Volatility spillovers between real exchange rate returns and real stock price returns in Malaysia

• Date: 01 January 2019
• DOI: http://doi.org/10.1002/ijfe.1653
• Published date: 01 January 2019
• Author: Hock Tsen Wong

RESEARCH ARTICLE

Volatility spillovers between real exchange rate returns and

real stock price returns in Malaysia

Hock Tsen Wong

Faculty of Business, Economics and

Accountancy, Universiti Malaysia Sabah,

Kota Kinabalu, Sabah, Malaysia

Correspondence

Wong Hock Tsen, Faculty of Business,

Economics and Accountancy, Universiti

Malaysia Sabah, Jalan UMS, 88400 Kota

Kinabalu, Sabah, Malaysia.

Email: htwong@ums.edu.my

Funding information

The UMS Research Grant Scheme 2017 –

Priority Field Research Scheme, Grant/

Award Number: SBK0328‐2017

Abstract

This study analyses volatility spillovers between real exchange rate returns and

real stock price returns in Malaysia. The component‐generalized autoregressive

conditional heteroskedasticity model with asymmetric effect is used to decom-

pose volatility into permanent or long‐run component and transitory or short‐

run component. Permanent and transitory components of volatility are

commonly high in the global financial crisis, 2008. The results of the seemingly

unrelated regressions framework show that volatility spillovers of permanent

component between real exchange rate returns and real stock price returns

are stronger than volatility spillovers of transitory component between real

exchange rate returns and real stock price returns. Moreover, volatility spill-

overs of permanent and transitory components between real Malaysian ringgit

against the U.S. dollar return and real stock price returns are stronger than real

Malaysian ringgit against the Japanese yen exchange rate return and real stock

price returns. There is some evidence of Granger causality between real

exchange rate returns and real stock price returns. On the whole, there is some

evidence of the link between the exchange rate market and the stock market in

Malaysia.

KEYWORDS

component‐generalized autoregressive conditional heteroskedasticity (C‐GARCH) model with

asymmetric effect, Granger causality, permanent component, real exchangerate return, real stock

price return, seemingly unrelated regressions (SUR) framework, transitory component

1|INTRODUCTION

There is a huge literature on financial asset return, which

is important for asset pricing, portfolio selection, hedging,

and market risk management. International portfolio

investment involves exchange rate, and therefore, change

in exchange rate can affect stock price (Leung, Schiereck,

& Schroeder, 2017). The exchange rate market and the

stock market shall be connected given that change in

exchange rate would affect international trade, which in

turn would affect profit of firms and thus their stock

prices. The variation of stock price would affect

international portfolio investment and consequently

capital movements (Reboredo, Rivera‐Castro, & Ugolini,

2016). Financial liberalization and globalization intensify

the linkages among financial markets within and across

countries. There are many studies on the relationship

between the exchange rate market and the stock market

as the relationship between both markets can explain

some of changes in the markets. There are two main the-

oretical approaches in the literature to explain the inter-

dependence between exchange rate return and stock

price return, namely, the flow‐oriented approach and

the stock‐oriented approach. The flow‐oriented approach

Received: 3 May 2018 Revised: 6 August 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1653

Int J Fin Econ. 2019;24:131–149. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 131

(Dornbusch & Fischer, 1980) explains that given the

Marshall–Lerner condition, depreciation of real exchange

rate can increase international competitiveness of domes-

tic firms and make domestic firms export more and there-

fore make more profit. This improves trade balance and

stimulates real economy through profitability of domestic

firms and increases stock prices of domestic firms in the

stock market. Conversely, depreciation of real exchange

rate increases importing cost of domestic firms, and this

reduces sales and profit of domestic firms. This will

reduce stock prices of domestic firms in the stock market.

Thus, the impact of exchange rate on stock price can be

either positive or negative (Caporale, Hunter, & Ali,

2014; Dornbusch & Fischer, 1980; Pan, Fok, & Liu,

2007; Ülkü & Demirci, 2012). On the other hand, the

stock‐oriented approach (Branson, 1993) explains that

exchange rate reacts to increase in demand for financial

assets. A bullish in the domestic stock market will attract

capital inflows to invest in the domestic stock market,

and this will increase stock prices and the net‐worth of

domestic firms, which will expand their production and

sale. This will increase aggregate demand in the econ-

omy, which will increase interest rate and induce more

capital inflows from abroad. Capital inflows can lead to

appreciation of exchange rate, whereas capital outflows

would lead to depreciation of exchange rate (Branson,

1993; Frankel, 1983; Moore & Wang, 2014; Tsagkanos &

Siriopoulos, 2013; Ülkü & Demirci, 2012). There is no

consensus on the relationship between exchange rate

return and stock price return (Lin, 2012; Sui & Sun,

2016; Tsai, 2012). An extensive literature strongly sug-

gests that the flow‐oriented approach is significant in

many cases, and it has been widely accepted (Naresh,

Vasudevan, Mahalakshmi, & Thiyagarajan, 2018).

The research in the relationship between exchange

rate and stock price is mainly on the relationship between

return and not volatility. The relationship between

exchange rate return and stock price return implies an

unexpected event in one market would influence both

return and volatility in other market. The development

and integration of financial markets shall increase the

relationship and volatility spillovers among financial

markets. Volatility spillovers across financial markets

can influence the stability of the monetary policy

(Harrison & Moore, 2009). The information of volatility

spillovers across financial markets can improve market

agents in assessing the risk of various financial products

and helping them to develop hedging strategies (Ng,

2000; Yavasa & Dedi, 2016). Nonetheless, the link

between volatility spillovers between exchange rate

return and stock price return is relatively limited (Naresh

et al., 2018). Exchange rate volatility could influence

financial markets and real economy. The balance sheet

of firms and portfolios of investors would be affected.

Speculative traders can influence transitory component

of exchange rate volatility and the fundamental factors

can influence permanent component of exchange rate

volatility (Tule, Dogo, & Uzonwanne, 2018).

This study examines volatility spillovers between real

exchange rate returns and real stock price returns in

Malaysia. Real exchange rate return is real Malaysian

ringgit (RM) against the U.S. dollar exchange rate return

and real RM against the Japanese yen (Yen) exchange

rate return. Real stock price returns are returns of the

stock market of Malaysia and some stocks of the technol-

ogy/infrastructure/finance sectors, consumer products

sector, industrial products sector, construction sector,

trading/services sector, properties sector, and plantation

sector. All the stocks are selected from the list of Sha-

riah‐compliant securities (Securities Commission Malay-

sia, 2018). The period of this study covers from October

2000 to March 2017. Islamic finance is an alternative

finance to conventional finance. Islamic finance differs

from conventional finance in terms of financial products

and principles. Muslim investors are prohibited to invest

in non‐Shariah‐compliant securities such as companies

involve in interest rate or riba, gambling, and illicit and

unethical business activities (Majdoub & Sassi, 2017;

Majdouba & Mansour, 2014; Mansour, Khoutem, &

Majdoub, 2015; Securities Commission Malaysia, 2018).

The Islamic finance industry is an important and growing

industry (Ahmeda & Elsayed, 2018; Global Islamic

Finance Report, 2017). Malaysia is a predominantly Mus-

lim country (Rahim & Masih, 2016). Moreover, Malaysia

is one of the leading countries in Islamic finance (Thom-

son Reuters, 2017). Malaysia has strong trade with the

United States and Japan. In 2016, the total trade of the

United States and Japan to total trade of Malaysia was

9.1% and 8.1%, respectively (Ministry of Finance Malay-

sia, 2017). The U.S. dollar and the Japanese yen are major

currencies in the world (Ito & Kawai, 2016). Therefore, it

is worthwhile to investigate volatility spillovers between

real exchange rate returns of the U.S. dollar and the Jap-

anese yen and real stock price returns of Shariah‐compli-

ant companies in Malaysia. This can provide some

knowledge on portfolio diversification among Shariah‐

compliant companies for Muslim and non‐Muslim inves-

tors and market participants in Malaysia. There is limited

study on volatility spillovers between permanent and

transitory components of real exchange rate return and

real stock price return. The component‐generalized

autoregressive conditional heteroskedasticity (C‐GARCH)

model with asymmetric effect is used to decompose time‐

varying volatility of real exchange rate returns and real

stock price returns into permanent or long‐run and tran-

sitory or short‐run components (Engle & Lee, 1993). The

132 WONG