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International diversification
International diversification

International diversification

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  • Pages: 3 (1359 words)
  • Published: October 6, 2018
  • Type: Research Paper
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Co-integration and financial models have determined a causal relationship between stock prices and exchange rates. The empirical result suggests a long-run bi-directional causal relationship between stock prices and exchange rates. “While a long-term self-correcting association exists in industrialized economies between the cumulative current account or net stock of certain countries' foreign assets or liabilities and other economic variables, nothing of this sort was found in the developing economies. Without a deliberate adjustment in the macroeconomic policies, their current account imbalances may continue to grow. ”

Primarily examining British; Japan, “There is, however, no evidence of uni or bi-directional causality between stock prices and exchange rate in short-run or long-run. The overall evidence supports the goods market approach of exchange rate determination. ” Two approaches developed to establish a connection between exchange rate and stock prices. Within the corporate infrastructure, “the first approach, known as goods market approach,” (Dornbusch et al, 1980 pg 960) suggest that changes in exchange rates affect competitiveness, which in turn influence a firm’s earnings or its cost of funds and hence its stock price.“On a macro basis, then, the impact of exchange rate fluctuations on the stock market would depend on both the degree of openness of the domestic economy and the degree of the trade imbalance. ” (Frankel, 1993) A rising stock market would attract capital flows which increase the demand for domestic currency and cause the exchange rate to appreciate.

“Direct international comparisons of personal-saving ratios are, however, not supportive of a simple relationship between stoc


k market performance, i. e. pension funding/savings, and FX rates. Countries with high levels of pension funding such as the USA, the UK, and Sweden have comparatively low savings, while countries dependent on pay-as-you-go such as Italy have high saving ratios. ” (Das, 1993, pg.14)

For example, “the use of monetary targets has to be based on an assumption about the relationship between current monetary growth and future inflation-and, indeed, if the policy instrument is interest rates, as it usually is, a further assumption is needed about the bond between current interest rates and future monetary growth.” (Frankel, 1993) The difference in this respect between inflation targeting and monetary targeting is not that inflation targeting makes forecasts necessary, “…but rather that inflation targeting makes the need for forecasts explicit rather than implicit. ” (Dickinson, 2002, pg 18) “Although theories suggest a causal relationship between exchange rate and stock prices, existing evidence indicates a weak link between them at a micro level.” (Bodnar, et al, 1993) “US firms were unable to find a significant link and for Japanese’s firms, found that only 25 percent of their sample of 171 Japanese’s multinationals has significant exchange rate exposure on stock returns. (He et al, 1998) “Financial shocks jointly account for about 0. 6% of market volatility.

Similar results are found for other countries as well, more specifically 3. 4% in the U. S. /UK scenario and 0. 3% in the U.S. / Japan case. Almost all the variances of the marginal utility growth differentials are due to the exogenous shocks to consumption, inflation, and monetary policies.” (Shigeru et al, 2005, pg. 1121) On the macro level,

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“… a currency appreciation negatively affects the domestic stock market for an export-dominant country and positively affects the domestic stock market for an import-dominant country, which seems to be consistent with goods market theory. ” (Ma, et al 1990) Using daily data for eight countries, “show significant interactions between foreign exchange and stock markets,” (Ajayi et al, 1996), While “…a country’s monthly exchange rates tend to lead its stock prices but not the other way around.

” (Abdulla et al 1997) On the issue of causality between exchange rate and the stock market, “noted that whether stock price movements cause exchange rate volatility or vice versa is country and time-dependent. ” (Ramasamy et al, 2001) “It is useful to distinguish between what the material and cosmological beliefs of different cultures and civilizations are. ” (VAsquez, 2000, pg 38) “Foreign banks and investors pulled their funds out of South Korea, quickly leading to a foreign exchange crisis. Despite efforts by the government and the Bank of Korea, the exchange rate and stock market plummeted, placing South Korea virtually on the brink of defaulting on its foreign debt obligations. ” (Armstrong, 2002, pg 101) “In this specific exchange rate/stock market example, Bahrain presents an illustration of a small open economy and considered as the financial hub for the gulf region. Bahrain follows a pegged exchange rate system with its currency, Bahraini Dinar (BD), being pegged against U.

S. Dollar. It is reasonable to expect that exchange rate, vis a vis US dollar, may not fully respond to stock price movements.” (Tahir et al, 2006) Therefore for this exercise, the plan is to consider a currency exchange rate between BD and some other Major currencies, say (Dutch Mark (DM), British Pound (GBP), Japanese Yen (YEN)), to seek evidence for any possible relationship between “Bahrain’s stock market and major exchange rates.

”(Ramasamy et al, 2001) Co-integration and error correction modeling technique involves three main steps. Testing the relevant time series for stationary (unit-roots), testing for co-integration, and finally error-correction modeling. We shall use standard textbook1 notation to explain briefly the steps involved. “A non-stationary time series Yt is said to be integrated of order d if it achieves stationary after being differenced d times2. “(Ma, et al 1990) To determine the order of integration, unit root tests have been developed. The most common test is known as Dickey-Fuller (DF)( Dickey et al, 1979, 427) or Augmented Dickey-Fuller (ADF).


  1. E. Philip Davis, 1997, Pension Funds: Retirement-Income Security and Capital Markets an International Perspective.Publisher: Clarendon Press. Place of Publication: Oxford.
  2. Page Number: 2. Dornbusch, R.and S. Fischer, 1980, “Exchange Rates and Current Account,” American Economic Review 70, 960-71 E. Philip Davis, 1997,
  3. Pension Funds: Retirement-Income Security and Capital Markets an International Perspective.
  4. Publisher: Clarendon Press. Place of Publication: Oxford. Page Number: 12.
  5. Frankel, Jeffrey A., 1993, “Monetary and Portfolio-Balance models of the determination of Exchange rates” In Jeffrey A. Frankel on exchange rates, Cambridge, MA: MIT Press Dilip K. Das, 1993,
  6. International Finance: Contemporary Issues.
  7. Contributors:  editor. Publisher: Routledge. Place of Publication: New York. PG 14 Ian VAsquez, 2000, Global Fortune: The Stumble and Rise of World Capitalism. Publisher:
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