The Contribution of Exchange Rate Fluctuations to Stock Market Volatility and Cross-Market Correlations

Abstract

This paper develops a direct, explicit model for the contribution of exchange rate fluctuations and examine how and to what extent international stock market volatility and cross-market correlations are influenced by exchange rate fluctuations. Evidence presented in this paper indicates that a higher foreign exchange rate variability contributes mostly to a higher local stock market volatility but to a lower volatility for the US stock market. The extent to which the stock market volatility is influenced by a foreign exchange variability is greater for local markets than for the US market, due to the fact that exchange rate changes are more strongly correlated with the local equity market returns than the US market returns. We also find that a higher exchange rate fluctuation contributes marginally to a lower US/local equity market correlation in most cases. While exchange rate fluctuations held a relatively large fraction of the variation in local stock market returns, there was no significant influence on the US/local market correlation.