Academic journal article Advances in Management

Long Run Co-Integrating Relationship between Exchange Rate and Stock Prices: Empirical Evidence from BRICS Countries

Academic journal article Advances in Management

Long Run Co-Integrating Relationship between Exchange Rate and Stock Prices: Empirical Evidence from BRICS Countries

Article excerpt

Abstract

The growing importance of inert linkages between foreign exchange market and stock market especially after the recent global financial crisis makes it important to analyse the relationship between these markets especially in emerging markets. Exponential growth of foreign investment flows to these markets also strengthens this relationship. This paper examines the long run dynamic relationship between exchange rate and stock prices in BRICS markets by using daily data for the period of 17 years from 1997 to 2014. The long run equilibrium relationship has been examined by using Johansen co integration test. This paper seeks to answer some intriguing questions relating to the relationship between exchange rate and stock prices in this new economic world order.

Preliminary results show that stock price and exchange rate of Russia and China track each other very closely. We find negative and significant relationship between exchange rate and stock prices of Russia, India and South Africa. We also find a long term co integrating relationship between these markets in Russia and China for the total period and during crisis period. In pre crisis period cointegration exits in Russia, India and China. However in the post crisis period the co integration seems to be lost.

Keywords: Exchange Rate, Stock Prizes, BRICS market, Foreign Investment.

(ProQuest: ... denotes formulae omitted.)

Introduction

The stock market plays a very important role in the modem economy since it acts as a mediator between lenders and borrowers. A well-functioning stock market may assist the development process in an economy. The economic theory suggests that stock prices should reflect expectations about future corporate performance. Thus, in order to formulate country's macroeconomic policies, the causal relations and dynamic interactions among macroeconomic factors and stock market are very important. Further, investors believe that monetary, exchange rate and interest rate policies of the country and macroeconomic events have a great influence on volatility of the stock prices which imply that macroeconomic variables can influence investors' investment decisions and motivate many researchers to observe the relationships between stock returns and macroeconomic variables. Thus detecting the association between stock prices and exchange rates has become crucial for the academicians, practitioners and policy makers.

The importance of exchange rates in influencing domestic prices, including stock prices, has been brightened. This issue has become more critical with the occurrence of recent US 2007 subprime crisis and the "Great Depression" of 2008. Financial Liberalization integration of the financial markets has increased sharply which has become the cause of the financial crisis. In the Last Three decades, world faced four types of crisis: Crisis of 1987, Asian Financial crisis 1997, Global Financial crisis 2007 and European debt crisis 2009. Interaction of exchange rates with stock prices exerts spill over effects on each other that becomes the cause of financial crises.

The Asian crisis of 1997-98 has made a strong pitch for dynamic linkage between stock prices and exchange rates. During the crisis period, the world has noticed that the emerging markets collapsed due to substantial depreciation of exchange rates (in terms of US$) as well as dramatic fall in the stock prices. This has become important again from the view point of large cross border movement of fiinds due to portfolio investment and not due to actual trade flows, though trade flows have some impact on stock prices of the companies whose main sources of revenue comes from foreign exchange.

There are number of hypotheses that support the existence of a causal relation between stock prices and exchange rates. For instance, 'goods market approaches' suggest that changes in exchange rates affect the competitiveness of a firm as fluctuations in exchange rate affect the value of the earnings and cost of its funds as many companies borrow in foreign currencies to fund their operations and hence its stock price. …

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