Stocks and currencies: are they related?

Li Lian Ong and H. Y. Izan

Applied Financial Economics, 1999, vol. 9, issue 5, 523-532

Abstract: With the advent of flexible exchange rates, research into the foreign exchange expectation relation based on the purchasing power parity and interest rate parity conditions has shown that the speed of transmission of economic variables, such as the price level and interest rates, is not rapid enough to maintain parity in the short-term with the foreign exchange market. In recent years, gold prices have been used to model exchange rate behaviour, based on the fact that it is a homogeneous commodity that is traded continuously on well-organized exchanges around the world. However, while the price of gold is shown to have explanatory power for exchange rates, the forecast horizons are found to be most significant only after lags of at least six months. Another approach to exchange rate determination, the asset market approach is based on the notion that exchange rates, like asset prices, are driven by 'news' or unanticipated announcements of changes in economic variables. Both exchange rates and asset prices instantaneously discount all available information about expected future economic activity. Using a 'law of one price' model, we use the asset market approach to investigate the validity of the equity parity theory, whereby a parity relationship exists between equity and foreign exchange markets. Our results show that equity parity is achieved within a very short time, in some cases, within a oneweek period. However, the relationship appears to be a weak one. Consistent with previous research, we also find evidence to support the existence of currency blocs. We suggest that these findings could have practical applications for international investors.

Date: 1999
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DOI: 10.1080/096031099332186

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