A Study on the Causal Relationship Between Relative Eequity Performance and the Exchange Rate: The Swedish Case

Abstract: The question whether there is a causal relationship between exchange rates and equities is unresolved both in theory and empirically. The Flow theory postulates that exchange rates cause equity returns while the Stock theory suggests that equity returns cause exchange rates. Previous empirical studies have found mixed results although the relationship between these variables tend to be stronger in more developed economies and those studies that have found causality usually conclude that equity returns causes exchange rates. While most previous research has investigated the causality by looking at a single countries equity market, we use the return differentials between the market returns in two currency areas to test against the exchange rate. By employing the traditional test for Granger-causality we find that equity return differentials Granger causes exchange rates although not in the way that the theoretical background would predict. The results are however not independent of time-period since tests of the final six months in our data-set (the crisis period) generate different results. We conclude that for Sweden, a rise in domestic equity prices encourages investors to diversify away to bonds and foreign assets, more than they increase demand for domestic money. Moreover, the possible failure of including explanatory variables might have caused the different outcomes for the two time periods.