Two theories attempt to explain the relationship between exchange rates, real economic activity, and equity markets.

1. Traditional Trade Theory

• This is the traditional view of the J-Curve effect.
• The value of the domestic currency and the performance of the domestic stock market are positively correlated in the short run but negatively correlated over the long term.

3. Model Demand Model

• Theorizes the following sequence:

• Real economic growth spurs domestic currency demand.

• More demand translates to appreciation in the international currency markets.

• The stock market responds positively to real economic growth.

• The money demand model indicates that domestic currency values and domestic stock markets are positively correlated.

Reality and Exchange Rate Movements

Developed Markets:

• Correlations between domestic exchange rates and domestic stock markets can be positively, negatively or zero correlated.

• Reasons:

• Only changes to real exchange rates impact trade terms.

• Different countries will have a different mix of exporters and importers in their stock markets, causing different responses to exchange rate movements.

• Real exchange rate movements have opposite short term and long term impacts, so the equity market response depends on the view taken by market participants.

• Real exchange rate movements have opposite short term and long term impacts, so the equity market response depends on the view taken by market participants.

Emerging Markets:

• Emerging equity market returns tend to correlate positively with domestic currency exchange rate movements against developed market currencies.

• Reasons:

• Emerging economies are heavily reliant on foreign capital for financing.

• Real currency appreciation signals economic strength.

• Emerging market stocks and currencies are positively correlated with domestic economic and political outlooks.

• Foreign investor face high risk in the positive correlation environment of emerging markets, because they will suffer losses on both the declining equity prices and depreciating local currencies of the equities.