Effects of Exchange Rate Fluctuations on Equity Market Volatility and Correlations: Evidence from the Asian Financial Crisis

Abstract

Introduction The Asian financial crisis that began in Thailand in the summer of 1997 quickly spread across borders to other countries in the region. Market returns on stocks sharply fell, local currencies rapidly depreciated, and the volatility in both stock and foreign exchange markets drastically rose to unprecedented levels during the crisis. While these episodes have been well documented, much less effort has been devoted to studying the role of exchange rate fluctuations in equity markets around the financial crisis. Several studies recently focused on the role of exchange rate fluctuations in the capital market around the Asian financial crisis. Aquino (2005, 2006) examines the foreign exchange exposure faced by Philippine firms around the Asian financial crisis and finds that while stock returns were not significantly affected by foreign exchange fluctuations before the crisis, there was a significant impact of the fluctuations on stock returns after the crisis. Chung (2005) documents that during the period of the financial crisis there was a contagious effect of Thai baht exchange rate fluctuations on Asian ADRs and country fund returns, while there was no contagious effect on non-Asian ADRs and country funds. Yau and Nieh (2006) investigate the interrelationship between new Taiwan dollar/Japanese yen exchange rate and stock prices of Taiwan and Japan for the period of January 1991 to July 2005 and find that there was no long-term linkage between the exchange rate and stock prices of Taiwan and Japan, but the linkage existed only for short durations. Tse and Yip (2006) investigate whether the Asian financial crisis led to changes in the correlation between the US and Singapore/Hong Kong interest rates and find that there was a correlation breakdown for the interest rates during the crisis, although the correlation was restored after the crisis. It is theoretically apparent that the US dollar returns of local market indexes are influenced by exchange rate movements due to the fact that the conversion process from local market returns into US dollar values already has introduced a direct link between exchange rates and US dollar returns. Yet empirical findings provide conflicting results for the linkage between foreign exchange rate movements and local equity market returns, as returns are expressed in US dollars. Some researchers claim that exchange rate movements provide little or no explanation for US investors making investment decisions (Jorion, 1990 and 1991; Amihud, 1993; Bartov and Bodnar, 1994; and Bernard and Galati, 2000), while others argue that stock returns in US dollars are affected significantly by exchange rate fluctuations (Roll, 1992; Ferson and Harvey, 1994; Dumas and Solnik, 1995; Chow et al., 1997; Choi et al., 1998; De Santis and Gerard, 1998; Doukas et al., 1999; Kaminsky and Schmukler, 1999; and Patro et al., 2002). Although models and empirical methodologies vary widely, these papers explain the relationship between exchange rate movements and stock market returns using various regression models of exchange rate exposure for which exchange rate fluctuations are linked to expected stock returns. The purpose of this paper is to examine how and to what extent international stock market volatility and US/local market correlations were influenced by exchange rate fluctuations around the Asian financial crisis. This paper contributes to the literature in the following two ways. First, in contrast to the regression-based models of the existing literature, this paper develops an alternative formulation of the model that captures the role of exchange rate fluctuations in a direct and explicit fashion. In our model market volatility, as well as cross-market correlation, is decomposed into fractions that are attributable to local market returns and exchange rate fluctuations. Thus, the role of exchange rate fluctuations relative to local market returns can be identified explicitly in explaining the market volatility and cross-market correlations. …

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