In a recent BusinessWeek article entitled “The Currency Game Has Brand-New Rules,” it was noted that a quarter-point increase in the Eurozone interest rate by the European Central Bank defied convention when the euro declined against the dollar. However, the announcement of the $183 billion takeover of Germany’s Mannesmann by the British mobile phone giant Vodafone AirTouch PLC caused the euro to increase by 2.5 cents against the dollar.
The article noted that the impact of deals and stock prices on exchange rates became “powerfully apparent” in 1999 when the yen failed to react to policy initiatives by the Bank of Japan, but reacted significantly to stock and deal news. On the other hand, the impact of the currency market on the equity market is highlighted in another article that partly attributes the underperformance of the US stock market in late 2000 to the third-quarter 2000 downward revisions in earnings due in part to a weak euro.
The above occurrences within the international financial markets suggest that there may be important, yet not fully understood, price transmission channels from the equity to the currency market. While several studies have examined spillovers in mean and/or volatility across currency markets (e.g., Bollerslev (1990), Baillie and Bollerslev (1990), Engle, Ito, and Lin (1990)), they have not allowed for an influence from the equity markets. Similarly, studies that have examined the spillovers between international equity markets (e.g., King, Sentana, and Wadhwani (1994), Lin, Engle, and Ito (1994), Hamao, Masulis, and Ng (1990), and King and Wadhwani (1990)) have either treated the currency market as exogenous or do not ascribe a specific role to the currency market in shaping these interdependencies.
Given the design of these studies, there is a general lack of evidence of the dynamic relationships between the currency, foreign equity, and domestic equity markets and, more specifically of the impact of changes in the equity (currency) market on the currency (equity) market. This oversight in the research design leads us to question how well the linkage(s) from currency to equity markets is understood, even though considerable effort has been expended in establishing this relationship(s).