Exchange Rate and Stock Price Interactions in European Emerging Financial Markets Before and after the Euro

Abstract

In this paper, we investigate price interactions between two main components of European emerging financial markets, namely the foreign exchange market and the stock market, before and after the adoption of the Euro by most European Union (EU) economies. We estimate and test a bivariate vector autoregressive model using daily observations on the stock price index and nominal exchange rate for Hungary, Czech Republic and Poland, during 2/1/1995 - 31/12/1998 for the pre-Euro period and 1/1/1999 - 31/12/2003 for the Euro period. We find that for the pre-Euro period, stock prices unidirectionally Granger-cause exchange rates in Hungary only; in the Czech Republic and Poland, mutually reinforcing interactions between exchange rates and stock prices seem to exist. During the Euro period, exchange rates unidirectionally Granger-cause stock prices in all the three sample economies. We also find higher positive correlations among the stock markets in Hungary, Czech and Poland during the Euro period than is the case in the pre-Euro period. Similar results are obtained with respect to the foreign exchange markets. These findings are consistent with the dynamic nature of the transition process, suggesting that causality and correlations are much more easier to detect as the markets become more integrated with the EU.

Keywords: European emerging financial markets, foreign exchange rates, stock prices

JEL Classification: G210, D240