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The Dynamic Relationship Between Stock, Bond and Foreign Exchange Markets

Author

Listed:
  • Suleyman Hilmi Kal
  • Ferhat Arslaner
  • Nuran Arslaner
Abstract
In this paper, we investigate whether deviation of a currency from its fundamentally determined rate of return affects its interaction with interest rates and stock market yields. A time varying transition probability Markov-Switching Vector Autoregressive (MS-VAR) model is utilized for this purpose. Wald and Likelihood ratio tests are used as model adequacy measures. In order to analyse the link among the variables, impulse-response functions are employed. States are defined as overvalued state and undervalued state depending on the position of the observed exchange rate to its fundamentally determined rate which is computed by sticky price exchange rate model. The model is implemented to four major currencies: Australian dollar, the Canadian dollar, the Japanese yen, and the British pound. Transition between the states are linked to risk adjusted excess return (the Sharpe ratio) of debt market and equity market returns of respected currencies in order to understand whether overvaluation and undervaluation is connected to the returns in these markets. The results provide evidence that the relationship between economic fundamentals and the nominal exchange rates are subject to change depending on the overvaluation or undervaluation of the currencies relative to their fundamentally determined rate of return. As an extension of the model, we found that the Sharpe ratios of debt and equity investments in the currencies influence the evolution of transitional dynamics of the exchange rates� deviation from their fundamental values.

Suggested Citation

  • Suleyman Hilmi Kal & Ferhat Arslaner & Nuran Arslaner, 2015. "The Dynamic Relationship Between Stock, Bond and Foreign Exchange Markets," Working Papers 1512, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
    • Handle: RePEc:tcb:wpaper:1512
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    File URL: https://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Publications/Research/Working+Paperss/2015/15-12
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    References listed on IDEAS

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    Cited by:

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    3. Abakah, Emmanuel Joel Aikins & Nasreen, Samia & Tiwari, Aviral Kumar & Lee, Chien-Chiang, 2023. "U.S. leveraged loan and debt markets: Implications for optimal portfolio and hedging," International Review of Financial Analysis, Elsevier, vol. 87(C).
    4. Neharika Sobti, 2018. "Domestic intermarket linkages: measuring dynamic return and volatility connectedness among Indian financial markets," DECISION: Official Journal of the Indian Institute of Management Calcutta, Springer;Indian Institute of Management Calcutta, vol. 45(4), pages 325-344, December.
    5. Mustafa Akay & Berat Bayram & Abdullah Kazdal & Muhammed Hasan Yilmaz, 2020. "Investigating Regime-Dependent Dynamics in Country Risk Premium: Evidence from Turkey and Emerging Markets," CBT Research Notes in Economics 2008, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
    6. Yip, Pick Schen & Brooks, Robert & Do, Hung Xuan & Vo, Xuan Vinh, 2022. "What drives cross-market correlations during the United States Q.E.?," International Review of Financial Analysis, Elsevier, vol. 83(C).
    7. Johnson, Leroy & Osabuohien, Evans, 2023. "Return and Volatility Connectedness in Foreign Exchange Markets of Sierra Leone," MPRA Paper 118135, University Library of Munich, Germany.
    8. Gözde YILDIRIM, Zafer ADALI, 2018. "Linear and Non-Linear Causality Tests of Stock Price and Real Exchange Rate Interactions in Turkey," Fiscaoeconomia, Tubitak Ulakbim JournalPark (Dergipark), issue 1.
    9. Arash Habibi & Chin Lee, 2019. "Asymmetric Effects of Exchange Rates on Stock Prices in G7 Countries," Capital Markets Review, Malaysian Finance Association, vol. 27(1), pages 19-33.

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    More about this item

    Keywords

    Bond price; Stock price; Exchange rate; Sharpe ratio; Wald ratio test; Likelihood test; Impulse-Response functions; Markov-Switching vector autoregressive model;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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