The effect of NAFTA on the relationship between stock returns and exchange rate volatility

There is an extensive literature on the economic consequences of free trade agreements, which includes the impact of free trade agreements on international trade flows; the effect on exchange rates; and the impact on equity markets of the member countries.  A separate issue that has received much attention in the literature is the relationship between stock prices and foreign exchange rates.  The direction of causality between variables is not quite clear.  On the one hand, good-market models of exchange rate determination imply that changes in exchange rates cause changes in stock prices.  The rationale is that changes in the exchange rate affect output and input prices thus impacting firms’ profits, which in turn affect firms’ stock prices.  On the other hand, the asset-market theory suggests that changes in stock prices cause changes in exchange rates through expectations of future asset prices.  Of course, a third possibility is that there is bidirectional causality between changes in foreign exchange rates and stock price movements

In this paper, we bring two strands of research together, one being the effect of free trade agreements on stock and foreign exchange markets and the other being the relationship between exchange rates and stock prices.  The main issue examined in this paper is whether free trade agreements impact the relationship between stock return volatility and exchange rate volatility.  We analyze empirically the effect of NAFTA on the spillover of volatility between the Canadian and U.S. equity and foreign exchange markets.  We use daily data and a multivariate GARCH specification with time-varying variance/covariance BEKK model.  We test whether the conditional correlation between stock return volatility and exchange rate volatility in Canada and the U.S. increased, decreased, or was unaffected by the formation of NAFTA in 1994.