Exchange rates and the global transmission of equity market shocks

Abstract

With the capacity to amplify or buffer the effect of shocks between equity markets in different countries, exchange rates play a crucial role in the transmission of shocks. By modelling the dependence structure between exchange rates and equity markets, we quantify the impact of an equity market shock on other equity markets through the cross-expected shortfall and assess the contribution of exchange rates to shock transmission. For emerging Latin American countries (Argentina, Brazil, Chile and Mexico) and two developed markets (the EU and USA), we document (a) that the contribution of exchange rates to shock transmission is time-varying and differs across countries; and (b) that exchange rates diversify (echo) shocks from abroad for investors based in emerging (developed) economies. Our results suggest that investors need to accurately measure the diversification role of their currency when making international portfolio and risk management decisions