Stock prices and exchange rates RELATIONSHIP BETWEEN STOCK PRICE AND EXCHANGE RATES Stock Prices and Exchange Rates: Are they Related? Evidence from Karachi Stock Exchange on Tobacco Industry. Ainy Ather Faisal Pervaiz Hina Arif Sabrina Irshad Syed Zaki Uddin Hussain BBA-H Department of Business Administration IQRA University, Karachi
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Stock prices and exchange rates
RELATIONSHIP BETWEEN STOCK PRICE AND EXCHANGE RATES
Stock Prices and Exchange Rates: Are they Related?
Evidence from Karachi Stock Exchange on Tobacco Industry.
Ainy Ather
Faisal Pervaiz
Hina Arif
Sabrina Irshad
Syed Zaki Uddin Hussain
BBA-H
Department of Business Administration
IQRA University, Karachi
Stock prices and exchange rates
Stock Prices and Exchange Rates: Are they Related? Evidence from Karachi Stock
Exchange on Tobacco Industry.
Abstract
This paper examines whether stock price and exchange rates are relater to each other or not. The
study uses monthly data of exchange rate of Dollar to PKR and the stock prices of the three listed
companies in tobacco sector of KSE-100 index namely Lakson Tobacco, Khyber Tobacco, and
Pakistan Tobacco for period of January 2003 to December 2007.Bivariate Correlations and
Regression test is employed to examine the association between stock price and exchange rate.
The result of this study shows the association between the said variables Stock Prices of three
listed Tobacco companies are dependent of Exchange Rates.The results have implications for
investors, policy makers and academicians.
Stock prices and exchange rates
Introduction
Over the past few years’ considerable attention has been received by the stock prices and the
exchange rates Beer and Hebein (2008). The Asian Financial Crises which started in July 1997
gave this issue its due attention. The following crises, in the effected countries gave rise to the
chaos in the money and stock markets. This resultantly also effected the exchange rates. Granger
et al. (2000) examined the relationship between exchange rates and stock prices for nine Asian
countries during the Asian financial crisis and found that exchange rates and stock prices were
not co integrated in any of the countries. Hence we can say that if a relationship between the two
markets exists, then the investors could use this information for predicting one market’s behavior
on another.
Due to the increasing trend toward globalization in financial markets, a substantial amount of
research has been devoted to the investigation of the correlation of stock returns across
international markets. According to Eun and Shim (1989), Hamao et al. (1990), and Bekaert and
Harvey (1996), it is extensively believed that varying exchange rates have an effect on the
competitiveness of firms busy in global competition. A declining home currency promotes the
competitiveness of firms in home country by allowing them to undercut prices charged for goods
manufactured overseas (Luehrman, 1991).
According to the traditional models of open economy relationship between the stock market
performance and the exchange rate; behaviour exist (Dornbusch and Fischer, 1980) and suggest
that changes in exchange rates affect the competitiveness of firms as fluctuations in exchange
rate affect the value of the earnings as well as the cost of its funds (as many companies borrow in
Stock prices and exchange rates
foreign currencies to fund their operations and hence its stock price). A depreciation of the local
currency makes exporting goods attractive and leads to an increase in foreign demand and hence
revenue for the firm and its value would appreciate and hence the stock prices. On the other
hand, an appreciation of the local currency decreases/increases the exporting/importing firms’
profits because it leads to a decrease in foreign demand of its products (Gavin, 1989).
The expected returns from the investment in foreign stocks are determined by changes in
local stock price and currency values. If the effect of exchange risk does not vanish in well-
diversified portfolios, exposure to this risk should command a risk premium. Therefore, the
interaction between currency value and stock price is an important determinant of global
investment returns (e.g., Doong et. al., 2005).
This research is carried on the basis of exchange rates and stock prices of KSE listed 3
tobacco companies namely, Pakistan Tobacco Company Limited, Khyber Tobacco Company
Limited, and Lakson Tobacco Company Limited. It began with a 50 share index and was grown
with the requirement. The KSE 100 index was introduced on November 1st, 1991 and today is
one of the most accepted measures of exchange. This index is also used to compare the prices of
the whole stock exchange over a period of time. It is one of the most widely and extensively used
exchange rates in the country.
Pakistan’s tobacco industry is one of the industries in Pakistan which also has a significant role
to play in the country’s economy. It is one of the largest taxes paying industry of Pakistan. This
industry has higher taxes and its product is advised against by the government and many other
people, it is still widely used and an important sector. Despite of the stigma attached to this
Stock prices and exchange rates
sector not only in Pakistan but around the world, it is still a major source of income for both the
government and the people. It is also one of the largest sources of direct and indirect
employment for the people.
If any relation between the two exists then this information could be made to use by the investors
in order to predict the behavior of one market on another. It can tell how one market or in
specific the change in one market would impact the other market or how will the other market be
effected. This information could be utilized to understand the relationship between the two
markets.
The purpose of this report is to find a relationship between stock prices and exchange rates of
Pakistan. It makes use of the stock prices of the exiting three tobacco companies in the stock
exchange and monthly Rates of the dollar value from 2003-2007. This research make of
Correlation and regression. This research tells how one market or in specific the change in one
market would impact the other market.
Literature Review:
This thesis deals with the existence of relationship between stock prices and exchange
rates. Researchers all over the globe have given most of their attention in determining the
existence of relationship between stock prices and dollar rate. Franck and Young (1972) were
among the first authors to analyze the association between stock prices and dollar rates. Using
correlation regression analysis, they reported significant interactions. Aggarwal (1981) finds that
the US stock prices and the trade-weighted dollar value are positively correlated.
Stock prices and exchange rates
Our main focus would be on two portfolio models which explain the interaction between
exchange rate and stock prices. First the ―Flow-Oriented‖ model (Dornbusch and Fischer, 1980
and Gavin, 1989) suggests that fluctuations in exchange rates affect the competitiveness of firms
and also the balance of economy. Secondly is the ―Stock-Oriented‖ model (Branson, 1983 and
Frankel, 1983) where the stock market exchange rate link explained through a country’s capital
accounts.
Flow- Oriented Models states that the exchange rate is determined largely by a
country’s current account or trade balance performance. The changes in exchange rates affects
global competitiveness and trade balance, thereby influencing real economic variables like real
income and output (Dornbusch and Fisher, 1980). Stock prices, are basically defined as a current
value of upcoming cash flows of firms, should adjust to the economic perspectives. Thus, flow
oriented models results in a positive relationship between stock prices and exchanges rates with
direction of causation running from exchange rates to stock prices.
Another classification of Portfolio Balance Method and Monetary Models is Stock
Oriented Model. A portfolio balance model shows a negative relationship between stock prices
and exchange rates and come to the conclusion that stock prices have an impact on exchange
rates. Such models presume an internationally diversified portfolios and the role of exchange
rates to balance the demand for and the supply of domestic as well as foreign assets.
Portfolio Balance models provides an alternative for the association between stock prices
and dollar rates, focusing on the role of capital account transactions. Developing markets can
attract many foreign investors to invest heavy capital flows, ultimately increasing demand for its
currency. But in contrary, if stock prices are decreasing investors would try to sell out their
Stock prices and exchange rates
stocks to avoid losses and would convert their currency into foreign currency in order to move at
foreign location. In such a case, local currency would decline. As a result, rising (declining)
stock prices would lead to depreciation in exchange rates. Furthermore, foreign investment in
local equities increases due to foreign diversifications that investors would gain.
For numerous reasons it is important to observe the association between stock prices and
dollar rates. Firstly, in order to predict the path of the exchange rate we need to find out the links
between the two markets. This can help the multinational corporations to manage their exposure
to foreign contracts and the exchange rate they face. Secondly, currency is more often being
included as an asset in investment funds’ portfolio. Knowledge about the link between
currency rates and other assets in a portfolio is vital for the performance of the fund. The
mean- variance approach to portfolio analysis suggests that the expected return depends on the
variance of the portfolio. Therefore, an accurate estimate of the variability of a given portfolio is
needed. This, in turn, requires estimates of the correlation between stock prices and
exchange rates. Third, the understanding of the stock price- exchange rate relationship may
prove helpful to foresee a crisis.
We will be employing the famous Granger causality test. (Granger, 1969) was developed
as a more efficient approach in comparison to the basic correlation tool, which does not imply
causation between Correlated variables in any significant sense of the word. The Granger test
addresses the issue of whether the current value of a variable y – yt - can be explained by past
values of the same variable – yt-k – and then whether adding lagged values of another variable x
– xtk– improves the explanation of yt. As such, the variable y is said to be Granger-caused by x if
the coefficients on the lagged values of x are discovered statistically significant.
Stock prices and exchange rates
Jorion (1990) found a weak link between stock returns of US multinational companies
and the effective US dollar exchange rate for the period 1971-1987. Roll (1992) finds a positive
relationship between market indices and exchange rates. Smith (1992) uses Portfolio Balance
Model to examine the determinants of exchange rates. The results show that equity values have a
significant influence on exchange rates but the stock of money and bond has little impact on
exchange rates.
Solnik (1987) observe a weak but positive relationship between the two variables. Soenen
and Aggarwal (1989) re-access the Solnik model using 1980 – 1987 data for the same eight
industrial countries. They report a positive correlation between stock return and exchange rates
for three countries and negative correlation for five. Soenen and Hennigar (1988) conclude that
the value of the U.S. dollar is negatively correlated, that is depreciation of the U.S. dollar
increases the U.S. stock price indexes. Giovannini and Jorion (1987) discovered empirical
regularities between exchange rates and stock markets in USA.
Early empirical studies, however, omit to recognize the fact that most financial variables
are non-stationary. To account for this problem, Bahmani-Oskooee and Sohrabian (1992) used
co-integration to investigate the relationship between monthly data on S&P 500 index and US
dollar effective exchange rates for the period 1973-1988. In early studies, many researchers
have discussed this issue in various timeframes. Franck and Young (1972) were among the first
authors to analyze the association between stock prices and dollar rates. Using correlation
regression analysis, they reported no significant interactions. Aggarwal (1981) finds that the US
stock prices and the trade-weighted dollar value are positively correlated.
Stock prices and exchange rates
In recent times, researchers have pointed out that such a system can be incomplete if you
omit some important variables. In such a situation the long run relationship of variables and
causality structure are invalid. Lutkepohl (1982) and more recently Caporale and Pittis (1997)
explains that the omitted variables in a system can be the only determining factor for sensitivity
of causality inferences between the variables of incomplete system.
Early empirical studies have not considered the fact that most financial variables are non-
stationary. To account for this problem, Bahmani-Oskooee and Sohrabian (1992) used co-
integration to investigate the relationship between monthly data on S&P 500 index and US dollar
effective exchange rates for the period 1973-1988.
Officer (1973) explained that during the period of Great Depression, aggregate stock
volatility, volatility of money growth and industrial production increased. But stock volatility
remained at same levels before and after Depression period. Black (1976) and Christie (1982)
discovered that in contrary to Officer (1973) financial leverage can partially explain the stock
market volatility. French et al. (1987) and Schwert (1989) found Market volatility as variance of
monthly returns of market index. It changes over time. Any uncertain situation in economy
would cause a proportionate change in stock return volatility. But French et al. found a negative
relationship between return and volatility.
Schwert (1989) and Hamilton and Lin (1996) found out that stock market volatility is
increases during the recession and Glosten et al. (1993) find out interest rates are to be an
important factor in explaining stock market volatility. Mao and Kao (1990) exporting firms’
stock values were comparatively more sensitive to changes in foreign exchange rates. Their
Stock prices and exchange rates
study also found out another topical issue of the relationship between stock prices at the macro
and micro levels. The existing available evidence indicates a fragile association involving them
at a micro level. According to the macro level, Ma & Kao (1990) originate that a currency
appreciation pessimistically affect the domestic stock market for an export-dominant country and
optimistically for an import-dominant country.
Yu (1997) investigated Hong Kong market, Tokyo market, and Singapore market for the
period 1983-1994. Using daily data, he detected bi-directional relationship in Tokyo and a
causality running from exchange rates to stock prices for Singapore. Abdalla and Murinde (1997)
applied co-integration approach to examine stock prices-exchange rates relationship in four
Asian countries using data from 1985 to 1994. Their results reject an occurrence of causality in
Pakistan and Korea but support its existence in India and Philippines. In India the relationship
occurs from exchange rates to stock prices, the opposite is found for Philippines.
Libly Rittenberg (1993) employed the Granger causality tests to examine the association
linking dollar rate changes and price level changes in Turkey. Since causality tests are sensitive
to lag selection, therefore he employed three different specific methods for optimal lag selection
[i.e., an arbitrarily selected, Hsiao method (1979), and the SMAR or subset model auto
regression method of Kunst and Marin (1989)]. In all cases, he found that causality runs from
price level change to exchange rate changes but there is no feedback causality from exchange
rate to price level changes.
Eli Bartov and Gordon M. Bodnor (1994) concluded that contemporaneous changes in the
dollar have problems in explaining abnormal stock returns properly. According to their findings
Stock prices and exchange rates
a lagged change in the dollar is negatively associated with abnormal stock returns. The
regression results showed that a lagged change in the dollar has explanatory power with respect
to errors in analyst’s forecasts of quarterly earnings.
Some of the researchers have focused on some specific industries rather than on whole
economy. Chamberlain et al. (1997) focusing on the banking industry reported that US banking
stock returns were responsive to exchange rates changes. But in contrary, Japanese banking stock
returns were not sensitive to changes in exchange rates. Ajayi et al. (1998) provided evidence to
indicate unidirectional causality from the stock to the foreign exchange markets for the advanced
economies (USA, Korea) and no consistent causal relations in the emerging markets (Malaysia).
Hamao et al. (1990) investigate the price and volatility spill over in three major stock
markets (New York, Tokyo, and London). Koutmos and Booth (1995) find asymmetric volatility
spillovers across the New York, Tokyo, and London stock markets. So (2001) studies the
dynamic spill over effect between interest rate and exchange value of US dollar.
Khoo (1994) estimated the mining companies’ economic exposure by using exchange
rates, interest rates and price of oil. He discovered that the sensitivity of stock returns to
exchange rate movement and proportion of stock are minor. Domely and Sheehy (1996) found a
contemporary relation involving the dollar rate and the market value of large exporters.
Several researchers consider the involvement of other macroeconomic factors they might
include in the exposure regression. Different macroeconomics factors including interest rates,
money reserve, inflation, different monetary policies, etc., have been applied to the exchange rate
exposure model by various researchers. Ibrahim (2000) has extended the exiting studies on the
Stock prices and exchange rates
stock prices – dollar rates causal association by investigating the concern for Malaysia. He used
three exchange rates, namely, nominal effective exchange rate, real effective exchange rate and
bilateral exchange rate. Using monthly data from January 1979 to June 1996, applying co
integration and Granger Causality tests he found that, in the bivariate models, no extended
relationship involving the stock market index and a few of the exchange rates.
Vygodina (2006) examines the exchange rates and stock prices for large and small stocks
for the period 1987-2005 in the USA and used Granger causality methodology. The study results
that there is Granger causality from large stocks to the exchange rate but there is no causality for
small stocks. Stock prices and exchange rates are affected by the same macroeconomic variables,
whereas the changes in monetary policy have an important effect on the nature of this
relationship. In other words, the nature of the correlation involving stock prices and dollar rate is
variable with time.
In economic analysis it is stated that firm value is related to exchange rate movements.
Shapiro (1975) stated that increase in value of home currency firm with depreciation of local
currency. Adler and Dumas (1984) stated that even firms operating local domestic markets,
might get effected by exchange rates movements. Luetherman (1991) found from testing his
hypothesis, that if the local currency depreciates it will give rise to competitiveness of local
manufacturers in comparison to foreign competitors. But in contrary, no firm can get benefit
when local currency depreciates, although significant decline is witnessed in market share of
industry with the depreciation of local currency.
Stock prices and exchange rates
Bodner and Gentry (1993) considered the three countries namely Canada, Japan, and USA.
According to the research some industries in these countries have significant exposure. Choi and
Prasad (1995) developed a model examining the exchange rates sensitivity of 409 US
multinationals. They came up with a conclusion that firm’s value is affected by change in
exchange rates. Around 60% of firms had significant exchange rate exposure.
Domely and Sheehy (1996) found contemporary relation involving the foreign exchange
rate and market value of exporters. Miller and Reuer (1998) conducted a study on differences in
strategy and industry structure of firm’s economic exposure in accordance to foreign exchange
rates fluctuations. Around 13 to 17% of US manufacturing firms affected by foreign exchange
movements. Foreign direct investment reduces economic exposure to foreign exchange rate
fluctuations. Glaum, Barunner and Himmet (2000) examined the German company’s exposure to
change in US dollar exchange rates. They found that German firms are significantly exposed to
changes in dollar rate.
Pan et al. (2000) noted that exchange rates had significant effects on stock prices in seven
Asian countries during 1988 – 1998. Similarly to Granger et al. (2000), they reported much
stronger interaction during and after the financial crisis of 1997. Wu (2000) explores the
existence of a balance correlation between stock prices and dollar rates in Singapore asset market
and it’s sensitive to different currencies. He concludes that Granger causality runs merely one
way from dollar rates to stock prices; the co integration investigation suggests that Indonesia
Rupiah has an optimistic long run effect on stock prices.
Stock prices and exchange rates
Erbaykal and Okuyan (2007) examined 13 developing countries to figure out the exchange
rates-stock price relations using different time period for each country. They came up with a
conclusion that indicated causality relations for eight countries. While there is a one directional
causality from stock price to dollar rates in the five of them, bidirectional causality exist for
remaining three economies. They also found no causality for these financial variables in Turkey,
but these findings are not found consistent with the results. This is due to the different time slots
used in the research. On the other hand, Sevuktekin and Nargelecekenler (2007) found positive
and bidirectional causality between these two financial variables in Turkey using monthly data
from 1986 to 2006.
Morley and Pentecost (2000) examine the nature of the correlation linking stock prices
and exchange rates for Canada, France, Germany, Italy, Japan, UK, and USA. They find that the
lack of correlation between the level of stock prices index and the level of the exchange rates is
due to the fact that dollar rates and stock prices do not display general trends, but rather exhibit
common cycles. Thus the statistical relationship is a short run rather than long run or trend
relationship.
Amare and Mohsin (2000) examine the long-run association between stock prices and
exchange rates for nine Asian countries (Japan, Hong Kong, Taiwan, Singapore, Thailand,
Malaysia, Korea, Indonesia, and Philippines). They use monthly data from January 1980 to June
1998 and employed co integration technique. The long-run correlation linking stock prices and
dollar rates was found only for Singapore and Philippines. They attributed this lack of co
integration between the said variables to the bias created by the ―omission of important
Stock prices and exchange rates
variables.‖ When interest rate variable was included in their co integrating equation they found
co integration between stock prices, exchange rates and interest rate for six of the nine countries.
Ramasamy and Yeung (2001) focused their research on two markets in nine East Asian
economies and they found that causality can differ according to the period of study. For the
period of the entire four years of the crisis (1997 – 2000) all countries, apart from Hong Kong,
showed that stock prices cause movements in the exchange rates.
Fama (1981) states that stock prices are reflected by the variables like, inflation, exchange
rate, interest rate, and industrial production.Maysami and Koh (2000) and Choi et.al (1992)
examine the impacts of the interest rate and exchange rate on the stock returns and showed that
the exchange rate and interest rate are the determinants in the stock prices. Likewise, Ehrhard
(1991) documents a powerful result of the interest rates on stock returns. Similar results are
achieved in various studies using different countries such as Campbell (1987), Shanken (1990),
Apergis andEleftheriou (2002).
Lee and Nieh (2001) examine both short-run co movements and long-run balance
interaction involving stock prices and exchange rates for each G-7 country: Canada, France,
Germany, Italy, Japan, the United Kingdom (U.K.) and the U.S. They found no long run
equilibrium relationship exists between the two variables. However, in the short-run causality
runs from exchange rates to stock prices in Germany, Canada, and the U.K, and runs from the
later to the former in Italy and Japan.
Griffin and Stulz (2001) also examined particular industries rather than on whole
economy. They noted that changes of weekly exchange rates had negligible impacts on industry
Stock prices and exchange rates
stock indices in developed countries. Nagayasu (2001) analysis empirically the recent Asian
financial crisis using the time series data of exchange rates and stock indices for Philippines and
Thailand which were the first two countries confronted by massive movements in financial asset
prices. He found unidirectional causality runs from the financial sector index to the exchange
rate, contagion effects running from Thailand to the Philippines.
Rim and Mohidin (2002) examined relations between industry indices and exchange rates
using monthly data before and during the Asian financial crisis. Their findings show that
industry indices had long run positive effects on exchange rates, and exchange rate also had long
– run positive effects on most indices. Short-run effects proved to be generally negative in both
directions. Hatemi and Irandoust (2002) also find that Granger causality is unidirectional running
from stock prices to exchange rates in Sweden.
Bhattacharya and Mukherjee (2003) investigated the nature of the causal relationship
between stock prices and macro economic aggregates for in India and found no significant
linkage. Muhammad and Rasheed (2003) used monthly data on four South Asian countries for
the period (1994 to 2000). They came up with no correlation involving stock prices and
exchange rates in Pakistan and India neither in short run or in long run. Whereas, in Bangladesh
and Srilanka markets are bi directionally linked.
Phylaktis and Ravazzolo (2005) considered the long run and short run correlation between
stock prices and dollar rates and the channels in the course of which exogenous shocks impact
these markets. Findings using co-integration methodology and multivariate Granger causality
Stock prices and exchange rates
tests on a sample of Pacific Basin countries propose that stock and overseas exchange markets
are positively correlated and that the US stock market acts as a medium for these associations.
Hatemi and Roca (2005) examines the link between exchange rates and stock prices before
and during the 1997 Asian crisis, for Indonesia, Malaysia, Philippines, and Thailand. They find
that with the exception of the Philippines, during the period before the Asian crisis, there was a
significant causal link between dollar rates and stock prices in each of the four Asian countries.
Causality ran from the former to the latter in the case of Indonesia and Thailand, while direction
of causality is reversed in the case of Malaysia. During the Asian crisis period that took place,
the relationship between those two variables ceased across the all countries.
Doong, Yang, and Wang (2005) examine he dynamic relationship and pricing of stock
and exchange rate, using Weekly data for Indonesia, Korea, Malaysia, Philippines, Thailand and
Taiwan. They find that stock prices and exchange rates are not co integrated, using Granger
causality test, bidirectional causality can be detected in all countries except Thailand.
Mansor (2000) examined the Malaysian markets and found no long-run correlation
involving stock prices and dollar rates; although in bivariate cases he found a short-run causal
correlation from stock prices to dollar rates. He also found a bi-directional causality in some
multivariate models.
Chong and Koh’s (2003) showed that stock prices, economic activities, real interest rates
and real money balances in Malaysia was linked in the long run both in the pre- and post capital
control sub periods. Islam and Watanapalachaikul (2003) showed a strong, significant long-run
relationship between stock prices and macroeconomic factors (interest rate, bonds price, foreign
Stock prices and exchange rates
exchange rate, price-earning ratio, market capitalization, and consumer price index) during 1992-
2001 in Thailand.
Dong (2006) argued that the market prices are not only important in determining the
conditional mean of exchange rate changes, but also directly affect the conditional volatility of
exchange rate changes. He also argued that the exchange rate exposure to macro innovations is
amplified by the market prices of risk which varies over time. The existing structural models of
exchange rates have a static and linear relationship between macro variables and exchange rates.
If the time-varying from macro shocks to exchange rate movements is correct, a static and linear
relationship, therefore, will not be specified. Dong (2006), however, using the recursive
identification of monetary policy shocks, which is said to be inappropriate, couldn’t get rid of the
delayed overshooting puzzle or the forward premium puzzle.
Hau and Rey (2006) developed an equilibrium model in which exchange rates, stock prices,
and capital flows are jointly determined. They show that net equity flows into the foreign market
are positively correlated with a foreign currency appreciation. According to Adler and Dumas
(1984) those firms whose entire operations are domestic are also has a possibility of being
effected by exchange rates, especially if their input and output prices are influenced by currency
movements.
When there is a falling home currency, it promotes competitiveness of home country firms
as it allows them to undercut the prices charged for goods manufactured abroad (Luehrman,
1991). Simple partial equilibrium models like Shapiro predict an increase in the value of the
home country firm in answer to a decrease in the value of the home currency. Benita and
Stock prices and exchange rates
Lauterbach (2004) in their research showed that exchange rate volatility have real economic
costs. It affects a country’s price stability, firm profitability and a country’s stability.
Developments that are done in the foreign exchange market have cost implications for the
households, firms and the state. There are three events, namely the Asian Currency Crises, the
advent of floating exchange rate in the early 1970s and financial market reforms in the early
1990s have over all prompted financial economist into determining the link between these two
markets (Mishra, 2004).
Adjasi and Biekpe (2005) studied the relationship between stock market returns and
exchange rates effects in 7 African countries. Co integration tests explained that in long run
decrease in exchange rates results in increase in stock market prices in some of the countries,
while in the short run decrease in exchange rates decreases stock market returns. Mishra (2004)
showed that stock return, exchange rate return, interest rates and money demand are interrelated
although no consistent relationship exists. Moreover, there is no Granger Causality between
stock returns and exchange rates are found.
Engle and Rangel (2005) also study the link between number of macro economic variables
and stock market volatility. This study concludes that volatility stock return forecast can be
easily being incorporated with macroeconomic variables forecast.
The effect of a stock price increase on expenditure is explained by Mishkin (2001) as
follows. First, it leads to increased investment by firms. The value of a firm’s equity increases as
its stock price rises while the prices of new equipment remain unchanged in the short run. As a
result, investment is now relatively cheaper and companies will tend to invest more.
Stock prices and exchange rates
Among some of the major researchers that are carried out on emerging markets namely;
Mishra (2004), Chortareas et al. (2000), Koutmoa et al. (1993). Early researchers like Smith
(1992), Franck and Young (1972), Solnik (1987), Granger et al. (2000), Abdalla and Murinde
(1997), and Apte (2001) have found a positive relationship between stock prices and exchange
rates. Where as researchers like, Soenen and Henniger (1998), Mao and Kao (1990), Ajayi and
Mougoue (1996), have reported negative relationship between the two variables. On the other
hand, Bartov and Bodnar (1994), Franck and Young (1972) have found weak or no relationship