The role of exchange rate fluctuations in the volatility and correlations in emerging markets

The recent episodes of sanctions on Russia by international communities and the quantitative easing by Japanese and European central banks highlight the importance of foreign exchange risk for international investors. This paper examines how and to what extent the volatility of exchange rate affect the volatility of local equity market for Latin American countries and transition economies. Compared to Mun [15], we find that the proportions of volatility of local equity market attributable to exchange rate fluctuations for Latin American countries and transition economies are much larger than those for more developed economies. Besides, an increase in exchange rate volatility is associated with an increase in the correlation between the local and the US equity markets for Latin American countries but with a decrease in the correlation for transition economies, both to a larger extend than developed countries. In particular, our study indicates that the sign of the conditional correlation coefficient between exchange rate and local equity market varies across countries and time, inconsistent with the prediction by the so called "equity parity condition" in Hau and Rey [8].