The Quarterly Review of Economics and Finance 40 (2000) 337354

A bivariate causality between stock prices and exchange

rates: evidence from recent Asian flu
Clive W.J. Grangera, Bwo-Nung Huangb,* Chin-Wei Yangc
a

Department of Economics, University of California, San Diego, La Jolla, CA 92093-0508, USA

b
Department of Economics, National Chung-Cheng University, Chia-Yi, Taiwan 621
c
Department of Economics, Clarion University of Pennsylvania, Clarion, PA 16214-1232, USA

Abstract
This paper applies recently developed unit root and cointegration models to determine the appropriate Granger relations between stock prices and exchange rates using recent Asian flu data. Via
impulse response functions, it is found that data from South Korea are in agreement with the
traditional approach. That is, exchange rates lead stock prices. On the other hand, data of the
Philippines suggest the result expected under the portfolio approach: stock prices lead exchange rates with
negative correlation. Data from Hong Kong, Malaysia, Singapore, Thailand, and Taiwan indicate strong
feedback relations, whereas that of Indonesia and Japan fail to reveal any recognizable pattern. 2000
Bureau of Economic and Business Research, University of Illinois. All rights reserved.
JEL classification: F300; G150
Keywords: Asian Flu; Bivariate Causality between Stock Prices and Exchange Rates

1. Introduction
The financial crisis sparked in Thailand in July 1997 has sent shock waves throughout
southeast Asia, South Korea, and Japan. On October 27, the short-run interest rate in Hong
Kong took a huge jump to maintain its exchange rate to the US dollar. As a result, the Hang
Seng Index plummeted 1438 points, setting off the crash in the US with the Dow Jones
Financial assistance from the National Science Council of Taiwan (NSC88-2415-H-194-002) and Fulbright
Scholarship Program is gratefully acknowledged. This paper is written during my tenure as a visiting scholar at UCSD.
We are grateful to two anonymous referees for valuable suggestions. However, we wish to absorb all the culpability.
* Corresponding author. E-mail address: ecdbnh@ccunix.ccu.edu.tw (B.-N. Huang).
1062-9769/00/$ see front matter 2000 Bureau of Economic and Business Research, University of Illinois. All rights reserved.
PII: S 1 0 6 2 - 9 7 6 9 ( 0 0 ) 0 0 0 4 2 - 9

338

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

Industrial Averages down by 554.26 points. On November 24, Yamaichithe fourth largest
financial corporationfiled for bankruptcy, which gave rise to a 854-point drop in Nikkei
Index. In mid-December, the Korean Won depreciated drastically from 888 wons (per dollar)
on July 1 to more than 2000 wons. The currency crisis in South Korea set off a financial
avalanche in its stock markets, which witnessed a 50.3% freefall. Similar debacles also
occurred in other Asian markets. After the devaluation of the Thai Baht (July 1997), other
southeast Asian currencies over the next 2 months abandoned their close links to the US
dollar and began to depreciate. The most severe pressures in foreign exchange markets, in the
third quarter of 1997, were experienced by Thailand, Malaysia, the Philippines, and Indonesia, but the currencies of Singapore and a number of other Asian countries also weakened.
As the pressure spread to Hong Kong and Korea in late October after the depreciation of the
New Taiwan dollar, the scale of the crisis worsened significantly. The financial tsunami
continued to exert its devastating force and did not slow down until the first quarter of 1998.
This is known as the Asian flu in which stock prices and exchange rates plunged in tandem.
Turmoils in both currency and stock markets are of paramount interest: does currency
depreciation lead to stock market downfall or vice versa? Such a study provides an opportunity for analyzing dynamics between stock prices and exchange rates. If a statistical
lead-lag relation can be ascertained, practitioners can profit from the arbitrage especially
during a severe financial crisis.
The bridge between the exchange rate and the asset market equilibrium is the interest
parity condition according to Krugman and Obstfeld, (1997, Chapt. 16): R R* (Ee
E)/E, where R and R* are interest rates of domestic and foreign currencies and E and Ee
denote exchange rate and expected future exchange rate respectively. For asset markets to
remain in equilibrium, ceteris paribus, a decrease in domestic output (hence lower R due to
reduced demand for money) must be accompanied by a currency depreciation (a greater
value for E). Aggarwal (1981) has argued that a change in exchange rates could change stock
prices of multinational firms directly and those of the domestic firms indirectly. In the case
of a multinational firm, a change in exchange rate will change the value of that firms foreign
operation, which will be reflected on its balance sheet as a profit or a loss. Consequently it
contributes to current account imbalance. Once the profit or a loss is announced, that firms
stock price will change. This argument shows that devaluation could either raise or lower a
firms stock price depending on whether that firm is an exporting firm or it is a heavy user
of imported inputs. If it involves in both activities, its stock price could move in either
direction. This is true especially when most stock prices are aggregated to investigate the
effects of devaluation on stock markets. From this viewpoint, exchange rate change is
expected to give rise to stock price change. Such a causal relation is known as the traditional
approach.
However, as capital market become more and more integrated, changes in stock prices and
exchange rates may reflect more of capital movement than current account imbalance. The
central point of such a portfolio approach lies in the following logical deductions: A decrease
in stock prices causes a reduction in the wealth of domestic investors, which in turn leads to
a lower demand for money with ensuing lower interest rates. The lower interest rates
encourage capital outflows ceteris paribus, which in turn is the cause of currency depreciation.1 Under the assumption of the portfolio approach, stock price is expected to lead

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

339

exchange rate with a negative correlation. If a market is subject to the influences of both
approaches simultaneously, a feedback loop will prevail with an arbitrary sign of correlation
between the two variables.
In the case of the US markets, empirical examinations of relation between stock returns
and exchange rate changes have largely provided only weak evidence on the following
relationship: exchange rate changes are significantly related to firm or portfolio stock returns
(Jorion, 1990; BahmaniOskooee and Sohrabian, 1992; Amihud, 1993; Bartov and Badnar,
1994). Similar tests are performed by Bondnar and Gentry (1993) for Japan and Canada. In
the case of emerging markets, only skimpy literature is available. For instance, the result of
Abdalla and Murinde (1997) supports the traditional approach: exchange rate changes lead
stock returns. However, their study includes only India, South Korea, Pakistan, and the
Philippines. The recent Asian flu raises a rather puzzling question: in the wake of depressing
stock and currency markets, which one is the culprit? The majority of previous studies
support the traditional approach: exchange rate change leads stock return. Only a few
indicate that opposite direction holds true or the feedback phenomenon exists. But they do
not discuss the sign between exchange rate and stock price. Well-known in the literature,
using monthly data may not be adequate in describing the effect of capital movement, which
is intrinsically a short-run occurrence. In this paper, we employ daily data of the emerging
markets in the hope that it will capture such effects. To further the analysis, we employ
impulse response functions to explore the relation (signs) and its dynamics. In addition, we
apply more advanced unit root and cointegration techniques, which account for structural
break (for example, the Asian flu), to avoid the potential estimation bias. The organization
of the paper is as follows: Section 2 describes empirical models; Section 3 introduces the unit
root and cointegration models with structural break; Section 4 discusses the empirical result;
Section 5 investigates some related problem of the model; and Section 6 provides a
conclusion.

2. Discussion of empirical models

Since (Nelson and Plossers (1982)), well-known paper, the unit-root property of macroeconomic variables has been widely accepted. As such, a unit-root test is often necessary
before empirical studies. Based on the result by Dickey and Fuller (1979), the Augmented
Dickey and Fuller (ADF) test is generally employed as shown below:

k1

y t t 1 y t1

ti

at

(1)

i1

where 1 L; y t is a macroeconomic variable such as exchange rate or stock price; t

is a trend variable; and a t is a white noise term. The null hypothesis is H 0 : 1 and y t is
said to possess the unit root property if one fails to reject H 0 .
Nevertheless, the ADF test is suspect when the sample period includes some major events
(for example, great depression, oil shocks). Failure to consider it properly can lead to
erroneous conclusions in the case when the null is not rejected. To circumvent this problem,

340

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

Perron and Vogelsang (1992) introduce dummy variable into Eq. (1) and recalculate the new
set of critical values. However, as pointed out by Zivot and Andrew (1992, p. 251), a skeptic
of Perrons approach would argue that his choices of breakpoints are based on prior
observation of the data, and hence problems associated with pre-testing are applicable to his
method.2 Consequently, they introduce an alternative formulation to overcome the pretesting problems.3

k1

y t t 1 y t1 DU t

ti

at

(2)

i1

where DU t ( ) 1 for t T , otherwise DU t ( ) 0; T B /T represents the location

where the structural break lies; T is sample size; and T B is the date when the structural break
occurred. Evident from Eq. (2), the estimation result hinges critically on the value as well.
One of better ways to test the existence of a unit root is to choose the breakpoint that gives
the least favorable result for the null of H 0 : 1 using the test statistics t ( ). That is,
is chosen to minimize the one-sided t statistic for testing 1, when small values of the
statistic lead to the rejection of the null. Let inf denote such a minimizing value for the
model. Then, by definition, t [ inf] inf () where is a specified closed subset of (0,
1) (Zivot and Andrew, 1992, p. 254). As is shown in this paper, a set of simulated critical
values is employed for hypothesis testing during the period of the Asian flu. To investigate
the stationarity assumption of several I(1) variables, majority of academicians still rely on the
widely-accepted and easy-to-apply model proposed by Engle and Granger (1987) despite its
normalization problem. Just as the ADF model fails to consider problems associated with
structural breaks, the EngleGranger formulation bypasses the same difficulty. Applying the
similar approach by Zivot and Andrews (1992), Gregory and Hansen (1996) revise the Engle
and Granger (1987) model to consider the regime shift via residual-based cointegration
technique. The Gregory and Hansen model is a two-stage estimation process of which the
first step is to estimate the following multiple regression:
y 1t t DU t 1y 2t e t

(3)

in which y 1t and y 2t are of I(1) and y 2t is a variable or a set of variables; and DU t ( ) has
the same definition as that in Eq. (2). The second step is to test if e t in Eq. (3) is of I(0) or
I(1) via the ADF or PhillipsPerron technique. If e t is found to be consistent with I(0), one
may claim that cointegration exist between y 1t and y 2t . Once the statistical property of e t is
established, one may adopt the bivariate VAR model to test the Granger causality. If the
cointegration does not exist, the following formulation is needed in testing the hypotheses:

y 1t 0

1iy 1ti

i1

y 2t 0

2iy 2ti

1t

i1

i1

(4)

1iy 1ti

i1

2iy 2ti

2t

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

341

in which y 1t and y 2t represent stock prices and exchange rates. Failing to reject the H 0 :
21 22 . . . 2k 0 implies that exchange rates do not Granger cause stock prices.
Likewise, failing to reject the H 0 : 11 12 . . . 1k 0 suggests that stock prices
do not Granger cause exchange rates. If cointegration exists between y 1t and y 2t , an error
correction term is required in testing Granger causality as shown below:

y 1t 0 1 y 1t1 y 2t1

1iy 1ti

i1

y 2t 0 2 y 1t1 y 2t1

2iy 2ti

1t

i1

i1

(5)

1iy 1ti

2iy 2ti

2t

i1

in which 1 and 2 denote speeds of adjustment. According to Engle and Granger (1987), the
existence of the cointegration implies a causality among the set of variables as manifested by
1 2 0. Failing to reject the H 0 : 21 22 . . . 2k 0 and 1 0 implies that
exchange rates do not Granger cause stock prices while failing to reject H 0 : 11 12
. . . 1k 0 and 2 0 indicates stock prices do not Granger cause exchange rates.
3. Data, time series trends, unit root, and cointegration results
Included in this sample study are exchange rates and stock prices from Hong Kong
(HKN), Indonesia (IND), Japan (JPN), South Korea (KOA), Malaysia (MAL), the Philippines (PHI), Singapore (SIG), Thailand (THA), and Taiwan (TWN). The sample period starts
from January 3, 1986 to June 16, 1998. Daily data (5 days a week) in total of 3247
observations are from Datastream.4 Three subperiods are used to better dissect the relations
between exchanges and stock prices. Period 1 (1987-Crash) covered from January 3, 1986
to November 30, 1987; Period 2 (After Crash) started on December 1, 1987 and ended on
May 31, 1997; Period 3 (the Asian-Flu Period) continued from June 1, 1997 through June 16,
1998.5 All data points are transformed into logarithmic scale and are shown in time series
plots (see Fig. 1).
Evident from Fig. 1, all the nine economies exhibit pronounced structural breaks. That is,
barring the Hong Kong dollar that maintained its peg to the US dollar, all other eight
currencies suffered noticeable depreciations since July, 1997. During the period of July 1
June 16, 1998, the Rupiah of Indonesia experienced the greatest slide in its value (144.83%),
followed by Thai Bhat (55.50%), Won of South Korea (46.73%), Ringgit of Malaysia
(45.82%), and Peso of the Philippines (45.52%). The rest of currencies witnessed between
18% and 23% depreciation (Table 1). Similar freefalls in stock prices were witnessed
ranging from 19.8% of the Taiwan market to 84.9% of the Malaysian market. As the Asian
flu worsened, the performance of Pacific funds outside Japan fell 35.5% on average. Because
the existence of the structural break is very clear from both Table 1 and Fig. 1, a revised
model is necessary to explore the subtle relations between exchange rates and stock prices.
To account for the structural change, we employ the Zivot and Andrew (1992) model to
test the unit root property for the nine economies, and the result is reported in Table 2.

342

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

Fig. 1a. Time Series of the Nine Asian Exchange Rates (in Logrithm)

Table 1
A comparison of daily stock prices and exchange rates between July 1 and June 16, 1998
Exchange
rate

HKN

IND

JPN

KOA

MAL

PHI

SIG

THA

TWN

07/01/97
06/16/98
% Change
Stock index
07/01/97
06/16/98
% Change

7.75
7.75
0.05%
HKN
15196.79
7526.45
67.51%

2431.32
15197.57
144.83%
IND
731.61
406.50
57.13%

114.90
143.33
22.02%
JPN
20175.52
14720.38
31.27%

888.10
1429.59
46.73%
KOA
758.03
380.91
66.22%

2.52
4.02
45.82%
MAL
1078.90
435.84
84.91%

26.37
41.91
45.52%
PHI
2815.54
1726.55
47.95%

1.43
1.73
18.82%
SIG
494.00
289.04
52.35%

24.45
43.23
55.50%
THA
527.28
263.39
66.75%

27.81
34.82
22.38%
TWN
9030.28
7404.27
19.79%

HKN, Hong Kong; IND, Indonesia; JPN, Japan; KOA, Korea; MAL, Malaysia; PHI, Philippines; SIG,
Singapore; THA, Thailand; TWN, Taiwan. All prices are based on daily market close; and all exchange rates are
expressed as number of local currencies per US dollar.

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

343

Fig. 1b. Time Series of the Nine Asian Stock Indexes (in Logrithm)

Table 2
Zivot and Andrew unit root results

Exchange
rate
Stock
index

HKN

IND

JPN

KOA

MAL

PHI

SIG

THA

TWN

7.28*
[0.43]
3.25
[0.96]

6.77
[0.98]
3.17
[0.17]

2.47
[0.78]
3.65
[0.36]

4.98*
[0.97]
3.18
[0.95]

6.38*
[0.95]
3.08
[0.95]

4.21**
[0.94]
3.47
[0.92]

3.10
[0.94]
2.40
[0.95]

11.0*
[0.94]
1.82
[0.88]

2.95
[0.97]
3.36
[0.06]

k1
Note: The estimation result is based on y t t ( 1) y t1 DU t ( ) i1
i y ti a t ,
where DU t ( ) 1 for t T ; otherwise, DU t ( ) 0. T B /T denotes the location of the structural break,
T sample size, TB date of structural break; * 1% significance level; critical value for various are from
Table 3 provided by Zivot and Andrew (1992). Value of are in brackets. For 0.1, 0.2, 0.3, 0.4, 0.5, 0.6,
0.7, 0.8, 0.9, the 5% critical values are 3.65, 3.80, 3.87, 3.94, 3.96, 3.95, 3.95, 3.82, 3.68,
respectively.

344

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

Table 3
Results of Gregory and Hansen cointegration test

y 1t on y 2t
y 2t on y 1t

JPN

SIG

TWN

3.08
3.59

4.65
3.11

3.00
3.17

Note: The first-stage estimation is based on y 1t t DU t ( ) 1 y 2t e t . The second-stage

estimation is to apply traditional ADF or PhillipsPerron approach to test if e t is of I(0) or I(1). The y 1t on the
first row represents exchange rate and y 2t denotes stock price. The reverse is true for the second row. The critical
values are taken from Table 1 in Gregory and Hansen (1996).

A perusal of Table 2 reveals that the null hypothesis of a unit root in stock indexes cannot
be rejected using the Zivot and Andrew approach. Nonetheless, the same cannot be said
about exchange rate markets.6 In particular, the null hypotheses of a unit root are easily
rejected for the markets of Hong Kong (Dollar), Indonesia (Rupiah), Korea (Won), Malaysia
(Ringgit), the Philippines (Peso), and Thai (Bhat). The prevalence of lacking a unit root may
be attributed to the fact that these currencies are pegged to the US dollar before the crisis.
The lack of the unit root property within the sample periods enables us to apply the
statistical model readily in terms of exchange rates and rate of change in stock price. Note
that from prior studies, rate of change in exchange rates was found to mirror exchange rate
exposure, hence it may have better economic interpretation. It is to be pointed out that the
cointegration analysis is not needed for the time periods in which the logarithmic exchange
rates are of I(0). Given the outcome of the unit root test, we present the cointegration results
based on the Gregory and Hansen model (1996) in Table 3.
The first line in Table 3 lists the statistics when y 1t (stock price) is regressed on y 2t
(exchange rate) whereas the statistics of the reverse-order regressions are reported in the
second line. In all cases of y 2t stock prices, y 1t exchange rates, we fail to reject the null
hypothesis that no cointegration exists between exchange rates and stock prices.7 This being
the case, we employ Eq. (4) to explore the relations between exchange rates and stock prices
in the Asian markets.

4. Discussion of empirical results

Despite the structural break in these Asian markets, traditional Granger causality test or
Eq. (4) would suffice for studying the relations between exchange rates and stock prices.
Based on the Schwarz Bayesian (SB) criterion, the optimum lag (k), except for Hong Kong
(k 3), is one for all other markets. The causality results for the three sub-periods are
reported in Table 4.
During Period 1 (Jan. 3, 1986 Nov. 30, 1987), there existed little interaction between
currency and stock markets except for Singapore. An examination indicates changes in the
exchange rates lead that of the stock prices in Singapore. Our result is in agreement with the
majority of prior studies using monthly data: only a few found either exchange rates lead
stock prices or there is no interaction.

0.0835
0.1086
0.7331
0.9916
0.2814
0.9745
0.6587
0.8065
0.4240
0.5389
0.3622
0.3046
0.2266
0.0949
0.5027
0.3208
0.0396
0.6552

3.3090**
1.3396
0.7344
1.2347
0.1392
1.3756
0.0008
17.8604*
2.6366***
3.6616**
2.5880
1.2832
5.2427**
13.5657*
6.8189*
3.7305**
10.9414*
7.4313*

0.0700
0.2481
0.3922
0.2675
0.7094
0.2419
0.9781
0.0000
0.1056
0.0567
0.1088
0.2583
0.0228
0.0003
0.0095
0.0545
0.0011
0.0068

3.7826***
0.9360
0.7351
0.7009
0.2729
2.6785***
0.0019
18.8471*
2.5562
2.5767
2.8004***
1.2201
5.2784**
12.2910*
6.6287**
3.8431**
11.8221*
7.1519*

0.0528
0.3342
0.3920
0.4032
0.6018
0.1029
0.9650
0.0000
0.1110
0.1096
0.0954
0.2703
0.0224
0.0005
0.0106
0.0510
0.0007
0.0079

3.8322**
2.3427
0.7278
1.2733
0.0887
1.3870
0.0057
17.9082*
2.6290***
3.6450***
2.6042
1.6981
5.0330**
13.8289*
6.7110*
3.8607**
11.0286*
7.4039*

0.0513
0.1271
0.3943
0.2602
0.7661
0.2399
0.9399
0.0000
0.1061
0.0573
0.1078
0.1937
0.0257
0.0002
0.0101
0.0505
0.0010
0.0069

3.3467***
1.4824
0.7388
1.2338
0.1196
1.3440
0.0045
17.7958*
2.6469***
3.6592**
2.2793
1.3077
5.2446**
12.0027*
6.6796*
3.7794**
11.1004*
7.6613*

0.0684
0.2245
0.3908
0.2677
0.7297
0.2474
0.9466
0.0000
0.1049
0.0568
0.1323
0.2538
0.0228
0.0006
0.0103
0.0529
0.0010
0.0060

3.4998***
1.3413
0.7445
1.5493
0.1430
1.5992
0.0003
19.0854*
2.7164***
3.7230***
2.6089
1.3863
6.0148**
13.5391
7.0278*
3.6829**
10.8029*
7.7743*

0.0625
0.2478
0.3890
0.2143
0.7056
0.2071
0.9872
0.0000
0.1005
0.0547
0.1074
0.2401
0.0148
0.0003
0.0085
0.0560
0.0011
0.0057

Note: /3 implies does not Granger cause. * 1% significance level; ** 5% significance level; *** 10% significance level.
The abbreviation for each market denotes exchange rate variations (e.g. HKN rate of changes of the Hong Kong dollar or simply Hong Kong exchange
rate variations) of the market. The prefix S represents rate of changes in stock prices of the market (e.g. SHKN rate of changes of Hong Kong stock prices
or simply stock prices changes of the Hong Kong market).
a
Changes in the U.S. stock index are included.
b
Federal fund rates are included.
c
Difference of federal fund rates is included.
d
Error correction term s t1 e t1 is included where s t : logrithmic stock prices, e t : logrithmic exchange rates.

2.2231***
2.0227
0.1163
0.0001
1.1606
0.0010
0.1952
0.0600
0.6395
0.3777
0.8305
1.0546
1.4630
2.7911***
0.4493
0.9862
4.2392**
0.1995

0.9281
0.6170
0.6356
0.6669
0.2305
0.1646
0.2971
0.7399
0.6208
0.6591
0.9209
0.8816
0.2379
0.0295
0.7115
0.3567
0.1891
0.3293

0.0082
0.2504
0.2249
0.1855
1.4411
1.9373
1.0895
0.1104
0.2451
0.1948
0.0099
0.0222
1.3964
4.7670**
0.1370
0.8512
1.7295
0.9534

SHKN /3 HKN
HKN /3 SHKN
SIND /3 IND
IND /3 SIND
SJPN /3 JPN
JPN /3 SJPN
SKOA /3 KOA
KOA /3 SKOA
SMAL /3 MAL
MAL /3 SMAL
SPHI /3 PHI
PHI /3 SPHI
SSIG /3 SIG
SIG /3 SSIG
STHA /3 THA
THA /3 STHA
STWN /3 TWN
TWN /3 STWN

p Value

97.6.1 98.6.16d
(7)

p Value F Value

97.6.1 98.6.16c
(6)

p Value F Value

97.6.1. 98.6.16b
(5)

p Value F Value

97.6.1. 98.16a
(4)

p Value F Value

97.6.1 98.6.16
(3)

p Value F Value

87.12.1 97.5.31
(2)

p Value F Value

86.13 87.11.30
(1)

H0: exch /3 stock F Value

H0: stock /3

Table 4
The causality test between changes in exchange rates and changes in stock prices for the nine Asian economics

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354
345

346

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

In Period 2 (or After-Crash period), there is no definitive pattern of interaction between

the two markets. As is shown in Table 4, changes in exchange rates lead that in stock prices
in the case of Singapore ( 10%) again. Additionally, changes in stock prices are found
to lead exchange rate changes in Taiwan ( 5%), and in Hong Kong ( 10%).
Known for its volatility, the Taiwan stock market reached its peak at 12 000 points in
February 1990, and fell to as low as 4000 points in the ensuing recession. It rebounded again
back to about 10 000 points, and fell to 7100 points in the midst of the Asian flu. The
exchange rate of the Taiwan dollar, built on large foreign exchange surplus from export-led
economic growth, had remained fairly stable (at approximately 38 to 40 dollars per US
dollar) before 1988. Since then, its currency began to appreciate in value owing to the
pressure from the US. The appreciation took place gradually so to minimize the impact on
firms. Such a policy was indeed considered suitable to alleviate adverse effects for domestic
manufacturers, but served as an open invitation to hot money that flowed into Taiwans
financial market. The overflow of the hot money inevitably led to the overheated stock
market and overvalued prices. In addition, the overflow of the hot money noticeably
increased the demand for the Taiwan dollar that in turn exerted the pressure for its currency
appreciation. Fig. 2 illustrates a picture of short-term capital inflows into Southeast Asia for
the past 10 years. In the first part of 1990s, before the Asian financial crisis, capital inflows
were on the rise. The increased capital inflows strengthen the local currency such as the New
Taiwan dollar hence its stock prices, as is anticipated under the flexible exchange rate.
However, the capital flight occurred in the fourth quarter of 1994, when China lobbed missiles
around the island. Consequently, the stock market experienced severe setbacks, which triggered
currency depreciation. This phenomenon is consistent with the portfolio approach.
In contrast, Singapore did not experience significant amount of capital inflows. And with
her current account in black frequently, its export-led economy, leads the stock market (see
Fig. 3). This seems to be in agreement with the traditional approach.
No definitive pattern has been identified between currency and stock markets according to
the previous literature. However, such is not the case during Period 3 (the Asian flu period).
Based on our analysis, seven of the nine nations suggest significant relations between the two
markets. In the case of South Korea, changes in the exchange rates lead that in stock prices.8
The reverse direction is found in Hong Kong and the Philippines. The rest of the markets
(Malaysia, Singapore, Thailand, and Taiwan) are characterized by feedback interactions in
which change in exchange rates can take the lead and vice versa. Given the definitive
patterns, the Granger causality test does not provide signs of these relations. To examine the
short run dynamic relations of the Asian markets during Period 3, we take advantage of the
impulse response (IR) functions and calculate standard deviation for each forecasting
period.9 The IR (10 periods) from shocks of each variable are shown in Table 5.
An inspection of Table 5 reveals that the results from the IR analysis are in conformity
with that of the Granger causality test. This is to say, if the Granger causality test indicates
change in stock prices leads that in exchange rates, the responses of stock prices from
one-unit shock of exchange rates are insignificant. Such is the case for Hong Kong and the
Philippines as shown in lower part of Table 5 (panel B). Overall, three distinguishing patterns
can be identified from Table 5 from the IR analysis of the nine economies in Asia.
First, one-unit shocks from the exchange rates have very discernible negative responses on

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

347

Fig. 2. Current Account and Portfolio Investment (Liability) of The Eight Asian Economies

their corresponding stock prices. This is clearly the case for South Korea. The IR analysis
provides further short-run dynamic relations (sign and timing) above and beyond that
obtained from the Granger causality test. For instance, it takes Korean stocks within the first
3 days to respond (negatively). The negative responses are found to be in Day 1, 2, and 3
after the one-unit shock was administered in Korea. The IR analysis for Korea confirms the
validity of the traditional approach. According to the traditional approach, exchange rate
leads stock price, but the correlation can go either way depending on whether the individual
firm is an exporter (output) or an importer (raw material). The net effect of the aggregation
(stock index) cannot be determined hence the sign is arbitrary.
In the Hong Kong and the Philippines markets, one standard deviation decrease in stock
prices gave rise to the depreciation of the Hong Kong dollar and Philippines Peso in the first
day and first 2 days, respectively. In the markets of Malaysia, Singapore, Thailand, and
Taiwan, the feedback relations prevailed. The portfolio approach (stock price leads exchange
rate) suggests a negative correlation while the traditional approach (exchange rate leads stock
price) implies an arbitrary correlation. As a result, the net correlation under the feedback
relationa simultaneous combination of the two approachesis uncertain. Barring Thai-

348

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

Fig. 3. Exchange Rates and Stock Indexes of the Nine Asian Economies (Quarterly Data)

land, one unit change in exchange rates has largely negative impacts on stock prices with the
length of two periods (for example, Malaysia, Singapore, and Taiwan as shown in Table 5).
In the case of one unit change in the stock prices, we observe the negative impacts on the
corresponding exchange rates: Thai Baht (three periods), Taiwan Dollar (two periods),
Malaysian Ringgit (one period), and Singapore Dollar (one period).
The result of our analysis indicates that (1) there existed no relation between the stock and
the exchange rate markets for Japan and Indonesia; (2) the exchange rate led the stock price
in Korea; and (3) stock prices led exchange rates to some extent for the rest of the markets.
Given these results, capital flow seems to be a major cause for currency depreciations. The
capital flight from Mexico in the Peso crisis (1994) went to equity markets of southeast Asia
(emerging markets) high growth area. The enormous amount of capital inflow, however,
does not cause exchange rates to change as most of local currencies are pegged to the US
dollar. This explains why we do not observe the phenomenon consistent with the portfolio
approach in Period 2. Unfortunately, trade deficit as well as inefficient banking system
brought about massive capital outflow during the crisis period. Central banks, unable to

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

349

Table 5
Estimation result of impulse response function
Panel A: response of exchange rates from one-unit shock in stock price change
Period
HKN
KOA
MAL
PHI
SIG
1
2
3
4
5
6
7
8
9
10

0.0071***
0.0060
0.0032
0.0014
0.0006
0.0003
0.0001
0.0000
0.0000
0.0000

0.0000
0.0054
0.0014
0.0003
0.0001
0.0000
0.0000
0.0000
0.0000
0.0000

0.0000
0.1729***
0.0130
0.0034
0.0004
0.0001
0.0000
0.0000
0.0000
0.0000

0.2139*
0.1867**
0.0659
0.0201
0.0059
0.0017
0.0005
0.0001
0.0000
0.0000

0.0000
0.0978*
0.0005
0.0040
0.0000
0.0002
0.0000
0.0000
0.0000
0.0000

Panel B: response of stock prices from one-unit shock in exchange rate change
Period
HKN
KOA
MAL
PHI
SIG
1
2
3
4
5
6
7
8
9
10

0.0000
0.1837
0.0918
0.0397
0.0167
0.0070
0.0029
0.0012
0.0005
0.0002

0.7670*
0.8979*
0.2258*
0.0488
0.0102
0.0021
0.0004
0.0001
0.0000
0.0000

1.2877*
0.4687*
0.0531
0.0105
0.0015
0.0003
0.0000
0.0000
0.0000
0.0000

0.0000
0.1455
0.0561
0.0175
0.0051
0.0015
0.0004
0.0001
0.0000
0.0000

0.4740*
0.4343*
0.0167
0.0175
0.0006
0.0007
0.0000
0.0000
0.0000
0.0000

THA

TWN

0.2073***
0.3353*
0.0896*
0.0160
0.0020
0.0001
0.0000
0.0000
0.0000
0.0000

0.0853*
0.1321*
0.0170
0.0065
0.0013
0.0004
0.0001
0.0000
0.0000
0.0000

THA

TWN

0.0000
0.2965**
0.0844**
0.0156
0.0020
0.0001
0.0000
0.0000
0.0000
0.0000

0.0000
0.2636*
0.0278
0.0123
0.0023
0.0007
0.0002
0.0000
0.0000
0.0000

Note: * 1% significance level; ** 5% significance level; *** 10% significance level.

maintain the pegged rates, can do nothing but let their currency values slide: a floating
exchange rate system in which we witness the result predicted under portfolio approach. For
detailed economic and financial descriptions readers are refereed to Kochhar et al. (1998).

5. Other related problems of the model

One of the frequently addressed problems in security price is the existence of predictable
portion of changes in stock prices. Based on the Granger causality, in five of the nine nations,
variations in exchange rates could be used to predict stock prices changes in Period 3 as
shown in Table 6.10 Reported in Table 6 are comparisons of adjusted R-squares (R 2 )
between the regression in which current stock price change is the dependent variable and its
lagged (k 1) variables are independent and the regression in which current stock price
change is the dependent variable and lagged (k 1) variables of exchange rate changes and
stock price changes are independent variables.11 An examination of Table 6 indicates that
past information (within a day) on exchange rate variations is useful in predicting stock price
changes in the five markets. This is reflected in increased adjusted R 2 from 18% to 293%.
That is, investors can better predict stock price change based on exchange rate changes by
adding changes of lagged (by one period) exchange rates.

350

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

Table 6
A comparison of predictable portion of stock price changes
(1) R 2
(2) R 2
(2) vs. (1)

KOA

MAL

SIG

THA

TWN

0.0147
0.0851
141.1%

0.0127
0.0223
54.9%

0.0181
0.0616
109.2%

0.0474
0.0569
18.2%

0.0037
0.0196
293.1%

Note: R 2 adjusted R-square. (1): R 2 from the regression in which current stock price change is the dependent
variable and its lagged values (k 1) are independent variables. (2): R 2 from the regression in which current
stock price change is the dependent variable and lagged values (k 1) of exchange rate variations and stock price
changes are independent variables. (2) vs. (1) percentage increases in R 2 percentage ((2) (1))/(((2)
(1))/2) 100%.

To test for robustness of the results, we have tried several alternative specifications in
which stock prices changes of the US and Japan are included. Trades with the US and Japan
historically play an important role in the region. A recent study by Wei et al. (1995) indicates
that US stock market exerts more impact on Asian stock markets than does the Japanese
market. For this reason, we include stock price changes of the US market in Eq. (4) to
reexamine the Granger causality model (Table 4, column 4).12 As is evident from Table 4,
with the exception of Japan and Malaysia, the lead-lag structures remain virtually unchanged.
During the period of Asian financial crisis, it seems worthwhile to include a variable
reflecting fundamental shocks other than the US and Japanese stock prices. Because daily
data of other economic variables are difficult to obtain, we use the interest rates (federal fund
rate) as a proxy to reflect fundamental shocks. In addition, interest rates are very much
related to exchange rates and stock prices, and as such mirror economic prospect to some
extent. Often used in the literature, difference of interest rates between the US and southeast
Asian economies reveals the capital flow between the two nations. For this reason, we
incorporate the interest rates and the differences into Eq. (4) to perform the Granger causality
test. The result shown in Table 4 [column (5) and (6)] indicates that the conclusions remain
about the same except in the case of the Philippines, in which the significance level (stock
price leads exchange rate) decreases somewhat. The overall lead-lag relations remain
unchanged in general with added interest rate variables.
No cointegration relation between stock prices and exchange rates is found, perhaps due
to the noise from using daily data, as indicated by the statistical analysis. However, by
including the error correction term in Eq. (4), we are able to examine the potential short-term
causality and long-term equilibrium relations. Adding the error correction term ( y 1t1
y 2t1 ) into Eq. (4), where y 1t and y 2t denote stock price and exchange rate, we have:

y 1t 0 1 y 1t1 y 2t1

i1

y 2t 0 2 y 1t1 y 2t1

i1

2iy 2ti

2iy 2ti

1iy 1ti

1t

i1

(6)

1iy 1ti

i1

2t

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

351

Table 7
Estimation result of impulse response function (reverse order)
Panel A: response of exchange rates from one-unit shock in stock price change
Period HKN
KOA
MAL
PHI
SIG
1
2
3
4
5
6
7
8
9
10

0.0000
0.0091***
0.0045***
0.0020
0.0008
0.0003
0.0001
0.0001
0.0000
0.0000

0.7892*
0.1602
0.0329
0.0068
0.0014
0.0003
0.0001
0.0000
0.0000
0.0000

0.7782*
0.1971***
0.0256
0.0047
0.0007
0.0001
0.0000
0.0000
0.0000
0.0000

0.0000
0.1540***
0.0593
0.0185
0.0054
0.0016
0.0005
0.0001
0.0000
0.0000

0.2040*
0.0829***
0.0078
0.0033
0.0003
0.0001
0.0000
0.0000
0.0000
0.0000

Panel B: response of stock prices from one-unit shock in exchange rate change
Period HKN
KOA
MAL
PHI
SIG
1
2
3
4
5
6
7
8
9
10

0.2504
0.1995
0.0913
0.0389
0.0164
0.0069
0.0029
0.0012
0.0005
0.0002

0.0000
0.8285*
0.2164*
0.0472
0.0099
0.0020
0.0004
0.0001
0.0000
0.0000

0.0000
0.3400***
0.0255
0.0066
0.0009
0.0002
0.0000
0.0000
0.0000
0.0000

0.2819**
0.2141
0.0745
0.0226
0.0066
0.0019
0.0005
0.0002
0.0000
0.0000

0.0000
0.3773*
0.0021
0.0153***
0.0002
0.0006
0.0000
0.0000
0.0000
0.0000

THA

TWN

0.0000
0.3250*
0.0926**
0.0171
0.0022
0.0002
0.0000
0.0000
0.0000
0.0000

0.0000
0.1201*
0.0127
0.0056
0.0010
0.0003
0.0001
0.0000
0.0000
0.0000

THA

TWN

0.2531***
0.2365
0.0746
0.0145
0.0020
0.0002
0.0000
0.0000
0.0000
0.0000

0.2320*
0.2613*
0.0358
0.0130
0.0026
0.0007
0.0002
0.0000
0.0000
0.0000

Note: * 1% significance level; ** 5% significance level; *** 10% significance level.

To test whether exchange rates Granger-cause stock prices, we examine the null hypothesis H 0 : 1 0 and 21 22 . . . 2k 0. Conversely, to test whether stock prices
Granger-cause exchange rates, we examine H 0 : 2 0 and 21 22 . . . 2k 0.
Including the error correction terms does not alter the lead-lag relations noticeably [Eq. (7)
in Table 4]. Besides, estimated 1 and 2 are insignificant (not shown), suggesting a lack of
long-term equilibrium relations between stock prices and exchange rates. It is to be pointed
out that these results are derived from estimating reduced form equations, and as such are
open to questions of the endogeneity of the two variables. In that case, structural equations
may be preferred. On the other hand, proponents of VAR models do not favor the structural
form approach (Canova 1995, pp. 103109). One problem associated with an unrestricted
VAR model is the sensitivity of the results in response to different order of variable
appearances. To examine the robustness of impulse responses under different contemporaneous identifying assumptions, we alter the order of variable appearances, and report the
result in Table 7.13
An examination of Table 7 indicates the impulse response functions (mostly negative
correlation) are similar to that of Table 5 save that the lengths of impact are different. In the
case of Korea, as we reverse the order of the two variables, the Granger causality that
exchange rate change leads stock price change becomes a feedback relation: a relation that

352

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

dominated the southeast Asian economies. In general, the Granger causality remains robust
in the period of the Asian flu.

6. Conclusion
Prior studies based on monthly data have found either little relation can be established
between the two markets or exchange rate market leads stock market. In this paper, we apply
the recently advanced statistical techniques with daily data to analyze the problem in the
Asian economies. The result indicates markets were largely characterized by the phenomenon predicted under the portfolio approach. Most markets exhibit either changes in stock
prices lead that in exchange rates or either market can take the lead (feedback interaction).
Built on the result of the Granger causality test, the IR analysis lends further support to the
importance of stock market as the leader or the existence of feedback interaction during the
Asian flu period. Likewise, the inclusion of exchange rate variations (within a day) can
improve predictable portion of stock price changes in the five Asian markets. In the early
1990s as barriers to capital movement were gradually removed, the role of the portfolio
approach cannot be downplayed. Capital movement into and out of the Asian economies is
as beneficial as it is detrimental. The Asian flu certainly has put the stock and the exchange
rate markets in a spotlight that suggests financial markets in the Asian economies need an
overhaul. Although the main objective of this paper is to explore short-term dynamic
relations between stock prices and exchange rates, it also provides a potential avenue for
future research in the spillover effects in southeast Asia.
It needs to be pointed out that although the Granger-Causality and IR may exhibit some
statistical relations, it is sometimes difficult to interpret the underlying fundamental economic relation based on those results. It is likely that the results may be generated from other
structure relations, i.e., via interest rate parity condition or IS-LM-related policies. For
example, some recessionary shocks or unfavorable information on the country will cause a
stock price decrease and an exchange rate depreciation. In this case the timing relation
between the stock price and exchange rate will be generated from the relative efficiency of
the stock market and foreign exchange market. In this case, both approaches may not play
any role in generating the timing relation.14

Notes
1. For an intuitive explanation of the portfolio approach, see Krueger (1983, pp. 8191).
Other related works include Dornbusch (1975), Frenkel and Rodriguez (1975), and
Boyer (1977).
2. The strength of the Zivot and Andrew approach lies in endogeneizing the breakpoint,
albeit a single one. Recently, tests with multiple break points are made possible by Bai
and Perron (1998), Garcia and Perron (1996), Liu et al. (1997), and Andrews et al.
(1996).
3. There are three different models provided by Zivot and Andrew (1992). We adopt the

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

4.
5.
6.

7.
8.

9.
10.

11.
12.

13.

14.

353

unit-root model as shown in Eq. (2) due to the existence of a trend in the time series.
Similar results are obtained using the other two models proposed by them.
We are grateful for the generosity extended by the economics department of UCSD
in providing the data.
After the convention in event study, the breakpoint for Period 3 would be approximately 1 month before the depreciation of the Thai Baht.
Note that values in 11 of the 18 unit root tests exceed the 95% value, indicating that
the Asian financial debacles have indeed caused structural changes. Such structures
break toward either end of the data could cast a doubt on the power of the Zivot and
Andrew unit root test statistic. It remains an interesting research topic in the future.
The cointegration test is performed only on the national stock prices and exchange
rates with the property of I(1), i.e., including that of Japan, Singapore, and Taiwan.
The significance level is greater than 10% in the case of the Philippines. The impulse
response functions indicate that change in stock price leads that in exchange rate. As
such, the Philippines market can be characterized by the portfolio approach.
As the cointegration relations are not found between the variables, we calculated the
IR functions based on Eq. (4).
In the case of Hong Kong, the analysis indicates that exchange rate changes lead that
of stock prices, and as such the predictable portion of stock price changes cannot be
improved upon noticeably.
Harvey (1995) employs adjusted R-square to investigate the predictability of stock
prices for both emerging and developed markets.
To conserve space, we present only the results in which changes in the US stock
prices are included. The lead-lag structures remain unchanged as well if Japanese data
are included in Eq. (4).
The variable order of the IR functions in Table 5 is based on that from the causality
tests shown in Table 4. For instance, changes in stock prices lead that in exchange
rates in the Hong Kong market. Hence, the variable order in which the IR functions
are calculated (Table 5) is stock price changes exchange rate changes. The order is
reversed to exchange ratestock price and the results of the IR function calculations
are reported in Table 7.
We are indebted to one of the reviewers for pointing this possibility out.

References
Abdalla, I. S. A., & Murinde, V. (1997). Exchange rate and stock price interactions in emerging financial markets:
evidence on India, Korea, Pakistan, and Philippines. Applied Financial Economics, 7, 2535.
Aggarwal, R. (1981). Exchange rates and stock prices: a study of the US capital markets under floating exchange
rates. Akron Bus Econ Rev, 12, 712.
Amihud, Y. (1993). Exchange Rates and the Valuation of Equity Shares. In Y. Amihud & R. Levich (Eds.)
Exchange rates and corporate performance. Homewood: Irwin.
Andrews, D. W. K., Lee, I., & Ploberger, W. (1996). Optimal changepoint tests for normal linear regression. J
Econometrics 70, 9 38.

354

C.W.J. Granger et al. / The Quarterly Review of Economics and Finance 40 (2000) 337354

BahmaniOskooee, M., & Sohrabian, A. (1992). Stock prices and the effective exchange rate of the dollar. Appl
Econ, 24, 459 464.
Bai, J., & Perron, P. (1998). Estimating and testing linear models with multiple structural change. Econometrica,
66(1), 4778.
Bartov, E., & Bondar, G. M. (1994). Firm valuation, earnings expectations and the exchange rate exposure effect.
J Finance, 49, 17551786.
Bodnar, G. M., & Gentry, W. M. (1993). Exchange rate exposure and industry characteristics: evidence from
Canada, Japan and the US. J Int Money Finance, 12, 29 45.
Boyer, R. S. (1977). Devaluation and portfolio balance. Am Econ Rev, 67, 54 63.
Canova, F. (1995). Vector autoregressive models: specification, estimation, inference, and forecasting. In M.
Hashem Pesaran & M. R. Wickens (Eds.). Handbook of Applied Econometrics: Macroeconomics. Oxford:
Blackwell Publishers.
Dickey, D. A., & Fuller, W. A. (1979). Distribution of the estimators for autoregressive time series with a unit
root. J Am Stat Assoc, 74, 427 431.
Dornbusch, R. (1975). A portfolio balance model of the open economy. J Monetary Econ, 1, 320.
Engle, R. F., & Granger, C. W. J. (1987). Cointegration and error correction: representation, estimation, and
testing. Econometrica, 55, 251276.
Frenkd, P., & Rodriguez, C. A. (1975). Portfolio equilibrium and the balance of payments: a monetary approach.
Am Econ Rev, 65, 674 688.
Garcia, R., & Perron, P. (1996). An analysis of the real interest rate under regime shifts. Rev Econ Stat, 78,
111125.
Granger, C. W. J. (1969). Investigating causal relations by econometric models and cross-spectral methods.
Econometrica, 37, 424 439.
Gregory, A. W., & Hansen, B. E. (1996). Residual-based tests for cointegration in models with regime shifts.
Econometrics, 70, 99 126.
Hamilton, J. D. (1994). Time Series Analysis. Princeton: Princeton University Press.
Harvey, C. R. (1995). Predictable risk and returns in emerging markets. Rev Finan Studies, 8(3), 773 816.
Jorion, P. (1990). The exchange exposure of US multinational firm. J Bus, 63, 331345.
Kochhar, K., Prakash, L., & Stone, M. R. (1998). The East Asian crisis: macroeconomic developments and policy
lessons. IMF Working Paper 98-128.
Krueger, A. O. (1983). Exchange-Rate Determination, Cambridge: Cambridge University Press.
Krugman, P. R., & Obstfeld, M. (1997). International Economics: Theory and Policy, 4th ed., Reading:
Addison-Wesley Inc.
Liu, J., Wu, S., & Zidek, J. V. (1997). On segmented multivariate regressions. Statistica Sinica, 7, 497525.
Nelson, C. R., & Plosser, C. I. (1982). Trends and random walks in macroeconomic time series: some evidence
and implications. J Monetary Econ, 10, 139 162.
Perron, P. (1989). The great crash, the oil price shock, and the unit root hypothesis. Econometrica, 57,
13611401.
Perron, P., & Vogelsang, T. J. (1992). Nonstationarity and the level shifts with an application to purchasing power
parity. J Bus Econ Stat, 10(3), 301320.
Wei, K. C. J., Liu, Y.-J., Yang, C.-C., Chaung, G.-S., (1995). Volatility and price change spillover effects across
the developed and emerging markets. Pacific-Basin Finan J, 3, 113136.
Zivot, E., & Andrews, D. W. K. (1992). Further evidence on the great crash, the oil-price shock, and the unit-root
hypothesis. J Bus Econ Stat, 10(3), 251270.