A long-run relationship between stock price index and exchange rate: A structural nonparametric cointegrating regression approach

In this paper we estimate the relationship between stock prices and exchange rates in EU and USA during the period of recent financial crisis (2008-2012) and compare the results with those in a previous period where stock markets were operating under normal conditions. According to the portfolio balance effect theory in periods of financial crisis there is a causal relationship from stock returns to exchange rate returns. Previous studies detect this relationship in short-run but not in long-run level. However, they use, for testing the long-run relationship, standard linear cointegrating regression models that suffer from biased estimations and cannot detect non-linear relationships. To overcome these problems, we examine the long-run relationship adopting a more advanced econometric model, the structural nonparametric cointegrating regression. The results exhibit a causal relationship from stock prices to exchange rates that is long-run in EU and short-run in USA. The finding of long-run relationship with this direction is particularly important because it is presented for first time in relative literature and shows the need for a new pattern of economic policy in EU. (C) 2013 Elsevier B.V. All rights reserved.