This paper is an attempt to examine the relationship between stock prices and exchange rates. By applying
the techniques of Unit-root test, Co-integration and the Granger causality test, the bivariate causality
between stock prices and exchange rates is analyzed. In this study the daily closing values of two popular
stock price indices (BSE Sensex, NSE Nifty) and Indian Rupee Exchange Rates are used for the period
January 1, 1995 to December 31, 2002. The results indicate that although there exists no long-term
causality between the stock market and rupee value, for the period of one year there has been a noticeable
and statistically significant causality from stock indices to rupee value. Also, there has been significant
reverse causality from rupee value to stock market for some years. The paper also analyzes the causality
for still shorter intervals i.e., for a period of six months and it was noticed that even though there is no
consistent relationship between the two markets, over the recent past, there has been a significant
causality from currency market to stock markets.
The relation between a country’s stock prices and its foreign exchange rates has been a
subject of theoretical and empirical investigations since the past two decades. An
exchange rate has two effects on stock prices (Agarwal, 1981: Ma and Kao, 1990), a direct
effect through multinational firms and indirect effect through domestic firms. In case of
a multinational firm involved in exports, a change in rate will change the demand of its
product in the international market, which ultimately reflects in its balance sheet as profit
or loss. Once the profit or loss is declared, the stock price will also change for a domestic
firm. On the other hand, currency devaluation could either raise or decrease a firm’s stock
prices. This depends on the nature of the firm’s operations. A domestic firm that exports
part of its output will benefit directly from devaluation due to an increase in demand for
its output. As higher sales result in higher profits, local currency devaluation will cause
firm stock price to rise in general. On the other hand, if the firm is a user of imported
inputs, currency devaluation will raise costs, and lower profits. Thus, it will decrease the
firm’s stock price.
From the viewpoint of microeconomics, an appreciation of the local currency most
likely will decrease the company’s profit, and hence its stock price. Likewise, from the
perspective of macroeconomics, an appreciation of the local currency under a flexible
exchange rate regime will lessen the competitiveness of its product and lower its stock
price. From both viewpoints, exchange rate change is expected to lead to stock price
change, and it is known as the traditional approach1 (Granger, Huang, and Yang 1998). |
