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.
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Notes
Should there be some common factors affecting both stock prices and exchange rates (e.g., interest rates) then one might expect a link between the two variables. See for example Ajayi and Mougoué (1996).
Although these methodologies have been extensively used in the relevant empirical literature, they are usually applied to full sample periods, thereby assuming that the relationship between the two markets is time-invariant. Rolling analysis is more appealing as it explicitly accounts for (more than one) changes in the underlying dependence and traces a possibly evolving system in the sense of time-varying parameters.
Rolling causality analysis is also more appropriate than the alternative recursive analysis with a growing window of data for two reasons. First, by adding observations recursively into the estimation process, one cannot differentiate whether the varying test statistics are due to a change in the extent and/or direction of causality, or to an increase in the power of tests arising from the additional observations. Second, in the case of structural breaks, recursive analysis suffers from the same drawbacks described in the main text.
Rolling ADF tests for the level and first differences of spr and DJ show that both variables are I(1). In order to ensure stationarity, both control variables appear in first difference form in Eqs. 6 and 7. Equations 6 and 7 were also estimated with one control variable at a time (spr or DJ) but the plots of the rolling F-statistics remain qualitatively the same. All results are available from the authors upon request.
Alternatively, one may use Euromarket rates. However, since both the U.S. and European markets are considered completely open, use of these rates is expected to yield the same results as using the onshore counterpart.
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Kollias, C., Mylonidis, N. & Paleologou, SM. The nexus between exchange rates and stock markets: evidence from the euro-dollar rate and composite European stock indices using rolling analysis. J Econ Finan 36, 136–147 (2012). https://doi.org/10.1007/s12197-010-9129-8
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DOI: https://doi.org/10.1007/s12197-010-9129-8