Exchange rate and stock market interaction: an empirical investigation

The aim of this thesis is to analyse theTelationship between the exchange rate and stockmarket, in the UK, USA, Germany, Japan, Canada and the Netherlands over the period 1974 to 1994. It is motivated by recent changes in the international financial environment, particularly the gradual removal of exchange restrictions and the consequent rise in capital flows between the main economies. A further motivation has been the increasing use of stock market variables in macroeconomic models. The theoretical literature indicates that for a variety of different exchange rate models, it is possible for the exchange rate and stock market to interact in a number of different ways, following an exogenous shock. It is therefore pnmanly an empirical question as to the specific signs on the variables in the models analysed. This thesis predominantly uses cointegration and error correction models, so that both the long run 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 to be inversely related. In addition the foreign exchange market risk premium is shown to be directly linked to the differential between the domestic and foreign equity risk premiums. It is also found that the expected change in the exchange rate is more closely linked to risk rather than return differentials.