DYNAMIC RELATIONSHIP BETWEEN INFLATION,

STOCK PRICES AND EXCHANGE RATES : a Case of The

UK

OCTOBER, 2018
 ABSTRACT

This study examined the relationship between COI Inflation, stock price and exchange rate
in the UK economy. The study employed the Augmented Dickey Test (ADF) so as to test
stationarity of the variables, the Structural VAR model to estimate the contemporaneous
relationships between these three variables and the impulse response function to find how
each of variables in the SVAR model responds to a positive one-time shock in other
variables. The study imposed a restriction based on the well-founded theoretical argument,
which indicates a contemporaneous feedback effect among the examined variables within
the SVAR model. The study found that the positive shock in CPI inflation has a negative
influence on the exchange rate changes over the short term and that the positive shock in
real stock price has a positive lagged effect on exchange rate changes over the short term.
Therefore, it can be noted that there is a dynamic relationship between CPI inflation, stock
price and exchange rate in the UK market. The practical implications suggest that the
portfolio managers and hedgers need to develop better investment decisions and come up
with the right hedging strategies against the currency shocks more so the importing
industries in which there is more exposure to currency shocks. In addition, for the
developed countries such as the UK, the stock market can be further enhanced through
pursuing an active policy for currency stabilization by the monetary policy instrument; this
shall not only stabilize the stock prices but also reduce the level of inflation. Further studies
need to focus on the comparative investigation of the developing countries to provide a
wider evaluation of the topic.

Keywords: CPI Inflation, stock price, exchange rate, UK, SVAR, relationship

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 TABLE OF CONTENTS

ABSTRACT ...................................................................................................................... II

CHAPTER ONE : INTRODUCTION .............................................................................1

1.1 Background and aim of the study ..................................................................................1

CHAPTER TWO : LITERATURE REVIEW ...............................................................3

2.1 Introduction ....................................................................................................................3

2.2 The relationship between inflation and stock price .......................................................3

2.3 The relationship between stock prices and exchange rate .............................................6

2.4 The relationship between exchange rate and inflation ...................................................9

CHAPTER THREE: DATA AND METHODOLOGY ...............................................13

3.1 Introduction ..................................................................................................................13

3.2 Philosophical paradigm and approach .........................................................................13

3.3 Research methodology .................................................................................................13

3.3.1 Dickey-Fuller Test .............................................................................................. 14

3.3.2 Structural Vector Autoregressive Approach (SVAR) ........................................ 17

3.4 Sample and data description ........................................................................................18

3.4.1 Sample selection ................................................................................................. 18

3.4.2 Hypothesis Development .................................................................................... 20

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CHAPTER FOUR: EMPIRICAL RESULTS ...............................................................22

4.1 Test of stationarity .......................................................................................................23

4.2 Testing the impulse response function of the SVAR model ........................................27

4.3 Answering the Hypotheses ..........................................................................................31

Hypothesis 1 ................................................................................................................ 31

Hypothesis 2 ................................................................................................................ 32

CHAPTER FIVE : CONCLUSIONS .............................................................................33

REFERENCES .................................................................................................................35

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TABLE OF FIGURES

Table 1: Descriptive statistics ........................................................................................... 19

Table 2: ADF Test for unit root ........................................................................................ 23

Table 3: Bayesian Schwartz Criteria for model 1 ............................................................. 24

Table 4: Bayesian Schwartz Criteria for model 2 ............................................................. 25

Table 5: Bayesian Schwartz Criteria for model 3 ............................................................. 26

Table 6: Impulse Response Function of exchange rate from a unit shock in CPI Inflation
........................................................................................................................................... 28

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 CHAPTER ONE : INTRODUCTION

1.1 Background and aim of the study

The continued growth in global trade, as well as capital movements, has made
consideration of inflation, stock prices and exchange rates as key determinants of the
profitability of the business (Ibrahim & Aziz, 2003; Dimitros, 2003). The authors Aslan et
al (2010), claims that the association among inflation, stock price, and the exchange rate
has preoccupied the minds of economists for reasons that the factors have key roles in the
influence of the economy of a country. These factors are believed to be the main culprits
behind interdependence of the emerging and transition countries. Global economists and
researchers have mixed views on the relationship of inflation, stock price, and exchange
rate, although these factors have been widely used as a measure of the investment
opportunities in emerging and transition countries.

Majority of the countries have adopted “floating exchange rate system” as a result of the
Bretton Woods Agreement (Aslan et al, 2010). However, success would be assured only
through adjustments on the costs or gains for multinational firms and growth in exchange
exposure to the enterprises and financial institutions (Nieh & Lee, 2001). The economic
theory is essential to understand the relationship between macroeconomic variables (Ozair,
2006). Evidently, level of globalization and interactions between the global markets greatly
influence the volatility prices across markets and so the need to understand the relationship
among the macroeconomic variables.

In consequence, understanding the relationship of inflation, stock prices, and the exchange
rate is essential so as to realize the economic policy goals in global economies. There are
risks associated with investment in any country. For instance, the global increase in oil
prices and extreme weather conditions in most parts of Europe imply that food gain prices
and this has been kept at historically high levels across the world, which pushes the level
of inflation in the UK up.
1
In this study, the dynamic relationship of inflation, stock price and exchange rate in the UK
were investigated using the structural VAR model. Past studies have focused on just two
factors and this study is one of its kind to try to understand the relationship of the three
variables of stock prices, exchange rate and inflation. The choice of this model was based
on the fact that it allows for evaluation of a contemptuous relationship of these variables,
unlike the conventional VAR model which does not have enough foundations to explain
the economic phenomenon on some extent (Enders, 2010).

2
 CHAPTER TWO : LITERATURE REVIEW

2.1 Introduction

The literature review in this section seeks to gather the relevant secondary data related to
inflation, stock price, and exchange rate. The section presents the data in relation to the
relationship between the variables. It is a critique of the available literature to understand
the research gaps in this area.

2.2 Inflation and stock price

Laopodis (2004) in his research has described the association of various macroeconomic
variables such as the equity market, inflation, and monetary policy. The study used
advanced econometrics through cointegration and causality by using the VAR model. The
results found out that the real stock returns-inflation pairs weakly in support of a negative
association between the stock prices and inflation, meanwhile, it is possible for the stock
market to hedge against inflation. Similarly, the bivariate findings claim a negative and
unidirectional relationship form the stock returns to the FED funds rate during the 1990s,
although very weak in the 1970s (Yutaka, 2006; Singh, 2010). By using the multivariate,
over the short run, it was found to have the strong backing of unidirectional linkage. This
implies that stock prices were found to have a less positive response to the monetary easing.

Clearly, there seems to be lack of consistency on the dynamic relationship of inflation and
stock prices. The findings are in contrast to the work of Fama (1981) which showed that
inflation and stock prices are negatively associated, although, real activity and real stock
prices are positively associated. However, arguments have been raised that inflation would
increase with expectations on the slow growth in the economy (Dimitrios, 2003; Choudri
& Hakura, 2001), whereas the real activity and the stock prices are positively correlated,
hence, a rise in inflation finally results to a reduction on the stock prices. The study’s
assumption was that the supply of money would remain unchanged with the rear shocks.
In order to clearly understand the relationship between inflation and real activity, the
3
money demand theory proves to play a key role. As described by Fisher (1911), the money
demand theory postulates that there is a link between the quantity of money and the total
amount of spending on the final goods and services. Changes in the money supply have an
effect on the prices of goods.

In this regard, not only is inflation but also other macroeconomic factors such as stock price
that is associated with the impact of financial aggregates. For instance, changes in the
interest rate movements have been considered to be closely associated with inflation
movement so as to compensate the lender for the changes in real value for the nominal
interest rate payments. Despite that, interest rates, often fail to move exactly with the
inflation since they are a reflection of expectations of the future inflation instead of the
current inflation. Therefore, it can be deduced that in the findings by Fama (1981), the
money effect is ignored. Nevertheless, in a business environment characterized by
moderate on the inflation, it is not easy to differentiate stock returns and the stock prices
within the real economy (Singh, 2010).

While the findings above indicate that inflation seems to have an impact on the stock prices,
it lacks clarity when inflation is “unexpected”. Although some studies such as Fama and
Schwert (1977), Schwert (1981) and Fama (1981) indicate a significant negative
association of these variables, other studies such as Pearce and Roley (1985) and
Hardouvelis (1988) have not shown any significant relationship on these two variables.
This means that there is an unclear relationship between inflation and stock prices, while
to most of them, they have only investigated the relationship of these two variables and no
further inquiries have been made on the relationship of inflation, stock prices, and exchange
rate. It is essential to examine the behavior of the three variables with the growing global
trade as well as capital movements that are considerations of inflation, exchange rate, and
stock prices to determine the profitability of the business.

The differences in the findings above can be associated with a different period of research.
This is why this study attempts to cover a longer time period (2000-2018) to try to address

4
the issue of differences in the time period of research that may have contributed to
inconsistent research findings. In particular, in the 20th century, the securities seem to be
similar (Rahman, 2009). Despite that, The studies have failed to consider that there were
essential differences across the securities of countries during this period, based on the
structure of ownership or the nature of the environment (Ozair, 2006).

Additionally, the stock prices represent activeness in the market. Unfortunately, the stock
prices might be influenced by a number of other macroeconomic factors and so create a
global phenomenon. More so, in the presently growing inflationary pressure, it will create
a rising international price of energy and commodity prices. Nonetheless, the influence of
inflation, stock price, and exchange rate together would supply the shock to the stock
market in a country. They grow the social cost in a country. When not addressed well by
policymakers, the crisis could create problems of social instability and hence result in the
political crisis. Potentially, the essential relationship of macroeconomic factors and stock
prices in the UK have not been precisely examined in recent years.

Other researchers (Singh, 2010; Nieh & Lee, 2001) suggest that the link of inflation and
stock prices might be negative or positive but this relies on the source of shocks. In an
evaluation by Ong and Izan (1999), they considered the disturbances from the supply and
the demand side within the VAR model; the period of study was “prewar” and “postwar”
in the U.S. This was meant to test the way in which the relationship of inflation and stock
prices would be influenced by shocks. The findings indicated that demand shock was more
dominant in the prewar period, which created a positive relationship between the stock
prices and inflation in the U.S, while the supply shock was considered more essential in
the postwar period, implying a negative association of the variables. In consequence, it
implies that there are other explanatory variables that need to be considered in
understanding the global trade and capital movements that influence the profitability of a
business. Therefore, the study by Ong and Izan (1999) only considers two variables
(inflation and stock prices) and different scholars can have different results depending on

5
the macroeconomic policies or inclusion of other additional factors that influence the
economic growth.

Further, other studies, try to document other factors which influence stock prices and
inflation. The studies used the UK data, Lee and Wang (2012), claim that the association
of these factors rely on the policies on inflation in a given country. Consequently, they
found that changes that are not anticipated in regard to policies on inflation would have a
negative influence on the stock prices over the short term. Choudhry (2001), contends that
there is a positive relationship for the countries associated with high inflation, and negative
for the countries with low inflation level.

In conclusion, various empirical investigations have supported the claim that there is a
negative association between inflation and stock prices, more so over the short run. Despite
that, the relationship might change when other factors are included such as exchange rate,
exogenous shocks, for instance, the supply and demand shock or a different inflationary
regime.

2.3 Stock prices and exchange rate

Much of the available literature, try to examine the association of stock prices and exchange
rate. The studies try to determine the way in which financial markets predict others and
vice versa. A study by Ong and Izan (1999) looked at the association among the stock
prices and exchange rates. The study used six diverse exchange rates and realized that there
was no association among the exchange rates and the stock prices. Phylaktis and Ravazzolo
(2002) tried to explain why there was no association between the exchange rate and the
stock prices, they argued that failure to account for the volatility of the stock prices brings
about such results. In addition, the major influence of the U.S dollar as a reference point to
other countries has not been considered in the work of Franck, the impact is inaccuracies
and inconsistency in the findings.

6
Over the last few decades, the investigations on the linkages of the exchange rate and the
stock prices have focused on the U.S market. In an evaluation by Aggarwal et al (1981),
they used data on the U.S monthly stock prices and effective exchange rates over the period
of 1974-1978. The study used simple regressions and found that both variables were
strongly and positively correlated over the long run and short run. This is because the
exchange rates are the ones that determine the profits in multinational firms within the
balance sheet, this makes the stock prices to change. It can be noted that in the traditional
model, the balance sheet items in a firm is affected by the changes in the exchange rates
through competitiveness as expressed on the foreign currency and eventually, the profits
as well as equity (Abdalla & Murinde, 1997). Evidently, the level of globalization and
interactions between the global markets greatly influence the volatility prices across
markets. One limitation of this study is that it used only two variables (exchange rate and
stock prices), although, a better understanding of the economic policy in global economies
required a deeper evaluation on the association of inflation, stock prices, and exchange
rate.

However, Kim (2003) suggests the adverse relationship between exchange rate and stock
prices, it implies that a devaluation of the U.S dollar would be followed by growth in the
stock prices. Jorion (1991) argued that the relationship between the U.S dollar and the stock
prices get closer with the growing proportion of overseas businesses. Reimers (1992) used
the co-integration analysis so as to test whether the US dollar exchange rate are associated
with US stock prices. The result found that the U.S underlying stochastic characteristics of
these variables were not related. The mixed empirical findings imply that there would be
additional factors that were not put into consideration, that would clearly demonstrate the
association of the exchange rate and stock prices or alter the relationship. Having to include
more variables to the model, could improve the accuracy of the model.

Kim (2003) has made attempts to address this research gap, he added three more variables
that included the industrial production, interest rate and inflation to the VAR model. He
found that there was a causal relationship between the exchange rate and the U.S stock
7
prices, and not vice versa. This means that the characteristics of a country are key towards
understanding the relationship of various macroeconomic variables and in this regard, there
are limited evaluations on this area with most of the studies focusing on two variables and
this study is the first of its kind to try to add inflation, exchange rate and stock prices into
the VAR model using the data from the UK over a long sample period.

For the other developed countries, Ong and Izan (1999) examined the association of the
exchange rate and future equity prices for Australia and the G-7, Britain, France, and the
U.S over the period of 1986 and 1992. The findings did not show any significant
association between the two variables. However, the use of daily data is essential in
improving the empirical findings. The reason for the findings could be inaccuracy caused
by failure to account for the stock price volatility in the U.S market. The findings are
supported by Nieh and Lee (2001), which found no significant long-run relationship of the
stock prices and the exchange rates for the G-7 countries through using Engle-Granger and
Johansen’s co-integration tests. In addition, they found an ambiguous significant
relationship in the short run for the countries. Nevertheless, for some of the countries, stock
indices and exchange rate would be essential in forecasting future direction for such
variables. For instance, they indicate that depreciation of currency stimulates Canadian and
UK stock markets with the one day lag and so growth in the stock prices brings about
currency depreciation in Italy and also Japan, again with the one day lag.

For the emerging markets, Ajayi et al (1998), suggests that the causality runs out of the
stock market to currency market in Indonesia and Philippines, while for Korea, it moves in
opposite direction. However, there is no significant causal relationship observed in Hong
Kong, Singapore, Thailand or Malaysia, although, for Taiwan, they detected a bi-
directional causality or the feedback. In addition, contemporaneous adjustments seem
significant in three of the eight countries above. For the developed countries, there is a
significant unidirectional causality from the stock to the currency markets with significant
contemporaneous effects. These differences might be explained by the differences in the
economic stage in each country, the government policy or expectation pattern.
8
From the above studies, it can be noted that there are differences on the influence of
exchange rate and stock prices across countries and this can be attributed to the capital
flows, different regimes and extent of openness of the economy. In addition, there is a high
interest in the association of exchange rate and stock price through various methodologies
and data sets. There is lack of consensus amongst the researchers about the validity of the
empirical investigations on the association of the two variables, suggesting the need for
further evaluation of this relationship to shed more light on the same. The interest in the
two variables more so with the East Asian crisis and now the Brexit. On what seemed that
the crisis affected nations face turmoil for the stock markets and currencies. When
associated with the stock prices, the exchange rate and causality move from exchange rate
to the stock prices and the crises within the stock markets are likely to be prevented through
control of the exchange rate. Further, countries can make use the link so as to attract foreign
investment and grow portfolio for their countries. Rather, when causality runs from the
stock prices to exchange rates, then the authorities could emphasize national economic
policies so as to ensure stability within the stock market.

2.4 Exchange rate and inflation

A common subject in this area is the “pass-through effect” of the exchange rate on domestic
prices. Choudri and Hakura (2001) started to look at the association of exchange rate and
inflation by working on the large data set for 71 nations between 1979 and 2000. The
findings showed that pass-through moves from the exchange rate to the prices. Pass
through gets higher for nations that have more levels of inflation and this implies that “the
more inflation the more pass through”. The findings are similar to Taylor’s and Peel (2000)
report. Further work by Edwards (2006), examined the pass through on the basis of
“inflation targeting” aspect. Edwards looked at the association of pass through and
effectiveness in the nominal exchange rate in regimes, that target reduction of inflation.
The findings showed that nations that policies on inflation have a reducing pass-through
effect on the two variables.

9
Besides, for the majority of the studies, they indicate that pass throughout of the exchange
rate to the prices is not fully over the short term and indicates a reducing trend. Taylor and
Peel (2000) argue that the relative stability in the monetary policy in a country is key to
determining the exchange rate and price levels. Countries that are associated with fewer
levels of economic growth, there is a low exchange pass through. Some of the other factors,
for instance, changes in the commodity for the US imports and the growth of China as a
major economic superpower in international trade, results to less speed of the exchange
rate pass through. Further, the declining trend in the pass-through has been proved in the
UK.

A key theory to understanding the the two variables is the theory of purchasing power
parity (PPP). According to this theory, when the goods are expensive for one country (the
high inflation rate), the exports reduce and the imports grow as a result of arbitrage across
the markets (Fisher, 1991). Therefore, the demand for the foreign currencies increases and
domestic currency value gets depressed. The impact is that currencies fluctuate to the point
that relative purchasing power for every country is the same, which it reaches parity.
Despite that, the majority of the available empirical studies question the validity of the PPP
model. Lothian (1997) examines the PPP model by focusing on the OECD countries. While
the findings indicated that the exchange rate continues to move away from the PPP over
the short run, there is support of the PPP model over the long term. These findings are
supported by Pilbeam (2013) that showed that exchange rate has no trend in returning to
the PPP over the long term, which indicates that PPP would have some likelihood to
determine exchange rate over the long run.

Aslan et al (2010) examined the PPP so as to understand whether it is applicable in the

developed countries or not over the long run. A large sample size of 1953 and 1998 was
used. The findings indicated lack of enough evidence to support the existence of PPP in
the developed countries over that period examined. This might be due to the fact that over
this period, most of the developed countries relied on trade from developing countries that
are far apart. Pantula (1989) indicates that PPP is more suitable when used in neighboring
10
countries and where there is a low cost associated with transportation. Similarly, for the
members of the European Union, there are limited tariff barriers that restrict trade for
countries such as Italy, Germany and the UK and that their relative locations mean that
there are fewer costs associated with transportation. In this regard, PPP can be key to
indicate bilateral exchange rate between the countries. Ozkan (2013) argues that the use of
an appropriate price index is essential so as to understand how effective PPP is. The use of
CPI might lower the level of credibility for the PPP model.

Over the recent past, various studies have begun to look at the relationship between
exchange rate and producer and domestic prices movements (Adjasi, 2009; Ahmed, 2009;
Alba & Park, 2005). For the developed countries, Alba and Park (2005), indicate limited
evidence on the influence of exchange rate volatility on the domestic and producer price
movements. Ozkan (2013), through the VAR model, showed that reduced domestic
currency value is strongly negatively associated with the PPP unlike the CPI for the U.S as
well as other six developed economies.

Yutaka (2006) tried to compare the developed countries in terms of the relationship of the
exchange rate and inflation, showed that changes on the exchange rate to inflation seem
more complete for the small open nations, which depend more on the imported products
for the purpose of domestic production. However, they found that the effect is not
contemporaneous with the lag of 18 months.

In conclusion, it can be stated that from the literature review above, most of the available
studies have tried to examine the relationship of inflation, stock price and exchange rate
through performing the VAR and co-integration tests. There are other studies that use
SVAR so as to test the impact of shocks on these variables. In addition, most of the studies
have focused on the U.S dollar while limited investigations have been made on the UK.
This study improves on the available literature by using the UK data over a long period
(2000-2018) to understand the relationship of the three variables with the growing aspects
of international trade in recent years.

11
12
 CHAPTER THREE: DATA AND METHODOLOGY

3.1 Introduction

The methodology is essential in research so as to meet the objectives of a study. Therefore,

this section provides the methodology followed in this study so as to meet its goals.

3.2 Research Philosophy and approach

The research paradigm is defined as a concept that provides a direction that a study
undertakes (Benard & Russell, 2000). Both positivist and interpretivist provide two
commonly used research paradigms in social and economic studies. The positivist
paradigm shares beliefs on the nature and reality in research (Young & Pauline, 1984). On
the other hand, for the interpretive paradigm researchers focus on their understanding about
a research issue (Young & Pauline, 1984). Generally, it depends on subjective assumptions
that are influenced by the intuitions of the researchers (Bernard & Russell, 2000). Hence,
interpretivism is often related to inductive methods, in which information is gathered and
used to develop theories.

This study borrows on the ideas of positivism so as to examine the relationship of inflation,
stock price, and exchange rate. When the process of research relies on the available
literature, then it takes a deductive approach and positivist philosophy. The choice of a
deductive approach was due to the fact that this study sought to test hypotheses and theories
so as to understand the association of the macroeconomic factors in the UK market.

3.3 Research methodology

Young and Russell (1984) assert that qualitative methods emphasize understanding
individual experiences while quantitative methods provide a structured way to examine
collected data. The quantitative methodology follows positivist paradigm (Turabian &
Kate, 1996), that goal, of which that seeks facts on the social and economic phenomenon

13
by analysis of empirical data. Generally, positivist improves research by examining data
quantitatively and in a structured manner (Young & Russell, 1984). Thus, this study
employs quantitative techniques to examine the association of inflation, stock price, and
exchange rate. The other reason for choosing this method was because this study sought to
conduct statistical tests that involved augmented Dickey-Fuller test (ADF) and Structural
VAR model by collection and analysis of secondary sources from the UK FTSE 100 Index
from 2000-2018, historical exchange rate data and inflation CPI.

3.3.1 Dickey-Fuller Test

Generally, macroeconomic time series variables are considered to be non-stationary

(Dickey & Fuller, 1981). The time series data is stationary when the mean and variance are
constant over a period of time, while the value of covariance between two time periods
relies on the gap between periods rather than actual time in which the variance is
considered. When one or both of the conditions are not met, then the process is non-
stationary. In this study, the stationarity of a time series data is examined through the
Augmented Dickey-Fuller (ADF) test/

A number of studies have indicated that most of the time series variables are non-stationary
or integrated of order 1 (i.e., the first difference is stationary). For the purpose of this study,
time series variables considered include the exchange rate, inflation, and the stock price.
In the application of the ADF test, we test both the trend and intercept. Generally, the model
is provided as follows:

p
xt    1   xt 1  t    i xt i   t ……………………………i.
i 1

The Bayesian Schwarz Information Criterion has been used in order to select the order of
lags (p) within the above equation i. Note that failure to reject null of a unit root, might be
attributed to the low power of the unit root test against the stationary alternatives, this study

14
came up with a null is stationarity and alternative is a unit root. The test is provided as
follows:

1 T
S t2
KPSS  2
T
 s L  ………………………………………………...ii.
t 1
2

In which,

t
S t   ei t  1,2,3....T …………….………………iii
i 1

and

1 T 2 2 L  s  T
s2   t T
e   L  1   et et  s

s 1 
1  ………………………….iv
T t 1 t  s 1

The residuals are provided by ei ´s , T provides the number of observations while L is lag
length.

Further, to ensure that the error terms are uncorrelated, there are three regression equations
to be considered:

iF t =β10 -β12 sp t -β13 ex t+γ11 iFt-1+γ12 sp t-1+γ13 ex t-1+εiFt……i.

sp t=β20 -β21 iF t -β23 ex t+γ21 iFt-1+γ22 sp t-1+γ23 ex t-1+εspt .…….ii.

ex t=β30 -β31 iF t -β32 sp t +γ31 iFt-1+γ32 sp t-1+γ33 ex t-1+εext………..iii.

Where,

15
iF t is the first difference of the log of CPI inflation.

sp t is the first difference of the log of FTSE 100 STOCK INDEX.

ex t is the first difference of the log of exchange rate (pounds/dollar).

εiFt, εspt, εext represent the shocks in CPI, FTSE 100 STOCK INDEX and exchange rate.

In which, the extra lagged terms have been included in the model so as to ensure that the
error terms are uncorrelated. The ADF relies on the following hypotheses:

H0 : iF t is not I (0) or iF t is nonstationary

H1: iF t is I (0) or iF t is stationary

H0: sp t is not I (0) or sp t is nonstationary

H1: sp t is I (0) or sp t is stationary

H0: ex t is not I (0) or ex t is nonstationary

H1: ex t is I (0) or ex t is stationary

In this model, comparisons are made on the calculated ADF statistics with critical values
from Fuller’s table. In case the test statistic is lower than the critical table value, the null
hypothesis (H0) is accepted and conclude that the series is non-stationary or it is not
integrated to order zero. The test value may also be compared to the level of significance
in drawing the conclusion. When the variable is stationary without a difference, then it is
integrated to order zero and when the stationary is only after the first difference, then it is
integrated to order 1.

16
3.3.2 Structural Vector Autoregressive Approach (SVAR)

The VAR model has been criticized because it does not take into consideration the
economic theories, which implies that there is no economic content in it. It is important to
note that the VAR model itself could lack some foundations to explain the economic
phenomenon (Fama, 1981). The development of the SVAR model was meant to solve the
shortcoming of the VAR model. The SVAR model does not only rely on the economic
concept but also on the practical experience. It can help in observing the contemporaneous
relationship between the variables in this study. Hence, the estimation of the SVAR model
is meant to analyze the dynamic relationship of inflation, stock price, and exchange rate.
After conducting the SVAR function, the impulse response is run. The impulse response
function helps to investigate the way in which each of the above variables responds to a
positive one-time shock in other variables in the SVAR model.

The various ordering of variables may bring different outcomes on the impulse response
function (Enders, 2010). As per the work of Bjornland and Leitemo (2009), the ordering
of the variables is placed as follows: CPI Inflation, Stock price, and Exchange rate. Having
the CPI Inflation coming first implies that it is supposed to have an effect on the stock price
and exchange rate simultaneously, although, it could not be affected by shocks for the other
two variables apart from its own shock. The stock price comes second and this implies that
it can only respond to the changes in the CPI Inflation and the exchange rate
simultaneously. Finally, comes the exchange rate, implying that the shocks in the CPI
inflation might not have an impact on the first two variables.

In addition, this study imposes a restriction based on the well-founded theoretical

argument, which indicates a contemporaneous feedback effect among the examined
variables within the SVAR model. Considering that the variables are 3 (n = 3), then the
restriction imposed should be n2 = 9; in which n2+ n / 2 = 6. Therefore, it follows that there
are 6 restrictions that should be imposed on the SVAR model. Out of the 6 restrictions, 3
of them are based on economic theories. This can be illustrated as follows:
17
α iF t 1 0 0

α sp t = y21 1 0

αex t y31 y32 1

For the left-hand side, the three structural shocks iF t, sp t, and ex t indicate real shocks for
the CPI Inflation, stock price and exchange rate in that order. The coefficients to be
estimated are denoted by y21, y31, and y31.

3.4 Sample and data description

3.4.1 Sample selection

For the purpose of empirical testing, the study chose a sample of monthly data from the
UK from January 2000 to January 2018. The CPI Inflation and the monthly nominal
effective exchange rate were obtained from the OECD data center and OFX respectively.
Using effective exchange rate provides overall competitiveness of the UK Sterling pound
in comparison to other foreign currencies and provided the rationale for the choice of the
effective exchange rate over the bilateral exchange rate. As a result of the limited
availability of data, the study adopted the FTSE 100 Index so as to describe the UK stock
price that was got from international financial statistics. The average daily FTSE 100 was
weighted to monthly data and only close prices were focused. This was done by the
following formula:

18
Real FTSE 100 Index = Nominal FTSE 100 Index / CPI / 100

Then a natural logarithm and first difference of the three variables is done i.e changing the
monthly nominal effective exchange rates, real FTSE 100 index and CPI to exchange rate
changes, the real stock price, and CPI Inflation respectively so as to offer an estimate of
the SVAR model. Table 1 provides a summary of descriptive statistics for every variable.

Table 1: Descriptive statistics

Jarque-Bera Probabilities

Variable Mean S.D Skewness Kurtosis

Stock index 2631.50 615.865 .452 .000 125.214 .000
Exchange rate 86.912 6.251 .837 .156 43.162 .001

Real stock price -.056 .068 .348 .342 14.453 .000

CPI Inflation rate .008 5.317 .273 .000 15.287 .001

Interpretation of descriptive statistics

Stock index

As indicated in Table 1, the average value of the stock index from the FTSE 100 is 2631.50
with the standard deviation being 615.865. The large standard deviation of this variable
shows that a wider dispersion exists in the data and this would probably have been as a
result of changes in the economic performance of the UK over the period of the sample.

Exchange rate

19
Following the findings as provided in Table 1, the mean value was 86.912 and the standard
deviation was 6.251. It follows that there were slight changes in the performance of the UK
Sterling Pound in relation to foreign currencies over the studied period.

Real Stock price

As indicated in Table 1, the average value of the stock index from the FTSE 100 is -.056
with the standard deviation being .068. This means that there were small changes in the
real stock price in the market for the UK over the sampled period.

CPI Inflation rate

As indicated in Table 1, the average value of the stock index from the FTSE 100 is .008
with the standard deviation being 5.317. This means that there were slightly large changes
in the CPI inflation over the sampled period, implying that the UK has experienced a slow
growth in the economic performance in recent past.

Interpreting other statistics from Table 1

The Jacque-Bera statistics in Table 1 indicates large values and associated probabilities at
5 % level of significance. This means that the variables in this study are normally
distributed. All the variables are positively skewed and so is the kurtosis and this means
that the regression variables are peaked at the top unlike in Gaussian distribution. When
the kurtosis values are less or equal to 3 and the skewness values are less or equal to 1, then
it is an implication of normal distribution of the variables and so regression analysis can be
performed on the data.

3.4.2 Hypothesis Development

20
As provided in the previous sections, two theories that relate to exchange rate, stock prices
and CPI Inflation are the traditional approach and money demand theory. The traditional
approach argues that the depreciation of currency brings about increased export and hence
corporate profits that result in higher stock prices over the short term period. As described
by Fisher (1911), the money demand theory postulates that there is a link between the
quantity of money and the total amount of spending on the final goods and services.
Changes in the money supply have an effect on the prices of goods.

Therefore, inflation and other macroeconomic variables seem to have a substantial

influence on the behavior of the financial aggregates, for instance, the stock prices. For
instance, changes in the interest rate movements have been considered to be closely
associated with inflation movement so as to compensate the lender for the changes in real
value for the nominal interest rate payments. Despite that, interest rates, often fail to move
exactly with the inflation since they are a reflection of expectations of the future inflation
instead of the current inflation.

Based on these theories, there are a number of studies that look at the relationship of
inflation, stock price and exchange rate but the studies only look at two variables at a time
rather than the three variables in combination and the findings have been different. Based
on the literature, the following hypotheses can be deduced:

Hypothesis 1: the positive shock in CPI inflation has a negative influence on the exchange
rate changes over the short term

Hypothesis 2: the positive shock in real stock price has a positive lagged effect on exchange
rate changes over the short term

21
 CHAPTER FOUR: EMPIRICAL RESULTS

In this section, we plot the FTSE 100, exchange rate and CPI inflation so as to get an overall
picture of the variables (Figure 1). After which, the study seeks to examine empirical
results of the impulse response function to find out how each of variables in the SVAR
model responds to a positive one-time shock in other variables and discuss the dynamic
relationships of the variables.

Figure 1: General Picture of the variables

GE NE RAL MOVE ME NT OF T HE VARIAB L E S

CPI Inflation rate FTSE 100 Stock Index

5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00% 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1 2 0 1 2 2 0 1 3 2 0 1 4 2 0 1 5 2 0 1 6 2 0 1 7 2 0 1 8
-2.00%
-3.00%
-4.00%
-5.00%

Figure 1 provides a general trend of FTSE 100 and the CPI Inflation from January 2000 to
January 2018. From the figure, it can be noted that the CPI Inflation seems to be more
volatile as compared to the stock index. Similar trends have been recognized between 2000
and 2002 while in much of the period, the variables were moving in different directions. A
growth in the CPI Inflation might be contributed by the growth in the money supply in an
economy, that brings about an increase in the stock price to a given level. However, there
would be some similar trend in the movement of prices and CPI inflation in some instances.
It can be noted that during the 2008 financial crisis, the CPI inflation dropped the lowest

22
in that period, something that influenced the oil prices in the UK do reduce, reduction of
the value-added tax in the UK as a remedy to encourage expenditure, reduction of interest
rates so as to improve the economy and the general effect of this was to reduce inflation in
the country.

4.1 Test of stationarity

The findings on ADF tests are presented in Table 2 below. The test indicates that all the
three variables are stationarity when integrated to the first order, with intercept and lagged
(0). This is because the test failed to reject the null hypothesis, which indicates that the
variables have a presence of the unit root.

Table 2: ADF Test for unit root

Exogenous: Constant

N : 54
Variables ADF-Level ADF-1st dif Null hypothesis Result
CPI -3.156 (5) -43.173(5) reject ho Variable is stationary
Stock Price -3.231(3) -18.292(3) reject ho Variable is stationary

Exchange rate -2.581(3) 5-21.282(3) reject ho Variable is stationary

1. Lag length provided in brackets

2. Test at 5 % level of significance

This means that the variables can be used to estimate the SVAR model. We choose the
optimal lag length (3) for the SVAR that minimizes the information criteria. This is further
confirmed by conducting a Bayesian Schwarz Criteria. Table 3, 4 and 5 provide the results
of the Bayesian Schwarz Criteria in which both the stock price and exchange rate share
similar values of Bayesian Schwartz Criteria.

23
Table 3: Bayesian Schwartz Criteria for model 1

OLS, using observations 2000-2018 (T = 18)

Dependent variable: CPI

Coefficient Std. Error t-ratio p-value

const 186.183 125.404 1.4847 0.16147
CPI 1.84199 1.21508 1.5159 0.15347
Schwarz criterion 185.3690 Hannan-Quinn 183.9378
rho 0.377926 Durbin-Watson 1.076961

Thus, pricet  186.183  1.84199cpit   t

Supposed we impose a short run restriction on the equation above, it is possible to reflect
the contemporanous feedback effect among the variables in the SVAR system.

Below is the output for model restriction with

Β10 + β12 + β13 + ϒ11 = 0

24
Restriction:

b[const] + b[CPI] + b[Stcok_price] + b[Exchange_rate] = 0

Test statistic: F(1, 2) = 2.29122, with p-value = 0.154035

Restricted estimates:

coefficient std. error t-ratio p-value

--------------------------------------------------------

const -3.63715 0.276347 -13.16 2.83e-09 ***

CPI 3.63715 0.276347 13.16 2.83e-09 ***

Standard error of the regression = 109.415

Table 4: Bayesian Schwartz Criteria for model 2

OLS, using observations 2000-2018 (T = 18)

Dependent variable: Stock_price

Coefficient Std. Error t-ratio p-value

const -10.061 23.7668 -4.2943 0.00087 ***
Stock_rice 2.12944 0.230284 9.2470 <0.00001 ***
Schwarz criterion 135.4715 Hannan-Quinn 134.0403
rho 0.637495 Durbin-Watson 0.603767

Thus, stock_price = -10.061 + 2.12944 ex t + ϵt

Supposed we impose a short run restriction on the equation above, it is possible to reflect
the contemporanous feedback effect among the variables in the SVAR system.

Below is the output for model restriction with

Β10 + β12 + β13 + ϒ11 = 1

25
Restriction:

b[const] + b[CPI] + b[Stcok_price] + b[Exchange_rate] = 1

Test statistic: F(1, 2) = 2.26691, with p-value = 0.156069

Restricted estimates:

coefficient std. error t-ratio p-value

const -2.62760 0.276127 -9.516 1.72e-07 ***

Stock_price 3.62760 0.276127 13.14 2.90e-09 ***

Standard error of the regression = 109.328

Table 5: Bayesian Schwartz Criteria for model 3

OLS, using observations 2000-2018 (T = 18)

Dependent variable: Exchange_rate

Coefficient Std. Error t-ratio p-value

const -3.061 3.7668 -2.046 0.00374 ***
Exchange_rate 2.085 0.230284 9.2470 <0.00001 ***
Schwarz criterion 135.4715 Hannan-Quinn 14.1313
rho 0.637495 Durbin-Watson 0.45156

Thus, Exchange rate = -3.061+ 2.085sp t + ϵt

Supposed we impose a short run restriction on the equation above, it is possible to reflect
the contemporanous feedback effect among the variables in the SVAR system.

Below is the output for model restriction with

Β10 + β12 + β13 + ϒ11 = 1

26
Restriction:

b[const] + b[CPI] + b[Stcok_price] + b[Exchange_rate] = 1

Test statistic: F(1, 13) = 18.0184, with p-value = 0.000956382

Restricted estimates:

coefficient std. error t-ratio p-value

---------------------------------------------------------

const -1.17536 0.0745938 -15.76 2.65e-010 ***

exchange_rate 1.17536 0.0745938 15.76 2.65e-010 ***

Standard error of the regression = 29.5343

In summary, it can be noted that the restriction indicates that the initial model is fit for
examining the relationship between CPI Inflation, Exchange rate, and stock price.

4.2 Testing the impulse response function of the SVAR model

As a way to understand the contemporaneous relationship of the three variables, this study
conducts an impulse response function over a period of 2000-2018. The impulse response
function is based on the SVAR model and would indicate the impact of the shocks for
every variable. The findings of the Impulse response function on the short-term dynamics
of lead-lag relationships of CPI Inflation, stock price, and exchange rates.

27
Table 6: Impulse Response Function of exchange rate from a unit shock in CPI
Inflation

Period (months)

Full 2000-2003 2004- 2007-2010 2011-2015 2016-2018

sample 2006
2 -.056* -.068* -.817* -.927* -.953* -1.004*
3 -.024* -.038* -.743* -.756* -.825* -.836*
4 -.012* -.029* -.683* -.692* -.697* -.705*
5 -.005* -.018* -.526* -.534* -.573* -.593*
6 -.003 -.001* -.463* -.504* -.527* -.603*
7 .000 .000 -.328* -.426* -.435* -.635*
8 .000 .000 .000 -.325* -.368* -.463*
9 .000 .000 .000 -.258* -.271* -.375*
10 .000 .000 .000 .000 -.001* -.006*
11 .000 .000 .000 .000 .000 .000
12 .000 .000 .000 .000 .000 .000

From the findings in Table 6, the positive shock in CPI Inflation his associated with a
negative influence on the exchange rate over a short period of time. The findings of this
study are consistent with the available literature in which the growth in the value of
currency brings about a small reduction on the CPI inflation for the developed countries.
This is a common phenomenon considering that movements in the exchange rate influence
consumer price index in two aspects. The first stage is the effect of the exchange rate on
the Sterling Pound cost of imports when the goods get into the country (Ibrahim & Aziz,
2003). The second way is the effect of changes on prices for the imported goods for the
overall consumer prices (Masih & Masih, 2001). Such transmission might be fairly direct,
for instance, if the consumers purchase imported goods, or could be indirect when the
prices for the goods produced domestically get influenced by the changes in the cost of
imported goods.

Therefore, in the first stage, it can be noted that the changes in the Sterling Pound prices
for imported goods would well be understood by the changes on the exchange rate as well
as the global prices. Clearly, the exchange rates are passed through and often to the

28
imported goods, that confirms the association of the exchange rate movements and the CPI
Inflation. Therefore, in regard to the two aspects of the relation of the exchange rate and
CPI Inflation, within the open economy in the UK, the country consumes a third of the
imported goods. As a result, the exchange rate has a key role to play in regard to influencing
the domestic prices by its effect on the prices for the imported goods.

Nonetheless, the changes in the cost of transportation and trade barriers might influence
the exchange rate pass-through that might offset the impact of exchange rate changes for
the domestic prices (Yutaka, 2006), that creates slight changes. Practically, the changes on
the exchange rate influence the CPI inflation to some level, with other implications on
forecasting inflation and monetary policies so as to improve inflation. This means that
policymakers should put into consideration the strength of the exchange rate pass-through
in coming up with monetary policies so as to adjust the domestic inflation.
Table 7: Impulse Response Function of Stock price from a unit shock in Exchange rate

Period (months)

Full 2000-2003 2004- 2007-2010 2011-2015 2016-2018

sample 2006
2 .245 .078 .507 .627 .743 1.004
3 .084 .048 .503 .726 .525 .436
4 .078 .062 .465 .692 .527 .415
5 .065 .036 .513 .434 .423 .453
6 .063 .004 .503 .304 .417 .406
7 .045 .003 .405 .256 .315 .536
8 .001 .002 .018 .125 .208 .414
9 .000 .000 .017 .108 .171 .306
10 .000 .000 .001 .003 .003 .004
11 .000 .000 .000 .001 .001 .002
12 .000 .000 .000 .000 .000 .000

Table 7 provides the findings of the impulse response function of positive shock stock price on the
exchange rate. It is clear that the positive shock in real stock price has a positive lagged effect on
exchange rate changes over the short term. However, the findings are not significant at 5 % level
of significance. This means that the positive shock in real stock price on the exchange rate is only
29
over a short period of time, with the delay. The findings of this study are in contrast to the work of
Pearce and Roley (1985) which argued that the changes in the exchange rate do not predict the
portion of stock prices both in the short run and in the long run. One interpretation for such
observation might be attributed to the fact that firms hedge against exchange rate risks in the market
and hence the stock prices are invariant of the exchange rate shocks in the market. This explanation
seems implausible in the UK economy with most of the goods sold in the foreign currency
particularly the U.S dollar and that unexpected devaluations might reduce the domestic wealth.
Hence, in order to hedge against the exchange rate risk, with the majority of the firms facing the
high premium and short maturity instruments, for instance, the futures, options, and debt associated
with US dollar.

However, as per the findings of the impulse response function, the growth in terms of the
value of the Sterling Pound would imply an increase in the stock price over a short period
of time. This could be attributed to the high level of openness of the UK market.
Accordingly, the growth in the value of the Sterling Pound would influence the inflow of
the foreign speculative funds and the capital for investment into the UK economy. This
could help to buy more assets with part of the money used in the stock market, that
increases the stock prices. Nonetheless, a growing value of the UK Sterling pound would
imply that the British products would be more expensive in the market as compared to the
foreign products, the impact would be a reduction of the competitiveness of the British
firms with most of the consumers likely to turn to the foreign brands, this suppresses the
exports from the UK. In addition, the growth in value of the sterling pound is associated
with a reduction of the price for some of the imported commodities and costs for imported
materials which are used for intermediate consumption within the UK, that promote its
imports.

Over the sample period in this study, it can be noted that the UK has been concerned of the
trade deficit with the EU and has continued to widen in the recent past. The report by the
Independent News (2018), show that 43 % of the trade deficits went to the EU countries in
2016. The UK’s trade performance with other countries of the EU has been woeful. Based
on the data by the House of Commons Library, the country has run a trade deficit for the
30
goods and services combined for each and every year since 2000. The deficit has doubled
from £41bn to £82bn in 2012-2017 (The House of Commons Library, 2018). For instance,
the deficit with Germany has grown by 5 % every year, 7 % every year with France and 11
% with the other countries in the EU. This trade deficit has largely been attributed to the
fact that the single market and customs union is designed to help other countries of the EU
and other parts of the world rather than the UK. In regard to this, the small delay on the
influence of exchange rate change shocks on the stock prices can be attributed to the high
reliance on the trade imports by the UK firms that are not export-oriented that saves on
production due to saving of costs from the exchange rate shocks, creating a growing cash
flow and more share prices. In consequence, the effect of exchange rate shocks on the stock
prices is likely to take time.

4.3 Answering the Hypotheses

Hypothesis 1

Table 6 covers the first hypothesis on the influence of positive shock in CPI inflation on
the exchange rate changes over the short term. The results demonstrate that the positive
shock in CPI inflation has a negative influence on the exchange rate changes over the short
term and the findings are significant. This suggests that the rise in the domestic CPI
Inflation in relation to the foreign CPI inflation rate, then there is depreciation in the
domestic currency with the same margin. The findings of this study are similar to the work
of Pilbeam (2013) that examined the relative PPP theory in regard to understanding the
role of CPI inflation in the exchange rate. Based on the results on the impulse response
function, the contemporaneous effect of positive CPI inflation shock on the exchange rate
is further reflected on the stock prices growth, although, the overall effect of the increased
CPI Inflation on the stock prices is negative over the short term as a result of the negative
lagged effect of the exchange rate. The positive shock of the CPI inflation creates
uncertainty in the financial asset returns, that means that the investors have to raise the
level of risk on the financial assets so as to realize increased returns, that further brings

31
about more premium and lower discount rate. Therefore, these variables play crucial roles
in understanding the response of firms in hedging against risk in the market over the short
term so as to increase their returns. This is due to the fact that the findings suggest that the
stock returns are not able to hedge against risk for the firms in the short run and so investors
in the market would not help to maintain the value of exchange rate over the short run.

Hypothesis 2

Over the research period (2000-2018), the positive shock in real stock price exhibited a
positive lagged effect on the exchange rate over the short period, however, the findings are
not statistically significant at 5 % level of significance. The findings are not consistent with
the available literature, for instance, Pearce and Roley (1985) argued that the changes in
the exchange rate do not predict the portion of stock prices both in the short run and in the
long run. One interpretation for such observation might be attributed to the fact that firms
hedge against exchange rate risks in the market and hence the stock prices are invariant of
the exchange rate shocks in the market. This explanation seems implausible in the UK
economy with most of the goods sold in the foreign currency particularly the U.S dollar
and that unexpected devaluations might reduce the domestic wealth. Hence, the need to
hedge against the exchange rate risk, with the majority of the firms facing the high premium
and short maturity instruments, for instance, the futures, options, and debt associated with
US dollar.

32
 CHAPTER FIVE : CONCLUSIONS

This study has made effort towards evaluating the relationship of CPI Inflation, stock price
and exchange rate in the UK market. In the current globalized era, in which capital markets
continue to be significantly integrated, it is essential to understand the underlying
fundamentals which influence the markets both at the domestic and global levels.
Therefore, the variables, for instance, CPI Inflation, exchange rate, and stock price become
key considerations. This study has presented evidence that there are significant
relationships of the exchange rate, CPI inflation, and stock prices in the UK economy. This
was done by employing the SVAR model over the sample period of 2000-2018. By the
estimation of the SVAR model, the study brought forth the contemporaneous relationship
of the three variables. Further, the impulse response function was used to examine if each
variable in the SVAR model responds to a positive one time shock in the other variable.

The literature indicates that the positive shock in real stock price has a positive lagged
effect on exchange rate changes over the short term. This was also the hypothesis set in
this study and the findings confirmed the hypothesis to be true. Considering the level of
openness in the UK economy, there are more international funds that move into the market
over a short time period, that could increase the demand for the domestic currency and so
the growth in value for the sterling pound.

For the interactions of the exchange rate and the CPI inflation, it has been noted that a small
lagged effect for the positive exchange rate shock on the CPI inflation indicates that
changes on the exchange rate are not completely moved to the local market in terms of the
consumer prices. There are changes in the exchange rate due to the changes in the consumer
price levels within the distribution channel. Under this channel, there is an influence of the
import and producer prices by changes in the exchange rate and then pass through domestic
consumer prices and CPI inflation. The literature review in this study showed that there is
growth in the CPI Inflation as a response to the positive shock in the stock prices. Despite
that, there is a positive shock CPI Inflation that is associated with an overall adverse effect

33
on stock prices over the short period, that shows failure for the equities to hedge against
risk in the market such as the CPI inflation.

In summary, it can be noted that there is a dynamic relationship between CPI inflation,
stock price and exchange rate in the UK market. However, this is in the short term. The
findings of this study have managerial implications. Firstly, the portfolio managers and
hedgers need to develop better investment decisions and come up with the right hedging
strategies against the currency shocks more so the importing industries in which there is
more exposure to currency shocks. In addition, for the developed countries such as the UK,
the stock market can be further enhanced through pursuing an active policy for currency
stabilization by the monetary policy instrument; this shall not only stabilize the stock prices
but also reduce the level of inflation.

The findings of this study have a further scope so as to be comprehensive. It can make
comparisons to other developing countries and include more economic variables so as to
understand the way in which the stock market is affected by other macroeconomic factors
in the developing countries. Therefore, the future study needs to focus on the comparative
investigation of the developing countries.

34
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