Co-Movement Between Stock Markets and Exchange Rates in Central and Eastern Europe

Abstract

Generally, the exchange rate and the stock market have been some of the most studied areas in finance. Furthermore, the nexus between the two assets has been reviewed in a significant number of studies, but with conflicting results. The flow oriented model posits a positive link between exchange rate and stock market (Dornbusch and Fischer, 1980), the portfolio based model assume a negative relationship between exchange rate and stock market, and the monetary model indicates a weaker or no link between the two assets (Branson and Henderson, 1985; Frankel, 1983). This article studies the nexus between exchange rates and stock markets in four countries in Central and Eastern Europe (Czech Republic, Hungary, Poland, and Romania) over the period from 1999 to 2016. In our opinion, our contribution to the literature is manifold. Firstly, even if the papers that analyse the correlation between exchange rates and stock markets are numerous (Lee et al., 2011; Lestano and Kuper, 2015; Caporale et al., 2014; Moore and Wang, 2014; Lin, 2012; Lee et al. 2014), surprisingly, to our knowledge, for Central and Eastern European countries there is a scarce literature in this area. Secondly, we document the time varying correlation in both normal period and crisis period, allowing us to investigate the differences. Thirdly, compared with other studies, we employ a DCC-MIDAS model that enables the extraction of short-and long-term correlation series. Generally, other DCC models estimate only a short-run component for the correlation. Therefore, solely by averaging the high-frequency component, we may obtain a low-frequency component. The DCC-MIDAS model obviates this disadvantage. Our findings are summarized as follows. Firstly, we find significant differences between the four countries. Secondly, we notice an increased variance in terms of time varying correlation between stock market and exchange rate. Therefore, we cannot identify a clear pattern for the correlation. Thirdly, during the most severe crisis episodes, we see an increased correlation, indicating some signs of contagion and lower portfolio diversification.

Uncovered equity returns parity in non‐euro Central European EU member countries

“…The heterogeneity of the local currencies offers a number of explanations for the variance of both the observed UERP correlations (Kunkler & MacDonald, 2018). Financial markets in these countries have become increasingly open, more developed and integrated with the EU and the euro area markets (Fedorova & Saleem, 2010;Grambovas, 2003;Nitoi, Stanciu, & Spulbar, 2018;Syriopoulos, 2004). At the same time, they have become more susceptible to exogenous shocks and contagion effects.…”

“…The on-going integration of financial markets has contributed to higher trading volumes of equities and enhanced transmission of cross-market returns. As a result, capital flows from the euro area and other EU financial areas to Central Europe have increased equity market returns and contributed to an appreciation of local currencies in EUR, thus not conforming to the UERP condition (Nitoi et al, 2018). As the integration has not been smooth, comovements of equity returns and exchange rates have been disrupted.…”

“…The co-movements between equity returns and exchange rates have been found as unstable and timevarying in the prior literature that has mainly employed dynamic conditional correlation as well as co-integration with vector error correction tests (Fedorova & Saleem, 2010;Grambovas, 2003;Hau & Rey, 2006;Nitoi et al, 2018;Syriopoulos, 2004). We employ different analytical procedures in order to ascertain dynamic changes, possible structural breaks and discernible phases in the evolving comovements between equity returns and exchange rates in CECs.…”

“…Among others, Hau and Rey (2006) as well as Melvin and Prins (2015) prove that net equity flows into foreign markets are positively correlated with a foreign currency appreciation, which was strongly supported among 17 OECD countries during the time frame of their analysis. More recent analyses pertaining to CECs markets by Islami and Welfens (2013) and Nitoi et al (2018) point out that the transmission of returns between equity and foreign exchange markets is not uniform among these countries and it is subject to increased variance over time. The analysis conducted by Aftab, Ahmad, and Ismail (2018) shows evidence contrary to the UERP prediction such that an over-performance of foreign equity market is associated with a foreign exchange rate appreciation.…”