Exchange Rates and Stock Prices: Implications for European Convergence

The aim of this paper is to investigate whether stock prices and exchange rates are related and whether there is evidence of convergence in the structure of this relationship across members of the European Union (EU). We then examine if this relationship differs, depending on whether the system of finance prevalent in a particular country is financial market based or dominated by the banking system. Given the differences between the financial systems in some European countries, the result is of importance to those countries that have joined the European Single Currency and those attempting to converge their economies in preparation for joining at a later date, such as the UK. Stock prices have been used extensively to explain and predict the exchange rate over recent years, as they reflect capital movements between stock markets. Equities have been incorporated into a number of empirical studies of the exchange rate and in general are shown to have a highly significant effect. The exchange rate model used in this study is a simple dynamic bivariate asset parity model, which can be derived from Roll's (1979) model. Following a discussion into the differing nature of the financial systems across the EU, the model and results from the empirical tests are discussed and finally there is a summary and a discussion on the policy implications.