CHAPTER ONE
1.1) Introduction
The aim of this chapter is to provide the research overview to the reader, by providing a background study on it, and explaining the aims and motivation for under taking the research. Finally the chapter provides a brief view on how the rest of the research work will be presented.
1.2) Background
The relationship between stock price and exchange rate has always been an important issue, mainly because of the concern about the impact of volatility of exchange rate on the value of the firms. There are plenty of literature that support such relation; majority of them states that the fluctuating exchange rates can have substantial impact on the performance and profitability of domestic firms and so does on the stock price of the firm. Moreover, the argument from arbitrage pricing theory suggests that, if a small number of factors describes an economy, then these factors may be priced in a such a way that to avoid the sources of risk, investors will be willing to pay a premium. In this context, if the relevant factors includes exchange rate as one among them, then hedging policy may affect the cost of capital of a firm. (Adler and Dumas, 1984).
In an attempt to examine the relation between exchange rate and stock prices, some empirical studies have found weak evidence on the relation. As per study by Jorion (1990), considering the monthly returns on a sample of 287 US MNC's find's that, the exposure of foreign exchange rate is heterogeneous across forms. Whereas, Bodnar and Gentry (1993) have found from their study on industry-level exchange rate exposure for US, Canada and Japan that, 9 some industries display insignificant exposure and also found that there is a positive relation between the degrees of exposure to a firm to the ratio of foreign sales to total sales.
Hence, identifying the kind of relationship that exists between the stock price and exchange rate is important for few reasons. In support of this, Desislava Dimitrova (2005) has given three main reasons behind exploring the relation. They are; (I) the relation between exchange rate and stock price may affect decisions about fiscal and monetary policy. For instance, if the stock market is booming it will show positive effect on aggregate demand, if this is large enough, the real exchange rate and interest rates will be neutralized by expansion of monetary policies and contraction of fiscal policies. Some time in order to boost the export sectors, the policy makers recommend less expensive currency, at this point it's important for the policy makers to know whether such policy has any effect on the stock markets. (ii) If the exchange rates could be predicted from markets, which are interlinked with each other's it would help the multinationals in stabilizing their profits by managing their foreign exchange rate risks and their foreign exposure. (iii) Investment funds portfolios includes currency as a major asset, for the better performance of founds its very critical to know the link between the currency rates and other assets in the portfolios. In a portfolio analysis, the mean-variance approach suggests that the expected returns to a portfolio are implied by the variance in it. Therefore, it is very vital to estimate the accurate variability of a portfolio, which requires to identifying the correlation between the exchange rate and stock price.
So, above all three reasons clearly state the importance in estimating the kind of relationship that prevails between the exchange rate and stock price. And moreover, as these two economic variables play a crucial role in influencing the development of a country's economy. Hence, exploring the relationship between them has become a great importance and has drowned much attention of economists in recent years for theoretical and empirical reasons. In addition, investors frequently have been utilizing the relationship between the stock price and exchange rate in predicting the future trends for each other. 10
1.3) Aim of the study
The traditional approach to establish the relation between the exchange rate and stock price concluded that exchange rate leads stock price, where as portfolio approach states that, the changes in stock prices will affect the exchange rate, since the decrease in stock prices will lower the demand for domestic assets and currency. Many research papers have been published in context to the relationship between the fluctuating exchange rate and stock price movement1, but there is no consensus about the relationship and moreover the empirical results are inconclusive (Joseph, 2002; Vygodina, 2006). The aim of this research study is to find out whether or not the fluctuating exchange rate and movement in stock prices in India has any relation with each other. An attempt will be made to explore the relation. Firstly for the empirical analysis, the researcher will use the traditional approach, that is by employing Ordinary Least Square Regression and secondly by employ the Granger causality test (which is most commonly used in recent years) and finally analyses the results from both the model to see the kind of relation that exist between the these two economic variables.
1.4) Motivation
Many factors such as the performance of an enterprise, its share prices in other countries, dividends, Gross Domestic products, money supply, exchange rate, current account, employment etc. can have an impact on the daily stock prices (kurihara, 2006). Especially, due to the continuing increase in the capital movements between the countries and increasing world trade have made the exchange rate as one of the main factor which affects on the equity prices of the firm (Kim, 2003). 11
On the other hand, in times of crisis the world has noticed that many of the developed and emerging markets were collapsed due to the substantial depreciation of exchange rate, particularly interims of US $ and as well as due to the fall in the stock prices. With the current activities like large cross border movement of funds and various turmoil's and high volatility in commodity prices have made a strong pitch for dynamic linkage between stock prices and exchange rate. Hence, the motivation for research in this area comes from these factors.
As the stock price and the exchange rate play important roles in the economic development of a country. Analysing the relationship between these is of great importance.
1.5) Sample selection and research methodology
1.5.1) Sample selection
The study has been conducted in context to Indian economy. The study uses the following samples
The returns for the samples were calculated by using the closing prices of each variable. The sample period extend from January 1997 to June 2009 (chapter four provides more detailed data description) 12
1.5.2) Research methodology
Two different models have been used in this research paper to explore the relationship between exchange rate and stock price. Firstly, Adler and Simon (1986) model was followed and extend this model by applying Jorion (1990) approach. This model has considered individual firms returns as dependent variable and return on exchange rate, and market index are considered as independent variable2. The Ordinary Least Square Regression was adopted to experiment this model.
This model will help in measuring the sensitivity of individual company's stock returns towards the exchange rate and market returns, it will measure the economic exposure as the slope coefficient from a regression of stock returns on the exchange rate.
For the Second model, the study employed Ganger causality test, which is more sophisticated statistical technique which is more commonly used in recent studies. The granger causality test was conducted on the exchange rate returns (INR/ US dollar) and market index returns 3(BSE 100). The first step in this test is to find out the stationarty of time series where in, ADF test was conducted to find the unit root. After this test we employ Johansen's (1991) maximum likelihood method to find whether or not the log returns of exchange rate and market index in India are co integrated. And finally, the Ganger causality test was employed to see the dynamic relation between exchange rate and stock price
1.6) Structure of the thesis:
In order to achieve the above mentioned aims and for easy understanding of this thesis, the rest of the research work would be divided into five different chapters: 13
The following is the structure of the thesis:
Chapter one: background introduction to the research area and its aim and motivation and describing the structure of the thesis
Chapter two: a Brief overview on the concept of exchange rate and exchange rate exposure. Explaining the direct and indirect relation between exchange rate and stock prices and an overview on Indian economy and its stock market
Chapter three: literature review covering a period of more than 30 years
Chapter four: methodology which provides brief description on both the models that will be experimented to find the relation and chapter also includes the data description and finally analysing the results
Chapter five: summery and conclusion, the chapter also explains the limitation and further recommendation on the research area 14
