Exchange Rate Risk, Stock Transactions and Financial Integration: The Republic of Korea and Japan
This paper examines the short-run and long-run relation between volatility in the real effective exchange rate and stock returns in the Republic of Korea. A trivariate vector autoregressive model is estimated in which the Japanese stock market is included as a variable representing the influence of both international and regional capital markets. All three variables, namely, stock returns in Korea and Japan and the real effective exchange rate are found to be integrated of order 1. The Johansen cointegration test indicates no long-run relation between the variables. Granger causality, however, indicates short-run bidirectional causality between volatility in the real effective exchange rate and stock returns in Korea, between volatility in the real effective exchange rate and stock returns in Japan, and also between stock returns in Korea and Japan. Thus although no long-run relationship between the variables is found to exist, Granger causality indicates a short-term relationship between the stock market and the foreign exchange market in Korea, and also regional interdependence between the stock markets in Korea and Japan. Thus exchange rate policies and stock transactions in Japan will most likely have significant short-term effects on stock transactions in Korea.