnance, 35, Burke, S. P., & Huner, J. (2005). Modellng non-saonary economc me seres: A mulvarae approach. Basngsoke: Palgrave. 23

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