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Abstract Both the goods market hypothesis and the portfolio balance theory, suggest a nexus between exchange rates and stock prices, albeit with a different direction of causality. This paper, using daily data, takes up the issue of the linkages between stock prices and exchange rates in the case of the euro-dollar rate and two composite European stock market indices: the FTSE Eurotop 300 and FTSE eTX All-Share Index. It addresses the causal ordering issue between the two markets using rolling unit root, cointegration and Granger causality tests. This methodological approach allows for the emergence of a clearer picture of the possible dynamic linkages between exchange rates and stock prices. The empirical results provide evidence of time-varying causality between the two markets.
Keywords Stock Prices . Exchange Rates . Rolling Causality Tests
JEL Classification C32 . F31 . G15
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1 Introduction
Given that both foreign exchange rates and stock prices are of vital importance to the development of a country's economy, they have attracted considerable attention in the relevant literature, both empirical and theoretical. Theoretical links between stock prices and exchange rates have taken three forms. First, unidirectional causality from exchange rates to stock prices is posited by the goods market hypothesis (Dornbusch and Fischer 1980) which suggests that changes in exchange rates affect the international competitiveness of local firms and hence their earnings and share prices. However, the sign of the impact of exchange rate fluctuations on stock markets cannot be easily predetermined. For example, in an export-oriented economy, domestic currency depreciation makes local firms more competitive, leading to an increase in their exports and earnings. Since stock prices are determined by the present values of future cash flows of firms, currency depreciation is expected to raise domestic share prices. However, the reverse relationship may also hold in the case of local firms utilising imported inputs in their production. In this case, domestic currency depreciation is expected to raise the cost of production, thereby reducing firms' sales and profits. This in turn might lead to a fall in their stock prices.
Second, the reverse causality (fromshare prices to exchange rates) is postulated by the portfolio balance models of exchange rate determination (Frankel 1983). According to these models, exchange...