Applied Economics Letters

ISSN: 1350-4851 (Print) 1466-4291 (Online) Journal homepage: http://www.tandfonline.com/loi/rael20

Bivariate causality between exchange rates and

stock prices in South Asia
R. Smyth & M. Nandha
To cite this article: R. Smyth & M. Nandha (2003) Bivariate causality between exchange
rates and stock prices in South Asia, Applied Economics Letters, 10:11, 699-704, DOI:
10.1080/1350485032000133282
To link to this article: http://dx.doi.org/10.1080/1350485032000133282

Published online: 04 Jun 2010.

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Applied Economics Letters, 2003, 10, 699704

Bivariate causality between exchange rates

and stock prices in South Asia
R . SM Y TH * and M . N A ND HA

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Department of Economics, PO Box 11E, Monash University, 3800, Victoria, Australia

This article examines the relationship between exchange rates and stock prices in
Bangladesh, India, Pakistan and Sri Lanka using daily data over a six-year period
from 1995 to 2001. Both the EngleGranger two-step and Johansen cointegration
methods suggest that there is no long-run equilibrium relationship between these two
nancial variables in any of the four countries. Granger causality tests nd that there
is uni-directional causality running from exchange rates to stock prices in India and
Sri Lanka, but in Bangladesh and Pakistan exchange rates and stock prices are
independent.

I. INTRODUCTION
This article investigates the interaction between exchange
rates and stock prices for four South Asian countries using
daily data over the period 1995 to 2001. The relationship
between exchange rates and stock prices has several important implications. First, the relationship between stock
prices and exchange rates is often used to predict future
trends in each other by fundamental investors (Nieh
and Lee, 2001). Second, both variables have a crucial role
in inuencing the development of emerging markets,
particularly in those countries which have expanding
corporate sectors with listed rms and growing tradable
sectors which are sensitive to exchange rate policies
(Abdalla and Murinde, 1997). Third, theoretically stock
prices might inuence or be inuenced by exchange rates.
The traditional approach based on the interest parity condition suggests that changes in exchange rates should give
rise to changes in stock prices, but portfolio approaches
suggest that changes in stock prices lead changes in
exchange rates.
A number of empirical studies have examined the
relationship between exchange rates and share prices for
various markets and timeframes. Granger et al. (2000)
found that exchange rates lead stock prices in South
Korea; no support for any relationship in Japan and
Indonesia; and that stock prices lead exchange rates in

Hong Kong, Malaysia, Philippines, Singapore, Thailand

and Taiwan. Abdalla and Murinde (1997) found that
exchange rates Granger-cause stock prices in Korea,
Pakistan and India, but the opposite is true for the
Philippines. Ajayi et al. (1998) found uni-directional
causality from stock prices to exchange rates in developed
markets (Canada, Germany, France, Italy, Japan and
UK), but their results for emerging markets were
mixed. Ajayi et al. (1998) found bi-directional causality
in Taiwan, causality running from stock prices to the
exchange rate in Indonesia and the Philippines; from the
exchange rate to stock prices in Korea and no signicant
causal relationship in Hong Kong, Singapore, Thailand
and Malaysia. Overall there is no consensus among
researchers on the relationship between stock prices and
exchange rates, suggesting further studies are needed to
shed light on the issue.
This study diers from the extant literature in the following ways. First, at least until very recently, most existing
studies have been biased towards the larger and more
developed markets. As Granger et al. (2000: 339) put it:
In the case of emerging markets only skimpy literature is
available. Second, this is the rst study that focuses exclusively on South Asia. Third, while Abdalla and Murinde
(1997) have previously considered the relationship between
exchange rates and stock prices in India and Pakistan as
part of a broader study of Asian markets from January

* Corresponding author. Email: Russell.Smyth@BusEco.monash.edu.au

Applied Economics Letters ISSN 13504851 print/ISSN 14664291 online # 2003 Taylor & Francis Ltd
http://www.tandf.co.uk/journals
DOI: 10.1080/1350485032000133282

699

700

R. Smyth and M. Nandha

1985 to July 1994 using monthly data, this study is dierent

to their study in two respects. One dierence is that one
uses daily data, which is more appropriate for this type
of study given that a sampling frequency less than one
day may introduce spurious statistical signicance into
the causality tests (Ajayi et al. 1998). The other is that
this article focuses on a more recent period than Abdalla
and Murinde (1997) that takes account of the continued
globalization of nancial markets.

II. METHODOLOGY AND RESULTS

stock price index, currency and exchange rate regime

for each country. Daily data (excluding weekends and
holidays) were used for the period 2 January 1995 to 23
November 2001, which gives a total of 1800 observations.
The start and end dates for the study were determined by
data availability. All data were obtained from Datastream
and transformed into logarithmic scale. Table 2 shows the
movements in the indices across the countries and returns
relative to the US dollar. The four pairs of stock price
index and exchange rate data used in the study are referred
to as BANPI and BANER for Bangladesh, INDPI and
INDER for India, PAKPI and PAKER for Pakistan,
and SRLPI and SRLER for Sri Lanka.

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Data Set
There are only four countries in the South Asian region,
namely Bangladesh (BAN), India (IND), Pakistan (PAK)
and Sri Lanka (SRL) for which share price index (PI) and
exchange rate (ER) data is available. Table 1 gives the

Unit root and cointegration tests

Table 3 reports the results of Augmented DickeyFuller
(ADF) and PhillipsPerron unit root tests for exchange

Table 1. Stock market indices, currencies and exchange rate regimes

Country

Stock index

Currency

Exchange rate regime

Bangladesh

Bangladesh SE
All share (dead)
BSE National 200
Karachi SE 100
Colombo SE All
Share

Taka

Managed oat based on a trade-weighted basket

of currencies of major trading partners
De facto crawling peg to US dollar
De facto crawling band or peg/parallel market
Pre-announced or de facto crawling band around
the US dollar

India
Pakistan
Sri Lanka

Indian rupee
Pakistan rupee
Sri Lankan rupee

Table 2. Comparative features of the data set

Item

BANPI

2 January 1995
23 November 2001
Change %a
US$ return %b

845.65
617.69

26.96

BANER
39.80
56.95
43.09

48.95

INDPI
441.57
338.61

23.32

INDER
31.37
48.05
53.18

49.94

PAKPI
2078.00
1358.81

34.61

PAKER
30.77
60.85
97.76

66.93

SRLPI
990.28
533.39

46.14

SRLER
49.67
93.19
87.63

71.29

Notes: aPositive change in exchange rates indicate appreciation of US$ against the local currencies. bRepresents return as viewed from
foreign investors perspective without adjusting for investment related costs.

Table 3. Unit root results for exchange rates and stock price indices
Variable

ADF test statistic

Levels

BANPI
BANER
INDPI
INDER
PAKPI
PAKER
SRLPI
SRLER

2.009

4.268*

2.590

2.483

2.791

2.490

2.771

2.439

PhillipsPerron
First dierences

(20)
(0)
(10)
(3)
(12)
(0)
(16)
(10)

Levels

7.646*

(19)

11.526*

21.645*

11.526*

26.014*

10.334*

13.627*

(9)
(2)
(9)
(2)
(15)
(9)

1.537

4.287*

2.251

2.420

2.571

2.394

2.753

2.487

First dierences
(4)
(3)
(8)
(13)
(15)
(7)
(22)
(8)

39.651*

(9)

37.961*

37.974*

40.689*

42.417*

28.151*

40.705*

(4)
(10)
(14)
(11)
(16)
(5)

Notes: *Coecient is signicant at the 1% level. Figures in parenthesis are lag lengths for the ADF test and
bandwidths for the PhillipsPerron test.

701

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Bivariate causality between exchange rates and stock prices

rates and stock prices in each of the countries. The lag
length, for the ADF tests was chosen so as to minimize
Akaikes Information Criterion (AIC) where the upper
bound on the lag length of 24 was selected according
to the formula kmax int(12(T/100)0.25) (see Hayashi,
2000: 594). The bandwiths for the PhillipsPerron test
follow the NeweyWest suggestion using Bartlett kernel.
Both unit root tests suggest that BANER is stationary
in levels (I(0)) and the other variables are stationary
in rst dierences (I(1)). Having established the order
of integration of each series, one proceeds to consider
tests for cointegration. Cointegration analysis is not applicable for Bangladesh given that BANER is I(0). Thus
one only considers whether exchange rates and stock
prices are cointegrated in India, Pakistan and Sri Lanka.
This is achieved using both the two-step residualbased procedure for testing the null of no cointegration
suggested by Engle and Granger (1987) and the systembased reduced rank regression approach, which was
pioneered by Johansen (1988, 1995) and Johansen and
Juselius (1990).
The EngleGranger (1987) procedure involves running
the following regressions:
PIt c aEXt v

vt
vt
1 1
vt
1    p
vt
p t

The procedure for selecting the lag length and upper

bound is the same as above. The null hypothesis (H0)
is that EXt and PIt are not cointegrated. If the computed
Table 4. EngleGranger cointegration tests between exchange
rates and stock price indices
Augmented EngleGranger
t-statistic
India
Pakistan
Sri Lanka

2.524

2.857

3.314

(10)
(12)
(24)

Notes: No coecient is signicant at the 5% level or better.

Figures in parenthesis are lag lengths.

Augmented EngleGranger test statistic t
is greater

than the critical value we reject the null. The critical
values tabulated in Engle and Yoo (1987) was used. The
results for India, Pakistan and Sri Lanka are presented
in Table 4. In each case one fails to reject the null of no
cointegration between exchange rates and stock prices at
the 5% level.
Next one considers the Johansen test. According to
Johansen (1988), a p-dimensional vector autoregression
(VAR) of order k[VAR(k)] can be specied as follows:
Y
Y
Zt d 1 Zt
1 . . . k Zt
k !t t 1 . . . T 3
This expression can be rewritten as:

Zt d

Z
k t
k

No. of CE(s)

Trace statistic

max
5% CV

i
Zt
i !t

i
1

Here
is the rst dierence operator,  and  are p by p

matrices of unknown parameters and !t is a Gaussian
error term. All long-run information about the relationship between exchange rates and stock prices in India,
Pakistan and Sri Lanka is contained in the impact matrix
. When the matrix  has full column rank, it implies that
all variables in Zt are stationary. When the matrix  has
zero column rank, the expression is a rst-dierenced VAR
involving no long-run elements. If, however, the rank of 
is intermediate meaning that 0<rank() r < p, there will
be r cointegrating vectors that make the linear combinations of Zt become stationary or integrated.
There are two Johansen cointegration tests. First, the
maximum likelihood estimation procedure provides a likelihood ratio test, called a trace test, which evaluates the null
hypothesis of, at most, r cointegrating vectors versus the
general null of p cointegrating vectors. A second, likelihood
ratio test is the maximum eigenvalue test, which evaluates
the null hypothesis of r cointegrating vectors against the
alternative of (r 1) cointegrating vectors. The results of
the cointegration tests are reported in Table 5. In each
case one cannot reject the null. This conrms the results
of the EngleGranger test, meaning that exchange rates

Table 5. Johansens cointegration tests between exchange rates and stock price indices
trace

k
1
X

Max-Eigen statistic

5% CV

India

None
At most 1

6.213
1.040

15.41
3.76

5.173
1.040

14.07
3.76

Pakistan

None
At most 1

7.196
1.348

15.41
3.76

5.848
1.348

14.07
3.76

Sri Lanka

None
At most 1

11.259
0.097

15.41
3.76

11.162
0.097

14.07
3.76

702

R. Smyth and M. Nandha

and stock prices in India, Pakistan and Sri Lanka are

not cointegrated.
Granger causality tests
On the basis of the results for the unit root and cointegration tests one applies the standard Granger causality
test to exchange rates and stock prices in Bangladesh,
India, Pakistan and Sri Lanka. This involves estimating
the following BVAR model:

EXt

m
X

j EXt
j

j1

PIt

n
X

j
PIt
j

"t

j1

j
PIt
j

j1

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n
X

m
X

j
ERt
j "t

j1

Following Abdalla and Murinde (1997), the lag length in

Equations 5 and 6 were selected using a two-stage procedure. In the rst stage we ran the following regressions:

EXt a1

m24
X

fi
EXt
i "1t

gi
PIt
i "2t

i1

PIt a2

nX
24
i1

The lag length for Equations 7 and 8 was selected that

minimized the AIC. In the second stage, Equations 5 and 6

were estimated xing the number of lags on
EX (in

Equation 5) and
PI (in Equation 6) at the optimal
level determined in stage 1 and then varying the number
of lags on the independent variables from 124 so as to
minimize the AIC. The results for Equation 5 are reported
in Table 6 and the results for Equation 6 are reported
in Table 7. These were subjected to diagnostic testing for
heteroscedasticity and serial correlation. Whites (1980)
heteroscedasity test suggests the results for Pakistan in
Equation 5 are homoscedastic, but we are unable to accept
the null of no heteroscedasticity for India, Sri Lanka or
Bangladesh in Equation 5 or for any of the countries
in Equation 6. For those cases we corrected for heteroscedasticity using robust estimation and report Whites
(1980) heteroscedastic consistent t-ratios. To test for serial
correalation we use the Lagrange Multiplier (LM) test for
general, higher order ARMA errors, given the presence
of lagged dependent variables in the model. The LM test
accepts the null of no serial correlation in all cases at the
5% level.
On the basis of the results reported in Tables 6 and 7,
Granger-causality was tested for
P using the standard F-test.
For PI to Granger-cause EX, P j 6 0 in Equation 5 and
for EX to Granger-cause PI,
j 6 0 in Equation 6. The
results are reported in Table 8. For India and Sri Lanka
there is uni-directional causality running from exchange
rates to stock prices, but in Bangladesh and Pakistan
ER and PI are independent.

Table 6. Full information estimates for stock prices Granger-cause exchange rate equations
Stock prices Granger-cause exchange rates

Constant

PIt
1

PIt
1

Bangladesh

India

Pakistan

Sri Lanka

7.95E
05
(
0.039)
0.0001
(0.052)
1.000
(18.839)*

0.0002
(2.925)*

0.007
(
1.478)
0.110
(1.684)
0.042
(0.866)
0.045
(0.999)

0.0004
(3.292)*
0.001
(0.177)
0.0004
(0.017)

0.0004
(3.667)*
0.008
(1.130)
0.040
(0.333)

0.035
(
0.343)

0.040
(
0.476)

0.030
(
1.012)
0.056
(1.073)

0.168
1.828
1.219
1.771
1.970

0.117
0.144
0.341
2.770
_

0.082
0.663
5.169
5.219
0.504

1.092
3.841
4.176
4.967
_

ERt
2

ERt
3

ERt
4

ERt
5
2 (1)
2 (2)
2 (3)
2 (4)
2WHITE

[0.682]
[0.554]
[0.748]
[0.778]
[0.742]

[0.732]
[0.866]
[0.952]
[0.597]

[0.775]
[0.718]
[0.159}
[0.265]
[0.973]

[0.296]
[0.147]
[0.243]
[0.291]

Notes: Dependent variable is
ERt; 2 (1), 2 (2), 2 (3) and 2 (4) are results for Lagrange multiplier rst
order, second order, third order and fourth order serial correlation. 2WHITE are the results for Whites
heteroscedasticity test. The gures in round parenthesis below the coecients are t-statistics. The gures
in square parenthesis next to the diagnostic tests are probability values.

703

Bivariate causality between exchange rates and stock prices

Table 7. Full information estimates for exchange rate Granger-cause stock prices equations
Exchange rates Granger-cause stock prices

Constant

PIt
1

PIt
2

PIt
3

PIt
4

PIt
5

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PIt
6

PIt
7

PIt
8

PIt
9

PIt
10

PIt
11

PIt
12

PIt
13

PIt
14

PIt
15

PIt
16

PIt
17

PIt
18

PIt
19

PIt
20

ERt
1

Bangladesh

India

Pakistan

Sri Lanka

0.003
(0.212)
0.082
(2.125)**

0.106
(
0.877)
0.057
(1.626)
0.014
(0.307)

0.017
(
0.411)

0.010
(
0.239)

0.016
(
0.475)
0.095
(1.920)
0.036
(1.317)
0.003
(0.077)
0.070
(2.191)**

0.102
(0.259)

0.037
(0.461)
0.031
(0.242)

0.004
(
0.090)
0.117
(1.270)

0.053
(
1.789)
0.038
(0.707)

0.021
(
0.663)
0.100
(2.071)**

0.001
(
0.226)

0.0001
(
0.314)
0.112
(3.300)*

0.0003
(
0.640)
0.052
(1.451)
0.058
(1.281)
0.042
(1.180)

0.0001
(
0.7220)
0.437
(10.021)*

0.059
(
1.568)
0.067
(1.914)

0.050
(
1.484)
0.058
(1.757)
0.028
(0.797)
0.054
(1.679)
0.059
(1.804)

0.055
(
1.740)

0.270
(
2.134)**
0.252
(2.113)**

0.183
(1.604)

0.041
(0.780)

0.135
(
3.276)*

ERt
2
2 (1)
2 (2)
2 (3)
2 (4)
2WHITE

0.002
0.031
0.155
0.646
_

[0.967]
[0.985]
[0.984]
[0.958]

1.130
1.518
2.061
2.278
_

[0.288]
[0.468]
[0.560]
[0.684]

0.353
0.365
0.521
0.999
_

[0.552]
[0.833]
[0.914]
[0.909]

2.936
2.949
3.224
3.230
_

[0.087]
[0.229]
[0.358]
[0.520]

Notes: Dependent variable is
PIt, 2 (1), 2 (2), 2 (3) and 2 (4) are results for Lagrange multiplier rst order, second order, third order
and fourth order serial correlation. 2WHITE are the results for Whites heteroscedasticity test. The gures in round parenthesis below the
coecients are t-statistics. The gures in square parenthesis next to the diagnostic tests are probability values.

704

R. Smyth and M. Nandha

Table 8. Results for Granger causality tests

Country

Null hypothesis (H0)

F-statistics

Bangladesh
Bangladesh
India
India
Pakistan
Pakistan
Sri Lanka
Sri Lanka

PIt does not Granger-cause EXt

EXt does not Granger-cause PIt
PIt does not Granger-cause EXt
EXt does not Granger-cause PIt
PIt does not Granger-cause EXt
EXt does not Granger-cause PIt
PIt does not Granger-cause EXt
EXt does not Granger-cause PIt

F(1,
F(1,
F(1,
F(2,
F(1,
F(1,
F(1,
F(2,

1795)
1757)
1791)
1793)
1795)
1791)
1777)
1778)

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III. CONCLUSION
This article examined the relationship between exchange
rates and stock prices in four South Asian countries.
An interesting nding of this article is that there is no
long-run equilibrium relationship between these two nancial variables in any of the four countries. This result is
obtained from both the EngleGranger two-steps and
Johansen cointegration tests. While this nding is inconsistent with that of most previous studies, it supports the
results of Bahamani-Oskooee and Sohrabian (1992) and
Nieh and Lee (2001) for G7 countries. The nding that
exchange rates Granger-cause stock prices in India and
Sri Lanka is consistent with the traditional view based on
the interest-parity condition, but there is no evidence of
causality running either way in Bangladesh or Pakistan.
Abdalla and Murinde (1997) also generally found that
exchange rates Granger-cause stock markets in emerging
markets, although they additionally found unidirectional
causality from exchange rates to stock prices in Pakistan.
The results for India and Sri Lanka have important policy
eects. The main implication is that changes in exchange
rates inuence rms exports and ultimately aect stock
prices in these countries.

REFERENCES
Abdalla, I. and Murinde, V. (1997) Exchange rate and stock
price interactions in emerging nancial markets: evidence
on India, Korea, Pakistan and the Philippines, Applied
Financial Economics, 7, 2535.

Results
0.0030 [0.959]
0.0510 [0.826]
2.1829 [0.140]
4.1979 [0.015]
0.0315 [0.859]
2.572 [0.1089]
1.2766 [0.259]
5.6304 [0.004]

Accept H0
Accept H0
Accept H0
Reject H0
Accept H0
Accept H0
Accept H0
Reject H0

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