A cointegration test of the impact of foreign exchange rates on U.S. stock market prices

Abstract

Since the removal of the governmentally enforced fixed exchange rate standard in the early 197Os, exchange rates have been determined by the forces of the global marketplace. A strong relationship between the dollar and U.S. stock prices is a popular view in the financial news media. The Wall Street Joournal often associates a U.S. stock market rally with a change in the value of the dollar. Unexpected changes in exchange rates create uncertainty regarding a firm’s assets, liabilities and future cash flows. Multinational firms, firms that rely on foreign direct investment, and firms that conduct import or export trade are especially susceptible to exchange rate risks. Indeed, even purely domestic firms are potentially impacted through foreign competition. A reduction in the value of U.S. currency is expected to favorably affect U.S. stock prices due to increased exports and domestic substitution foi imported goods. Conversely, a strengthening dollar is expected to result in declining stock prices. The belief that a depreciating dollar will result in rising exports is based on the assumption that as the dollar begins to fall, it will continue moving in that direction for some time. The market will respond by reassessing expectations regarding future changes in exchange rates. Although this conviction is common among “technical analysts,” it is inconsistent with modern rational expectations theory As exchange rates are financial prices, they should only be affected by changes in expectations about economic activity In an efficient market, they already reflect all information about expected future economic activity and policy The purpose of this paper is to test if U.S. dollar exchange rates affect U.S. stock prices using cointegration analysis. Evidence is presented that demonstrates no systematic relationship between U.S. currency value and stock prices. The remainder