The Dynamic Relationship Between Stock, Bond and Foreign Exchange Markets

The Dynamic Relationship Between Stock, Bond and Foreign Exchange Markets

Title:

The Dynamic Relationship Between Stock, Bond and Foreign Exchange Markets

Number:

15/12

Author(s):

S. Hilmi Kal, Ferhat Arslaner, Nuran Arslaner

Language:

English

Date:

April 2015

Abstract:

In this paper, we investigate whether deviation of a currency from its fundamentally determined rate of return affects its interaction with interest rates and stock market yields. A time varying transition probability Markov-Switching Vector Autoregressive (MS-VAR) model is utilized for this purpose. Wald and Likelihood ratio tests are used as model adequacy measures. In order to analyse the link among the variables, impulse-response functions are employed. States are defined as overvalued state and undervalued state depending on the position of the observed exchange rate to its fundamentally determined rate which is computed by sticky price exchange rate model. The model is implemented to four major currencies: Australian dollar, the Canadian dollar, the Japanese yen, and the British pound. Transition between the states are linked to risk adjusted excess return (the Sharpe ratio) of debt market and equity market returns of respected currencies in order to understand whether overvaluation and undervaluation is connected to the returns in these markets. The results provide evidence that the relationship between economic fundamentals and the nominal exchange rates are subject to change depending on the overvaluation or undervaluation of the currencies relative to their fundamentally determined rate of return. As an extension of the model, we found that the Sharpe ratios of debt and equity investments in the currencies influence the evolution of transitional dynamics of the exchange rates’ deviation from their fundamental values.

Keywords:

 Bond price, Stock price, Exchange rate, Sharpe ratio, Wald ratio test, Likelihood test, Impulse-Response functions, Markov-Switching vector autoregressive model 

JEL Codes:

 C32, C58, E44, F31, G15

The Dynamic Relationship Between Stock, Bond and Foreign Exchange Markets
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