OkMohammad Raza Dynamics of Stock Returns and Exchange Rates

Asia Pacific Journal of Applied Finance ISSN 2277 - 9027
Vol. III Issue Vol. III Issue Vol. III Issue Vol. III Issue 3, 3, 3, 3, March March March March 2014 2014 2014 2014
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Dynamics of Stock Returns and Exchange Rates: Evidence from India

Mohammad Tanzeem Raza* S. Aravanan

Abstract
The foreign exchange market and the stock market are vital for any well-defined financial system
of a country. The study explores the long-run and short-run causal relationship between the stock
market and the exchange rate in India by using the daily data covering the period from March 1,
2004 to August 31, 2012. The study used returns of two Indices i.e. BSE Sensex and Nifty; and
the exchange rate variables for four major currencies viz. US Dollar, Euro, Japanese Yen and
British Pound in Indian Rupee. The tools applied in the study are the Engle and Granger (1987)
test of cointegration and Granger Causality test. The empirical results show no long run relation
between the two markets but found both short run uni-directional and feedback causality
between stock returns and exchange rates for different currencies.
Keywords: Engle and Granger Cointegration Test, Exchange Rates, Granger Causality Test,
India, Stock Returns.

1. Introduction
1.1 Background of the Study
The relationship between equity and currency markets has been the subject matter of much
scholastic debate and empirical examination over the past 25 years. This is understandable that
equity and currency markets play crucial role in facilitating economic activity. Classical
economic theory hypothesizes that stock prices and exchange rates can interact by way of the
flow oriented and portfolio balance models. Traditionally, stock market and foreign exchange
market have been regarded as sensitive segments of the financial markets. These two markets
quickly reflected the impact of any policy changes in the financial market with respect to stock
market and foreign exchange market. At the same time, interruptions in either or both markets
are likely to elevate concern among policy makers, i.e., the two markets have tremendous policy
implications. In addition, the dynamic relationship between both markets has promoted
researchers, policy makers as well as analysts to carry out detailed analyses of this relationship.
This study is undertaken to analyze the dynamics between stock prices and exchange rates. This
link can be exploited to predict the path of the exchange rates. This will also assist in the
management of corporations exposure to foreign exchange rate risk of their earnings. More
importantly for investors, since currency assets are an important part of investment funds, the
knowledge of the link between currency and other assets in the portfolio is vital. Also, stock
markets have been found to impact aggregate demand through wealth and liquidity effects,
influencing money demand and exchange rates (Gavin, 1989). Thus while formulating monetary
policy or undertaking foreign exchange intervention, its impact on the stock market needs to be
taken into consideration.
1.2 Statement of Problems
This study tries to identify the long run and short run relationship between Stock Returns and
foreign Exchange Rates in India. The stock market index and the Forex market can give the idea
of the overall health of economy. Stock Returns and Exchange rates have been chosen in this
study for determining the relationship between the two markets. In India, the investors are most
interested in making investment in these two markets; hence the investors are sensitive to the
changes in the Stock market and Forex market. Furthermore, India is an export oriented country;
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changes in the exchange rate will stimulate the export and might have significant impact on the
foreign investors as well as on the local investors. There is general perception among the
investors that Stock market and Forex market are interrelated and they can influence each other.
If the findings of the study are consistence with the general perception, then Indian policy maker
can carefully plan and implement an appropriate policy to attract the foreign investors to invest
in the stock and Forex market.
1.3 Objectives of the Study
On the basis of the above outlined theoretical background, literature gap and the present position
of Indian economy, the main objectives of the present study are:
i) To investigate the Long-Run relationship between the Stock Returns and the Foreign
Exchange Rates.
ii) To investigate the Short-Run causal relationship between the Stock Returns and the Foreign
Exchange Rates.
1.4 Significance of the study
Exchange rate fluctuation is widely believed to influence stock returns. In practice, during past
three decades academics investigate the effect of exchange rate on stock returns, mainly in
developed countries. Therefore, the effect of exchange rate movements on the stock returns has
become an important field both in academic research and practical investment analysis.
Secondly, after an extensive literature review, the empirical researches have met with limited
success to identify significant effects of exchange rate on stock returns in developed and
industrialized countries. The empirical researches of the causal relationship between exchange
rate movement and stock price in Asian emerging markets are very few, particularly in India.
In addition, the information from this research can also lead to effective policy implementation
by policy makers. To the investor it aids investment decision in different economic climate. This
may provide insights for currency traders and investors to make decisions about short term and
long term trading. The results and finding can be used for filling the gap of currency effects on
the exchange market and also could be foundations for further research to the related areas as
well as aid teaching.
1.5 Research Hypothesis
Hypothesis H
0:
There is no long run relationship (cointegration) between exchange rate return
and Stock Return
H
1
: There is long run relationship (cointegration) between exchange rate return and Stock Return
Hypothesis No.2
H
0:
Exchange rate returns does not Granger cause Stock Return and vice-versa
H
1
: Exchange rate returns Granger cause Stock Return and vice-versa.
1.6 Limitations of the study
Due to the time and knowledge limitation, the study cannot cover all the aspects of the stock
index and exchange rate. The study covered only two Indian Stock Indices and Four major
currencies as the variables. More variables related to politics, macro-economic variables and
another market (using dummy variables is a good choice) can also be used to make the study
more fruitful for the investors and policy makers. Then only the clear picture of Indian Economy
can be drawn.
2. Review of Literature
2.1 Studies in Foreign Countries
Stefanescu and Dumitriu (2011) study the relationship between the exchange rates and the
differentials of the stock returns between Romania and the US in the period of the global crisis.
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By splitting the sample in three sub samples corresponding to three stages of the evolution of
Romanian capital market during the global crisis the study found unidirectional causality from
the stock prices to the exchange rates, only in those stages when the Bucharest Stock Exchange
was in a substantial decline. Parsva and Lean (2011) examine the relationship between stock
returns and exchange rates for Egypt, Iran, Jordan, Kuwait, Oman, and Saudi Arabia before and
during the 2007 global financial crisis. They used the Johansen-Juselius (JJ) test of cointegration
and Granger causality test in VECM model. The empirical results show long run relationship and
feedback causal relationship between stock prices and exchange rates after the crisis. Later the
study pointed out that there is no distinction in results before and after the crisis period; hence
the results are mixed either bidirectional or no directional cause. Abdalla and Murinde (2010)
used monthly data from January 1985 to July 1994 to examine the long run relation between the
exchange rate and stock price index for Pakistan, Korea, India and Philippines. They applied the
two step Engle-Granger test of cointegration and Granger Causality test. The empirical
findings show unidirectional causality run from exchange rates to stock prices for all the
countries except Philippines. Chen and Chen (2011) used monthly data to investigate the
relationship between stock prices and exchange rates for 12 OECD countries including the
developed countries (the G-7) and several emerging economies (Poland, Turkey, South Korea,
the Czech Republic and Hungary). The empirical results show the existence of long-run
relationship between exchange rates and stock prices only for seven countries out of twelve
countries. The empirical results also show short-run and long-run causal relationships and
unidirectional and bidirectional non-linear causal relationships between stock prices and
exchange rates. Richards and Simpson (2009) examined the interaction between Australian stock
prices and the Australian-USD exchange rate. Using the daily data from Jan 2, 2003 to Jun 30,
2006; the study provides the evidence of a positive long-run relationship and Granger causality is
found to run from stock prices to exchange rates .The result of this study suggested that
Australian stock prices and the exchange rate can interact in a manner in accordance with the
portfolio model, whereby stock price movements influence exchange rates via capital account
transactions. Granger, Huang and Yang (1998) used the recently developed unit root and
cointegration models to the samples of exchange rates and stock prices from Hong Kong (HKN),
Indonesia (IND), Japan (JPN), South Korea (KOA), Malaysia (MAL), Philippines (PHI),
Singapore (SIG), Thailand (THA) and Taiwan (TWN). They found that causality leads from
exchange rates to stock prices with a positive correlation for Japan and Thailand. However, for
Taiwan stock prices were found to lead exchange rates with a negative correlation. The data for
Korea, Malaysia and Philippines indicated a strong relationship between variables, no such
relationship was found for Singapore.
2.2 Studies in India
Malarvizhi and Jaya (2012) investigate the relationship between Exchange rate and Nifty Index
movement of NSE Exchange rate and Nifty Index. US Dollar has been taken for the exchange
rate of the rupee. The empirical results showed no long-run relationship but bidirectional causal
relationship between exchange rate and nifty, i.e. changes in stock market will affect exchange
rate and vice versa. Agrawal and Srivastava (2010) found the negative relation between Nifty
returns and Exchange Rates. Further investigation is made for capturing the degree and the
direction of long term relation between Nifty returns and exchange rates and the unidirectional
causality running from stock returns to exchange rates. The study can be concluded that with an
increase in the returns of Nifty Index may cause a decline in the exchange rates but conversely it
was not. Nath and Samanta (2003) employed two different methodologies, Granger (1969)
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Causality Test in Vector auto Regression (VAR) framework and the Gewekes feedback
measures. The empirical results explored through VAR-framework do not show stronger causal
relationship between the returns of two markets whereas Gewekes feedback detects strong bi-
directional as well as contemporaneous causal relationship between the returns of two markets.
2.3 Research gap
Many studies have been carried out within this field to test the theory of relationship between
exchange rate and stock price. These studies are focused on different countries which have
different degrees of foreign exchange controls, exchange rate system as well as the development
of the stock market itself. Additionally, it is found that at the early stage, studies were mostly
conducted in developed countries where the market mechanisms were more mature. In recent
years, because of the increasing degree of the integration among the world financial markets, the
studies about causal relationship are widely conducted both in developed and developing
countries. From the review of all the studies mentioned above, it appears that in India, there
remains the scope to conduct the study.
3. Data and Methodology
The study is focused towards BSE Sensex (BSE), S&P CNX Nifty (NIFTY) and nominal
exchange rates of United States Dollar (USD), Euro (EUR), Japanese Yen (JPY) and Pound
Sterling (GBP) respectively. For the exchange rates, Indian Rupee is taken as per unit of foreign
currency. The frequency of data is kept at daily basis because it provides the results, which are
more precise and are better, able to capture the dynamics between exchange rates and Stock
Indices. The period of study is taken from March 1, 2004 to August 31, 2012, based on the
availability of data. The daily stock prices and daily exchange rates have been matched by
calendar date. The missing dates are deleted to match the date of both the variables. The numbers
of total observations are 2057 after deleting the missing frequency. All the variables are in their
logarithmic form. The data on stock prices of BSE Sensex are collected from the BSEs Official
(www.bseindia.com) website and of S&P CNX Nifty are collected from the NSE Official
(www.nseindia.com)Website. The exchange rates data are collected from the database
maintained by the Centre for Monitoring Indian Economy (CMIE).
For calculating daily returns, natural logarithm of direct quotation has been used for exchange
rates and natural logarithm for closing price of stock price.
2 . 3 ) ln(
1 . 3 ) ln(
t
t
t t
SP SR
ER ERR
=
=

Where ERR
t
and SR
t
are exchange rate return and stock return at time t, ER is the direct
quotation of exchange rates and SP is the closing price of Index. Ln ( ) represents natural
logarithm function used for calculating the daily returns.
3.1 Unit Root Tests.
Augmented Dickey-Fuller (1979) & Phillips and Peron (1988) are implemented to investigate
whether the time series of exchange rate and stock price are stationary or not to avoid the
problem of spurious results.
Augmented Dickey-Fuller (1979) test is obtained by the following regression
3 . 3
1
1
1 0 t t
p
i
t t
u Y i Y a Y + + + =
=

Where is the difference operator, is the constant and is the coefficient to be estimated, Y is
the variable whose time series properties are examined and u
t
is the white-noise error term.
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Phillips and Peron (1988) test suggests a non-parametric method of controlling for higher order
autocorrelation in a series and is based on the following first order auto-regressive AR(1)
process:
4 . 3
1 t t t
Y a Y + + =

Where is the difference operator, is the constant, is the slope and Y
t-1
is the first lag of the
variable Y.
3.2 Engle and Granger (1987) cointegration test
Engle-Granger (1987) two-step method is applied to determine the long-run relationship between
the stock returns and exchange rates. In the first step the stock returns are regressed on the
exchange rates. The reverse-order regression is also taken into account. As a second step the
presence of cointegrating relationship between the two variables is tested by applying ADF test
of unit roots on the residual obtained from the cointegrating equation.
The Engle-Granger two-step method consists of two equations as follows:
6 . 3
5 . 3
t t t
t t t
LS LEX
LEX LS

+ + =
+ + =

Where LS
t
is the logarithm of stock index return, LEX
t
is the logarithm of exchange rate returns,
t
is the residual from cointegrating equation and is residual from the equation of ADF unit root
test which is assumed to be white noise. If the residual series are stationary, then these two
variables have cointegration relations among the related variable pairs.
3.3 Granger causality Test
To test whether there is any association between stock and currency markets, Granger Causality
test has been used. Granger Causality test is used when it is known that some relationship exists
between two variables but it is not known which variable causes the other to move.
Suppose ER and SR are two variables representing exchange rates and stock index respectively.
To see whether ER granger causes SR or SR granger causes ER, following equations are run
8 . 3
7 . 3
2
1
2
1 1
1 0
1
1
2
1
1 0
t i t
p
i
i
t
p
i
i t
t i t
p
i
i
i t
p
i
i t
u ER SR ER
u ER SR SR
+ + + =
+ + + =
= =
= =

where SR and ER represent stock returns and exchange rates returns, respectively. The
disturbances u1t and u
2t
are assumed to be uncorrelated, and t denotes the time period. Granger
causality test requires that all data series involved are stationary. Otherwise the inference from
the F-statistics might be spurious because the test statistics will have nonstandard distributions.
Accordingly, the first differences of all log-level series are employed and the first difference
operator is marked by .
4. Results and Discussion
4.1 Descriptive Statistics
Table 4.1 provides a summary of descriptive statistics for each series (logarithmic differenced
changes). As shown in Table 4.1, the skewness coefficient, in excess of unity is taken to be fairly
extreme [Chou 1969]. High or low kurtosis value indicates extreme leptokurtic or extreme
platykurtic [Parkinson 1987]. Generally values for zero skewness and kurtosis at 3 represents
that the observed distribution is normally distributed. It is seen that the frequency distribution of
the mentioned variables are not normal. Jarque-Bera statistics also indicates that the frequency
distribution of the underlying series does not fit normal distribution.. Each series generally
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appears to follow a non-normal distribution as the Jarque-Bera statistics reject the null
hypothesis of a normal distribution at the 1 percent level of significance.

Table 4.1 Descriptive Statistics of Daily Stock Returns and Exchange Rate Returns
Variables LSENSEX LNIFTY LUSD LEUR LJPY LGBP
Mean 9.436303 8.2359 3.8183 4.1044 3.8265 4.3692
Median 9.591886 8.3758 3.8122 4.086 3.7436 4.3795
Maximum 9.949057 8.7486 4.0468 4.2707 4.2783 4.4934
Minimum 8.412979 7.2362 3.6705 3.9482 3.4871 4.1843
Std. Dev. 0.410153 0.3954 0.0755 0.0853 0.2026 0.0686
Skewness -0.870485 -0.803 0.455 0.1527 0.4192 -0.438
Kurtosis 2.500924 2.4122 3.665 1.7958 2.1183 2.2834
Jarque-Bera 281.128 250.57 108.87 132.27 126.86 109.82
Probability 0 0 0 0 0 0
Observations 2057 2057 2057 2057 2057 2057
Notes:
LSENSEX is the daily return of Sensex Index
LNIFTY is the daily return of S&P CNX Nifty
LUSD is daily return for exchange rates of United States Dollar/Indian Rupee
LEUR is the daily return for exchange rates of Euro/ Indian Rupee
LJPY is the daily return for exchange rates of Japanese Yen/ Indian Rupee
LGBP is the daily return for exchange rates of Pound Sterling/ Indian Rupee
4.2 Daily Stock Returns
Mean returns attempt to quantify the relationship between the risk of a portfolio of securities and
its return. It assumes that while investors have different risk tolerances, rational investors will
always seek the maximum rate of return for every level of acceptable risk. It is the mean, or
expected, return that investors try to maximize at each level of risk In case of Stock Index, mean
daily return of Sensex is 9.436303% while standard deviation is 0.410153%. Over the analysis
period of 1 March 2004 to 31 August 2012, daily mean returns of Sensex are higher than those of
mean daily return of Nifty Index which is 8.2359%. Sensex Index also have higher maximum
(9.949057%) and minimum (8.412979%) daily return compared to Nifty. Standard Deviation is
measured as under root of the variance and is used as a measure of risk. Standard deviation of
Sensex Index is 0.410153% and of Nifty is 0.3954%. Both the Index are riskier but on the basis
of standard deviation Sensex seems to be more riskier showing higher standard deviation as
compared to Nifty Index. From the above statistics, it can be concluded that Stock Index which
have higher rate of return can be risky like Sensex.
4.3 Daily Exchange Rates Return
In the present study, Exchange rates return has been calculated by taking the log of direct
quotation of exchange rates. Table 4.1 show the exchange rates return of the sample currencies.
In case of exchange rates, positive values of daily mean return indicates depreciation in all the
four currencies over the analysis period. The highest depreciation in its value is experienced by
the Pound Sterling, with daily mean depreciation of 4.3692% from 1
st
March 2004 to 31
st
August
2012. Second highest depreciation has been observed in Euro, which has the mean value of
4.1044%. Japanese Yen has experienced the daily mean depreciation of 3.8265% which is
followed by the United States Dollar with mean depreciation of 3.8183%. As far as volatility or
riskiness of exchange rates is concerned standard deviation for exchange rate of Japanese Yen is
having the highest volatility among all the currencies showing standard deviation of 0.2026%.
Volatility of Euro is 0.0853% which is followed by United States Dollar and Pound Sterling with
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standard deviation of 0.0755% and 0.0686% respectively. Pound sterling which has experienced
the highest mean value is less volatile as compared to other exchange rates.
4.4 Line Graphs of Exchange Rates and Stock Indices
Unit root in the time series data can also be estimated by drawing the Line graphs of the samples
but it is informal way of detecting the unit root. Continuous increasing or decreasing trend of the
sample series over time indicates the existence of unit root in the series. If there is unit root in the
series mean the data is not stationary and the results obtained from such data are not valid. Hence
it will be required to make it stationary. Line Graph of Sensex Index, S&P CNX Nifty Index, US
Dollar Exchange Rate, Euro Exchange Rate, Japanese Yen Exchange Rate and Pound Sterling
Exchange Rate are shown in figure 4.1, 4.2, 4.3, 4.4, 4.5, and 4.6 respectively.

Line graphs of all the variables are showing increasing trend over time which means the
variables contain unit root in the series. Hence it is needed to investigate the unit root by formal
test of unit root. The above outlined graphs show that all the four series of exchange rates as well
as both the series of stock indices have unit root, and hence are non stationary. However, the line
graphs of exchange rates of United States Dollar and Pound Sterling do not provide clear idea
about the existence of unit root. Through formal investigation, the stationarity and the order of
integration can be determined. For this, two unit root tests Augmented Dickey-Fuller (ADF) test
and Phillips-Perron (PP) test have been employed.
4.5 Results of Unit Root Tests
The study employed two unit root tests to determine the stationarity of the variables viz.
Augmented Dickey- Fuller test (ADF) and Phillip-Perron test (PP), which are conducted at the
level series and at the first difference series respectively. The optimal lag length is determined by
using Schwarz Information Criterion (SIC). Both ADF as well Phillip Peron Tests, test the null
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hypothesis of unit root in the series. It reports test statistics, which are compared to McKinnon
Critical values. The results obtained from stationary test are shown in Table 4.2 and Table 4.3.
Null Hypothesis (H
0
): Data is not stationary (Unit root exists)
Alternative Hypothesis (H
1
): Data is stationary (Unit root does not exist)
If ADF statistics or PP statistics exceed critical value, the null hypothesis can be rejected. Hence
the alternative hypothesis is accepted which means the data are at stationary.
Table 4.2 Unit Root Test Result at the Level Series
Variable Test Test Statistics Critical Value
1% Level 5% Level 10% Level
LSENSEX ADF Test -1.336544 -2.566088 -1.940978 -1.616596
PP Test -1.328093 -2.566087 -1.940978 -1.616596
LNIFTY ADF Test -1.189195 -2.566088 -1.940978 -1.616596
PP Test -1.244204 -2.566087 -1.940978 -1.616596
LUSD ADF Test -0.944373 -2.566087 -1.940978 -1.616596
PP Test -0.887781 -2.566087 -1.940978 -1.616596
LEURO ADF Test -0.728382 -2.566087 -1.940978 -1.616596
PP Test -0.724160 -2.566087 -1.940978 -1.616596
LJPY ADF Test -1.387302 -2.566087 -1.940978 -1.616596
PP Test -1.547399 -2.566087 -1.940978 -1.616596
LGBP ADF Test -0.173589 -2.566087 -1.940978 -1.616596
PP Test -0.180112 -2.566087 -1.940978 -1.616596

The results obtained in Table 4.2 at level series does not reject the null hypothesis of unit root as
t-statistics of ADF test and PP test does not exceed the critical value at each of the level i.e. 1%,
5% and 10% level. So, both the series of stock indices and four series of exchange rates variable
are non-stationary.
Table 4.3 Unit Root Test Result at the First Difference Series
Variable Test Test Statistics Critical Value
1% Level 5% Level 10% Level
LSENSEX ADF Test -32.77130* -2.566088 -1.940978 -1.616596
PP Test -42.19459* -2.566088 -1.940978 -1.616596
LNIFTY ADF Test -42.45853* -2.566088 -1.940978 -1.616596
PP Test -42.37887* -2.566088 -1.940978 -1.616596
LUSD ADF Test -44.35557* -2.566088 -1.940978 -1.616596
PP Test -44.41281* -2.566088 -1.940978 -1.616596
LEURO ADF Test -44.83894* -2.566088 -1.940978 -1.616596
PP Test -44.83907* -2.566088 -1.940978 -1.616596
LJPY ADF Test -47.40619* -2.566088 -1.940978 -1.616596
PP Test -47.61770* -2.566088 -1.940978 -1.616596
LGBP ADF Test -34.21405* -2.566088 -1.940978 -1.616596
PP Test -44.49300* -2.566088 -1.940978 -1.616596
Notes
Using critical value by Mackinnon, 1996
Maximum lag length is chosen by using Schwarz Information Criterion (SIC) in case of ADF test
Selection of bandwidth in case of PP unit root test according to Newey-West, 1994
* indicates stationary at 1% level and 5% and 10% level
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The results obtained in table 4.3 at first difference series reject the null hypothesis of unit root as
t- statistics of ADF test and PP test exceed the critical value at all the level i.e. 1%, 5% as well as
10%. So, both the series of stock indices and four series of exchange rates variable are stationary.
4.6 Results of Cointegration Tests
Null hypothesis: There is no long-run relationship between stock returns and exchange rates. (No
Cointegration).
Alternative hypothesis: There is long-run relationship between stock returns and exchange rates.
(Cointegration exists).
Decision rule: when t-statistics does not exceed the critical value, Null hypothesis of no
cointegration cannot be rejected, hence it is accepted which means there is no cointegration or
long-run relationship between the variables.
In this section, Engle-Granger two-step method of cointegration is carried out to examine
whether any combinations of the said variables are cointegrated. Table 4.4, presents the results of
Engle-Granger cointegration test. The 2
nd
column of this table lists the statistics when (stock
return) is regressed on (exchange rate return) whereas the statistics of the reverse-order
regression is reported in the 4
th
column. The results obtained from the Engle Granger test of
cointegration cannot reject the Null hypothesis of No cointegration in each case of Stock Index
and Exchange Rates variables as t-statistics is less than the critical value indicate that there is
unit root in the residual for all the series. This implies that the two series are not cointegrated for
the periods under analysis. So there is no long-run relationship between the stock returns and
exchange rates. In summary, the findings from Engle-Granger two-step method of cointegration
procedure suggest no evidence of cointegrating (long-run) relationship between exchange rates
and stock prices covering the period of 1
st
March 2004 to 31
st
August 2012. This is not surprising
as it could be explained by the particular exchange rate policy.. Thus, mutual relations between
stock prices and exchange rates could not emerge completely in the long-run. This finding is
similar to the previous study such as Granger et al. (2000) which state that there is no long-run
significant relationship between stock prices and exchange rates. Since stock prices and
exchange rates are not cointegrated, the Granger causality test is applied whether there exists
short-run relationship between the two markets.
Table 4.4 Results of Engle-Granger cointegration test
y
1t
is regressed y
2t
t-statistics y
2t
is regressed ony
1t
t-statistics
LSENSEX/LUSD -1.790063* LUSD/LSENSEX -0.267296*
LSENSEX/LEUR -2.034798* LEUR/LSENSEX -1.926100*
LSENSEX/LJPY -1.925448* LJPY/LSENSEX -0.448983*
LSENSEX/LGBP -1.483186* LGBP/LSENSEX -1.965966*
LNIFTY/LUSD -1.778007* LUSD/LNIFTY -0.285726*
LNIFTY/LEUR -2.047950* LEUR/LNIFTY -1.966913*
LNIFTY/LJPY -1.920134* LJPY/LNIFTY -0.517952*
LNIFTY/LGBP -1.440365* LGBP/LNIFTY -1.973448*
*Indicates no cointegration at 5% level
Notes: y
1t
denotes the stock return while y
2t
denotes the exchange rate return.
ADF critical
values: 1% level -4.00

5% level -3.37

10% level -3.02

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4.7 Results of Granger Causality Test
As the results of Eangle-Granger test of cointegration shown in Table 4.4 indicates no
cointegrating (long-run) relationship between stock returns and exchange rates, this section
continues to seek for any possible short-run causal relationship between exchange rates and
Index returns and vice-versa. An attempt is made to answer the following question: Do changes
in exchange rates cause stock prices or do changes in stock prices cause exchange rates in short-
run? When two variables are known to be related but the direction of their causality is not
known, then granger causality is applied. In the present study stock returns and exchange rates
are two series, which are assumed to be correlated. The literature in the present study provides
the supporting evidence of possible linkage between exchange rate and stock market, however,
direction of the causality is not known. The Empirical investigation will determine the nature and
direction of this relationship. Null hypothesis of Granger Causality Test is that one series does
not cause the other series. By comparing the probability value with 0.05 will test the null
hypothesis of no granger causality. First hypothesis is that exchange rates do not granger cause
stock returns while the second null hypothesis is that stock returns do not granger cause
exchange rates.
Table 4.5 shows the results of Granger Causality test. Null hypotheses is stated in column 1,
column 2 shows the lag period, F-statistics is reported in column 3 and Column 4 shows the p-
value of corresponding F-statistics. The lag period is selected on the basis of LR test statistic,
Final Prediction Error and Akaike Information Criterion, Schwarz Information criterion and
Hannn-Quinn Information Criterion. The lags were set equal to 8 and dropped until the last lag
become significant. In case of Sensex and Euro, Sensex and Pound Sterling, Nifty and Euro and,
Nifty and Pound Sterling lag 2 is significant while 3 and 4 are significant lags in rest of the
combinations of Exchange Rates and Stock Index.
Null hypothesis (H
0
): Exchange Rate Return does not Granger Cause Stock Return and vice-
versa
Alternative Hypothesis (H
0
): Exchange Rate Return does Granger Cause Stock Return and vice-
versa.
Decision Rule: when p-value is less than 5%, can reject the Null hypothesis, Hence, Alternative
hypothesis is accepted which means causality exists between the two series of exchange rate and
stock index.
Table 4.5 Pairwise Granger Causality Test between Stock Returns and Exchange Rates

Null Hypothesis Lag F-
Statistics
p-value
DLUSD does not Granger Cause DLSENSEX
DLSENSEX does not Granger Cause DLUSD
3 4.81058
33.7388
0.0024*
3.E-21*
DLEUR does not Granger Cause DLSENSEX
DLSENSEX does not Granger Cause DLEUR
2 2.81224
16.7940
0.0603
6.E-08*
DLJPY does not Granger Cause DLSENSEX
LSENSEX does not Granger Cause DLJPY
4 3.44391
30.1237
0.0082*
2.E-24*
DLGBP does not Granger Cause DLSENSEX
DLSENSEX does not Granger Cause DLGBP
2 1.90153
7.66366
0.1496
0.0005*
DLUSD does not Granger Cause DNIFTY
DLNIFTY does not Granger Cause DLUSD
3 5.18971
34.0711
0.0014*
2.E-21*
DLEUR does not Granger Cause DLNIFTY
DLNIFTY does not Granger Cause DLEUR
2 3.16983
16.3017
0.0422*
9.E-08*
DLJPY does not Granger Cause DLNIFTY
LNIFTY does not Granger Cause DLJPY
4 3.28148
29.6212
0.0108*
6.E-24*
11

DLGBP does not Granger Cause DLNIFTY
DLNIFTY does not Granger Cause DLGBP
2 2.89014
7.95592
0.0558
0.0004*
*indicate significance at 5% level
DLSENSEX differenced return of Sensex
DLNIFTY differenced return of S&P CNX Nifty
DLUSD differenced return from Exchange Rates of US Dollar
DLEUR differenced return Exchange Rates of Euro
DLJPY differenced return Exchange Rates of US Japanese Yen
DLGBP differenced return Exchange Rates of Pound Sterling
Table 4.5 shows that bi-directional causality runs from stock market to exchange rate in case of
Sensex and US Dollar. P-value of the null hypotheses of no granger causality from exchange rate
to stock market and from Stock market to exchange rate is below 0.05 in both the cases, thus null
hypotheses can be rejected in both the cases of Sensex and US Dollar. The empirical results
show the feedback relationship between Sensex and the exchange rates of US Dollar.
In case of Sensex and Exchange rate of Euro, the results show the uni-directional causality,
running from stock market to exchange rate. P-value of Null Hypothesis of no Granger Causality
from Euro to Sensex exceeds 0.05, thus null hypothesis cannot be rejected, hence the Null is
accepted which means Euro does not Granger cause Sensex. On the other hand, p- value of Null
hypothesis of no Granger causality from Sensex to Euro does not exceed 0.05 which can be
rejected. Hence the uni-directional causality is found between the Sensex and Euro Exchange
rates.
In case of Sensex and Exchange rate of Japanese Yen, the empirical results show the bi-
directional causality running from Sensex to Exchange rate of Japanese Yen and vice-versa. The
null hypothesis of no granger causality from stock market to exchange rate or from exchange rate
to stock market can be rejected as probability values do not exceed 0.05. Therefore, bi directional
causality has been found in case of Sensex and Japanese Yen.
In case of Sensex and Exchange Rate of Pound Sterling, supports the existence of uni-
directional causality running from Stock market to Exchange rate. Null hypothesis of no granger
causality running from Pound Sterling to Sensex Index cannot be rejected but the null hypothesis
of no granger causality from Sensex to pound Sterling can be rejected. Thus, only one way
causality exists between the Sensex and Exchange rate of Pound Sterling.
In case of Index Nifty, the bi-directional causal relationship exists with the exchange rates
except the relationship with the Pound Sterling Exchange rates showing uni-directional
relationship. The null hypothesis of no causality running from Nifty Index to Exchange Rates
and from Exchange rate to Nifty Index can be rejected in all the cases except for Pound Sterling
exchange rates. The probability value for causality running from Pound Sterling exchange rate to
Nifty Index is above 0.05, which means Null hypothesis cannot be rejected and thus the
statistical results does not support the causality run from Pound Sterling to Nifty but the causality
run from Nifty to Exchange rate of Pound Sterling as p-value is 0.0004, which is less than 0.05,
means Nifty Granger cause Pound Sterling
If the relationship of both the Indices is compared with the four different exchange rates, Sensex
Index is showing bidirectional causal relationship with exchange rates of US Dollar and Japanese
yen while only one way causality run from Sensex Index to Exchange rates of Euro and Pound
Sterling. In case of Nifty Index, bidirectional causality runs from Nifty to Exchange rates of US
Dollar, Euro and Japanese Yen while one way causality found, running from Nifty Index to
Exchange rates of Pound Sterling.
If the relationship of four exchange rates is compared with respect to Stock index, Exchange
rates of US Dollar is causing short run effect to both the Index i.e Sensex and Nifty but effect of
12

Dollar seems to be stronger as compared to Nifty as the p-value is lesser than that of Nifty. Euro
is showing no effect or no causality run from Euro to Sensex but Nifty is showing the effect of
Euro on its daily return. Exchange rates of Japanese Yen causing both the Index but Pound
Sterling showing no significant effect on Sensex, and the weak effect on Nifty Index.
This finding implies that there exists short run causal relationship between stock market and
Forex market considered over the study period. Thus, this may indicate that the foreign exchange
and stock markets become more efficient or that they cease to be integrated. Similar to the
finding by Ajayi et al. (1998) who show insignificant causality between these markets, it is not
possible to hedge the currency and stock risks by investing in both markets over the crisis period.
In this case, one market cannot also serve as a base for policy intervention for stabilizing the
other market. That is, the foreign exchange market cannot serve as venue for intervention for the
purpose of stabilizing the stock market and vice versa.
As suggested by Kasman (2003), the inadequate lag selection could result in the omission of
important information and hence lead to the spurious rejection of causal relationship.
Considering that the results derived from the Granger causality test might be sensitive to the
selection of the lag length, other lag length (lag = 1, 3, 4) is also selected to re-examine the
causal relationship of both variables. However, as presented in Table 4.5, the conclusion in
general is irrelevant with the different lags used in the estimation. It may be noted that the
empirical findings in this area unveil the fact that the results are dependent on the time period of
the study. This has been confirmed by Ramasamy and Yeung (2005), who point out that the
causality between stock prices and exchange rates may vary depending on the state of the
business cycle and the uncertainties surrounding the different markets for the period under study.
They also argue that the results of causality are switched according to the length of period
chosen. In terms of this, the present study thereby provides further evidence on the causality
between the said variables using daily data and specific sample period that has been chosen. The
study found no long-run evidence but short run relations exists between the exchange rates and
stock market.
5. Conclusions
This study is undertaken to analyze the dynamics of stock returns and exchange rates. This link
can be exploited to predict the path of the exchange rates. This will also assist in the management
of corporations exposure to foreign exchange rate risk of their earnings. More importantly for
Investors, since currency assets are an important part of investment funds, the knowledge of the
link between currency and other assets in the portfolio is vital. Also, stock markets have been
found to impact aggregate demand through wealth and liquidity effects, influencing money
demand and exchange rates. Thus while formulating monetary policy or undertaking foreign
exchange intervention, its impact on the stock market needs to be taken into consideration. The
objectives of the study are to investigate the Long-Run relationship and the Short-Run causal
relationship between the stock returns and the exchange rates. The study is focused towards BSE
Sensex (BSE), S&P CNX Nifty (NIFTY) and nominal exchange rates of United States Dollar
(USD), Euro (EUR), Japanese Yen (JPY) and Pound Sterling (GBP) respectively for the period
of 1 March 2004 to 31 August 2012. For the exchange rates, Indian Rupee is taken as per unit of
foreign currency. The frequency of data is kept at daily basis because it provides the results,
which are more precise and are better, able to capture the dynamics between exchange rates and
Stock Indices. First of all the Augmented Dickey Fuller (ADF) test proposed by Dickey and
Fuller (1979) and Phillips-Peron (PP) (1988) tests are employed to examine whether the series
are stationary or not. After checking the stationarity of the variable Engle Granger Test of
13

cointegration has been employed to determine the long-run relationship between the stock
returns and exchange rates. Finally granger Causality is applied to capture both the short-run
relationship between the stock returns and the exchange rates.
The results show that all the data series of the variables are non-stationary and integrated of order
one. Then Engle Granger test of cointegration is applied for the possibility of a cointegrating
relationship. Result shows that there is no cointegrating relationship between stock prices and
exchange rates which means there is no relationship between the stock returns and the exchange
rates. The empirical results obtained by Granger causality test showed the existence of causal
relationship in the short run either uni-directional or bi-directional for different exchange rates
variable. The major findings of the study are: (i) bi-directional causality runs from stock index to
exchange rate in case of Sensex and US Dollar (ii) uni-directional causality running from Sensex
to exchange rates of Euro. (iii) bi-directional causality runs from stock index to exchange rate in
case of Sensex and exchange rates of Japanese Yen. (iv) uni-directional causality running from
Sensex and Nifty Index to exchange rates of Pound Sterling and; (v) bi-directional causality
exists between Nifty and exchange rates of US Dollar, Euro and Japanese Yen. There is a
common belief among the investors that there is an association between exchange rates and stock
prices and they are predictable on the basis of the values of other variables. But the result of no
cointegration of the study counters this belief and states that the variables are not predictable on
the basis of the past values of other variables. As the study found bidirectional and uni-
directional relationship exists between the stock return and exchange rates, this information can
be used to forecast Stock market and Forex market. This hit-and-run pattern of causational
behaviour across all the currencies in the analysis raises doubts as to whether the results can be
used to make any meaningful policy recommendation other than to accept the fact that
movements in the stock and exchange rate markets are highly robust and vigorous. This implies
that great caution must be employed while interpreting the results of such Granger causality
results.
5.1 Contributions of the Study
The contribution of this study is embodied in the issue it addresses referred to above.
Firstly, the study took less theory ladenapproach to the examination of the research question
than is normally taken but at the same time applied models of the relationship between exchange
rates and stock index. Secondly, the findings of this study have a number of important
implications for future practice as the stock returns exchange rates play a vital role in Indian
economy. Therefore there is a definite need to determine the relationship between exchange rates
and stock returns which the present study contributes. The empirical results of the research
confirm previous findings and contribute additional evidence to the academic literature and will
help in improving the policy implications for the investors. In particular the findings are relevant
for a better understanding for emerging economy of India.
5.2 Suggestions for Further Research
For further study, some more variables related to politics, macro-economic variables and
economic stability (using dummy variables is a good choice) can be added as the present study
used only two variables. After introducing some new variables and other market then only a clear
picture of India can be predict, and the same type of analyses in other developing countries.
Moreover, spillover effect is another interesting aspect of this topic which can also be
determined. Then, this study will be more helpful for investors in the market and also for
researchers in economics.

14

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Websites
www.nseindia.com/
www.bseindia.com/
www.forex-market-history.com/
www.essaybank.degree-essays.com/
http://currencyinformation.org/
www.wikipedia.org/
www.slideshare.net/

Authors
Mohammad Tanzeem Raza*, M.Phil Research Scholar, Department Of Commerce,
Pondicherry University, Puducherry-605014, m.tanzeemraza@gmail.com
S. Aravanan, Selection Grade Asst. Professor, Department Of Commerce, Pondicherry
University, Puducherry-605014, aravanan1954@gmail.com

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