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A Study on the Impact of Currency Fluctuation on the Indian Stock Market

(2000-2021)

Research · August 2021

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IMPACT OF CURRENCY FLUCTUATION ON

THE INDIAN STOCK MARKET

AN EMPIRICAL STUDY

Under the guidance of

Prof.Bhaskar Sinha
Written by

Mr. Shreyas Lavekar

 TABLE OF CONTENTS

Sr.No Contents Page No.

1 Objectives 1

2 Introduction 2

3 Exchange Rates? 3

4 Factors affecting Exchange Rates 4

5 Approaches towards their relationship 7

6 Bombay Stock Exchange 8

7 Asian Financial Crises 11

8 2008-2009 Global Financial Crises 13

9 Literature Review 16

10 Research Methodology 24

11 Regression Analysis 25

12 Co-relation Graphs 28

13 Regression Analysis Summary 37

14 Conclusion 43

15 Bibliography 44
Objectives

1. To examine the relationship between the performance indicator of Bombay

Stock Exchange – SENSEX and the three major currencies, USD, EUR and
GBP.
2. To understand overall what is the approach in the relationship between both
the variables.
3. To understand what are exchange rates?
4. To understand what factors, impact the exchange rate of a currency.
5. To understand the forex exchange market from a global as well an Indian
point of view.

Page | 1
 INTRODUCTION

The advent of the floating exchange rate in 1973, reforms of financial markets in the
early nineties, the Asian currency crisis of 1997–98, and the 2008 economic recession
have collectively made a strong pitch for the dynamic linkage between the stock and
foreign exchange market.

Traditionally both the markets have been regarded as sensitive segments of the
financial market as the impact of any policy change gets quickly reflected in these
two markets. At the same time, ruptures in either or both the markets tend to raise
concern among policy makers, i.e., the two markets have tremendous policy
implications. Clubbed with this, the dynamic interrelationship between both the
markets has prompted researchers, policy makers as well as analysts to carry out
detailed analyses of this relationship. There is still no consensus on the relationship
between stock market and exchange rate although the topic has been widely
discussed. Financial theory explains that the value of firm should be influenced by
exchange rates and interest rates

In India, foreign direct investment (FDI) is an important element of stock prices and
the trend of FDI may considerably be affected by changes in exchange rate either
depreciating or appreciating. Similarly, the exchange rates are affected by the
movements in stock prices.

In this context the study is motivated to examine any such linkage in the Indian
context.

Page | 2
 EXCHANGE RATES

Foreign currency exchange rates measure one currency’s strength relative to another.
A strong currency is considered to be one that is valuable, and this manifests itself
when comparing its value to another currency. The strength of a currency depends on
a number of factors such as its inflation rate, prevailing interest rates in its home
country, or the stability of the government, to name a few.

Exchange Rates are of two types:

1) Fixed Exchange Rate

2) Floating Exchange Rate or Pegged Exchange Rate

Fixed Exchange Rates

A fixed exchange rate (also known as the gold standard) uses a steady reference point
to quantify the worth of currencies. Gold has always been used as a benchmark. This
is due to the fact that it is a valuable commodity on a global scale, and its value is less
affected by interest rate swings. Until the mid-nineteenth century, the method of
connecting money values to gold worked pretty successfully.

The gold standard system in the early 1900s pegged the value of gold at US$35 per
ounce of gold, which was the reference point those other nations used to fix the value
of their currencies. It is important to note that this price was not the commodity price
of gold. Private investors could not purchase gold at this price point. Governments
had exclusive rights over private individuals to buy gold at this below-market price,
thus reducing the volatility of currency values.

In 1944, the U.S. pursued an expansionary monetary policy in a bid to financially

support the country’s participation in World War II. This policy caused inflation to
rise and resulted in the US dollar losing value fairly quickly. Other nations quickly
began stockpiling gold to prevent fluctuations in their own currencies.

Eventually, the practice became quite unsustainable due to placing unrealistic

demands on the inflation of the US dollar. In 1944, the “Gold Standard” was
abolished and was replaced with the Pegged Exchange Rate System.

Page | 3
Pegged Exchange Rates

The pegged exchange rate system combines elements of both floating and fixed
exchange rates. Smaller economies are more vulnerable to currency changes, thus
often "peg" their currency to a single major currency or a basket of currencies. These
currencies are chosen based on which countries the smaller economy does a lot of
trade with or the currency in which the country's debt is denominated.

For example, if a small nation that does a lot of business with the United States
decides to peg its currency to the US dollar, its currency will fluctuate in value in a
similar way to the USD. The method eliminates large-scale swings and makes the
currency of the smaller economy a safer investment. Larger economies are less
hesitant to enter into trade agreements with such currencies because their value is
unlikely to change much.

When pegged exchange rate agreements are established, the participating countries
agree on an initial target exchange rate. In addition, a fluctuation range is established
to define permissible deviations from the target exchange rate. Pegged exchange rate
agreements are typically reviewed multiple times throughout the course of their lives
in order to adjust the target rate and variations to changing economic conditions.

Such systems have been shown to lessen currency volatility in developing economies
and to put pressure on governments to be more disciplined in their monetary policy
decisions. However, this opens the door to investor speculations, which could have an
impact on the currency's value. Once the weaker currency gets momentum and sees
its true market value rise considerably ahead of its pegged value, fixed rate schemes
may be abandoned entirely.

Page | 4
Factors affecting the Exchange Rate:

1. Inflation

Typically, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last
half of the 20th century, the countries with low inflation included Japan, Germany,
and Switzerland, while the U.S. and Canada achieved low inflation only later.1 Those
countries with higher inflation typically see depreciation in their currency about the
currencies of their trading partners. This is also usually accompanied by higher
interest rates.

2. Interest Rates

Interest rates, inflation, and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates,
and changing interest rates impact inflation and currency values. Higher interest rates
offer lenders in an economy a higher return relative to other countries. Therefore,
higher interest rates attract foreign capital and cause the exchange rate to rise. The
impact of higher interest rates is mitigated, however, if inflation in the country is
much higher than in others, or if additional factors serve to drive the currency down.
The opposite relationship exists for decreasing interest rates – that is, lower interest
rates tend to decrease exchange rates.

3. Current Account Deficits

The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest, and dividends.
A deficit in the current account shows the country is spending more on foreign trade
than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives
through sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.

Page | 5
 4. Public Debt

Public debt or national debt owned by the central government. A country with
government debt is less likely to acquire foreign capital, leading to inflation. A large
debt encourages inflation, and if inflation is high, the debt will be serviced and
ultimately paid off with cheaper real dollars in the future.

In the worst-case scenario, a government might create money to pay off a portion of a
massive debt, but expanding the money supply will surely lead to inflation.
Furthermore, if a government cannot service its deficit by selling domestic bonds or
expanding the money supply, it must increase the amount of assets available for sale
to foreigners, lowering their prices. Finally, outsiders may be concerned about a huge
debt if they perceive the country is at risk of defaulting on its obligations. If the risk
of default is high, foreigners will be less eager to invest in assets denominated in that
currency.

5. Import and Exports

A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports rises
by a greater rate than that of its imports, its terms of trade have favorably improved.
Increasing terms of trade shows' greater demand for the country's exports. This, in
turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports
rises by a smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners.

6. Strong Economic Performance

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes
will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of more stable
countries.

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 APPROACHES TOWARDS THEIR RELATIONSHIP

Economic theory suggests three key theories explaining the relationship between
exchange rates and stock markets: the goods market theory, also known as the
flow-oriented model or the traditional approach, the portfolio balance theory
and the Asset Market Approach.

According to the good market theory, there is a positive relationship between stock
market and exchange market and the causality runs from exchange rate to stock
market. It suggested that a positive relationship between stock prices and exchange
rates exists when local currency depreciates and local firms become more competitive
which leads to an increase in their exports. This will result in an ultimate increase in
stock prices.

The Portfolio Balance theory suggests the causality between the stock market and
exchange rates goes from the stock market to the exchange rate. The theory advocates
that the stock market affects the exchange rates through changes in stock prices.
Domestic investors invest more in domestic market when there is an increase in prices
of assets which in turn increase the demand for local currency and also increase the
behaviour of selling the foreign assets. The increase in demand of local currency will
force the interest rates to become higher which will ultimately attract the foreign
investors to invest and gain maximum benefit. The exchange rate of local currency
will appreciate against that of foreign currency and shows negative relationship.

According to the Asset Market approach, it proposes that there is no interaction or

very weak association between the exchange rate and stock market. This is due to the
reason that both the variables may be driven by different factors.

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 BOMBAY STOCK EXCHANGE

The Bombay Stock Exchange (BSE) is the first and largest securities market in India
and was established in 1875 as the Native Share and Stock Brokers' Association.
Based at Dalal Street, Mumbai, India, the BSE lists close to 6,000 companies and is
one of the largest exchanges in the world, along with the New York Stock Exchange
(NYSE), Nasdaq, London Stock Exchange Group, Japan Exchange Group, and
Shanghai Stock Exchange.
After decades of its working, it became the first exchange in India that was
recognized as the exchange in 1957 under the Securities Contracts (Regulation) Act
by the government.
After some years of its recognition, in the year 1986, a tool was developed to measure
the Bombay stock exchange’s overall performance known as the SENSEX, which is
the stock market index consisting of the 30 well established as well as financially
sound companies that are listed on the Bombay stock exchange.
In 1995, the Bombay stock exchange switched to the electronic trading system known
as BOLT (BSE On-Line Trading). Also, it became the first stock exchange in the
world, which introduced an internet trading system at a centralized level.
Main Functions of Bombay Stock Exchange:
 Price Determination -The price determination in the secondary market
depends upon the demand and supply of the securities. Bombay Stock
Exchange helps in the process of valuation by constantly valuing all the listed
securities. Such share prices can be easily tracked through the index that is
popularly known as SENSEX.
 Economical Contribution - Since the Bombay Stock Exchange deals with the
securities listed and these securities are sold and re-sold continuously, it
allows the funds to keep moving instead of remaining idle, which boosts the
economy.
 Marketability and Liquidity - They provide high liquidity as the listed
securities can be sold at any point in time, converting it into cash. It works
continually, and the investor can sell and purchase the security simply
according to their wish.

Page | 8
 Market Capitalization BSE (2001-2021)
2,50,00,000.00

2,00,00,000.00

1,50,00,000.00

1,00,00,000.00

50,00,000.00

0.00

Sensex

 Sensex, otherwise known as the S&P BSE Sensex index, is the

benchmark index of India's BSE.
 The Sensex is comprised of 30 of the largest and most actively-traded stocks
on the BSE, providing a gauge of India's economy. The index's composition is
reviewed in June and December each year.
 Created in 1986, the Sensex is the oldest stock index in India. Analysts and
investors use it to observe the cycles of India's economy and the development
and decline of particular industries.
 The constituents of the index are selected by the S&P BSE index Committee
based on five criteria:
o it should be listed in India on BSE,
o it should be a large-to mega-cap company,
o the stock should be relatively liquid,
o the company should generate revenue from core activities,
o it should keep the sector balanced broadly in line with the Indian
equity market.
 A free-float capitalization approach is used to calculate the Sensex. This
strategy is similar to the market-capitalization weighting method, which
weights firms based on their percentage of the index's overall market
capitalization.

Page | 9
 As a result, the Sensex assigns greater weight to the index's top companies.
 Unlike the market-capitalization method, the free-float capitalization method
only considers shares that are freely available to trade, rather than restricted
shares or shares held by company insiders.
 Between 1986 and 2021, the Sensex has grown at a compounded rate of
roughly 14% per year.
 This growth reflects the substantial growth of the Indian economy during that
time-frame, and in particular the expansion of that nation’s middle class.
 More recently, the Sensex declined by nearly 40% in March 2020 in the midst
of the coronavirus health crisis, but recovered strongly over the remainder of
the year.

Page |
ASIAN FINANCIAL CRISES

 The Asian Financial Crisis is a crisis caused by the collapse of the currency
exchange rate when Bank of Thailand cut the baht loose after it had been
under sustained attacks by speculators.
 It started in Thailand in July 1997 and swept over East and Southeast Asia.
The financial crisis heavily damaged currency values, stock markets, and other
asset prices in many East and Southeast Asian countries.
 On July 2, 1997, the Thai government ran out of foreign currency. No longer
able to support its exchange rate, the government was forced to float the Thai
baht, which was pegged to the U.S. dollar before. The currency exchange rate
of the baht thus collapsed immediately.
 The Asian stock markets plunged to their multi-year lows in August. The
capital market of South Korea maintained relatively stable until October.
 On October 27, the short-run interest rate in Hong Kong took a huge jump in
order to maintain its pegged exchange rate to the U.S. dollars, and as a result
the Hang Seng Index plummeted 1438 points.
 On November 24, Yamaichi – the fourth largest financial corporation - filed
for bankruptcy which gave rises to a 854-point drop in Nikkei Index.
 In mid-December, the Korean won depreciated drastically from 888 wons
(per dollar) in 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

Causes of the Asian Financial Crisis

 During the late 1980s and early 1990s, many Southeast Asian countries,
achieved massive economic growth of an 8% to 12% increase in their gross
domestic product (GDP). The achievement was known as the “Asian
economic miracle.” However, a significant risk was embedded in the
achievement.
 The economic developments in the countries mentioned above were mainly
boosted by export growth and foreign investment. Therefore, high interest
rates and fixed currency exchange rates (pegged to the U.S. dollar) were

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 implemented to attract hot money. Also, the exchange rate was pegged at a
rate favourable to exporters. However, both the capital market and corporates
were left exposed to foreign exchange risk due to the fixed currency exchange
rate policy.
 In the mid-1990s, the Federal Reserve raised the interest rate against inflation
and this higher interest rate attracted money to flow into the U.S. market,
leading to an appreciation of the U.S. dollar.
 The currencies pegged to the U.S. dollar also appreciated, and thus hurt export
growth. With a shock in both export and foreign investment, asset prices,
which were leveraged by large amounts of credits, began to collapse. The
panicked foreign investors began to withdraw.
 The massive capital outflow caused a depreciation pressure on the currencies
of the Asian countries, and this led to a domino effect on all the currencies of
the South Asian countries.

Effects of the Asian Financial Crisis

 Several countries saw their currency exchange rates, stock markets, and prices
of other assets all plunge. The GDPs of the affected countries even fell by
double digits.
 From 1996 to 1997, the nominal GDP per capita dropped by 43.2% in
Indonesia, 21.2% in Thailand, 19% in Malaysia, 18.5% in South Korea, and
12.5% in the Philippines.
 Hong Kong, Mainland China, Singapore, and Japan were also affected, but
less significantly.
 The impact of the Asian Financial Crisis was not limited to Asia. International
investors became less willing to invest in and lend to developing countries, not
only in Asia in other areas of the world. Oil prices also fell due to the crisis.
As a result, some major mergers and acquisitions in the oil industry took place
to achieve economies of scale.

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2008-2009 GLOBAL FINANCIAL CRISES

 The crisis, often referred to as “The Great Recession,” didn’t happen

overnight. There were many factors present leading up to the crisis, and it took
its toll on individuals and institutions around the globe, with millions of
people and hundreds of financial institutions being deeply impacted.
 After facing the burst of the dot-com bubble, a series of corporate accounting
scandals, and the September 11 terrorist attacks, the Federal Reserve lowered
the federal funds rate from 6.5% in May 2001 to 1% in June 2003.
 The aim was to boost the economy by making money available to businesses
and consumers at bargain rates.
 The result was an upward spiral in home prices as borrowers took advantage
of the low mortgage rates. Even subprime borrowers, those with poor or no
credit history, were able to realize the dream of buying a home.
 The banks then sold those loans on to Wall Street banks, which packaged
them into what were billed as low-risk financial instruments such as mortgage-
backed securities and collateralized debt obligations (CDOs). Soon a big
secondary market for originating and distributing subprime loans developed.
 Eventually, interest rates started to rise and homeownership reached a
saturation point. The Fed started raising rates in June 2004, and two years later
the Federal funds rate had reached 5.25%, where it remained until August
2007.
 By 2004, U.S. homeownership had peaked at 69.2%.5 Then, during early
2006, home prices started to fall.
 This caused real hardship to many Americans. Their homes were worth less
than they paid for them. They couldn't sell their houses without owing money
to their lenders. If they had adjustable-rate mortgages, their costs were going
up as their homes' values were going down. The most vulnerable subprime
borrowers were stuck with mortgages they couldn't afford in the first place.
 As 2007 got underway, one subprime lender after another filed for bankruptcy.
During February and March, more than 25 subprime lenders went under.
 In April, New Century Financial, which specialized in sub-prime lending, filed
for bankruptcy and laid off half of its workforce.

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  By June, Bear Stearns stopped redemptions in two of its hedge funds,
prompting Merrill Lynch to seize $800 million in assets from the
funds.
 The housing market was deeply impacted by the crisis. Evictions and
foreclosures began within months. The stock market, in response, began to
plummet and major businesses worldwide began to fail, losing millions. This,
of course, resulted in widespread layoffs and extended periods of
unemployment worldwide. Declining credit availability and failing confidence
in financial stability led to fewer and more cautious investments, and
international trade slowed to a crawl.
 Eventually, the United States responded to the crisis by passing the American
Recovery and Reinvestment Act of 2009, which used an expansionary
monetary policy, facilitated bank bailouts and mergers, and worked towards
stimulating economic growth.

Impact on India

 Post the 2008 crisis, as India’s growth and exports fell sharply, our
policymakers stepped in to support growth.
 The Reserve Bank of India slashed policy interest rates from 7% to an
effective low of 3.25%. India’s 10y government bond yield dropped from 9%
to 5% by end 2008. Moreover, the central government expanded the fiscal
deficit from 2.5% of GDP in FY08 to 6% in FY09, and 6.5% in FY10.
 The sudden withdrawal of FIIs from the Indian stock market brought about a
crash in the market in January 2008.
 The benchmark stock price index, the BSE Sensex, plummeted from 20,873
on 8 January to 9093 on 28 November 2008, a 56 per cent fall over a period of
11 months.
 The fall in Wall Street started two months before in November 2007, but the
intensity of the market crash taking place after a lag in Dalal Street (India’s
stock exchange) had been much larger.
 The crisis then moved to the foreign exchange market. The rupee began to
tumble from end-April 2008 to November 2008 by about 20 per cent

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 The Reserve Bank of India intervened by selling dollars to smoothen the fall
of the rupee.
 The heavy selling led to a massive depletion of the stock of reserves from US$
315 billion in May 2008 to US$ 246 billion in November 2008. A part of the
loss of reserves had been due to valuation changes as the dollar appreciated
against other reserve currencies but still the actual depletion of official
reserves has been quite large during this period.

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 LITERATURE REVIEW

To examine the impact of exchange rate changes on stock markets, Frank and
Young’s (1972) was the first study that investigated the relationship between stock
prices and exchange rates. They used six different exchange rates and found no
relationship between these two financial variables.

Aggarwal (1981) explored the relationship between changes in the dollar exchange
rates and change in indices of stock prices. He used monthly U.S. stock price data and
the effective exchange rate for the period 1974–1978. His results, which were
completely based on simple regressions, showed that stock prices and the value of the
U.S. dollar is positively related and this relationship is stronger in the short run than in
the long run.

Solnik (1987) examined the impact of several variables (exchange rates, interest rates
and changes in inflationary expectation) on stock prices. He uses monthly data from
nine western markets (U.S., Japan, Germany, U.K., France, Canada, Netherlands,
Switzerland, and Belgium). He found depreciation to have a positive but insignificant
influence on the U.S. stock market compared to change in inflationary expectation
and interest rates.

Soenen and Hanniger (1988) employed monthly data on stock prices and effective
exchange rates for the period 1980-1986. They discover a strong negative relationship
between the value of the U.S. dollar and the change in stock prices. However, when
they analysed the above relationship for a different period, they found a statistical
significant negative impact of revaluation on stock prices

Jorion (1988) attempted to analyze and compare the empirical distribution of returns
in the stock market and in the foreign exchange market by using the maximum
likelihood estimation procedure and ARCH model in daily data of exchange rates and
stock returns spanning from June 1973 to December 1985. The study found that
exchange rates display significant jump components, which are more manifest than in
the stock market. The statistical analysis of the study for the foreign exchange market
and stock market suggests there are important differences in the structures of these
markets.

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Taylor and Tonks (1989) studied the impact of the abolition of the UK exchange
control on the degree of integration of the UK and its overseas stock markets such as
West Germany, the Netherlands, Japan and the US. By employing the Granger
Causality and Engel Granger co-integration tests over the two sub periods, spanning
from April 1973 to September 1979 and October 1979 to June 1986 respectively, the
study concluded that there was no significant increase in the correlation of stock
market returns as a result of the abolition of exchange control. The co-integration test
confirmed that the UK and foreign (non-US) stock-market indices were co-integrated
in post-1979 period but not before that.

Ma and Kao (1990), using the monthly data from 1973 to 1983 of six major
industrialized countries, found that domestic currency appreciation negatively
affected the domestic stock price movements for an export-dominant economy and
positively affects an import-dominant economy.

Jorion (1991) in his study published in the Journal of Financial and Quantitative
analysis examined the exposure of US industries to movements in the value of the
dollar and also investigated the pricing of exchange rate risk in the U.S. stock market,
using two factor and multi factor arbitrage pricing models

Bahmani-Oskooee and Sohrabian (1992) analysed the long-run relationship

between stock prices and exchange rates using cointegration as well as the casual
relationship between the two by using Granger causality test. They employed monthly
data on S&P 500 index and effective exchange rate for the period 1973– 1988. They
concluded that there is a dual causal relationship between the stock prices and
effective exchange rate, at least in the short-run. But they were unable to find any
long-run relationship between these variables.

Smith (1992) used a Portfolio Balance Model to examine the determinants of

exchange rates. The model considers values of equities, stocks of bonds and money as
important determinants of exchange rates. The results show that equity values had a
significant influence on exchange rates but the stock of money and bond has little
impact on exchange rates. These results implied not only those equities are an
important additional factor to include in portfolio balance models of the exchange
rate, but also suggest that the impact of equities is more important than the impact of
government bonds and money.

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Bartov and Bodnar (1994) concluded that contemporaneous changes in the dollar
have little power in explaining abnormal stock returns. They also found a lagged
change in the dollar is negatively associated with abnormal stock returns. The
regression results showed that a lagged change in the dollar has explanatory power
with respect to errors in analysts’ forecasts of quarterly earnings.

Ajayi and Mougoue (1996) made an attempt to examine the intertemporal relation
between stock indices and exchange rates for a sample of eight advanced countries
during the period 1985 to 1991. By employing the co-integration and causality tests
on daily closing stock market indices and exchange rates, the study found (a) an
increase in aggregate domestic-stock price has a negative shortrun effect on domestic
currency values, (b) sustained increase in domestic stock prices will induce domestic
currency appreciation in the long run, (c) currency depreciation has negative short-run
and long-run effects on the stock market.

Yu (1997) employed daily stock price indices and spot exchange rates obtained from
the financial markets of Hong Kong, Tokyo, and Singapore over the period from
January 3, 1983 to June 15, 1994 to examine the possible interaction between these
financial variables. His results, based on the Granger causality test, show that the
changes in stock prices are caused by changes in exchange rates in Tokyo and Hong
Kong markets. However, no such causation was found for the Singapore market. On
the reverse causality from stock prices to exchange rates, his results show such
causation for only Tokyo market. Therefore, for Tokyo market there is a bi-
directional causal relationship between stock returns and changes in exchange rates.
He also uses vector autoregressive model to analyse a long-run stable relationship
between stock prices and exchange rates in the above Asian financial markets. His
results found a strong long-run stable relationship between stock prices and exchange
rates on levels for all three markets.

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Abdalla and Murinde (1997) have done a study on the interaction between exchange
rates and stock prices in the cases of India, Korea, Pakistan and the Philippines by
applying bi-variate Vector Auto Regressive models on monthly observations of stock
price index and the real effective exchange rate over 1985 to 1994. The study found
the unidirectional causality from exchange rate to stock prices in all the countries
except the Philippines. This finding suggests policy implication that the respective
governments should be cautious in their implementations of exchange rate policies in
such a way that these policies have ramifications in their stock markets.

Granger, Huang and Yang (1998) in their paper examined the causality issue using
Granger causality tests and Impulse response function for nine Asian countries. They
used daily data for the period January 3, 1986 to November 14, 1997. The countries
included in their study are: Hong Kong, Indonesia, Japan, South Korea, Malaysia,
Philippines, Singapore, Thailand and Taiwan. For Japan and Thailand they found that
exchange rates leads stock prices with positive correlation. The data from Taiwan
suggests stock prices leads exchange rates with negative correlation. No relationship
was found for Singapore and bi-directional causality was discovered for the remaining
countries.

Ong and Izan (1999) employed the Non-linear Least Square method to examine the
association between stock prices and exchange rates by comparing spot rate and 90-
dy forward exchange rate for G-7 countries and Australia. They found that US share
price returns fully reflect the information conveyed by movements in both the
Japanese Yen and the French Franc after four weeks. However, this result suggests a
very weak relationship between the US equity market and exchange rates. They
concluded that depreciation in a country’s currency would cause its share market
returns to rise, while an appreciation would have the opposite effect.

Ibrahim (2000) made an attempt to investigate the interactions between stock prices
and exchange rates in Malaysia using bi-variate and multivariate cointegration and the
Granger Causality test. The study has taken multiple variables such as stock price,
three exchange rate measures viz., the real effective exchange rate, the nominal
effective exchange rate and RM/US$, money supply, and reserves during the period
1979 to 1996. The results from bi-variate models indicate that there is no long-run
relationship between the stock market and any of the exchange rates. However, there

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is some evidence of co-integration, when the models are extended to include money
supply and reserves. This finding indicates that in the short run, a concerted stance on
monetary policy, exchange rate and reserve policy is vital for stock market stability
and that there is informational inefficiency in the Malaysian stock market. The
multivariate test suggests that (a) there is unidirectional causality from stock market
to exchange rate, (b) both the exchange rates and the stock index are Granger-caused
by the money supply and reserves, (c) there is bi-directional causality between
variables only in the case of nominal effective exchange rate.

Bodart and Reding (2001) investigated the impact of foreign exchange markets on
the conditional distribution of industry stock returns for a set of European countries
by using the bi-variate GARCH model over the period 5 January 1990 to 12
November 1998. The analysis of the study confirmed that industries from traded
sectors are usually more sensitive to exchange rates than industries from non-traded
sectors, both in mean and volatility. Regarding the volatility spillovers, the study
concluded that the influence of the foreign exchange market on the mean and to a
lesser extent on the volatility of industry stock returns is modified when exchange rate
innovations are abnormally large.

Apte (2001) investigated the relationship between the volatility of the stock market
and the nominal exchange rate of India by using the EGARCH specifications on the
daily closing USD/INR exchange rate, BSE 30 (Sensex) and NIFTY-50 over the
period 1991 to 2000. The study suggests that there appears to be a spillover from the
foreign exchange market to the stock market but not the reverse. Bhattacharya and

Fang and Miller (2002) attempted to investigate empirically the effects of daily
currency depreciation on Korean stock market returns during the Korean financial
turmoil of 1997 to 2000. By employing the Granger causality test and an unrestrictive
bi-variate GARCH-M model over the period spanning from 3 January 1997 to 21
December 2000, the study found (a) there exists a bi-directional causality between the
Korean exchange market and the Korean stock market, (b) currency depreciation has
statistically significant effects on stock market returns through three channels such as,
first, the level of exchange rate depreciation which negatively affects stock market
returns. Second, exchange rate depreciation volatility positively affects stock market

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returns. Third, stock-market returns volatility responds to exchange rate depreciation
volatility.

Bhattacharya and Mukharjee (2002) in their paper CAUSAL RELATIONSHIP

BETWEEN STOCK MARKET AND EXCHANGE RATE, FOREIGN EXCHANGE
RESERVES AND VALUE OF TRADE BALANCE: A CASE STUDY FOR INDIA
studied the nature of causal relation between the stock market, exchange rate, foreign
exchange reserves and value of trade balance in India from 1990 to 2001 by applying
the techniques of unit root test, the co-integration and long-run Granger Non-causality
tests. The study suggests that there is no causal linkage between stock prices and the
three variables under consideration.

Muhammad and Rasheed (2002) examined the long-run and short-run association
between stock prices and exchange rates for four south Asian countries, namely,
Pakistan, India, Bangladesh and Sri Lanka for the period January 1994 to December
2000. The study employed monthly data and applied co-integration, error correction
modelling approach and standard Granger Causality tests. The major findings of the
study are as follows. There is no long-run equilibrium relationship between stock
prices and exchange rates for Pakistan and India. In the case of Bangladesh, there is a
long-run relationship between the variables considered for the study. The results for
Sri Lanka shows a long-run relationship for lag one and two but for a higher lag order,
the study did not find any cointegration between the stock price and exchange rate.
However, the Engel and Granger tests found a co-integrating relationship stock prices
and exchange rates for Sri Lanka. The Granger Causality test confirmed that there
seems to be no short-run association between stock prices and exchange rates either in
the case of Pakistan and India. The error correction model confirmed that there is bi-
directional long-run causality in the case of Sri Lanka. However, there is no short-run
causation in either direction for Bangladesh or Sri Lanka.

To examine the dynamic linkages between the foreign exchange and stock markets
for India, Nath and Samanta (2003) employed the Granger causality test on daily
data during the period March 1993 to December 2002. The empirical findings of the
study suggests that these two markets did not have any causal relationship. When the
study extended its analysis to verify if liberalization in both the markets brought them
together, it found no significant causal relationship between the exchange rate and

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stock price movements, except for the years 1993, 2001 and 2002 during when a
unidirectional causal influence from stock index return to return in forex market is
detected and a very mild causal influence in the reverse direction is found in some
years such as 1997 and 2002.

Alok Kumar Mishra (2004) examined whether stock market and foreign exchange
markets are related to each other or not. The study used Granger’s Causality test and
Vector Auto Regression technique on monthly stock return, exchange rate, interest
rate and demand for money for the period April 1992 to March 2002. The major
findings of the study were (a) there exists a unidirectional causality between the
exchange rate and interest rate and between the exchange rate return and demand for
money; (b) there is no Granger’s causality between the exchange rate return and stock
return. Through Vector Auto Regression modelling, the study confirmed that though
stock return, exchange rate return, the demand for money and interest rate are related
to each other but any consistent relationship doesn’t exist between them.

Duncan and Kihui(2018) in their study Exchange Rate Fluctuations and Stock
Market Performance in Nairobi Securities Exchange, Kenya investigated the
relationship between the exchange rates and stock market performance in Nairobi
securities exchange using monthly data for the period between January 2010 and July
2015. They considered five foreign currencies of the major development partners and
players in the region which were the United States’ dollar, the British pound,
European euro, Japanese yen and Chinese Yuan. The stock market performance was
measured using the major stock market index in NSE; the 20 share index (NSE20).
The Johansen’s cointegration approach and the VECM framework were used to
estimate the short run and long run equilibrium relationship between stock market
performance and exchange rates. Granger causality test performed to determine the
direction of causality, and the impulse response analysis to evaluate the impact of
shocks on the exchange rates on the stock performance. Through their study is was
concluded that their is existence of both short run and long run relationships between
exchange rates and the stock market index.

Dileep Kumar and Seri Suriani (2019) in their paper studied the relationship
between the stock market and exchange market of Pakistan by using KSE-100 index
as an indicator of Stock Prices while currency rate of Pak Rupee against US Dollar

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(Rs/US$) were taken for exchange rate exposure. The data they collected was on
monthly basis and the time period was January 2004 to December 2009. They used
ADF test to check the unit roots and to reach at the conclusion whether the data is
stationary or not. Further, Granger Causality test is applied to determine the
relationship between the both variables, and reach at the conclusion that they are
independent of each other without having any interaction. Regression Analysis test
was also performed to check the authenticity of the results of Granger Causality
which also supported that there was no relationship exist between exchange rate and
stock price.

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RESEARCH METHODOLOGY

This study is an exploratory study based on quantitative methodology of research. The

stock index of India, SENSEX is considered as the barometer of the performance of
Indian Stock Market. Three Major currencies through which India exports and
imports are considered in this study, which are as follows:

1) US dollar
2) Euro
3) Pound

As Quantitative method, regression analysis is necessary to analyse the causal

relationship between SENSEX and Dollar, Euro, Pound. As the study will require
figures to carry out the regression, it mainly depends on the secondary data.

The daily data of SENSEX and the rate of the three currencies against Indian rupee
for a period from January 2000 to June 2021 is considered in the study.

Secondary Sources through which the data have been collected are as follows:

 BSE Website
 Bloomberg
 Magazines
 Government Websites
 Moneycontrol

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REGRESSION ANALYSIS

Regression analysis is a set of statistical processes for estimating the relationships

between a dependent variable (often called the 'outcome' or 'response' variable) and
one or more independent variables (often called 'predictors', 'covariates', 'explanatory
variables' or 'features').

The simplest case is when there are just two variables, such as height and weight,
income and intelligence quotient, ages of husband and wife at marriage, population
size and time, length and breadth of leave, temperature and pressure of a certain
volume of gas, and so on.

If we have a pair of observations, we can plot these points, giving a scatter diagram,
and endeavour to fit a smooth curve through the points in such a way that the points
are as close to the curve as possible.

Clearly, we cannot expect an exact fit, as at least one variable is subject to chance
fluctuations due to factors outside our control.

Even if there is an exact relationship between such variables as temperature and

pressure, fluctuations would still show up in the scatter diagram because of errors of
measurement.

Regression analysis is primarily used for two conceptually distinct purposes.

First, regression analysis is widely used for prediction and forecasting, where its
use has substantial overlap with the field of machine learning.

Second, in some situation’s regression analysis can be used to infer causal

relationships between the independent and dependent variables. Importantly,
regressions by themselves only reveal relationships between a dependent variable and
a collection of independent variables in a fixed dataset.

To use regressions for prediction or to infer causal relationships, respectively, a

researcher must carefully justify why existing relationships have predictive power for
a new context or why a relationship between two variables has a causal interpretation.
The latter is especially important when researchers hope to estimate causal
relationships using observational data.

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SIGNIFICANCE OF R-SQUARED AND ADJUSTED R-SQUARE MEASURE

R-Squared

The R-Squared (in Microsoft Excel) indicates how well the model or regression line
“fits” the data. It indicates the proportion of variance in the dependent variable (Y)
explained by the independent variable (X).

We know a variable could be impacted by one or more factors. Therefore, the R-

Squared indicates the percentage of variation in the dependent variable explained by
the independent variables.

So, if the R-square of a model is 0.50, then approximately half of the observed
variation can be explained by the model's inputs.

An R-squared result of 70 to 100 indicates that a given portfolio closely tracks the
stock index in question, while a score between 0 and 40 indicates a very low
correlation with the index.

While R-squared can return a figure that indicates a level of correlation with an index,
it has certain limitations when it comes to measuring the impact of independent
variables on the correlation. This is where adjusted R-squared is useful in measuring
correlation.

Adjusted R-squared

It is a modified version of R-squared that has been adjusted for the number of
predictors in the model.

The adjusted R-squared increases when the new term improves the model more than
would be expected by chance. It decreases when a predictor improves the model by
less than expected. Typically, the adjusted R-squared is positive, not negative. It is
always lower than the R-squared.

Adding more independent variables or predictors to a regression model tends to

increase the R-squared value, which tempts makers of the model to add even more
variables. This is called overfitting and can return an unwarranted high R-squared
value.

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 Adjusted R-squared is used to determine how reliable the correlation is and how
much it is determined by the addition of independent variables.

Adjusted R-squared will assist evaluate how much of the correlation with the index is
due to the addition of those variables in a portfolio model with more independent
variables. The adjusted R-squared accounts for the adding of variables and only rises
if the new predictor improves the model above what might be predicted by chance.
When a predictor improves the model less than what is predicted by chance, it will
decline.

The most obvious difference between adjusted R-squared and R-squared is simply
that adjusted R-squared considers and tests different independent variables against the
stock index and R-squared does not. Because of this, many investment professionals
prefer using adjusted R-squared because it has the potential to be more accurate.
Furthermore, investors can gain additional information about what is affecting a stock
by testing various independent variables using the adjusted R-squared model.

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CO-RELATION BETWEEN RATE MOVEMENT OF SENSEX AND USDINR
JAN 2000 – JUNE 2021

JAN 2020 – JUNE 2021

Page |
CO-RELATION BETWEEN RATE MOVEMENT OF SENSEX AND USDINR
NOV 2007-MARCH 2009

25TH FEB 2020 – 23RD MARCH 2020

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INTERPRETATION:
In the period from January 2000 to July 2021, Sensex improved by 912% whereas the
INR rate depreciated by 70%, which shows a big gap in co-relation between of the
variables.

In the period from January 2020 to June 2021, Sensex improved by 26% whereas the
Indian rupee depreciated by 4.2%, which does not signify any co-relation between
both the prices.

In the long term, we cannot deduce proper co-relation between both the prices.

If we look intuitively at shorter period, we are able to see strong relationship around
pivot points.

We can infer from the data that, between November 2007 till March 2009, when the
whole witnessed the global economic recession, the Sensex fell by 49% and on the
other hand the Indian Rupee value depreciated from 39.4/$ to 51.2/$, which equates
to 30%.

When we look at the time period from 25th Feb, 2020 to 23rd March, 2020, the Sensex
fell from 40,000 levels to 26,000 which is a big 35% and on the other hand, the Indian
Rupee depreciated from 71.66/% to 75.42/$ which is 5%.

During both these economic shock incidents, we can see strong co-relationship
between the volatility of Sensex and volatility of USDINR rate.

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CO-RELATION BETWEEN RATE MOVEMENT OF SENSEX AND EURINR.
JAN 2000 – JUNE 2021

JAN 2020 – JUNE 2021

Page |
CO-RELATION BETWEEN RATE MOVEMENT OF SENSEX AND EURINR
NOV 2007-MARCH 2009

25TH FEB 2020 – 23RD MARCH 2020

Page |
INTERPRETATION:
In the period from January 2000 to July 2021, Sensex improved by 912% whereas the
INR rate against EUR depreciated by 99%, which again depicts a divergence of
relationship between both the variables.

In the period from January 2020 to June 2021, Sensex improved by 26% whereas the
Indian rupee depreciated by 10.5%, which does not signify any co-relation between
both the prices.

Between November 2007 till March 2009, during the global economic recession, the
Sensex fell by 49% and on the other hand the Indian Rupee value against EUR
depreciated from 58 to 67, which equates to 15%.

When we look at the time period from 25th Feb, 2020 to 23rd March, 2020, the Sensex
fell from 40,000 levels to 26,000 which is a big 35% and on the other hand, the Indian
Rupee depreciated against EUR from 78.17 to 82.13 which is 5%.

In the long time period, we cannot infer any co-relation between both the variables,
but as we go on making the time period short, these co-relations go on becoming
strong.

Again, during global economic shock events we can infer strong relationship between
the volatility of Sensex and volatility of EURINR.

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CO-RELATION BETWEEN RATE MOVEMENT OF SENSEX AND GBPINR
JAN 2000 – JUNE 2021

JAN 2020 – JUNE 2021

Page |
CO-RELATION BETWEEN RATE MOVEMENT OF SENSEX AND GBPINR
NOV 2007-MARCH 2009

25TH FEB 2020 – 23RD MARCH 2020

Page |
INTERPRETATION:
In the period from January 2000 to July 2021, Sensex improved by 912% whereas the
INR rate against GBP depreciated by 44%, which shows a big gap in co-relation
between of the variables.

In the period from January 2020 to June 2021, Sensex improved by 26% whereas the
Indian rupee depreciated by 9%, which does not signify any co-relation between both
the prices.

Between November 2007 till March 2009, during the global economic recession, the
Sensex fell by 49% and on the other hand the Indian Rupee value against GBP
appreciated from 82 to 73, which equates to a 10% increase in rate.

When we look at the time period from 25th Feb, 2020 to 23rd March, 2020, the Sensex
fell from 40,000 levels to 26,000 which is a big 35% and on the other hand, the Indian
Rupee appreciated against GBP from 92.62 to 89 which is a appreciation of 3%.

In this case we can infer mild relationship between volatility of SENSEX and the
volatility of GBPINR rate.

Page |
 Page | 37
Regression Statistics
REGRESSION ANALYSIS OF DOLLAR AGAINST SENSEX

Multiple R 0.862680673
R Square 0.744217943
Adjusted R Square 0.743222682
Standard Error 6312.502441
Observations 259

ANOVA
df SS MS F Significance F
Regression 1 29796571969 2.98E+10 747.7616 4.69279E-78
Residual 257 10240855577 39847687
Total 258 40037427547

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -34977.08319 2010.439038 -17.3977 2.48E-45 -38936.11512 -31018.05125 -38936.11512 -31018.05125
USDINR 992.2134098 36.28469695 27.34523 4.69E-78 920.760224 1063.666596 920.760224 1063.666596
INTERPRETATION:
Through the regression analysis summary, we can infer that the Multiple R, which is
the co-relation co-efficient, and tells us how strong is the linear relationship, is 0.86.
Hence, there is a strong positive relationship between the variables.

R-square which is the co-efficient of determination, is 0.744. So, around 75% of the
values fall on the regression line, which means 75% of values fit the model.

Adjusted R-Square is 0.74, which again confirms that there is a strong relationship.

Significance F is the probability that our regression model is wrong and needs to be
discarded, so we want it to be as small as possible. In this case, the significance F is
4.69-78 which is almost zero. Hence, there is a no probability that the model is wrong.

Overall, this summary implies that there is strong relationship between the volatility
of SENSEX and volatility of USDINR rate.

The regression equation for this analysis is,

Y = -34977 +992*X

Page | 38
 Page | 39
Regression Statistics
Multiple R 0.884109712
REGRESSION ANALYSIS OF EURO AGAINST SENSEX

R Square 0.781649982
Adjusted R Square 0.780800371
Standard Error 5832.344078
Observations 259

ANOVA
df SS MS F Significance F
Regression 1 31295254524 3.13E+10 920.0092919 6.7728E-87
Residual 257 8742173023 34016237
Total 258 40037427547

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -34843.71571 1809.919309 -19.2515 9.59457E-52 -38407.87668 -31279.55474 -38407.87668 -31279.55474
EURINR 825.5568876 27.21766712 30.33165 6.7728E-87 771.958837 879.1549383 771.958837 879.1549383
INTERPRETATION:
Through the regression analysis summary, we can infer that the Multiple R, which is
the co-relation co-efficient, and tells us how strong is the linear relationship, is 0.88.
Hence, there is a strong positive relationship between the variables.

R-square which is the co-efficient of determination, is 0.781. So, around 78% of the
values fall on the regression line, which means 78% of values fit the model.

Adjusted R-Square is 0.78, which again confirms that there is a strong relationship.

Significance F is the probability that our regression model is wrong and needs to be
discarded, so we want it to be as small as possible. In this case, the significance F is
6.77E-97 which is almost zero. Hence, there is a no probability that the model is
wrong.

Overall, this summary implies that there is strongest relationship between the
volatility of SENSEX and volatility of EURINR rate.

The regression equation for this analysis is,

Y = -34843+826*X

Page | 40
 Page | 41
Regression Statistics
Multiple R 0.722345015
REGRESSION ANALYSIS OF POUND AGAINST SENSEX

R Square 0.521782321
Adjusted R Square 0.519921552
Standard Error 8631.362071
Observations 259

ANOVA
df SS MS F Significance F
Regression 1 20890821867 2.09E+10 280.4122 4.65775E-43
Residual 257 19146605680 74500411
Total 258 40037427547

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -54619.53563 4425.550984 -12.3419 8.6E-28 -63334.49657 -45904.57469 -63334.49657 -45904.57469
GBPINR 881.2539706 52.62627838 16.74551 4.66E-43 777.6203299 984.8876113 777.6203299 984.8876113
INTERPRETATION:
Through the regression analysis summary, we can infer that the Multiple R, which is
the co-relation co-efficient, and tells us how strong is the linear relationship, is 0.72.
Hence, there is a strong positive relationship between the variables.

R-square which is the co-efficient of determination, is 0.521. So, around 52% of the
values fall on the regression line, which means 52% of values fit the model.

Adjusted R-Square is 0.52, which again confirms that there is a strong relationship.

Significance F is the probability that our regression model is wrong and needs to be
discarded, so we want it to be as small as possible. In this case, the significance F is
4.69-78 which is almost zero. Hence, there is a no probability that the model is wrong.

Overall, this summary implies that there is somewhat relationship between the
volatility of SENSEX and volatility of GBPINR rate.

The regression equation for this analysis is,

Y = -54619 +881*X

Page |
CONCLUSION:
Performance of the stock market plays an important role in the economic situation of
any country. On the other hand, fluctuations in the country’s exchange rate is also
likely to influence the performance of the stock market.

In our study we have investigated the impact of currency fluctuation on the Indian
Stock Market and for that we have worked on to find the relationship between
exchange rates and stock market performance in Bombay Stock Exchange using
monthly adjusted data for the period between January 2000 and June 2021.

Three foreign currencies of the major development partners and players in the region
were considered: that is the United States’ dollar, the British pound, European euro.

The stock market performance was measured using the major stock market index in
BSE; the 30-share index, SENSEX.

We applied the linear regression technique in order to find any existence between
both the markets.

Through our study, we found that the volatility of EURINR rate has the strongest
relationship with the volatility of SENSEX. Relationship between volatility of
USDINR with SENSEX, was slightly weaker than EURINR. Any change in the
GBPINR rate, has the weakest impact on SENSEX.

These findings have several implications. One is that the domestic firms in India are
exposed to foreign market shocks and risks that hit the major foreign currencies like
the United States dollar, the British pound and the Euro, and these shocks will in turn
have lasting impact on the performance of stock market. The policy makers must
therefore formulate appropriate monetary policies that would not only facilitate the
development of the stock market, but secure the stock market against the external
shocks.

Secondly, curbing swings in the exchange rate would help attract new investments
and sustain existing ones, thereby encouraging growth. Additionally, firms listed in
should consider adopting more efficient hedging instruments to ensure the elimination
of negative effects of volatility in Indian Rupee.

Page |
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