Stock prices, exchange rates and portfolio equity flows

Abstract

Purpose The purpose of this paper is to develop a new framework to test the hypothesis that portfolio model predicts a negative correlation between stock prices and exchange rates in a trivariate transmission channel for foreign portfolio equity investment. Design/methodology/approach This paper utilizes panel data for eight economies to extend the Dumitrescu and Hurlin (2012) Granger non-causality test of heterogeneous panels to a trivariate model by integrating the Toda and Yamamoto (1995) approach to Granger causality. Findings The evidence suggests that stock prices Granger-cause exchange rates and portfolio equity flows Granger-cause exchange rates. However, the overall panel evidence casts doubt on the explicit trivariate model of portfolio balance model. The study shows that Indonesia may be the only case where stock prices affect exchange rates through portfolio equity flows. Research limitations/implications The proposed test does not account for potential asymmetries or structural shifts associated with the crisis period. To isolate the impact of the Asian Financial crisis, this paper rather splits the sample period into two sub-periods: pre- and post-crises. The sample period and countries are also limited due to the use of the balance of payment statistics. Practical implications The study casts doubt on the maintained hypothesis of a trivariate transmission channel, as posited by the portfolio model. Policy makers of an economy may integrate capital market and fiscal policies in order to maintain stable exchange rate. Originality/value This paper integrates a portfolio equity inflow variable into a single framework with stock price and exchange rate variables. It extends the Dumitrescu and Hurlin’s (2012) bivariate stationary Granger non-causality test in heterogeneous panels to a trivariate setting in the framework of Toda and Yamamoto (1995).