Quantile Dependence between Foreign Exchange Market and Stock Market: The Case of Korea

Abstract

(ProQuest: ... denotes formulae omitted.)I. INTRODUCTIONThe interaction between stock market and currency market has been the subject of a long-drawn academic debate with inconclusive results. There are two competing hypotheses to explain these macroeconomic variables; traditional and portfolio approaches. The traditional approach, suggested by Dornbusch et al. (1980) is that exchange rate movements lead change in stock prices since the stock prices represent firm's values denominated in foreign currency. In contrast to traditional theory, portfolio approach, first discussed by Branson et al. (1977) postulates that changes in stock prices may have an influence on exchange rate via portfolio adjustments.Even though the theoretical explanations have attempted to show causal relation between stock market and exchange rate market, the empirical findings are rather mixed for the causal direction. Furthermore, the empirical results of causal relation between two financial markets have been varied by countries and time periods. Table 1 reports the summary of previous empirical studies.Abdalla and Murinde (1997) find the supportive evidences in favor of traditional approach using a country's monthly exchange rates. The studies show that there is uni-directional causality from exchange rate to stock return in India, Korea and Pakistan. Similarly, Wu (2000) shows Singapore-dollar exchange rates Granger stock prices. In contrast, Ajayi et al. (1998) find significant linkage between two financial markets by indicating uni-directional causality from the stock market to the currency market for advanced countries including Canada, France, Germany, Italy, Japan, U.K, and U.S from 1985 to 1991. Hatemi-J and Irandoust (2002) confirm that stock market tends to lead exchange rates in favor of the portfolio approach for Sweden. In a similar vein, Pan et al. (2007) find out there is unidirectional causal relationship from stock price to exchange rate for Korea and Singapore before Asian financial crisis.On the other hand, some of the studies have found bi-directional causality between two financial markets (Ajayi and Mougoue, 1996). In this regard, Pan et al. (2007) also provide evidences to indicate bi-directional causal relationship for Hong Kong before the Asian financial crisis. Granger et al. (2000) investigate causality based on Granger causality tests for nine Asian countries during the Asian financial crisis then obtain fairly differing results by country. They show that exchange rate market tends to lead the stock market in Japan and Thailand, which support traditional approach whereas stock market takes the lead in Taiwan. Furthermore, bi-directional relation is discovered for Korea, Malaysia and the Philippines. In Singapore, there exists no such causal relation.The ratio of foreign investors in Korean stock market has been high as shown in Table 3. It has been mostly more than thirty percent since 2001 and it reached its peak 40.1% in 2004. In other words, the foreign investment in Korea is a major component in Korean financial market. There have been numerous studies to investigate the relation between two financial markets, however, the existing literature is inconclusive on the relation between stock market and exchange rate.Korean stock market can be affected by the change in exchange rate of Korean Won via the traditional approach (Abdalla and Murinde, 1997; Kang and Yoon, 2012) while it also can affect the foreign exchange market via the portfolio approach (Lee and Ahn, 2010). On the other hand, Lee (2007) and Granger et al. (2000) provide bi-directional interaction between exchange rates and stock prices in Korea. In addition, Pan et al. (2007) find out that the results are in line with the traditional approach during Asian crisis, while they agree with the portfolio approach before Asian crisis in Korea. Therefore, examining the detailed relationship between foreign exchange market and stock market in Korea is appropriate to study the interaction between two markets and moreover it is very important for investors and policy makers in Korea. …