The correlations between volatility in cross-currency rates and other financial markets such as equities are not as clear-cut as one might imagine. The dynamic relationships existing between currencies and equities is sufficiently complex, to warrant an in-depth study of how each component affects the other, and is in turn impacted by other market forces. For starters, it's important to understand what creates volatility in currency markets.
From an elementary perspective at least, it is clear that anything which causes a currency to strengthen relative to other currencies will impact volatility and exchange rates. For example, If the European Central Bank (ECB) embarks upon an aggressive policy of monetary tightening, it will enact measures designed to strengthen the euro relative to other currencies such as the USD, CAD, JPY, ZAR and so forth.
Monetary tightening measures are designed to reduce the money supply in order to boost its value. Central banks have several tools available to do such things, including interest-rate hikes. There is an unambiguous correlation between interest-rate hikes and volatility. If the ECB raises interest rates, and the Fed does nothing, the EUR will be stronger relative to the USD, all things being equal.
When currencies are discussed, it's important to speak of strengths and weaknesses in relative terms. A strengthening of the USD for example (by way of an interest-rate hike) will make the dollar stronger against the EUR, but the EUR will remain stronger than the USD overall, all things being equal. This rather rudimentary explanation of relative strengths and weaknesses serves to increase or decrease volatility in the currency markets.
Developing economies such as Brazil, Russia, India, China, and South Africa (BRICS countries) typically take their cue from the developed economies since much of the foreign direct investment flowing into these nations comes from the likes of the US, the EU, Canada, Australia, Japan and the like.
The multinational conglomerates with deep roots in developed countries and developing countries have a tremendous influence on the performance of bourses around the world. It is fair to say that a strengthening of the USD, EUR, GBP, or AUD relative to another currency such as the Nigerian naira will make stocks in Nigeria worth relatively less on international markets.
The impact of this is perhaps best exemplified by the ongoing dilemma faced by the UK vis-a-vis the Brexit issue. Many UK companies operate in Europe and are listed on European bourses. When Brexit fears are stoked, the GBP loses value relative to the EUR. This means that foreign-denominated earnings from companies listed abroad are worth more in GBP terms. However, if the geopolitical situation is such that the GBP is strengthening relative to the EUR, then EUR earnings abroad will be worthless in GBP terms for people in the UK.
The same logic applies to markets in Africa, particularly during times of increased volatility. When stock markets convert earnings into reserve currency like the USD, GBP, or JPY, those earnings are dependent upon the currency cross exchange rate between the Nigerian naira and the USD, etc. A stronger home currency means that the respective value in foreign currency is more. A weaker home currency means that the respective value in the foreign currency is less.
There is currently no linear relationship between currency volatility and stock prices per se, although lots of interesting analyses can be drawn. One such study by Bollerslev (1990), Baillie and Bollerslev (1990), Engle, Ito, and Lin (1990)) found that there was no specific role ascribed to currency markets and equities markets in terms of interdependencies. Upon closer examination, it is clear that there are in fact spillovers between equity markets and currency markets, and the two are indeed linked in obtuse ways.
Each currency purchase drives up demand for a particular currency while simultaneously reducing demand for the currency being sold. This is what creates relative strengths and weaknesses. This transmission mechanism certainly has a part to play in how financial markets operate. For example, if US investors decide to divest from the local market and diversify their portfolio into the Nigerian stock market, this would result in a transmission mechanism which sold USD denominated assets and purchased naira-denominated assets. It is clear that this would have a positive overall effect on Nigerian stock prices. From a currency perspective, greater demand for Nigerian stocks instantly boosts demand for the naira. Foreign investors exchange their forex for Nigerian naira for purchasing stocks on the exchange. Increased demand for the naira leads to a more favourable exchange rate.
Nowadays, the volatility in currency markets is used for financial gain on trading volumes estimated at approximately $5 billion daily. Individuals, small businesses, medium businesses, and large businesses engage in cross-currency exchanges around the clock, to facilitate trading of goods and services, and monetary transfers a.k.a. remittances with international money transfer organisations. Countries like Nigeria are seeing large inflows of FDI and remittances from migrant workers abroad and from the burgeoning petroleum industry at home. As forex flows from abroad into Nigeria, it increases overall economic activity and boosts the exchange rate of the local currency.
Today, a shift has taken place whereby much of the foreign currency transfers for remittances are being conducted through companies like TransferWise, Western Union and the like. Banks are profiting to the tune of approximately 11% on the spread and transactions fees, leading many everyday folks to purchase their currencies and transfer them via non-bank entities. Whether it is for remittances, investing in foreign stock markets, or simply to diversify into different asset holdings, cross-currency exchanges are now incredibly popular.
Developing economies may want to retain weaker currencies in order to facilitate a robust export-driven market. This occurs when goods and services are relatively cheaper to overseas buyers. China is a classic example of an industrial juggernaut that artificially maintains a weak currency to boost its export potential. Nigeria’s economy is largely driven by crude oil and natural resources which are dependent on market rates for commodities denominated in USD.
Countries do not always want their currencies to be stronger than the competition since this hurts export markets, although it makes imports much more affordable. From the perspective of FDI and remittances to Nigeria, there is a clear correlation between inflows and the impact on the naira: appreciation. It is worth pointing out that global remittances contribute significantly to the volume of currency trading activity.
Currency cross rates can increase or decrease demand for Nigerian assets (stocks, commodities, indices and forex), but the precise relationship is never clear cut, owing to the complexity of the financial markets. Other important factors also come into play such as political stability, regulation, corruption, rights bestowed on foreign businesses, inflationary pressures et al.
About The Author
*Neil Obrea is an investment advisor and a prolific stocks trader with over 10 years of experience in global finance and macro-economics, Neil’s areas of expertise include business, investing and communications. Neil can be reached via e-mail: firstname.lastname@example.org