The IUP Journal of Applied Finance
The Causal Relationship Between Stock Prices and Exchange Rate: A Toda-Yamamoto Approach

Article Details
Pub. Date : April, 2020
Product Name : The IUP Journal of Applied Finance
Product Type : Article
Product Code : IJAF20420
Author Name : Tulika Mattack
Availability : YES
Subject/Domain : Finance
Download Format : PDF Format
No. of Pages : 10

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Abstract

The linkages between the stock market and foreign exchange market have been widely explored in different economies of the world. The diverse theoretical models suggest how exchange rate may affect stock prices and how stock prices may affect exchange rate. The study uses the Toda-Yamamoto approach to test the causality between exchange rate and stock prices employing a modified Wald statistics in an augmented VAR framework. The test results reveal a bidirectional causality running from exchange rate to stock prices and stock prices to exchange rate as well.


Description

The study intends to examine the causal relationship between exchange rate and stock prices in India. There are two primary approaches to the relationship between exchange rate and stock prices: flow-oriented model and stock-oriented approach. The flow-oriented model (Dornbusch and Fischer, 1980) implies that causal relationship runs from exchange rate to stock prices. Depreciation in domestic currency tends to make the local firms more competitive as their cost of exports gets cheaper. This implies higher profit for small firms, thereby leading to increase in stock prices. Likewise, an appreciation in the domestic currency makes goods and services costly in the international market. This leads to a decline in the exports as buyers in the international market would see them as expensive. As a result the income of the firm will drop and the stock prices would decline. Thus, the flow-oriented model postulates that share prices of firms are influenced by exchange rate changes and exchange rate changes and stock price returns are positively related. The stock-oriented approach (Branson, 1983; and Frankel, 1983) postulates that changes in stock prices lead to a change in the exchange rate. Decrease in stock prices leads to outflow of foreign capital in the form of portfolio investments, thus lowering the demand for domestic equities and hence foreign currency. This leads to depreciation of domestic currency. Similarly, a rise in stock prices leads to inflow of foreign international investments and thus currency appreciation.


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