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2. Literature Review
In the existing literature in finance, the dynamic relationship between stock prices and exchange rates has drawn much attention from financial economists and practitioners since these two macroeconomics variables have influential impact on portfolio combinations for investors in financial markets. Most of the empirical literature examining the stock prices-exchange rates relationship focuses on examining this relationship for developed countries. In the past decade, however, more and more studies have studied this relationship based upon developed and emerging markets.
Classical economic theory suggests a relationship between the stock market performance and the exchange rate behavior. For instance, Dornbusch and Fischer (1980) put forward the “flow-oriented” model which suggests that changes in exchange rates affect international competitiveness and trade balances, thereby influencing real income and output. Stock prices, generally interpreted as the present values of future cash flows of firms, react to exchange rates changes and form the link among future income, interest rate innovations, and current investment and consumption decisions. Contrary to the “flow-oriented” model, Branson (1983) and Frankel (1983) put forward “stock-oriented” models of exchange rates. These models view exchange rates as equating the supply and demand for assets such as stocks and bonds. This approach gives the capital account an important role in determining exchange rate dynamics.
Frank and Young (1972) are the first investigation that examines the relationship between the stock prices and exchange rates. They use six different exchange rates and find no significant relationship between these two variables. Employing monthly data, Aggarwal (1981) examines the relationship between US stock market indexes
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and a trade-weighted value of the dollar for the period 1974-1978. He finds that the stock prices and exchange rates are positively correlated. In contrast, Soenen and Hanniger (1988) employ monthly data on stock prices and effective exchange rates for the period 1980-1986. They discover a strong negative relationship between the value of the US dollar and the change in stock prices. However, when they analyze the above relationship for a different period, they find a statistical significant negative impact of revaluation on stock prices.
Solnik (1987) examines the impact of several variables (exchange rates, interest rates and changes in inflationary expectation) on stock prices. He uses monthly data from 9 countries, including US, Japan, Germany, UK, France, Canada, Netherlands, Belgium and Switzerland. He finds depreciation to have a positive but insignificant influence on the US stock market compared to change in inflationary expectation and interest rate. Ma and Kao (1990) provide some insights into probable reasons for the different correlations between stock prices and exchange rates. They include six industrial economies to investigate the impact of changes in currency values on stock prices. Their results suggest that for an export-dominant economy, currency appreciation has a negative impact on the stock market, while currency appreciation boosts the stock market for an import-dominant country. The above early empirical studies have focused on the contemporaneous relation between stock returns and exchange rates.
Empirical works from the early stage focus on the linkage between the returns in the stock and exchange markets and does not use the levels of the series. Such a limitation was due to econometric assumptions about insufficient stationarity of financial data series. Stationarity is strictly required in regression analysis to avoid spurious inferences. By differencing the variables some information regarding a possible linear combination between the levels of the variables may be lost. The use
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of cointegration technique overcomes the problem of nonstationarity and allows an investigation of both the levels and differences of exchange rates and stock prices (Phylaktis and Ravazzolo, 2000). Bahmani-Oskooee and Sohrabian (1992) are among the first to use cointegration and Granger causality to explain the direction of mutual relationships between the two variables. They analyze the long-run relationship between stock prices and exchange rates using cointegration as well as the causal relationship between the two by using Granger causality test. They employ monthly data on S&P 500 index and effective exchange rate for the period 1973-1988.
They are unable to find any long-run relationship between these variables.
Rittenberg (1993) employs the Granger causality tests to examine the relationship between exchange rates changes and price level changes in Turkey. Since causality tests are sensitive to lag selection, therefore he employs three different specific methods for optimal lag selection. In all cases, he finds that causality runs from price level change to exchange rate changes but there is no feedback causality from exchange rate to price level changes. Bartov and Bodnor (1994) conclude that contemporaneous changes in the dollar have little power in explaining abnormal stock returns. In addition, they find a lagged change in the dollar is negatively associated with abnormal stock returns. The regression results show that a lagged change in the dollar has explanatory power with respect to errors in analysts’ forecasts of quarterly earnings.
Ajayi and Mougoue (1996) observe significant interactions in eight industrial economies during 1985-1991. More concretely, they reveal a negative short-run and positive long-run effect of increase in domestic stock prices on domestic exchange rates. However, domestic currency depreciation influences the stock market in a negative way in the short-run. Donnelly and Sheehy (1996) document a significant contemporaneous relation between exchange rate and the market value of large UK
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exporters. They attribute the difference between their findings and those based on US firms to (1) the UK is a more open economy than the US and (2) their focus on export-intensive firms.
Yu (1997) employs daily data on markets of Hong Kong, Tokyo and Singapore over the period from January 3, 1983 to June 14, 1994 and detects bidirectional relationship in Tokyo but no causation for the Singapore market. Abdalla and Murinde (1997) apply cointegration approach to examine the long-run relationship between stock prices and real effective exchange rates in four Asian countries—India, Korea, Pakistan and Philippines, using data from 1985 to 1994. Their study finds no long-run relationship for Pakistan and Korea but does find a long-run relationship for India and Philippines. Since a long-run association is found for India and Philippines, they use an error correction modeling approach to examine the causality for these two countries. The results show a unidirectional causality from exchange rate to stock price for India but for Philippines the reverse causation from stock price to exchange rate is found. Wu (2000) explores the effects on Singapore stock prices of Singapore-dollar exchange rates. The cointegration analysis suggests that for most of the selected periods in the 1990s both the Singapore dollar appreciation against the US dollar and Malaysian ringgit and depreciation against Japanese yen and Indonesian rupiah have positive long-run effects on stock prices. The influence of exchange rates on stock prices increases in a chronological order in the 1990s.
Phylaktis and Ravazzolo (2000) apply the cointegration methodology and multivariate Granger causality tests to a group of Pacific Basin countries over the period 1980 to 1998. Their evidence suggests that stock and foreign exchange markets are positively related and that the US stock market acts as a conduit for these links.
And these links are not found to be determined by foreign exchange restrictions. The general increase in international trade and the resultant increase in economic
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integration have also increased financial integration and reduced the benefit of international diversification.
Muhammad and Rasheed (2003) use monthly data from four South Asian countries, Bangladesh, India, Pakistan and Sri Lanka, and employ cointegration and error correction modeling approach to examine whether stock prices and exchange rates are related and the direction of causation if they are related. Their results show no long-run and short-run associations between stock prices and exchange rates for India and Pakistan. And there seems to be a bidirectional long-run causality between these variables for Bangladesh and Sri Lanka.
Yang and Doong (2004) explores the nature of the mean and volatility transmission mechanism between stock and foreign exchange markets for the G-7 countries. Evidence shows that movements of stock prices will affect future exchange rate movements, but changes in exchange rates have less direct impact on future changes of stock prices. Stavarek (2004) investigates the nature of the causal relationships among sock prices and effective exchange rates in four old EU member countries (Austria, France, Germany and the UK), four new EU member countries (Czech Republic, Hungary, Poland and Slovakia), and the United States. The results show much stronger relationship in countries with developed capital and foreign-exchange market (i.e., old EU member and the US).
Pan, Fok and Liu (2007) examine the dynamic linkages between the foreign exchange and stock markets for seven East Asian countries. Their results show a significant causal relation from exchange rates to stock prices for Hong Kong, Japan, Malaysia, and Thailand before 1997 Asian Financial Crisis. They also find a causal relation from the equity market to the foreign exchange market for Hong Kong, Korea and Singapore. Baharom, Habibullah and Royfaizal (2008) investigate the relationship between stock price and exchange rate pre and post Asian Financial Crisis
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(i.e., January 1988 to June 1997 and July 1998 to December 2006) for Malaysia. By employing Johansen cointegration test, they conclude that there is no evidence of long-run relationship between the two variables of interest in the pre-and post-crisis periods.
This study mainly focuses on the long-term relationship between stock prices and exchange rates. Our findings are consistent with Soenen and Hanniger (1988), Ajayi and Mougoue (1996) and Wu (2000), but in contrast to Ma and Kao (1990).
Such differences are probably due to the sample period and pattern of data (i.e., daily or monthly).
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