Exchange Rate and Equity Market Dependence under Shifts in Volatility Expectations

Abstract: Exchange rate movements have important implications for both policy makers and investors, as they can have large effects on the real economy and the return on investments. Lately, their relation to capital flows have attracted growing interest due to the failure of macroeconomic fundamentals to explain them. This paper uses a copula framework to investigate the short-term dependence between the SEK and OMX in reference to the three developed markets of USA, EU, and Japan, and for both the absolute and relative performance of OMX. By considering shifts in volatility expectations as a third variable, the dynamic dependence between the SEK and OMX is assessed in light of existing theories such as portfolio rebalancing, the hedging channel, return chasing, and the notion of safe havens. For the absolute performance of OMX, we document a negative dependence with the exchange rate which is more pronounced when volatility expectation shifts are large, which is in accordance with the theories of safe havens and the hedging channel of exchange rate determination. The dependence is strongest in reference to Japan, and weakest in reference to USA. For the relative performance of OMX, a positive but weak dependence with the exchange rate is identified, which is in agreement with the predicted e↵ects of portfolio rebalancing and hedging adjustments but contrary to that of return chasing. The results have implications for investors in terms of hedging, as the results indicate that the referenced currencies provide a natural hedge in times of market distress. Furthermore, the results indicate that relative outperformance is linked to a depreciation of the currency, creating an opportunity for foreign investors to benefit from both.