Correlation between the Exchange and the Stock Market - Literature review Example

CORRELATION BETWEEN THE EXCHANGE AND THE STOCK MARKET By of School and Stock-oriented model of exchange rates According to Stock-oriented models, the financial account balance of the country determines the exchange rates. The model can thus be distinguished as a model of portfolio balance and monetary model. As far as the portfolio balance model is concerned, there is an indication of negative relationship between the stock prices and the exchange rates, and that the exchange rates are affected by the stock prices (Rafayet, 2010). In this respect, therefore, in line with the portfolio model, an increase in the price returns of domestic stock results in depreciation of the domestic currency, considering that domestic stock price increase stimulates investors to consider buying more of the domestic assets and opt to sell foreign assets in order to make domestic currency to be used in buying new domestic-based assets (Nishat and Shaheen, 2004). The monetary model, on the other hand, proposes that the actual exchange rate should be determined by the future value of the exchange rate and thus lacks any linkage between exchange rates and stock prices. The stock-oriented model or the portfolio balance approach supposes that the stock prices could affect the rates of currency exchange. This is particularly in contrast with the flow oriented model, in which it is postulated that currency movements have an influence on the earnings of the firm and by extension results in changes in stock prices (Phylaktis and Ravazzolo, 2005). The stock oriented model suggests that the movements in the stock prices result in changes in the rates of exchange through capital account transactions. The level at which the stock oriented models exactly explain the real world currency and stock market reactions is virtually dependent on other issues that include market segmentation and liquidity (Jin, 2007). For instance, illiquidity markets results in difficulties as well as making it less timely for the targeted investors to either sell or buy their stock, whereas the segmented markets are characterized by imperfections, among which are the investment related government constraints, high costs of transaction together with high risks of foreign currency, all of which could possibly discourage the foreign investments (Yang and Doong, 2004). From this theoretical view, therefore, it is clear that there exist numerous ways through which currency and stock markets have interactions. This constitutes the empirical analysis of the extent and direction of casualty between the prices of stock and the currency exchange rates more interesting and also provides the motivation for numerous studies towards the examination of interactions between exchange rates and stock prices. Ideally, the stock-oriented model explains the link between the stock market and exchange using the capital accounts of the country. In this respect, the exchange rates equate supply and demand for the stocks and bonds that constitute the assets. Therefore, the stock price movement could either influence or be influenced by the exchange rate movement. Thus, the portfolio balance view towards determination of exchange rate, as observed by Reilly and Brown (2005), proposes that a share market that is on a rise is bound to attract capital inflows which lead to the increase in demand together with home currency appreciation. From this, it can be understood that the approach of portfolio balance supposes that casualty direction runs from the prices of the shares to exchange rates (Berben and Jansen, 2005). For example, if the Chinese Yuan depreciates against any of the major foreign currencies with which it trades, such as the British pound, the exports from China will appear cheaper in the British markets, and as a result, the companies that export to this market have higher likelihood of increasing returns on the exports. On the other hand, it could most likely improve the corporate performance followed by the stock market performance (Chaojun, 2007). However, such situations could make the pound become an option as far as trade of currency commodity is concerned. If this occurs, the investors will be motivated to consider moving assets from the domestic assets to the pound assets, and this result in the depression of the stock assets. In this case, the depreciating currency inevitably has a negative impact on the returns of the stock market, as observed by Mohammad, Hussain and Ali (2009), in a different study, suggests that the exchange rates are led in a negative relationship by stock prices.  Researches on the relations between stock price and exchange rates Majority of the past studies, as witnessed here, concentrated significantly on the link between exchange rates and stock prices and the dynamic relationship between them. As suggested by Mishra (2004) and Longin and Solnik (2001), the volatile financial market periods have a correlation with the increased correlation among assets. It is also true that there is no sufficient investigation in many of the studies done hence the results reported could be misleading. The Chinese market has been particularly described as an emerging one, yet is one of the least researched into up to now in regard to the relationship between stock market and exchange rate (Yang and Doong, 2004). On the other hand, there appears to be no consensus among the researchers all over the world. The study findings in Bhattacharya and Mukherjee (2001), for example, indicate that there is no any relationship between foreign exchange rates and the stock prices. In a different study, while using the Box-Jenkins ARIMA model, Reilly and Brown (2005) discovered no significant link between the index prices of the stock market and exchange rates. Similarly, Tsai (2012) fails to establish any sort of causal relationship in majority of the countries they studied. The link between stock prices and exchange rates has been the center of attention for many academics and researchers (Smyth and Nandha, 2003). Within the international financial system, for instance, the emerging markets have resulted in great changes to the restrictions of the foreign exchange, which include adoption of more flexible rates of exchange and the exchange rate volatility that has equally raised and increased a significant portion of decision making risks and the risks of portfolio diversification. In this respect, therefore, as observed by Kanas (2000), the interaction between stock market and foreign exchange markets has gradually grown important but complex. Several researches have been done in regard to the interaction between stock prices and exchange rates. The early studies that specify the link between exchange rates and stock prices, like those done by Longin and Solnik (2001), suggest that there is no important interaction between stock prices and exchange rates. However Granger, Huang and Yang (2000) demonstrated a significantly negative relationship between stock prices and the rates of exchange. According to the results obtained from Nishat and Shaheen (2004) study, the volatility of the exchange rate impacts negatively on the operations and profits of multinational firms. The study by Obeng, Brafo- Nsaidoo and Annim (2006) also discovered that there was a relationship between stock returns within multinational companies in the US and the effective exchange rates of the US dollar. The empirical studies from initial stages were basically based on the correlation between the stock returns and the rates of exchange in the market but failed to discuss the existing dynamic relations (Yang and Doong, 2004). The recent studies have seen more researchers being interested in the dynamic linkage that exists between stock prices and exchange rates. Many of the studies, however, have their basis on the Generalized ARCH (GARCH) framework for examination of volatile spillover between different countries and different financial assets (Yang and Doong, 2004). Sohail and Hussain (2009), for instance, study the dynamic link between the rate of exchange for the US dollar and the interest rates by Nelson (1991)’s model of multivariate exponential GARCH. In the study, it was discovered that there exists the volatility spillover effect between the markets under study. Ramasamy and Yeung (2001) in their study concluded that there existed volatility and price spillovers in major stock markets under study. The same was backed by Yucel and Kurt (2003) in a study that demonstrated the existence of asymmetric spillover of volatility from the stock returns to exchange rates for the UK, US, Canada, France and Japan. In addition, Ramasamy and Yeung, (2002) examined the real nature of the volatile and mean transmission scheme that exists between exchange rates and stock prices for the G-7 countries. Based on the evidence from this, it can be concluded that the effect of asymmetric volatility spillover exists and that the stock price movements are bound to affect the future dynamic of the exchange rate (Yang and Doong, 2004). In the recent researches, particularly that by Mohammad, Adnan, Hussain and Ali (2009), it has discovered that the foreign exchange rates have a significant impact on the stock market. This is a notion similarly observed by Dimintrova (2005), who finds unambiguous deprecation effects of the stock prices following the depreciation of the exchange rate, by use of the open-economy, multivariate, short-run model. However, Sohail and Hussain (2009) registered a negative effect of price index of the consumers on stock returns, whereas the real effective exchange rate, industrial production price index, money supply, demonstrated a great positive effect in stock return over some period of time. While concluding the findings by Sohail and Hussain (2009),it can be observed that together with the increase in exchange rates or the domestic money depreciation, it comes with a positive impact on the firms that are export-oriented, thus leading to the increase in firm returns which will eventually cause an increase in the stock prices. This fact is supported by the findings in research report by Ratanapakorn and Sharma (2007). As much as they failed to find any association between the two markets, Yang and Doong (2004) contributed greatly to the dimension of the study that links the two markets. For instance, they were able to discover that the stock value of the exporting firms have high sensitivity to foreign exchange rate changes. At the macro level, for instance, So (2001) observes that appreciation of the currency had a negative impact on domestic stock market for a country that is dominantly exporting its products, while it impacted positively the stock market at domestic level for the import-dominant countries, and this is in consistency with the good market theory. On the other hand, Meanwhile, Yang and Doong (2004) find out that stock returns have high sensitivity to the movement of exchange rate. However, the proportion of stock return as explained by the movement of exchange rate is fairly minimal. Other researchers have also sought to investigate the relationship between exchange rate movement and market returns. For instance, Adjasi and Biekpe (2005) found out that over some time, the depreciation of exchange rates could result in increased prices of the stock market in certain countries, while in the short-run, depreciation in exchange rate causes reduced stock market returns. On the other hand, the Granger causality tests demonstrate that the exchange rate movement causes stock market returns in certain countries, whereas stock market returns result in exchange rate movement in some. While using the forecast error variance decomposition Mishra (2004) found out that returns of the exchange rate had a great impact on stock returns. According to Choi and Fu (2006), suppose the leverage effect is present within the stock market, there needs to be a consideration for the volatility of exchange rate effect, as well as the leverage effect reflection. While applying the GJR model, the two identified a great effect of leverage within the stock market (Tabak, 2006). They were also able to discover that effect of exchange rate volatility on the stock market does not go away when the variability of exchange rate is introduced. In this study, the investigation is carried out on the basis of the experience within China as an emerging world economy. Additionally, the country has been widely affected by the financial systems in practice globally and this, therefore, provides an ideal examination of the relationship between foreign exchange and stock market. The results of the study are meant to show whether or not there are significant spillovers from the stock returns to the changes in exchange rate in China. References Berben, R.P. and W.J. Jansen., 2005. Comovement in international equity markets: A sectoral view. Journal of International Money and Finance, 24, pp. 832-857. Chaojun, D. S. Y., 2007. An Empirical Study on the Relationship between Stock Price and Exchange Rate in China [J]. Journal of Financial Research,12, pp. 007. Granger, C.W.J., B, Huang. and C.W. Yang., 2000. A bivariate causality between stock prices and exchange rates: Evidence form recent Asian flu. Quarterly Review of Economics and Finance, 40, pp. 337-354. Jin, L. J., 2007. 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Price and volatility spillovers between stock prices and exchange rates: empirical evidence from the G-7 countries. International Journal of Business and Economics, 3( 2), 139-153. Yang, S.Y. and S.C. Doong., 2004. Price and volatility spillovers between stock prices Yucel, T. and Kurt, G., 2003. Foreign exchange rate sensitivity and stock price: Estimating economic exposure of Turkish Firms. European Trade Study Group, Madrid. Zhao, H., 2010. Dynamic relationship between exchange rate and stock price: Evidence from China. Research in International Business and Finance,24(2), pp. 103-112. Read More