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Applied Financial Economics

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Exchange rate and stock price interactions in

emerging financial markets: evidence on India,
Korea, Pakistan and the Philippines
Issam S.A. Abdalla & Victor Murinde
Published online: 06 Oct 2010.

To cite this article: Issam S.A. Abdalla & Victor Murinde (1997) Exchange rate and stock price interactions in
emerging financial markets: evidence on India, Korea, Pakistan and the Philippines, Applied Financial Economics,
7:1, 25-35, DOI: 10.1080/096031097333826

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 Applied Financial Economics, 1997, 7, 25Ð 35

Exchange rate and stock price interactions

in emerging Þ nancial markets: evidence
on India, Korea, Pakistan and
the Philippines
I S S A M S . A . A B D A L L A and V I C T O R M U R I N D E * §
United Saudi Commercial Bank, Riyadh 11476 , Saudi Arabia and *Department of
Accounting and Finance, University of Birmingham, UK
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Interactions are investigated between exchange rates and stock prices in the emerging
® nancial markets of India, Korea, Pakistan and the Philippines. The motivation is to
establish the causal linkages between leading prices in the foreign exchange market
and the stock market; the linkages have implications for the ongoing attempts to
develop stock markets in emerging economies simultaneously with a policy shift
towards independently ¯ oating exchange rates. Some recent econometric techniques
are applied to a bivariate vector autoregressive model using monthly observations on
the IFC stock price index and the real e€ ective exchange rate over 1985:01Ð 1994 :07.
The results show unidirectional causality from exchange rates to stock prices in all the
sample countries, except the Philippines. This ® nding has policy implications; it
suggests that respective governments should be cautious in their implementation of
exchange rate policies, given that such policies have rami® cations on their stock
markets.

I. INTRODUCTION and to increase overall e ciency, competitiveness and

Two interesting issues that have recently occurred, albeit
separately, in the area of ® nance are the establishment of
stock markets in the emerging economies, and the policy shift
towards independently ¯ oating exchange rates. Some global
economic institutions, especially the International Finance
Corporation (IFC), have been encouraging less developed
countries (LDCs) to launch stock markets or revitalize exist-
ing ones. It is thought that the creation of emerging stock
markets (ESMs)1 provides a vehicle for mobilizing savings for
private sector investment (Hartman and Khambata, 1993). In
particular, it has been argued that funds raised in the ESMs
enable ® rms to decrease their over reliance on debt ® nance,
solvency (Murinde, 1996). Some ESMs are performing ex-
ceptionally well: in 1992 eight of the top 10 places on a list of
54 developed and developing stock markets were taken by
the ESMs (IFC, 1993). Notwithstanding the high returns
and rapid growth potential of some ESMs, most of the
markets tend to be very small in size, with very low volume
of transactions, and lack high quality accounting data and
other market information. Indeed, Scown (1990) points out
that, given some of the ESMs are still developing, they may
be riskier than their counterparts in industrialized countries.
Meanwhile, the rapid expansion in international trade
during the 1970s, and the adoption of freely ¯ oating ex-
change rate regimes by many industrialized countries in

§
Address all correspondence to Victor Murinde, Department of Accounting and Finance, University of Birmingham, Edgbaston,
Birmingham B15 2TT, England.
1
According to IFC (1993), the term emerging stock markets refers to any market belonging to low- and middle-income LDCs, with the
implication that all have the potential for development. See also Divecha et al. (1992).
0960Ð 3107 Ó 1997 Routledge 25
 26
1973, heralded a new era of increased exchange rate volatil-
ity. Jorion (1990) points out that exchange rates were 4 times
as volatile as interest rates and 10 times as volatile as
in¯ ation during the 1980s. Inevitably, the exposure of ® rms
to exchange rate risks has increased (Murinde, 1996). Three
di€ erent types of risks under an independently ¯ oating
exchange rate regime are identi® ed in the existing literature:
transactions exposure, which arises due to gains or losses
arising from settlement of investment transactions stated in
foreign currency terms; economic exposure, which arises
from variations in ® rms’ discounted cash ¯ ows when ex-
change rates ¯ uctuate; and operating exposure, which is the
sensitivity of the home currency value of the ® rm to changes
in exchange rates (Ma and Kao, 1990; Loudon, 1993).
This paper brings together the two recent, but separate,
developments in the area of ® nance, namely the ESMs and
the adoption of independently ¯ oating exchange rates. It is
motivated to investigate the causal interactions between the
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leading prices in two components of emerging ® nancial
markets; namely, exchange rates in the foreign exchange
market and share prices in the stock market. The main
contributions of the paper are threefold. First, as high-
lighted above, the linkages between exchange rates and
stock prices bear implications for the ongoing attempts
to develop stock markets in emerging market economies
simultaneously with a policy shift towards independently
¯ exible exchange rates. Essentially, we explore the compati-
bility of the two policy moves. Second, the paper takes as its
testing ground the main ESMs in the Paci® c Basin and
India which have recently attracted much attention in the
media and in some policy circles. The newly industrializing
countries have an expanding corporate sector with listed
® rms and a growing tradable sector that is sensitive to
exchange rates policy. However, due to data availability, we
restrict the sample to four economies which have readily
available monthly series on stock prices and the real e€ ec-
tive exchange rate (REER). Third, we call upon some recent
econometric techniques to test for unit root (non-stationar-
ity), cointegration, error correction and Granger-causality ,
in order to investigate the causal linkages between exchange
rates and stock prices.
The rest of this paper is structured into four sections.
Section II highlights the main economic underpinnings
and empirical ® ndings on the relationship between stock
prices and exchange rates. Section III speci® es a bivariate
vector autoregressive (BVAR) model as an empirical
framework for investigating causal linkages between stock
prices and exchange rates. Section IV reports empirical
procedures and evidence. Section V o€ ers a summary and
conclusions.
2
Rst is measured as the dollar price of foreign currency; thus a positive value for Rst indicates a dollar depreciation and a negative value
indicates a dollar appreciation.
I. S. A. Abdalla and V . Murinde
I I . TH E E C O N O MI C T H E O R Y
It is useful to examine the microeconomic as well as the
macroeconomic theoretical foundations of the linkages be-
tween exchange rates and stock prices. At the micro level, it
is argued that exchange rate changes in¯ uence the value
of a portfolio of domestic and multinational ® rms. For
example, it is predicted that if the real dollar exchange rate
rises, ® rms’ pro® ts fall, and so does the ® rm’s share price.
See, among others, Jorion (1990). Accordingly, the link
between exchange rates and stock prices can be speci® ed as
follows:
R it = b 0i + b 1i Rst + e it (1)
where R it = the rate of return on the common stock of
company i; and Rst = the rate of change in a trade-weighted
exchange rate;2 and t = 1, ¼ , T . However, the behaviour of
the stock prices of domestic ® rms tends to di€ er from that of
multinational ® rms. Thus, it is important to determine the
relationship between exchange rate exposure and the degree
of foreign involvement, as follows:
b 1i = a0 + a1 F i + m i (2)
where F i = the ratio of foreign to total sales; i = 1, ¼ , N. In
addition, the foreign exchange exposure of stocks may be
examined in an extended framework as follows:
R it = b 0i + b 1i Rst + b 2i Rmt + e it (3)
where Rmt = the return on the domestic stock exchange
accumulation index in month t. Empirical studies, in the
spirit of Equations 1 to 3 suggest that there is generally
weak evidence of exposure of ® rms’ share prices to exchange
rate risks. It has, however, been found that resource stocks
(gold, other metal, solid fuels, gas and oil industries, etc.) and
industrial stocks (building materials, chemicals, banking
and ® nance, etc.) respond di€ erently to ¯ uctuations in the
exchange rate. When currency appreciates, industrial stocks
tend to perform better whereas resource stocks perform
better when currency depreciates (e.g. Loudon, 1993).
At the macro level, the main line of enquiry relates to the
relationship between aggregate stock prices and the ¯ oating
value of the exchange rate. It is predicted that a negative
relationship exists between the strength of the home cur-
rency and the aggregate stock prices index, as given by
Dst = a + b DRSt + cDit + e t (4)
where Dst = change in the real exchange rate; DRSt = the
real stock return di€ erential (domestic minus foreign); and
Dit = the change in interest rate di€ erential. Where two
di€ erent measures of the aggregate stock price index are
 Exchange rate and stock price in emerging markets
quoted, for example the New York Stock Exchange Index
(NY SEI) and the S&P500 Index (S&P500I ) for the US stock
market, the speci® cation is given by
NY SEI = a1 + b
S&P500I = a2 + b
l1 = a3 + b
where l i = the index of industrial sector i; and XR = broad
measure of the value of the e€ ective exchange rate. How-
ever, the above speci® cations may be sensitive to the ex-
change rate regime in force. For example, economic theory
suggests that, under a ¯ oating exchange rate regime, ex-
change rate appreciation reduces the competitiveness of
export markets; it therefore has a negative e€ ect on the
domestic stock market. Conversely, for an import de-
nominated country, exchange rate appreciation lowers in-
put costs and generates a positive impact on the stock
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27
In all, at the macro and micro levels, there is neither
a theoretical nor an empirical consensus on the relationship
between exchange rates and stock prices. Speci® cally, the
causal direction between the two ® nancial price variables is
1 XR + m 1 (5)
not resolved. Furthermore, none of the previous studies
2 XR + m 2 (6) investigated this issue with respect to emerging markets for
which the issue has great policy relevance. It is intended in
3 XR + m 3 (7) this paper to draw on the recent developments in econo-
metrics to set up a framework for testing this issue in the
light of experience in the Paci® c Basin. We depart from the
previous literature which has attempted to test each of the
above reviewed theories in isolation; rather, we design
a BVAR model as a statistical framework that encapsulates
the main theories.
I I I . MO D E L

market. Thus, in a macroeconomic framework, the relation- In studying the relationship between exchange rates and
ship between exchange rates and stock prices can best be stock prices, we need to establish whether changes in stock
captured by including other macro variables in the model. prices causally a€ ect exchange rates or vice versa. Although
Following Smith (1992a) such a broad model is speci® ed as there are many approaches to modelling causality in tem-
follows: poral systems, we ® rst apply the prototype model by Gran-
ger (1969) not only because it is the simplest and most
Eug = a 0 + a 1 Euj - a 2 Rgu + a 3 Rj u + a 4 Sg + a 5 Sj straightforward, but also the existence of causal ordering in
+ a 6 Su + a 7 Ag + a 8 Aj + a 9 Au Granger’s sense points to a low of causation and implies
predictability and exogeneity. We therefore consider Gran-
+a 10 (Ag - Agg( D) ) - a 11 CCAS g (8) ger’s four de® nitions of causality, based on the following
Euj = b + b Eug + b Rgu - b Rj u + b Sg + b Sj BVAR model:
0 1 2 3 4 5
m n
+ b 6 Su + b 7 Ag + b 8 Aj + b 9 Au EXt = + a j EXt ± j + + b j SP t ± j + e t (10)
j= 1 j= 1
+ b 10 (Aj - j D
Aj ( ) ) - b 11 CCAS j
(9)
m n
where Eug = USÐ German exchange rate; Agg( D ) = the debt SPt = + cj EXt ± j + + dj SPt ± j + m t (11)
of the German government; Euj = USÐ Japanese ex- j=1 j= 1

change rate; CCAS g = the German current account surplus; where EX = exchange rate variable; SP = stock price vari-
CCAS j = the Japanese current account surplus; Rgu = able; and e t , m t are assumed to be serially uncorrelated with
the GermanÐ US interest rate di€ erentials; Rj u = the zero mean and ® nite covariance matrix. Granger (1969)
JapaneseÐ US interest rate di€ erential; S j , Su , Sg = the o€ ers four de® nitions of causality, which in this context
Japanese, US and German equity values, respectively; comprise unidirectional causality from EX to SP; uni-
Aj , Au , Ag = the Japanese, US and German bond values, directional causality from SP to EX; feedback causality
respectively; and (Aj - Ajj ( D ) ) = the debt of the Japanese between EX and SP; and independence between EX and
government. Empirical studies, based on the speci® cations SP.3
which follow Equations 4 to 9, have uncovered mixed re- The four de® nitions, according to Granger, imply that for
sults. On the one hand, it has been found that a signi® cant SP to Granger-cause EX, the coe cient b j ¹ 0 in Equation
positive relationship exists between equity prices and ex- 10, whereas cj = 0 in Equation 11; and for EX to Granger-
change rates (Smith, 1992a; Solnik, 1987). On the other cause SP, cj ¹ 0 whereas b j = 0. If we allow for the possibili-
hand, it has been shown that, as predicted by economic ty of j = 0 in the summation symbol for Equations 10 and
theory, a strong negative relationship exists between stock 11, the relationship between the two time series is said to be
prices and exchange rates (Soenen and Hennigar, 1988). instantaneous. 4

3
See Granger (1969). The speci® cation of this well-established empirical method, in the context of EX and SP, is obtainable on request
from the authors.
4
Thus, instantaneous causality is established when the inclusion of the present values of the independent variable improves the prediction
or goodness of ® t (or R2 ) of both equations.
 28 I. S. A. Abdalla and V . Murinde
I V . E M P I R I C A L PR O C E D U R E A N D Unit root (non-stationarity) and cointegration tests
EVIDENC E and results
We ® rst tested for stationarity and the order of integration
Sample and data set
of the variables, in the levels as well as ® rst di€ erences. More
The data set consists of monthly observations for 1985:01Ð speci® cally, we tested whether stock prices and exchange
1994:07. The starting date was dictated by data availability rates are integrated of order zero, I(0), that is, whether SPt
and the need to maintain consistency. and EXt are stationary. This was achieved by performing
Our sample selection procedure involved the following the DickeyÐ Fuller (DF) and the augmented DickeyÐ Fuller
steps. All non-OECD countries which adopted a ¯ oating (ADF) tests, based on a standard regression with a constant
exchange rate since 1980 were considered. Information on and a time trend.6 As a matter of procedure, we ® rst per-
the di€ erent exchange rate arrangements adopted by di€ er- formed the ADF tests with di€ erent autoregressive orders
ent countries was obtained from the International Financial until we obtained individual series for SP and EX that were
Statistics, June 1994. Those LDCs which adopted a ¯ exible consistent with white noise error terms. The results are
exchange rate, under the IFS classi® cation, were split into reported in Table 1.
four regions: Africa, Asia, Latin America and the Middle The results clearly show that all the variables are not
East. Next we shortlisted only those countries which had stationary in the levels; however, both DF and ADF statis-
ESMs, based on IFC (1993). We found we had to drop tics reject the null hypothesis of non-stationarit y at the 5%
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Africa and the Middle East region because of the relatively and 1% levels of signi® cance after the variables have been
small number of countries which ful® lled these criteria. ® rst di€ erenced. Thus, the variables are I(1).
A good number of countries in Latin America and Asia Having established the order of integration of the indi-
ful® lled our criteria, but Latin America was dropped be- vidual series, we moved to test for cointegration. The idea
cause it had fewer countries which ful® lled the criteria than was to determine whether the stochastic trends in SPt and
Asia. Moreover, Asia was chosen because of her status as an EXt that contain unit roots have long-run relationships.
emerging force in international trade and ® nance, consistent Speci® cally, we applied the two-step cointegration proced-
with the aim of this paper. Among the Asian countries, only ure suggested by Engle and Granger (1987).7
India, Korea, Pakistan and the Philippines had a full set of On the basis of the results we obtained from the cointeg-
monthly data on stock prices and REER for the period ration tests, we rejected the null hypothesis of no cointegra-
1985:01Ð 1994:07; hence our sample. tion between the stock price index and the e€ ective
Monthly data on the IFC Stock Market Index exchange rate in India and the Philippines only.8 For Korea
(1990 = 100) were obtained from Datastream; the monthly and Pakistan we accepted the null hypothesis of no cointeg-
REER (1990 = 100) data were obtained from Morgan ration between the two variables. These results led to two
Guaranty Trust company of New York.5 di€ erent methodologies of proceeding. Firstly we used

5
The REER is an index which adjusts the nominal e€ ective exchange rate index (itself a trade-weighted average value of a currency against
the currencies of the corresponding country’s principal trade partners) for relative price changes; it gauges the e€ ect of currency changes
and di€ erential in¯ ation on the international price competitiveness of the countries’ tradables. The weights for the broad index are
calculated in relation to currencies for 18 industrialized countries and 22 LDCs. On the theory of indices of e€ ective exchange rates, see
Rhomberg (1981).
6
Our DF and ADF test are based on the following:
n
D SPt =a 0 + b 1 T + l 1 SPt ± 1 + + a i D SPt ± 1 +e 1t (A)
i= 1
r
D EXt =a 0 + b 2 T +l 2 EXt ± 1 + + / iD EXt ± 1 + e 2t (B)
i= 1
where, D = ® rst di€ erence operator, hence D SPt = SPt - SPt ± 1 and D EXt = EXt - EXt ± 1 ; a 0 , b 1 , b 2 , l 1 , l 2 , a i , / i are the coe cients;
T = time trend; and e 1 t and e 2 t are white noise errors. In the DF test S a i = S / i = 0; in the ADF test n and r are chosen so that e 1 t and e 2 t ,
respectively, are white noise. The null hypothesis (H0 ) is that SPt and EXt have unit roots, that is H0 : l 1 = l 2 = 1. The alternative
hypothesis (H1 ) is that both variables are I (0). The null hypothesis is rejected if l 1 and l 2 are signi® cantly negative and t-statistics are less
(or greater in absolute values) than the critical values in Fuller (1976).
7
We run the following cointegrating regressions for each country:
SPt = aEXt + c + n (A)
The null hypothesis is H0 : EXt , SPt not cointegrated. Using the residuals n t , we run the following regression:
D n t =/ n t± 1 + b 1D n t± 1 + ¼ + b pD n t± p + m t (B)
If the computed ADF ( = t / , the t-statistic for / ) is greater than the critical, we reject the null (Engle and Granger, 1987).
8
Detailed results for cointegration are not reported here; these can be obtained from the authors on request.
 Exchange rate and stock price in emerging markets 29
Table 1. Unit root test results for the stock price index and the real e¤ ective exchange rate index

India Korea Pakistan Philippines

Variable DF ADF DF ADF DF ADF DF ADF

SPt - 2.6950 - 3.4708 (1)a - 1.4340 - 1.3957 (1) - 1.2396 - 1.8710 (1) - 1.5581 - 1.7897(1)
EXt - 1.7641 - 2.4098 (1) - 1.6696 - 1.9339 (2) - 2.6104 - 3.1845 (1) - 2.4716 - 3.5416(1) a
ln SPt - 2.7850 - 3.2275 (1) - 1.3718 - 1.4417 (1) - 1.3776 - 1.9266 (1) - 1.7425 - 1.8487(1)
ln EXt - 2.4432 - 3.0274 (1) - 1.4801 - 2.0288 (1) - 2.0559 - 2.6620 (1) - 2.3885 - 3.2620(1)
D SPt - 8.6515 a - 8.3163 (1)b - 11.0819 b - 6.9448 (1)b - 8.1425 b - 8.2397 (1)b - 9.7271 b - 6.8368(1) b
D EXt - 8.6369 b - 6.6106 (1)b - 6.2385 b - 5.3058 (1)b - 8.4556 b - 8.0868 (1)b - 9.0454 b - 6.9999(1) b
Notes: critical values for DF and ADF are as follows: 1% = - 4.04, 5% = - 3.45 (Fuller, 1976, p. 373, Table 8.5.2); the number of lags
for the ADF are in parentheses; D denotes a ® rst di€ erence operator; SP = stock price index; EX = real e€ ective exchange rate index,
ln = natural logarithm; the critical values in Fuller (1976) are generally consistent with other critical values, as in for example Dolado
and Jenkinson (1990), which are computed by the micro TSP package; see Hall and Cummins (1993a, 1993b).
a
Statistical signi® cance at the 5% level.
b
Statistical signi® cance at the 1% level.
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a standard Granger-causalit y test where the variables were
non-cointegrate d (Korea and Pakistan); and secondly we
used an error correction model (ECM) where the variables
were cointegrated (India and Philippines). This was because
the Granger representation theorem implies that SPt and
EXt may be generated by an ECM in the case of India and
the Philippines. Indeed, it has been con® rmed elsewhere
that Granger-causalit y tests are misspeci® ed if they are
applied in a standard vector autoregressive form to di€ er-
enced data for cointegrated variables (MacDonald and
Kearney, 1987; Miller and Russek, 1990; Lyons and
Murinde, 1994).
Further estimation and testing
Before applying Granger-causalit y tests, we determined the
optimum lag length for the exchange rate and stock price
variables in the standard Granger-causal model (variants of
Equations 10 and 11) for Korea and Pakistan. A two-stage
procedure was adopted. In the ® rst stage we ran the follow-
ing regressions:
m= 1 2
D EXt = a 1 + + b i D EXt ± i +
i= 1
n= 1 2
D SP i = e2 + + f i D SPt ± i +
i= 1
We then selected the lag length,9 which yielded the highest
R2 . In the second stage, having determined the optimum
number of lags for Equations 12 and 13, we included the
other independent variables and estimated the equations by
setting the number of lags ® xed at the level determined in
stage one and varied the number of lags on the independent
variables, from 1 to 12, to determine the correct lag combi-
nation. By determining the optimum combinations of
lags for all equations, we derived the model variants of
Equations 10 and 11 that were used to test for standard
Granger-causalit y for Korea and Pakistan. The results are
reported in Table 2.
For Korea the optimum number of lags for testing for
Granger-causalit y from stock prices to exchange rates
(SP Þ EX) is shown to be 1 for exchange rates (m = 1) and
1 for stock prices (n = 1). The combination of lags for testing
causality from exchange rates to stock prices (EX Þ SP) is
shown to be 12 for exchange rates (m = 12) and 4 for stock
prices (n = 4). As for Pakistan, we selected 1 lag for ex-
change rates (m = 1) and 11 lags for stock prices (n = 11) in
order to test the standard Granger-causality from SP to EX
(i.e. SP Þ EX). The number of lags selected for testing the
causality from exchange rates to stock prices (i.e. EX Þ SP)
is 9 lags for exchange rates (m = 9) and 1 lag for stock prices
(n = 1); see Table 2. These newly speci® ed equations which
m 1t (12) include the lag structure for Korea and Pakistan are there-
fore variants of the more general Equations 10 and 11.
Having selected the appropriate lag structure for the
n 2t (13) standard Granger-causal model, we subjected the respective
variants of Equations 10 and 11 (based on Table 2) to some
key econometric testing procedures. This step was under-
taken to ensure that the speci® ed equations of the model to
be used for causality testing were free from conventional

9
Initially, we also apply other techniques such as Akaike’s ® nal prediction error criterion (FPE), Akaike’s information criterion (AIC) and
the SchwartzÐ Bayes information criterion. However, we were faced with some con¯ icting results from these methods. We therefore relied
solely on the R2 criterion.
 30 I. S. A. Abdalla and V . Murinde
Table 2. Full information estimation results for Korea and Pakistan

Exchange rates Exchange rates Stock prices Stock prices

Granger-cause Granger-cause Granger-cause Granger-cause
Equation stock prices stock prices exchange rate exchange rate

Sample country Korea Pakistan Korea Pakistan

Lag structure m = 12, n = 4 m = 9, n = 1 m = 1, n = 1 m = 1, n = 11
Dependent variable D SPt D SPt D EXt D EXt

Constant 0.0113 0.0132 - 0.0016 - 0.0030

(1.2682) (1.7173) (- 1.245) (- 1.5525)
D SPt ± 1 - 0.1669 0.2646 - 0.0049 0.0363
(- 1.5830) (2.6876) a (- 0.3180) (1.2756)
D SPt ± 2 0.1171 - 0.0041
(1.1429) (- 0.1409)
D SPt ± 3 - 0.0204 0.0222
(- 0.2014) (0.7404)
D SPt ± 4 0.0984 0.0303
(0.9686) (1.0144)
D SPt ± 5 - 0.0095
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(- 0.389)
D SPt ± 6 - 0.0127
(- 0.4127)
D SPt ± 7 - 0.0075
(- 0.2256)
D SPt ± 8 - 0.0098
(- 0.2983)
D SPt ± 9 - 0.0048
(- 0.1400)
D SPt ± 10 - 0.0115
(- 0.3504)
D SPt ± 11 0.0368
(1.1158)
D EXt ± 1 1.0342 - 0.1125 - 0.4839 0.3448
(4.4404) a (- 2.2720) a (- 5.5492) b (3.5020) b
D EXt ± 2 - 0.5063 - 0.0251
(- 2.6253) a (- 5.0554) b
D EXt ± 3 0.6874 0.1613
(1.8467) (4.3533) b
D EXt ± 4 0.6816 0.2731
(2.8649) a (1.5906)
D EXt ± 5 - 0.3849 - 0.6412
(- 0.5099) (- 1.3634)
D EXt ± 6 - 0.8739 0.2067
(- 1.1623) (0.4359)
D EXt ± 7 1.0493 0.0940
(1.3827) (0.2032)
D EXt ± 8 0.0752 0.0600
(0.0984) (0.1335)
D EXt ± 9 1.1792 0.5451
(1.5222) (1.3140)
D EXt ± 10 - 0.5989
(- 0.8119)
D EXt ± 11 - 0.6483
(- 0.8866)
D EXt ± 12 - 1.5188
(- 2.3218) a

Notes: t-values are in parentheses; SP = stock price index; EX = real e€ ective exchange rate index;
D = ® rst di€ erence.
a
Signi® cance at the 5% level.
b
Signi® cance at the 1% level.
 Exchange rate and stock price in emerging markets
econometric problems. First, we tested for heteroscedasti-
city: this occurs when the residuals of a model do not have
a common variance i.e. var e t ¹ s 2 ¹ constant for all t. We
considered di€ erent methods for testing the null hypothesis
of no heteroscedasticity, namely the White, Glejser and
Ramsey tests (Murinde, 1993). The test results reported
in Appendix A suggest that the equations are homo-
scedastic for Korea but not for Pakistan.1 0 To test for
autocorrelation, we used the Lagrange multiplier (LM)
test, especially given the presence of lagged dependent vari-
ables in the model (Murinde, 1993). Consider the following
regression:
k
D Yt= + D X it b
i= 1
ut = r 1 ut ± 1 + r 2 ut ± 2 + ¼
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where e t ~ IN (0, s 2 ) and X includes lagged dependent vari-
ables. The null hypothesis is that there is no autocorrelation:
H0 = r 1 = r 2 = r 3 = ¼ = r p = 0. The results of the LM
tests, reported in Appendix A, suggest that autocorrelation
is not a problem for both countries.
We then tested the equations (the lagged variants of
Equations 10 and 11 as in Table 2) for structural break,
precisely to examine whether the economic relationship
between stock prices and exchange rates holds over the
entire sample period in all the sample countries. To this end,
we arbitrarily split the sample period into two subperiods
1985:01Ð 1989:12 and 1990:01Ð 1994:07, and estimated the
equations to test the null hypothesis (H0 ) that there is
equality of coe cients generated in the two subperiods. We
then calculated Chow’s structural break test in the standard
manner using an F-test constructed as per Murinde,
(1993). 1 1 The calculated F-statistic was compared with the
critical value with k, (n1 + n2 - 2k) degrees of freedom.1 2
Appendix A shows that all the model equations have no
structural break. The results indicate that the important
assumptions of consistency, e ciency and unbiasedness
hold with respect to our speci® cations for Korea and Pakis-
tan.
On the basis of the lag structure earlier reported in Table
2 and the diagnostic test results reported in Appendix A,
we tested for Granger-causalit y using the standard F-test
10
For Pakistan we corrected for heteroscedasticity by using the robust option that causes TSP to compute standard errors which are
consistent even in the presence of unknown heteroscedasticity (White, 1980; Hall and Cummins, 1993a, b).
11
We calculated the Chow test based on the following:
where, SSRp = sum of square residual for the entire period; SSRp 1 = sum of squared residual for period 1; SSRp 2 = sum of squared
residual for period 2; n1 = number of observation in period 1; n2 = number of observations in period 2; and k = the number of parameters.
12
If the calculated F-statistic exceeds the critical value, H0 is rejected, otherwise H0 is accepted.
31
computed from restricted and unrestricted versions of the
variants of Equations 10 and 11. The results are reported in
Table 3. With respect to Korea, it is shown that the results
for the exchange rate equation fail to reject the null hypo-
thesis, whereas the results for the stock price equation
support the existence of unidirectional causality from the
exchange rate to stock prices. With regard to instantaneous
causality, the evidence supports the existence of bidirec-
tional causality from exchange rates to stock prices and
from stock prices to exchange rates at the 5% signi® cance
level. The above results therefore indicate that the two-way
causal interaction between exchange rates and stock prices
is only instantaneous; the exchange rate gradually asserts
i + m t (14) itself as the main in¯ uence on movements in stock prices in
Korea. This result is similar to those of Aggarwal (1981) and
Bahmani-Oskooee and Sohrabian (1992), who found uni-
+ r p ut ± p +e t (15) directional as well as feedback Granger-causalit y between
the exchange rate and stock prices. Thus, exchange rate
movements in Korea have great implications for stock price
behaviour. A simple explanation is that depreciation (and
appreciation) of the exchange rate a€ ects the performance of
® rms on domestic as well as international markets, and this
in turn a€ ects the share price of the ® rm.
For Pakistan Table 3 shows that the standard Granger-
causality test rejects the null hypothesis that exchange rates
do not Granger-cause stock prices. And Pakistan also
shows no instantaneous causality from EX to SP or vice
versa. Our ® ndings for Pakistan are consistent with our
earlier results for Korea; in general, the results lend support
to Aggrawal (1981), who concluded that, when big exporters
face huge exchange rate risks, the risks are re¯ ected in the
® rms’ stock prices.
The results for Korea and Pakistan generally give a clear
indication that exchange rates Granger-cause stock prices.
This ® nding is important because, although both countries
have ESMs, they are also export-oriented (Korea is an
export-dominan t economy and Pakistan has recently ad-
opted an export-oriente d drive).
Error correction model and Granger-causality
According to the Granger representation theorem, since SPt
and EXt were found to be I(1) and cointegrated for India
and the Philippines, the two variables are considered to be
SSRp - (SSRp 1 + SSRp 2 )/k
F* =
(SSRp 1 + SSRp 2 )/(n1 + n2 - 2k)
 32 I. S. A. Abdalla and V . Murinde
Table 3. T he results of Granger-causality tests for India, Korea, Pakistan and the Philippines

Country Null hypothesis (H0 ) F-statistics Results

Korea SPt does not Granger-cause EXt 0.1057 Accept H0

F(1,110)
Korea EXt does not Granger-cause SPt 2.0684 Reject H0
F(12,85)
Korea SPt does not Granger-cause EXt instantaneously 2.5626 Reject H0
F(13,84)
Korea EXt does not Granger-cause SPt instantaneously 3.3867 Reject H0
F(2,109)
Pakistan SPt does not Granger-cause EXt 0.4263 Accept H0
F(11,90)
Pakistan EXt does not Granger-cause SPt 2.7320 Reject H0
F(9,94)
Pakistan EXt does not Granger-cause SPt instantaneously 0.3959 Accept H0
F(12,89)
Pakistan EXt does not Granger-cause SPt instantaneously 1.2873 Accept H0
F(10,93)
India SPt does not Granger-cause EXt 0.5715 Accept H0
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F(7,95)
India EXt does not Granger-cause SPt 2.8731 Reject H0
F(8,94)
Philippines EXt does not Granger-cause SPt 1.2663 Accept H0
F(5,102)
Philippines EXt does not Granger-cause SPt instantaneously 1.9609 Accept H0
F(6,101)

Notes: the values of F0 . 0 5 (1, 110) = 3.92, F0 . 0 5 (12, 85) = 1.92, F0 . 0 1 (1, 110) = 6.85, F0 . 0 1 (12, 85) = 2.50,
F0 . 0 5 (2, 109) = 3.07, F0 . 0 5 (13, 84) = 1.92, F0 . 0 1 (2, 109) = 4.79, F0 . 0 1 (13, 84) = 2.50, F0 . 0 5 (11, 90) = 1.91,
F0 . 0 5 (9, 94) = 1.96, F0 . 0 1 (11, 90) = 2.34, F0 . 0 1 (9, 94) = 2.56, F0 . 0 5 (12, 89) = 1.92, F0 . 0 5 (10, 93) = 1.91,
F0 . 0 1 (12, 89) = 2.50, F0 . 0 1 (10, 93) = 2.66, F0 . 0 5 (7, 95) = 2.09, F0 . 0 1 (7, 95) = 2.79, F0 . 0 5 (8, 94) = 2.02, F0 . 0 1 (8, 94)
2.47, F0 . 0 5 (5, 102) = 2.29, F0 . 0 1 (5, 102) = 3.17, F0 . 0 5 (6, 101) = 2.18 and F0 . 0 1 (6, 101) = 2.96. SP = stock prices;
EX = real e€ ective exchange rates.

generated by ECMs of the following form: shocks to the foreign exchange market or to the stock
q
exchange in India and the Philippines.
D SPt = a + + b We ® rst carried out the essential diagnostics on the
0 xiD SPt ± i
i= 1 ECMs in order to determine the e ciency, unbiasedness
q and consistency of the speci® cations. The results of these
+ + b yi D EXt ± i +a 1 n t± 1 + e 1t (16) tests are reported in Appendix B. The ECM speci® cations
i= 1 are homoscedastic, serially independent and have no struc-
r tural break.
D EXt = u 0 + + u 1 iD EXt ± i The results for the ECM are reported in Table 4. For
i= 1
India the best ECM estimated is based on the stock price
h equation and it includes the residual lagged once (the error
+ + u 2 iD SPt ± i + l 1 m t± 1 + e 2t (17) correction term). Based on this equation, we applied an
i= 1
F-test and reported the results in Table 3. The F-test results
where, n t ± 1 and m t ± 1 are the error correction terms. The suggest we reject the null hypothesis that exchange rates do
error correction coe cients, a 1 and l 1 , are expected to not Granger-cause stock prices. And as pointed out by
capture the adjustments of D SPt and D EXt towards long- Miller and Russek (1990), the null hypothesis is rejected not
run equilibrium, whereas the coe cients on D SPtt ± i and only if the coe cients of EXt are jointly signi® cant but also
D EXt ± i are expected to capture the short-run dynamics of if the coe cients on the error correction term (a 1 and l 1 ) are
the model. Thus, in using Equations 16 and 17 to test for the signi® cant. The signi® cant t-statistics of the error correction
Granger-causal relationship between SPt and EXt , we in- term in the ECM in Table 4 indicate that exchange rates
cluded the error-correction terms in order to introduce Granger-cause stock prices in India. This is consistent with
additional channels through which causality could emerge our earlier results for Korea and Pakistan, which were based
and equilibrium could be re-established in the event of on standard Granger-causalit y tests rather than the ECM.
 Exchange rate and stock price in emerging markets 33
In the case of the Philippines, the F-statistic fails to reject signi® cant at 5% and 1%, indicating that stock prices
the null hypothesis that the exchange rate does not Gran- Granger-cause exchange rates. This is consistent with
ger-cause stock prices, either after a lag or instantaneously . Smith’s (1992b) ® nding that equity prices have a signi® cant
However, when we tested using the error correction term, in¯ uence on exchange rate determination in Germany,
we found that the t-statistics of the coe cient of the term are Japan, and the USA.
In conclusion, the results of the standard Granger-causal-
ity tests indicate that the exchange rate Granger-cause s
Table 4. Full information estimates of the error correction model for stock prices in Korea and Pakistan. Granger-causalit y tests
India and the Philippines based on the ECM indicate that the ® ndings for Korea and
Pakistan also hold for India but that equity prices Gran-
Exchange rates Stock prices ger-cause exchange rates in the Philippines.
Granger-cause Granger-cause
Equation stock prices exchange rates
Interactions among the Þ nancial markets
Country India Philippines
Dependent variable D SPt D EXt We also tested whether there are interactions among these
emerging ® nancial markets, by calculating the correlation
Constant 0.423 0.226
(2.920) a (3.874) b coe cients of the returns of the markets. As Pindyck and
- 0.1333 - 0.0995 Rubinfeld (1991, p. 64) have shown, correlation techniques
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EC term (a 1 or l 1 ) ( - 2.9913) a (- 2.9740) a do not involve an implicit assumption of causality, unlike

0.1439 - 0.0062 regression analysis. However, the correlations should be
D SPt ± 1 (1.5068) (- 0.3018) able to shed light on the opportunities for investors to
0.0244
D SPt ± (1.1263) diversify across these markets, and on the implications of
2
- 0.0271 diversi® cation for our ® ndings about the causality from
D SPt ± 3 (- 1.2400) exchange rates to stock prices.
0.0243 Table 5 reports the correlation between market returns
D SPt ± 4 (1.1906) for India, Korea, Pakistan, the Philippines and the IFC
0.2614 0.2764
D EXt ± (0.8790) (2.9581) a group (represented by the IFC composite index or IFC(C)).
1
- 0.2047 The correlation coe cients between India and Pakistan
D EXt ± 2 (- 2.6774) a seem to be rather high (0.57) suggesting that, all other things
- 0.2190 being equal, the two markets do not o€ er good diversi® ca-
D EXt ± 3 (- 1.7266) tion opportunities for investors. However, we ® nd very low
0.0771
D EXt ± (0.2559) correlation coe cients between India and Korea, Pakistan
4
- 0.1915 and Korea, the Philippines and India, Korea and the Philip-
D EXt ± 5 (- 0.6275) pines, and the Philippines and Pakistan. The correlation
- 0.2128 coe cients are also much lower between the four emerging
D EXt ± 6 (- 0.7079) markets and the IFC emerging markets group (represented
- 0.1095
D EXt ± (- 0.3632) by the IFC(C)). Thus, investors can diversify (and thus
7
- 0.1354 reduce) risk by investing in the emerging ® nancial markets;
D EXt ± 8 (- 0.4493) diversi® cation may further be enhanced by investors select-
- 1.08330 ing the pairs of markets (named above) which have very low
D EXt ± 9 (- 3.6306) b correlation coe cients.
Notes: t-statistics are in parentheses. In terms of the foregoing investigation on the linkages
a
Signi® cance at the 5% level. between stock prices and exchange rates, the results in Table
b
Signi® cance at the 1% level. 5 suggest that the causal linkage from exchange rates to

Table 5. Interactions among the Þ nancial markets using a correlation matrix of market returns

India Korea Pakistan Philippines IFC(C)

India 1.00
Korea 0.21 1.00
Pakistan 0.57 0.11 1.00
Philippines 0.23 0.32 0.24 1.00
IFC(C) 0.16 0.27 0.22 0.19 1.00

Note: IFC(C) = returns based on the IFC composite index.

 34
stock prices is likely to be independent of the markets, as
these markets do not exhibit very high comovements. The
exceptions are India and Pakistan, two markets which may
be related in terms of the causal linkage from exchange rates
to stock prices.
V. S U M M A R Y A N D C O N C L U S I O N
This paper sheds lights on the linkages between exchange
rates and stock prices in some emerging markets. Some
recent econometric techniques are applied to a BVAR
model of stock prices and exchange rates in order to test for
Granger-causalit y between the two variables. Essentially,
we perform the ADF tests with di€ erent autoregressive
orders until we obtain individual series for SP and EX that
are consistent with white noise error terms. Having estab-
lished the order of integration of the individual series,
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we move to test for cointegration using the two-step
EngleÐ Granger procedure. The results suggest that we have
to proceed with a standard VAR for Korea and Pakistan,
and an error correction model (ECM) for India and the
Philippines. Taking the standard VAR model, we determine
the optimum lag length of the bivariate VAR (BVAR), then
carry out diagnostics on the resulting equations, proceeding
to test for inference of Granger-causalit y with these equa-
tions for Korea and Pakistan. And taking the ECM we
determine the optimum lag length of the ECM equations,
then carry out diagnostics on the resulting equations, pro-
ceeding to test for inference of Granger-causalit y with these
equations for India and the Philippines.
Among the ® ndings of interest, exchange rates Granger-
cause stock prices in Korea, Pakistan and India, whereas
stock prices Granger-cause exchange rates in the Philip-
pines. Not only is the evidence on the causal in¯ uence of
exchange rates on stock prices strong, it is also consistent
with some earlier research based on developed economies,
instead of the emerging market economies we investigate in
this paper. The main implications are that, in the case of
Granger-causalit y from exchange rates to stock prices,
changes in exchange rates a€ ect ® rms’ exports and ultimate-
ly a€ ect stock prices. Thus, in terms of policy relevance, the
® ndings of this paper suggest that the respective govern-
ments of these emerging markets should well be cautious in
their implementation of exchange rate policies, since they
have rami® cations for the budding stock markets. A promis-
ing way to proceed in further empirical investigation is to
use a `uni® ed framework’ for Granger-causal testing, re-
cently suggested by Lutkepohl and Reimers (1992).1 3
13
Lutkepohl and Reimers (1992) propose and implement a consistent procedure for Granger-causality testing. First, they perform ADF
with di€ erent autoregressive orders. Second, they apply the order selection criterion (SC) to unrestricted VAR in order to determine the lag
length. Third, they conduct the Johansen test for cointegration. Fourth, they do the diagnostic tests. Finally, they perform Granger-
causality inference.
I. S. A. Abdalla and V . Murinde
A C K N O WL ED G EM E N T S
We thank, without implication, Morgan Guaranty Trust
Company of New York for giving us REER data, and an
anonymous referee of this journal for constructive com-
ments on a previous draft of this paper.
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35
Notes: A1.1 has the null hypothesis (H0 ) that there is no hetero-
scedasticity (i.e. homoscedasticity holds); this relies on an F-test
whose critical values are as follows: (3, 111) 1% = 3.95; (3, 111)
5% = 2.68; (17, 86) 1% = 2.50; (17, 86) 5% = 1.84; (13, 91)
1% = 2.34; (13, 91) 5% = 1.83; (11, 95) 1% = 2.47; (11, 95)
5% = 1.91. A1.2 has the null hypothesis (H0 ) that there is no
autocorrelation; this relies on a Lagrange multiplier test (reported
in column 3 for A1.2) whose chi-square critical values at 1% are
6.63 (1) for Korea (Equation 10); 26.2 (12) for Korea (Equation 11);
24.7 (11) for Pakistan (Equation 10); and 21.7 (9) for Pakistan
(Equation 11), where the number of the independent variables
including the constant are given in parentheses after the chi-square
critical value. A1.3 has the null hypothesis (H0 ) that there is no
structural break; this relies on an F-test whose critical values are
as follows: (3, 107) = 2.68 at 5% and 3.95 at 1%; (17, 68) = 1.84
at 5% and 2.35 at 1%; (13, 77) = 1.92 at 5% and 2.50 at 1%;
(11, 83) = 1.99 at 5% and 2.63 at 1%.
A P P E N D I X B : T E S T R E S U L T S FO R H E T E R O -
SCEDASTIC ITY, A UTOCOR RELATION AND

STRUCTURAL B REAK FOR THE ECMS

AP P EN D I X A . T E S T R E S U L T S F O R
HETEROSCEDA STICIT Y, AUTO- Test Computed test
CO R R E L A T I O N A N D S T R U C T U R A L type Country statistic Conclusion
BR E A K F O R T H E S TA N D A R D M O D E L
A2.1 India 1.1228 Accept H0
(12, 94)
Test Country Computed test A2.1 Philippines 0.3746 Accept H0
type (equation) statistic Conclusion (7, 104)
A2.2 India 1st order = 0.7497 Accept H0
A1.1 Korea (10) 0.3554 Accept H0 2nd order = 0.6263 Accept H0
(3, 111) 3rd order = 0.6007 Accept H0
A1.1 Korea (11) 0.5359 Accept H0 4th order = 0.6739 Accept H0
(17, 86) A2.2 Philippines 1st order = 0.9102 Accept H0
A1.1 Pakistan (10) 0.5138 Accept H0 2nd order = 0.3472 Accept H0
(13, 91) 3rd order = 0.9894 Accept H0
A1.1 Pakistan (11) 2.3875 Reject H0 4th order = 2.8890 Accept H0
(11, 95) A2.3 India 1.3961 Accept H0
A1.2 Korea (10) 1st order = 0.1163 Accept H0 (11, 83)
2nd order = 4.5921 Accept H0 A2.3 Philippines 1.4088 Accept H0
3rd order = 5.3250 Accept H0 (6, 97)
4th order = 6.1864 Accept H0
A1.2 Korea (11) 1st order = 0.5279 Accept H0 Notes: A2.1 has H0 : there is no heteroscedasticity; this relies on an
2nd order = 2.7310 Accept H0 F-test whose critical values are as follows: (12, 94) = 2.34 at 1%
3rd order = 3.5300 Accept H0 and 1.83 at 5%; (7, 104) = 2.79 at 1% and 2.09 at 5%. A2.2 has H0 :
4th order = 5.4465 Accept H0 there is no autocorrelation; this relies on a Lagrange multiplier
A1.2 Pakistan (10) 1st order = 2.6252 Accept H0 test; the critical values are chi-square at 5% and 1%. A2.3 has H0 :
2nd order = 3.3256 Accept H0 there is no structural break; this relies on an F-test whose critical
3rd order = 3.3953 Accept H0 values are (11, 83) = 1.95 at 5% and 2.56 at 1%; (6, 97) = 2.18 at
4th order = 5.9896 Accept H0 5% and 2.96 at 1%.
A1.2 Pakistan (11) 1st order = 9.6258 Accept H0
2nd order = 9.4063 Accept H0
3rd order = 10.3517 Accept H0
4th order = 10.9360 Accept H0
A1.3 Korea (10) 0.2478 Accept H0
(3, 107)
A1.3 Korea (11) 0.7770 Accept H0
(17, 68)
A1.3 Pakistan (10) 1.1399 Accept H0
(13, 77)
A1.3 Pakistan (11) 0.5025 Accept H0
(11, 83)
.