Exchange rate and stock market interaction: an empirical investigation

The aim of this thesis is to analyse theTelationship between the exchange rate andstockmarket, in the UK, USA, Germany, Japan, Canada and the Netherlands over theperiod 1974 to 1994. It is motivated by recent changes in the international financialenvironment, particularly the gradual removal of exchange restrictions and theconsequent rise in capital flows between the main economies. A further motivationhas been the increasing use of stock market variables in macroeconomic models.The theoretical literature indicates that for a variety of different exchange ratemodels, it is possible for the exchange rate and stock market to interact in a number ofdifferent ways, following an exogenous shock. It is therefore pnmanly an empiricalquestion as to the specific signs on the variables in the models analysed. This thesispredominantly uses cointegration and error correction models, so that both the longrun relationship and short run dynamics can be examined separately.The thesis shows that stock prices and exchange rates do not have common trends,but do have common cycles. In general exchange rates and stock prices are found tobe inversely related. In addition the foreign exchange market risk premium is shownto be directly linked to the differential between the domestic and foreign equity riskpremiums. It is also found that the expected change in the exchange rate is moreclosely linked to risk rather than return differentials.