This paper uses the Gregory and Hansen (1996) cointegration test and the bounds testing approach to
cointegration, which was developed by Pesaran et al. (2001) to examine the existence of long-run
relationship and Granger F-tests to examine any causal relationship between exchange rates and stock
prices in four South Asian countries. The study finds that there is no long-run equilibrium relationship
between these two financial variables in three of the four countries studied. Exchange rates, Grangercause
stock prices in India in both the long-run and short-run and in Pakistan in the short-run.
This paper examines the relationship between exchange rates and stock prices for India,
Pakistan, Sri Lanka and Bangladesh within a cointegration and causality framework using
daily data over the period 1995 to 2001. This is an important research issue for several
reasons. First, from a theoretical standpoint, the interest parity condition suggests that
changes in exchange rates should give rise to changes in stock prices, but portfolio
approaches suggest that changes in stock prices lead to changes in exchange rates. Second,
from a practical investor perspective the relationship between stock prices and exchange
rates is often used by fundamental investors to predict future trends in the other variables
(Nieh and Lee 2001). Third, both exchange rates and stock prices have an important role
in influencing the development of emerging markets which have expanding corporate
sectors with listed firms and growing tradable sectors sensitive to exchange rate policies
(Abdalla and Murinde 1997).
Until relatively recently most research has concentrated on the exchange rate-stock
price nexus in developed markets. The limited empirical evidence available for emerging
markets has reached mixed conclusions suggesting that there is scope for further studies.
Of the existing literature for emerging markets, most studies focus on Asian countries.
Abdalla and Murinde (1997) found that exchange rates Granger-cause stock prices in
South Korea, Pakistan and India, but that the stock price Granger causes the exchange rate
in the Philippines. Ajayi et al. (1998) found that in philippines and Indonesia Granger
causality runs from the stock market to the currency market, in South Korea causality runs
from the currency to the stock market and that in Hong Kong, Singapore, Malaysia and
Thailand there was no significant causal relationship. For the Asian crisis period
(1997-1999), Granger et al. (2000) found that the exchange rate Granger causes the stock
price in South Korea; neutrality between the two series in Indonesia and that stock prices
Granger cause exchange rates in Hong Kong, Malaysia, Philippines, Singapore, Thailand
and Taiwan. |
