Liquidity Risk and Time‐varying Correlation Between Equity and Currency Returns

Abstract

Using data on twenty major OECD countries over time, this paper documents a new evidence on real equity and real currency prices: higher real returns in the home equity market relative to foreign counterparts are generally associated with real home currency depreciation at a monthly frequency, but this negative correlation breaks down or even reverses during times of relatively higher aggregate economic uncertainty or volatility. This paper also proposes one plausible explanation for this time-varying correlation structure. The suggested model is based on a long-run risks type model, combined with time-varying liquidity risks in stock markets. With recursive preference for the early resolution of uncertainty and a negative link between the level of short-run economic growth and equity market liquidity volatility, the model demonstrates that severe short-run economic uncertainty overturns the otherwise negative link between the real currency and real relative equity returns.Keywords: foreign exchange rates, long run risks models, liquidity risks JEL Classification Numbers: E43, F31, G12, G15 * Address: Ming Lun Street, Kaifeng, Henan, 475001, China, Phone Number: +86-187-4986-2307, e-mail: kmjung@ucdavis.edu. I am indebted to Paul Bergin for continuous advice and support for this project. I am also grateful to Katheryn Russ and Kevin Salyer for useful comments and suggestions. I would also like to thank participants at Henan University Brownbag seminar for helpful comments. I am especially indebted to William Branch and anonymous referees for help and many valuable suggestions. I also thank Niu Yongqing for excellent research assistance. All errors are mine.

Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities

“…In another related work, Pástor and Stambaugh (2003) also found that their liquidity measure sharply dropped in times of severe financial distress. In fact, in a recent study, examining the time-varying correlations between equity and currency returns, Jung (2017) argue that idiosyncratic volatility driven by the volatility in market liquidity acts as a channel that drives the time-variation in currency-equity correlations.All this evidence raises a question as to whether liquidity could possibly serve as the underlying factor, drivingthe time-variation incorrelations and/or amplifying the effect of volatility on correlations among asset classses, particularly in times of financial distress. This paper examines the effect of liquidity on the time-variation in the correlations among three major asset classes, particularly stocks, corporate bonds and commodities.…”