* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Download Exchange rate volatility and stock market returns:
Survey
Document related concepts
Auction rate security wikipedia , lookup
Foreign exchange market wikipedia , lookup
Hedge (finance) wikipedia , lookup
Foreign-exchange reserves wikipedia , lookup
Securities fraud wikipedia , lookup
Short (finance) wikipedia , lookup
Purchasing power parity wikipedia , lookup
Fixed exchange-rate system wikipedia , lookup
Efficient-market hypothesis wikipedia , lookup
Market sentiment wikipedia , lookup
Exchange rate wikipedia , lookup
2010 Flash Crash wikipedia , lookup
International monetary systems wikipedia , lookup
Stock market wikipedia , lookup
Stock exchange wikipedia , lookup
Transcript
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 accountthrough the national account identityalso 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 shocksmonetary 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 factorsstructural, cultural, and psychologicalthat 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 variablemonetary or fiscalplays 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 shocksfiscal, monetary, oil price, and stock market.