Liquidity Risk and Time-Varying Correlation Between Equity and Currency Returns

Jung, Kuk Mo (2015): 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.

• Item Type: MPRA Paper
• Language: English
• Keywords: foreign exchange rates, long run risks models, liquidity risks
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets

References

Acharya, V., and L. Pedersen (2005): \Asset Pricing with Liquidity risk," Journal of Financial Economics, 77, 375{410.

Amihud, Y. (2002): \Illiquidity and Stock Returns:Cross-Section and Time-Series E�ects," Journal of Fianancial Market, 5, 31{56.

Amihud, Y., H. Mendelson, and L. H. Pedersen (2013): Market Liquidity: Asset Pricing, Risk, and Crises. Cambridge University Press.

Amihud, Y., H. Mendelson, and R. Wood (1990): \Liquidity and the 1987 Stock Market Crash," Journal of Portfolio Mangement, 16(3), 65{69.

Backus, D., G. Allan, and T. Chris (2001): \A�ne Term Structure Models and the Forward Premium Anomaly," Journal of Finance, 56, 279{304.

Bansal, R., and I. Shaliastovich (2013): \A Long-Run Risks Explanation of Predict- bility Puzzles in Bond and Currency Markets," Review of Financial Studies, 26(1), 1{33.

Bansal, R., and A. Yaron (2004): \Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, 59(4), 1481{1509.

Brooks, R., H. Edison, M. Kumar, and T. Slock (2001): \Exchange Rates and Capital Flows," Working Paper 01-190, IMF.

Brunnermeier, M., and L. Pedersen (2008): \Market Liquidity and Funding Liquidity," Review of Financial Studies, 22(6), 2201{2238.

Brunnermeier, M. K., S. Nagel, and L. H. Pedersen (2008): \Carry Trades and Currency Crashes," NBER Macroeconomics Annual, 23.

Cappiello, L., and R. D. Santis (2007): \The Uncovered Return Parity Condtion," Working Paper Series 812, European Central Bank.

Cenedese, G., R. Payne, L. Sarno, and G. Valente (2015): \What do stock markets tell us about exchange rates?," Bank of England Working Paper, (537).

Chabot, B., E. Ghysels, and R. Jagannathan (2014): \Momentum Trading, Return Chasing, and Predictable Crashes," NBER Working Paper.

Evans, M. D., and R. Lyons (2002): \Order ow and Exchange Rate Dynamics," Journal of Political Economy, 110, 170{180.

Granger, C. W. J., B. Huang, and C. Yang (2000): \A bivariate causality between stock prices and exchange rates: Evidence from recent Asian u," The Quarterly Review of Economics and Fianance, 40, 337{354

Griffin, J., F. Nardari, and R. Stultz (2004): \Are Daily Cross-Border Equity Flows Pushed or Pulled?," Review of Economics and Statistics, 86, 641{657.

Hau, H., and H. Rey (2006): \Exchange Rates, Equity Prices, and Capital Flows," The Review of Financial Studies, 19(1), 273{317.

Heathcote, J., and F. Perri (2013): \The International Diversi�cation Puzzle Is Not As Bad As You Think," Journal of Political Economy, 121(6), 1108{1159.

Kim, H. (2011): \The Risk Adjusted Uncovered Equity Parity," Journal of International Money and Finance, 30, 1491{1505.

Meese, R., and K. Rogoff (1983): \Empirical Exchange Rate Models of the Seventies," Journal of International Economics, 14, 3{24.

Melvin, M., and J. Prins (2015): \Equity Hedging and Exchange Rates at the London 4 p.m. Fix," Journal of Financial Markets, 22(50-72).

Pastor, L., and P. Veronesi (2006): \Was there a Nasdaq bubble in the late 1990s?," Journal of Financial Economics, 81(1), 61{100.

Pavlova, A., and R. Rigobon (2007): \Asset Prices and Exchange Rates," The Review of Financial Studies, 20(1), 1139{1181.