Stock market information and the relationship between real exchange rate and real interest rates

Abstract

In this article, we propose to augment the traditional relationship between real exchange rates and real interest rates (RERI) by adding the stock market equilibrium condition to it. We introduce the relative dividend yield as the new information variable. In the empirical analysis, we use recent monthly observations from the UK, Japan, Canada and Eurozone, all relative to the US. We show that the introduction of stock market information is highly relevant to the functioning of the RERI hypothesis. Based on the results from the cointegration analysis, the role of relative stock market performance is especially important in the short-term (3-month) horizon, where the augmented RERI representation is most strongly supported.

Keywords:

• RER
• real interest rates
• stock markets
• cointegration

JEL Classification:

• E44
• F21
• F31
• F41

Acknowledgments

This study is part of the research program of the Oulu Macroeconomic Group (OMaG), and the financial support from the Yrjö Jahnsson foundation and the OP-Pohjola research foundation for the launching of the OMaG is gratefully acknowledged.

Notes

1 Theoretical details of the original, pure RERI hypothesis are given in the next section.

2 As emphasized by Baxter (1994), it is important to differentiate between the ex ante and ex post measures at this point. For example, in terms of ex ante values for the RERI, if the euro RER is above its long-run level against the US dollar, the euro is expected to depreciate in real terms in the future, and to equate the ex ante real returns between the Euro area and the US, the ex ante real return on the euro-denominated securities must exceed the corresponding return on the US securities by the expected real devaluation of the euro over the term of the securities. Hence, there is a predicted link between the level of the RER and the ex ante relative real interest rate.

3 For the more recent studies, see, e.g. Malliaropulos (1998), Hau and Rey (2006), Mercereau (2006), Andersen et al. (2007), Pavlova and Rigobon (2007), Matsumoto et al. (2008) and Engel and Matsumoto (2009).

4 Note that we wish to define inflation differential here as the difference between the domestic and foreign inflation rates, because it suits better to Equation 1, even though in the equation right above the differential is given the other way around.

5 Put more precisely, our specification of the Euler equation follows the Romer (2006, pp. 54–56) presentation for household behaviour, assuming that household consumption growth is strongly connected to the expectations of future aggregate economic activity (see also the introduction in Cochrane (2006)).

6 A somewhat similar representation has previously been analysed by Malliaropulos (1998), but not by using the same kind of stock market information we emphasize, i.e. the dividend yield data.

7 This is analogous to the flexible price equilibrium value.

8 In Datastream the dividend yield is calculated based on the equation , where d_t is the aggregate dividend yield on day t (and we use the values for the last trading day in each month), D_t is the dividend per share on day t, N_t is the number of shares in issue on day t, P_t ^s is the unadjusted share price on day t and n is the number of constituents in the index. The useful data on dividend yields for our purposes are calculated for the shares quoted only in the domestic market of each of the analysed countries, and these series are available from Datastream.

9 The use of a 3-year period for the long-term (10-year) real rate calculations was based on the empirical finding that the expected values of inflation generated from the rolling AR-procedure did not change materially when moving from the 36-month horizon to the longer horizons, so the 10-year horizon values were very close to the 3-year horizon values.

10 For similar kinds of arguments on the inference from the unit root test results for RERs, see Engel (2000).

11 For this kind of preliminary regression based analysis of parity-type relationships see Ang and Bekaert (2007).

12 Our main decision rule in judging between the various restricted versions was that the most preferable representations are the ones where the most stringent restrictions on the most extensive (i.e. augmented) model are passed at the 5% significance level of the LR-test statistics. For example, when deciding between the most suitable cointegration vector for the Japanese ex post long-term data, the choice was between versions Equations 1 and 4 (see Table 5) and because the augmented model with freely estimated parameter values for the dividend yield spread and constant terms was clearly approved, we chose the representation based on Case 1 as the most preferable one.