Dynamic Relations between Stock Price and Exchange Rate: Evidence from South Asia

International Journal of Economics and Financial Issues ISSN: 2146-4138 available at http: www.econjournals.com International Journal of Economics and Financial Issues, 2017, 7(3), 331-341. Dynamic Relations between Stock Price and Exchange Rate: Evidence from South Asia Mostafa Ali1,2,*, Gang Sun3 Dongbei University of Finance and Economics, Dalian, P.R. China, 2Department of Finance, University of Chittagong, Chittagong, Bangladesh, 3Dongbei University of Finance and Economics, Dalian, P.R. China. *Email: 1 ABSTRACT Our study strives to explore the dynamic association between stock price and foreign exchange rate by taking daily data for a period of January 1, 2009 to June 30, 2015. We employ bivariate vector auto regression model as well as vector error correction model to discover the short run and long run relationship between these two financial variables. We fail to uncover any short run or long run association between these two financial variables for Bangladesh but identify a unilateral causal relationship running from stock price to exchange rate in Pakistan. Moreover, we find a long run negative relation that leads from exchange rate to stock price and a short run unidirectional causal linkage running from stock price to exchange rate in India. Granger causality test results confirmed these findings. The empirical findings of the study do not provide any precise evident in favor of portfolio hypothesis or goods market hypothesis but a mixed interaction of all theories. Keywords: Dynamic Relations, Stock Price, Exchange Rate, Vector Error Correction Model JEL Classifications: C32, E44, F31, G15 1. INTRODUCTION Stock market is the barometer of measuring the economic health of any country. The economic environment is mirrored in the stock market movements. In this globalization era, it is very challenging as well as complex to explain the underlying reasons of the volatility of the stock market as it is influenced by both domestic and international financial and economic activities. Among various international events, international trade and flow of funds are the major cause of volatility in the economic sector, particularly in the stock market. Exchange rate plays dominating role in international trade and flow of funds. The importance of exchange rate has also increased largely in today’s globalized world for transfer of capital among and between countries which has influenced on stock price as well. Because of its sheer importance and role in prompting the advancement of economies, many academicians, economists, professionals, policymakers and researchers pay great attention in determining the association between stock price and exchanger rate. There are two main approaches that explain the relationship between these two variables namely; (i) flow-oriented model (also known as either goods market hypothesis or traditional approach) (ii) portfolio balance approach (also known as stock-oriented model). Flow oriented model suggested by Dornbusch and Fischer (1980) posits that change in the value of domestic currency will change the price of local products which will change the international competitiveness and current account balances and therefore effect on the profitability as well as outputs of the multinational companies and their stock prices. So this model concludes that causality runs from exchange rate to stock price but it should be mentioned here that the sign of this causal direction depends on whether the economy is an import or export dominated one. On the contrary, portfolio balance model (Branson, 1983; Frankel, 1983) proclaims that there is a negative correlation between exchange rate and stock price and stock price leads exchange rate. In this model, volatility in stock price causes variability in exchange rate that forces investors to adjust their portfolios. A boom capital market attracts foreign capital flow by encouraging foreign investors which boost demand for local currency. As a result, increase in stock price is associated to appreciation in foreign exchange rate. The opposite is also true for the bear capital market. International Journal of Economics and Financial Issues | Vol 7 • Issue 3 • 2017 331 Ali and Sun: Dynamic Relations between Stock Price and Exchange Rate: Evidence from South Asia Given the importance and the role of stock market and foreign exchange market, the present study investigates the dynamic relations between stock price and exchange rate in three major South Asian economies (such as Bangladesh, India, and Pakistan) to uncover its dynamic characteristics by employing traditional vector auto regression (VAR) methodologies. Unveiling such dynamic properties of these two markets may provide potential implications for different stakeholders. In addition, such information about dynamic associations between these two markets can help in the understanding of their possible causal relations. Some of the fundamentals characteristics of these three economies are documented in Table 1. These three economies can be significantly distinguished from each other in terms of degree of openness, size of the economy, exchange rate regime, development and maturity of financial markets. The capital market of India and Pakistan is more developed than that of Bangladesh but regarding to the capital restrictions and control, Bangladesh is more favorable than that of India and Pakistan. All of these reasons encourage the authors to reexamine the dynamic relationship between stock price and exchange rate in three major South Asian economies. Only a few literatures are available for the South Asian countries which report contradictory findings. The divergences of research findings motivate us to investigate the dynamic relationship between stock price and exchange rate in South Asian countries. However, this study can be distinguished from the existing literatures in following ways. First, this is the first study on South Asia after the global financial crisis. We use the most updated daily data covering from January 1, 2009 to June 30, 2015. Second, this paper simultaneously investigates short run and long run dynamic relations between stock price and exchange rate by employing VAR methodology. We pay great attention to choose lag order on which most of the prior researchers did not focus. Finally, we check the robustness of the findings of this study by employing different econometric tools including bivariate VAR, vector error correction model (VECM), Granger causality tests, variance decomposition analysis, and ımpulse response analysis. The objective of this study is to explore the dynamic relationship between stock price and exchange rate in three major South Asian countries. Our empirical results reveal a negative long run relation that leads from exchange rate to stock price as well as a short run causal relation from stock price to exchange rate in India. Our study also finds a short run unidirectional relation running (...truncated)