24-03-2014, 10:30 AM
Relationship between Exchange rate and Stock Indices
Exchange rate and Stock .docx (Size: 41.04 KB / Downloads: 15)
Abstract
Stock market and foreign exchange market are the barometers of the Economy and both the markets are sensitive segments of the economy. Any changes in the policies of the country are quickly reflected in these markets. There are different factors, which affect the stock markets like interest rates, company performance, future growth prospects, inflation, political stability, exchange rates etc. There are different factors, which affect the Exchange rates are like the flow of capital between nations, inflation, interest rates, faith in government's ability to protect the value of currency, speculation etc.
But in this era of financial integration, there is a lot of movement of funds between the markets and have ushered in a sea change in the financial architecture of the Indian economy.
This study attempts to analyze the interlinkages between exchange rates and stock prices. The study is conducted by considering exchange rates and various indices form 2001 to 2006. This is analyzed by using statistical tools like Augmented Dickey Fuller Test and Johnson’s Co-integration test by taking 4 day lag. From the results it is clear that there is no significant relationship between the exchange rates and index values.
Introduction
Globalization and financial liberalization in India have brought about battery of changes in the financial functioning of the economy, as a result of which, the resultant gain of the global integration of domestic and foreign financial markets has thrown open new opportunities but at the same time exposed the financial system to significant risks.
Consequently, it is important to understand the mutual relationship between the financial markets from the standpoint of financial stability. Though the inception of the financial sector reforms has taken place initiated in the beginning of the 1990s, particularly since 1997, there has been a dramatic change in the functioning of the financial sector of the economy.
The recent emergence of new capital markets, the relaxation of foreign capital controls and the adoption of more flexible exchange rate regimes have increased the interest of academics and practitioners in studying the interactions between the stock and foreign exchange markets. The gradual abolition of foreign exchange controls in emerging economies like India has opened the possibility of international investment and portfolio diversification. At the same time, the adoption of more flexible exchange rate regimes by these countries in the late 1980's and early 1990's has increased the volatility of foreign exchange markets and the risk associated with such investments.
Exchange Rate:
The Exchange rate or FX rate is the rate between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 33 Indian Rupees (IND, Rs.) to the United States Dollar (USD, $) means that IND 33 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 2 trillion USD worth of currency changes hands every day.
The Spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
Foreign Exchange Market:
The foreign exchange market exists wherever one currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The trade happening in the forex markets across the globe currently exceeds US$1.9 trillion/day (on average). Retail traders (individuals) are currently a very small part of this market and may only participate indirectly through brokers or banks.
The foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed.
The retail market for foreign exchange deals with transactions involving travellers and tourists exchanging one currency for another in the form of currency notes or travelers’ cheques. The wholesale market often referred to as the interbank market is entirely different and the participants in this market are commercial banks, corporations and central banks.
Importance of Capital Market
Absence of capital market serves as a deterrent factor to capital formation and economic growth. Resources would remain idle if finances are not funneled through capital market.
• It serves as an important source for the productive use of the economy’s savings.
• It provides incentives to saving and facilitates capital formation by offering suitable rates of interest as the price of the capital.
• It provides avenue for investors to invest in financial assets.
• It facilitates increase in production and productivity in the economy and thus enhances the economic welfare of the society.
• A healthy market consisting of expert intermediaries promotes stability in the value of securities representing capital funds.
• It serves as an important source for technological up gradation in the industrial sector by utilizing the funds invested by the public.
The major stock indices also have a correlation with the currency rates.
Test for Co-integration
Cointegration is an econometric technique for testing the correlation between stationary time series variables. If two or more series are themselves stationary, and a linear combination of them is stationary, then the series are said to be cointegrated. For instance, a stock market index and the price of its associated futures contract move through time, each roughly following a random walk. Testing the hypothesis that there is a statistically significant connection between the futures price and the spot price could now be done by finding a cointegrating vector. (If such a vector has a low order of integration it can signify an equilibrium relationship between the original series.
Conclusions:
In this paper, we have examined the long-run and short-run dynamics between stock prices and exchange rates in India. Our main concerns were to examine whether these links were affected by the existence of foreign exchange controls, floating rates and raising value of Rupee and raising indices in India.
We have examined these issues by applying stationarity tests and cointegration methodology, which tests for a long-run relationship between the stock market and exchange rate of the country ie., its real exchange rate.