“Exchange Rates and Stock Prices Nexus in South Asia”

• Author: Muhammad Mansoor/Zahid Ali Akbar/Saima Nasir Choudhry/Kanwal Nawaz/Haroon Hussain/Hina Muneer

Introduction

Stock prices and exchange rates play a vital role in the development of economy of a country. The causal relationship between stock prices and exchange rate has received considerable attention in both developed and developing countries. Investors can use information of exchange rate to predict behavior of stock market prices.

Stock prices are effected by many factors like exchange rates, interest rates, current account, money supply, employment, gross domestic product, dividends, stock prices of other countries etc(Kurihara, 2006 p.376).The continuous increase in world trade and capital movements have made the exchange rates as one of the important factors that impact the business profitability and equity prices(kim,2003).

Firms are exposed to foreign exchange risk as a result of international trade activities. Exchange rate fluctuations affect input prices and assets denominated in foreign currencies (Bodnar and Gentry, 1993).Share prices of firms (engaged in foreign trade) are affected by changes in profits due to fluctuations in exchange rate. Firms engaged in foreign trade interact domestically with firms (with no foreign trade) hence indirectly affect their share prices. Bahmani-Oskooee and Sohrabian (1992) argue that through firms’ portfolio adjustments, changes in stock prices may affect exchange rates.

Linkage between these financial variables (stock prices and exchange rate) can be established through instruments of wealth, demand for money, interest rate and many other factors (Mishra, 2004).

According to economic theory, foreign exchange changes can have an important impact on stock prices as it effect cash flow, investment and profitability of firm. Traditional approach suggests that exchange rates lead stock prices.

According to portfolio balanced approach, exchange rates are determined by market mechanism that is changes in stock prices might have impact on exchange rate movements. Stock price is expected to lead exchange rate with a negative correlation, as decrease in stock prices reduces domestic wealth, which leads to lower domestic money demand and interest rates. Moreover decrease in domestic stock prices leads foreign investor to lower demand for domestic assets and domestic currency. Therefore capital outflows and depreciation of domestic currency is caused by these shifts in demand and supply of currencies.

Foreign investors become willing to invest in a country’s equity securities when stock prices rise. In this way they will get benefit from international diversification. This will lead to capital inflows and currency depreciation (Granger et al., 2000:p.338; Caporale et al., 2002; Pan et al, 2007).

Asset market approach to exchange rate determination suggests a weak or no association between exchange rates and stock prices. In this approach exchange rate is treated as price of an asset (that is price of one unit of foreign currency). Expected future exchange rates determine the exchange rates and factors affecting exchange rates and thus stock prices may be different(Muhammad and Rasheed,2002:p.536).

There is no consensus about the relationship of stock prices and exchange rate and empirical studies are inconclusive. Nature of relationship of these two financial variables is changing over time. The direction of causality remains unresolved because of econometric models, economic policies of countries and time period.

This paper attempts to examine how changes in exchange rates and stock prices are related to each other in South East Asian countries.

Stock prices and exchange rates play important roles in development of a country’s economy. Understanding the relationship between these two variables will help domestic as well as international investors for hedging and diversifying their portfolio. Investors diversify their funds across the emerging markets in order to minimize portfolio risk.

Emerging markets are more volatile than the well developed stock markets. Stock markets of emerging economies have recently been of vital importance to global investment community. The phenomenon of stock market and exchange rate nexus received substantial attention after East Asian financial crises. If there is any linkage between these variables then the crises can be averted either by managing exchange rate or by adopting policies to stable the stock market.

The causation between the two variables may be uni-directional or bi-directional. There is lack of theoretical and empirical consensus on relationship and direction of causation of these two financial variables. The directions of causality remain unresolved because of time period, economic models and economic policies of countries.

According to economic theory foreign exchange changes can have an important impact on the stock prices by effecting cash flows, investment and profitability of firm. Investors can use the information of exchange rate market to predict the behavior of stock market.

Literature Review

Several studies attempted to investigate the interaction between stock prices and exchange rates in the...