Download Exchange rate volatility and stock market returns:

Exchange rate volatility and stock market returns:
Empirical evidence from G-7 countries:
I-Introduction:
Although most economists agree that monetary policy affects the real economy, there is less
agreement about exactly how it exerts its influence. The weaknesses of the traditional
textbook monetary channel prompted economists to assert that the monetary transmission
mechanism operates through the credit channel, as first mentioned by Bernanke and Gertler
(1995). According to the credit channel, the direct effects of monetary policy on interest rates
are amplified by endogenous changes in the external finance premium. The credit channel
transmission affects the real economy not only through balance sheet channel but also
through the bank-lending channel. However, in a world with integrated capital markets,
investors’ expectations are more likely to be affected by long-run risk premium, measured by
stock returns than by interest rates or amounts of bank lending. If loans, government
securities, and corporate securities are perfect substitutes, there is no reason to assume that
monetary transmission channel operates only through the money or credit channel as
suggested by traditional monetary policy analysis. In fact, investors’ perception of the risk
premium is best measured by stock returns since it reflects long-run expectations about the
market.
Over the past decade, many empirical studies have uncovered predictive relationships
between exchange rates and stock market returns. Long-run stock returns and the equity risk
premium play an important role in a host of financial decisions, underlining animal spirits.
The empirical study in this chapter suggests that the stock market transmission channel shape
the dynamic response of the economy to shifts in monetary policy and has become
increasingly potent in determining macroeconomic variables, especially for exchange rates.
My original motivation for carrying out this study is twofold. First, I investigate whether
stock markets are efficient in the weak sense as argued by Fama and French (1988), and,
second, I explore whether the monetary policy transmission channel operates through stock
market returns. To do so, I follow the approach adopted by Kim and Roubini (2000), using a
vector autoregression (VAR) technique. Kim and Roubini, among others, have used a VAR
technique to investigate the impact of monetary policy on the exchange rate. Their approach
emphasizes the traditional monetary channel and ignores the stock market channel, whereas
many authors, including Ang and Bekaert (2000), Peersman and Smets (2001), and Leigh
(1997), have emphasized the stock market transmission channel. Stock market returns,
especially dividend yields shape the dynamics of many macroeconomic variables, including
the exchange rate. As Kim and Roubini themselves have emphasized, their study ignores the
fiscal policy variable. Nonetheless, the relationship between the exchange rate and the fiscal
policy variable has been emphasized by Froot and Rogoff (1991) and by MacDonald (1997),
among others. MacDonald points out that the exchange rate movement is driven by the
current account, among other variables, and the current account, in turn, is influenced by
national saving and investment. Thus, it follows that fiscal policy as a crucial variable that
affects national savings and the current accountthrough the national account identityalso
affects the exchange rate.
To compensate for the weaknesses of Kim and Roubini study, I employ a non-recursive VAR
technique using dividend yield as a measure of stock return and government expenditures as
a measure of fiscal policy. One of the novel features of this study is that it captures the
effects of fiscal policy, measured by government expenditures, as well as monetary policy. I
use different techniques, including Cholesky forecast variance decomposition and impulse
response functions, to investigate the response of domestic variables and real effective
exchange rates to different shocksmonetary policy, fiscal policy, oil price, and stock
market. The results help identify the main determinants of exchange rate movements. In
addition, I use impulse response functions to search for evidence of exchange rate
overshooting.
I also address the market efficiency hypothesis in this paper. This is an important question in
the finance literature because if markets are efficient, then it follows that investors are
rational and that noise traders are unable to affect the stock market behavior, in a way that
needs to be controlled by government interventions. Many authors, including Fama and
French, have argued that stock markets are efficient in the weak sense, and the theory can
accommodate temporary booms, bubbles, and minor crashes with only few modifications.
Others, however, argue that markets are inefficient. For example, Shiller (2000) identifies
three sets of factorsstructural, cultural, and psychologicalthat can cause fads and noise in
stock markets. In addition, Shefrin and Statman (1994) cite abnormal returns, variability in
earnings-to-price ratios, and excessive volatility as indicators of market inefficiency. Romer
(1993) maintains that an important part of price movements is caused neither by external
news nor irrationality, but by internal news that the trading process provides. He argues that
price movements, which occur without any clear news, often convey important information
about fundamentals. Stiglitz (1990) argues that, when fundamental factors do not seem to
justify high prices, then a bubble must exist. To investigate the market efficiency puzzle, I
use the cointegration technique for different stock market variables in the G-7 countries. If
stock returns are stationary, one may conclude that markets are efficient in the weak sense.
In sharp contrast to the results of Kim and Roubini, the impulse response function and the
Cholesky variance decomposition results of this paper show that the oil price does not matter
for exchange rate behavior in the G-7 countries, except for the United Kingdom, and Canada.
The results of a non-recursive VAR approach confirm that fiscal policy matters more than
monetary policy for exchange rate behavior. As many equilibrium models suggest, I find that
industrial production has more contribution in exchange rate movements than monetary
policy, even in the short run. The Cholesky forecast variance decomposition of exchange rate
shows that, in many scenarios, the contribution of monetary policy in exchange rate behavior
does not exceed 6%, at most. However, the U.S. and domestic dividend yield contribute
substantially to exchange rate behavior, highlighting the importance of the stock market
transmission channel. I find that stock returns, measured by dividend yields, are markedly
superior to monetary aggregates and the federal fund rate. I obtain similar results in three
different scenarios, using the VAR approach, bolstering credibility of my results. The results
of this paper abandon the widespread perception that monetary policy operates through the
federal fund rate.
The results of the Cholesky variance decomposition of industrial production in the G-7
countries suggest that the contribution of monetary policy to output fluctuations does not
exceed 17%, at most, for Japan. In contrast to Kim and Roubini, I find that the price of oil
and the federal fund rate play a trivial role in explaining output fluctuations. Moreover, the
results suggest a number of conclusions: fiscal policy has a greater impact than monetary
policy on output fluctuations in both the short and the long run, and the U.S. dividend yield
has a substantial impact on output, with a peak of over 27% in France and Italy, reflecting the
importance of the stock market transmission channel for output fluctuations in the EMS
countries. Domestic dividend yields, however, play a crucial role in explaining output
movements in Canada and Japan. In sum, the U.S. and domestic dividend yields explain
almost 25% of output movements for all non-US G-7 countries, underlining the significance
of the stock market transmission channel.
The Cholesky variance decomposition of dividend yields suggests that the U.S. dividend
yield causes at least one-fourth of changes in domestic yields in the non-US G-7 countries,
with a peak contribution of over 60% for the United Kingdom. The oil price and the federal
fund rate, as in the previous cases, play a trivial role in explaining dividend yields.
Interestingly enough, fiscal policy explains dividend yields among the G-7 countries better
than monetary policy does.
Moreover, in line with Eichenbaum and Evans (1995) and Grilli and Roubini (1995), using
the impulse response function technique, I find no evidence of exchange rate overshooting in
response to monetary policy shocks.
The rest of the paper is organized as follows: after a brief review of empirical studies in
Section II, I turn to theoretical models in Section III and describe the data I have used in
Section IV. I investigate whether stock markets are efficient, in the weak sense, based on the
definition presented by Fama and French, in Section V. I use a unit root test and the Johansen
cointegration technique to see if the data are stationary. In Section VI, I use the least-squared
technique to explore whether financial variables, including stock market prices and dividend
yields, have any power in explaining exchange rate movements for non-US G-7 currencies
against the U.S. dollar. In Section VII, I describe specifications of the non-recursive VAR
technique I have used in this study. Section VIII, presents the empirical results of the
structural VAR approach with non-recursive contemporaneous restrictions. Section IX
portrays a different VAR approach with particular emphasis on fiscal policy, to determine
which policy variablemonetary or fiscalplays a more crucial role in explaining the
exchange rate. Section X displays the impulse response functions of domestic variables and
real effective exchange rates to different shocksfiscal, monetary, oil price, and stock
market.