Stock Prices and Exchange Rates in a VEC Model-The Case of Singapore in the 1990s

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This paper uses an error correction model to explore 1) the asymmetric effects of four different exchange rates on Singapore stock prices and 2) the effects' sensitivity to economic instability. Both the Singapore currency appreciation against the U.S. dollar and Malaysian ringgit and depreciation against the Japanese yen and Indonesian rupiah lead to a long-- run increase in stock prices for most selected periods of the 1990s; however, the effect associated with the U.S. dollar exchange rate has a sign reversal between the 1997-98 crisis period and the 1999-2000 recovery period. The influence of exchange rates on stock prices increases in a chronological order in the 1990s. (JEL E44, G15, F31)


The relationship between stock prices and exchange rate fluctuations is a controversial subject among financial economists though there is a dearth of literature on it. Gavin provided a modified Mundell-Fleming model to analyze stock market and exchange rate dynamics (see Gavin 1989), but the results of empirical studies on the subject have been mixed. Although some studies conclude that there is no long-run relationship between stock prices and exchange rates (Bhandari and Genberg 1989; Bahmani-Oskooee and Sohrabian 1992; Nieh 1996), others find the evidence of a positive relationship (Frennberg 1994; Choi 1995; Ajayi and Mougone 1996; Bahmani-Oskooee and Domac 1997).

According to macroeconomic theory, exchange rates and stock prices are positively related (if the exchange rate is expressed in units of the domestic currency per unit of foreign currency). A fall in the exchange value of a nation's currency stimulates exports and increases the income of export and import-competing industries, thus boosting the average level of stock prices. Nevertheless, the foreign-trade channel needs to be supplemented by the Fisher effect and financial theory in order to explain volatile asset prices and the resulting complex stock price-exchange rate relationship.

A positive relationship between the exchange rate and stock prices may result from a real interest rate disturbance: as the real interest rate rises, capital inflow increases and the exchange rate falls (appreciation); on the other hand, the theory of arbitrage suggests that a higher real interest rate reduces the present value of firms' future cash flows and causes stock prices to fall. However, under an inflationary disturbance, the exchange rate-stock price relationship could be negative: when inflation increases, the exchange rate rises because the domestic currency loses its value not only in terms of the goods and services but also in terms of foreign currencies; higher inflation expectations lead investors to demand a higher risk premium and demand a higher rate of return so that stock prices decrease. Although asset prices could exhibit deviations from the predicted stock price-exchange rate relationship, the consequent dynamic adjustments eliminate profit opportunities as predicted by efficient markets theory and thus restore equilibrium.

The focus of this paper is on exploring the existence of an equilibrium relationship between stock prices and exchange rates in Singapore's assets market and its sensitivity to different currencies and economic and financial conditions. Is there any pattern of asymmetry for Singapore-dollar exchange rates vis-ii-vis different currencies to influence stock prices? If the asymmetry exists, how is it sensitive to business cycle and financial market instability? The empirical investigation intends to extend our understanding of the asset price relationship embodied in efficient asset markets. The rest of the paper is organized as follows. The second section discusses the methodology used in the vector-error-correction model. The third section describes the data and the model setting. The fourth section summarizes the main findings. The fifth section concludes.


This section explains the methodology used to estimate the equilibrium relationship between stock prices and exchange rates. …