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Conditional correlation between exchange rates and stock prices

Liang Ding

The Quarterly Review of Economics and Finance, 2021, vol. 80, issue C, 452-463

Abstract: This paper develops a model to explain a time-varying and currency-dependent interaction between stock prices and exchange rates. The linkage is proposed based on portfolio managers’ rebalance between foreign and domestic stocks. Stock prices in two industrialized countries are usually correlated but have different sensitivities to a common risk factor. When a common positive shock occurs, the country with higher sensitivity will attract relatively more investment on their stocks, which generates a net order flow toward that country’s currency in the foreign exchange market and further causes the country’s currency to appreciate. The paper concludes that the correlation between exchange rates and stock prices is determined by the relative sensitivity of two countries’ stock prices to the common stock factor. In specific, rising US stock prices are associated with appreciation(depreciation) of the Dollar when US(foreign) stock prices have higher sensitivity.

Keywords: Exchange rates; Cross market analysis; Stock prices and exchange rate dynamics; Stock prices and exchange rate correlation (search for similar items in EconPapers)
JEL-codes: F31 G11 G15 (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eee:quaeco:v:80:y:2021:i:c:p:452-463

DOI: 10.1016/j.qref.2021.02.004

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