New Shocks, Exchange Rates and Equity Prices
IMF Working Papers, December 1, 2008
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Bibliographic details
- Authors: Pietro Cova, Alessandro Rebucci, Akito Matsumoto, Massimiliano Pisani
- Published: December 1, 2008
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451871425.001
Summary and main findings
- Study focus: exchange rate and equity price dynamics in general equilibrium with news shocks about future productivity and monetary policy.
- Key identification: a condition under which asset prices become more volatile without affecting the volatility of the underlying processes — a positive correlation between news and current shocks.
- Explanation: the same positive correlation condition explains why persistent underlying processes generate volatile asset prices.
- Additional result: the correlation between exchange rate and equity returns depends critically on the currency denomination of the equity return and the monetary policy reaction to productivity shocks.
- Empirical performance: the model matches second moments of exchange rate and equity returns for major floating currencies.
Model mechanisms and theoretical insights
- News shocks considered: information about future productivity and future monetary policy.
- Essential condition for increased asset-price volatility: positive correlation between news shocks and contemporaneous (current) shocks.
- Role of persistence: persistent underlying processes amplify asset-price volatility when combined with the identified correlation structure.
- Determinants of exchange rate — equity return correlation:
- Currency denomination of the equity return.
- Monetary policy reaction to productivity shocks.
Empirical fit and scope
- The model is reported to do well at matching second moments of exchange rate and equity returns for major floating currencies.