This article uses the Dynamic Conditional Correlation (DCC) model and the data from 11 economies to examine the inter-temporal interactions between stock return differential relative to the US and real exchange rate in the two financial crises of 1997 and 2008. The theoretical model suggests that relative stock return differential and real exchange rate that contain both permanent and temporary components are negatively correlated with each other. Evidence shows that sharp and rapid changes in conditional correlation occurred during the two financial crises. This study provides strong evidence in supporting the stochastic relationship between relative stock prices and real exchange rates, and exchange rate stability becomes crucial in a financial crisis.
ARDL model, cointegration, forward-looking ability, present value model 1 | INTRODUCTION Many existing papers in the body of exchange rate literature documented that the changes in exchange rates contain sufficient information to forecast the future changes of their fundamentals (see, e.g., Engel & West, 2005; Hoffmann & MacDonald, 2009; MacDonald & Taylor, 1993). Other works, such as Marks (1995), provide robust evidence that the long-horizon changes in nominal exchange rates contain an economic significant predictable component by regressing the long-horizon changes in exchange rates on the current exchange rate's deviation from a linear combination of relative money stocks and relative real income. All these papers provide empirical evidence to support the long-horizon predictability of real exchange rates. In practice, one may often perceive that the changes in the exchange rate affect the performance of the stock market, or, conversely, that the changes in the stock price influence the capital movement. In fact, the remarkable increase in international capital mobility over the course of the past two decades has apparently amplified the importance of the flow of capital on financial markets. Exchange rates, asset prices, economic performance and capital movements have become closely related to each other. Blanchard (1981) indicates that if an asset has a higher expected level of future profitability, the international capital funds would move towards the assets, even across countries. The capital movement would initially reflect on the changes in the exchange rate. If so, it is worth questioning whether the exchange rate can predict future changes in the stock market return and in the economic performance of a country. On the other hand, it can be observed that if the relative stock prices of a country fall below its permanent level, this would create expectations for a future increase in relative stock prices among international investors, as the temporary component of relative stock prices contains a mean-reverting
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