Recent high exchange rate fluctuations in the sphere of growing trade and financial liberalization have attracted a great deal of interest from both economists and policy-makers. Of particular interest has been the question of domestic economies' exposure to exchange rate risk. It is noted that fluctuations in the exchange rate can substantially affect the values of firms, through the changes in the terms of competition, the changes in the input prices, and the changes in the values of foreign currency-denominated assets (Bodnar and Gentry 1993). Domestic firms with foreign operations are obviously affected directly and, given these various channels of influences, even the firms with no foreign operations may be indirectly affected. Accordingly, firms' stock prices and the stock market may react to changes in the exchange rates. Conversely, changes in stock prices may influence the movements in the exchange rate, via firms' portfolio adjustments (Bahmani-Oskooee and Sohrabian 1992) or outflows of capital (Qiao 1996). The latter is likely to be operative if the changes in stock prices are sufficiently persistent to generate or destroy confidence in the market.
Empirically, there are quite a number of studies that attempt to determine the impact on stock prices of exchange rate changes. The findings, however, are not uniform across the various studies. Some studies documented positive effects of exchange rate changes on the stock market (Aggrawal 1981), while others found negative effects (Soenen and Hennigar 1988). Yet other studies concluded that the exchange rate changes have no significant impact on the stock market (Solnik 1984). In a more recent study, Bahmani-Oskooee and Sohrabian (1992) evaluated the interactions between the Standard and Poor's Composite Index and the effective exchange rate of the dollar, using monthly observations from July 1973 to December 1988. Applying standard co-integration and Granger tests, they found bi-directional causality between the stock price index and the exchange rate. However, there was no long-run relationship between the two variables. Using daily data for the cases of Japan, Hong Kong and Singapore, Qiao (1996) found the stock price-exchange rate causal nexus to be different across countries. Specifically, the direction of causation is bi-directional for Japan, is unidirectional from the exchange rate to stock returns for Hong Kong, and is non-causal for Singapore. He also noted the presence of a strong long-run relationship in these three countries.
Recently, Abdalla and Murinde (1997) investigated the same issue for the emerging markets of India, Korea, Pakistan and the Philippines. They noted that the understanding of the issue is crucial, as these countries attempt to develop their financial markets and, at the same time, move towards more flexible exchange rates. Their analysis is based on monthly observations from January 1985 to July 1994, using the IFC stock market indices for the countries and the real effective exchange rates. The results from their studies suggested unidirectional causality from exchange rates to stock prices in all the countries, except the Philippines. In the case of the Philippines, Abdalla and Murinde found the stock price to Granger caused the exchange rate. Additionally, they documented the presence of a long-run relationship for the cases of India and Pakistan. These results led them to conclude that, for the cases of unidirectional causality from exchange rates to stock prices, "the respective governments of these emerging markets should well be cautious in their implementation of exchange rate policies".
The objective of this study is to extend existing studies on the stock price-exchange rate causal relationship by investigating the issue for another emerging market, Malaysia. The country is one of the open and fast-growing economies in the region. The development of its stock market is also Exceptional. …