EXECUTIVE SUMMARY

The dynamic linkage between exchange rate and stock prices has been subjected to
extensive

research for over a decade and attracted considerable attention from

researchers worldwide

during the Asian crisis of 1997-98. The issue is also important from the
viewpoint of recent

large cross-border movement of funds. In India the issue is also gaining

importance in the

liberalization era. With this background, the present study examines the
causal relationship

between returns in stock market and forex market in India. Using daily data from
January 2000

to March 2016, we found that causal link is generally present though in recent years
there has

been strong causal influence from stock market prices to forex market prices. The
changes in the

capital market bring transformation in the entire economy of the country. The
boom and

depression of the capital market is reflected in all sectors of the economy. Stock
price downward

movement continuously in the market forewarns the crisis period in advance.

Numerous studies

were conducted to trace the movement of stock market and its relationship
with various

economic factors. NIFTY Index of NSE has been taken to compare the stock market
movement

with exchange rate. This Index is a well-diversified one, which represents the major
industries of

the economy. Monthly data ranging from 2000-2016 is considered. Primary

hypothesis

evaluates that whether the performance of NSE/BSE is dependent on the given

indicator or not.

This study analyses the dynamic relationship between stock market and
exchange

rate. As US Dollar is a prominent currency for foreign trade, the exchange rate of
rupee and US

Dollar has been taken for the study. The result found out that there is a
bidirectional causal
relationship between exchange rate and Nifty Index.

INTRODUCTION

The changes in the capital market bring transformation in the entire economy of the
country. The boom

and depression of the capital market is reflected in all sectors of the economy. Stock
price downward

movement continuously in the market forewarns the crisis period in advance.

Numerous studies were

conducted to trace the movement of stock market and its relationship with various
economic factors.

This study analyses the dynamic relationship between stock market and exchange
rate. As US Dollar is a

prominent currency for foreign trade, the exchange rate of rupee and US Dollar has
been taken for the

study. Exchange rate is decided by the market driven forces after the LERMS
(Liberalized Exchange

Rate Management System). Due to the global crisis, the rupee dollar exchange rate
has depreciated

conspicuously. Exchange rate also affects various macro-economic factors like GDP,
BOP, Money

Supply, Interest rate and foreign reserves. CNXNIFTY Index of NSE has been taken to
compare the

stock market movement with exchange rate. This Index is a well-diversified one,
which represents the

major industries of the economy. It starts with introduction of the

study followed by review of literature. The third section deals with the objectives.
The last section discusses the data analysis, interpretations and conclusions. Many
factors, such as

enterprise performance, dividends, stock prices of other countries, gross domestic

product, exchange

rates, interest rates, current account, money supply, employment, their information
etc. have an

impacton daily stock prices (Kurihara, 2006: p.376).The issue of inter temporal
relation between stock

returns and exchange rates has recently preoccupied the minds of economists, for
theoretical and

empirical reasons, since they both play important roles in influencing the
development of a countrys

economy. In addition, the relationship between stock returns and foreign exchange
rates has frequently

been utilized in predicting the future trends for each other by investors. Moreover,
the continuing

increases in the world trade and capital movements have made the exchange rates
as one of the main

determinants of business profitability and equity prices (Kim, 2003). Exchange rate
changes directly

influence the international competitiveness of firms, given their impact on input and
output price

(Joseph, 2002). Basically, foreign exchange rate volatility influences the value of the
firm since the

future cash flows of the firm change with the fluctuations in the foreign exchange
rates. When the

Exchange rate appreciates, since exporters will lose their competitiveness in

international market, the

sales and profits of exporters will shrink and the stock prices will decline. This paper
attempts to

examine whether or not a causal relationship exists between foreign exchange rates
and stock market.

(SENSEX and NIFTY 50) were determined for data between 2004 and 2012.

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 funds 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. In retrospect of the literature, a number

of hypotheses support

the existence of a causal relation between stock prices and exchange rates. For
instance, goods market

approaches (Dornbusch and Fischer, 1980) suggest that changes in exchange rates
affect the

competitiveness of a firm as fluctuations in exchange rate affects 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.

A depreciation of the local currency makes exporting goods attractive and leads to
an increase in foreign

demand and hence revenue for the firm and its value would appreciate and hence
the stock prices. On

the other hand, an appreciation of the local currency decreases profits for an
exporting firm because it

leads to a decrease in foreign demand of its products. However, the sensitivity of

the value of an

importing firm to exchange rate changes is just the opposite to that of an exporting
firm.

In addition, variations in exchange rates affect a firm's transaction exposure. That

is, exchange rate

movements also affect the value of a firms future payables (or receivables)
denominated in foreign

currency. Therefore, on a macro basis, the impact of exchange rate fluctuations on

stock market seems

to depend on both the importance of a countrys international trades in its economy

and the degree of the

trade imbalance.

An alternative explanation for the relation between exchange rates and stock prices
can be provided

through portfolio balance approaches that stress the role of capital account
transaction. Like all
commodities, exchange rates are determined by market mechanism, i.e., the
demand and supply

condition. A blooming stock market would attract capital flows from foreign
investors, which may cause

an increase in the demand for a countrys currency. The reverse would happen in
case of falling stock

prices where the investors would try to sell their stocks to avoid further losses and
would convert their

money into foreign currency to move out of the country. There would be demand for
foreign currency in

exchange of local currency and it would lead depreciation of local currency. As a

result, rising

(declining) stock prices would lead to an appreciation (depreciation) in exchange

rates. Moreover,

foreign investment in domestic equities could increase over time due to benefits of
international

diversification that foreign investors would gain. Furthermore, movements in stock

prices may influence

exchange rates and money demand because investors wealth and liquidity demand
could depend on the performance of the stock market. NATIONAL STOCK EXCHANGE

The National Stock Exchange of India Limited (NSE) is the leading stock exchange of
India, located

in Mumbai. NSE was established in 1992 as the first demutualized electronic

exchange in the country.

NSE was the first exchange in the country to provide a modern, fully automated
screen-based electronic

trading system which offered easy trading facility to the investors spread across the
length and breadth

of the country.

NSE has a market capitalization of more than US$1.65 trillion, making it the worlds
12th-largest stock

exchange as of 23 January 2015.

[1]

NSE's flagship index, the CNX Nifty,the 50 stock index, is used

extensively by investors in India and around the world as a barometer of the Indian
capital markets.

NSE was set up by a group of leading Indian financial institutions at the behest of
the government of
India to bring transparency to the Indian capital market. Based on the
recommendations laid out by the

government committee, NSE has been established with a diversified shareholding

comprising domestic

and global investors. The key domestic investors include Life Insurance
Corporation of India, State

Bank of India, IFCI Limited IDFC Limited and Stock Holding Corporation of India
Limited. And the

key global investors are Gagil FDI Limited, GS Strategic Investments Limited, SAIF II
SE Investments

Mauritius Limited, Aranda Investments (Mauritius) Pte Limited and PI Opportunities

Fund.

NSE offers trading, clearing and settlement services in equity, equity

derivatives, debt and currency

derivatives segments. It is the first exchange in India to introduce electronic

trading facility thus

connecting together the investor base of the entire country. NSE has 2500 VSATs
and 3000 leased lines

spread over more than 2000 cities across India.

The exchange was incorporated in 1992 as a tax-paying company and was

recognized as a stock

exchange in 1993 under the Securities Contracts (Regulation) Act, 1956, when P. V.
Narasimha

Rao was the Prime Minister of India and Manmohan Singh was the Finance Minister.
NSE commenced

operations in the Wholesale Debt Market (WDM) segment in June 1994. The capital
market (equities)

segment of the NSE commenced operations in November 1994, while operations in

the derivatives

segment commenced in June 2000.

FOREIGN EXCHANGE MARKETS

The Foreign Exchange Market is known to be the most liquid financial market in the
world. It is also

called the Forex Market. It is very important to understand how values of

different currencies are

determined since they are the main regulation mechanism for individuals
interactions in an economy.
Currencies have increasingly become the most actively traded assets and so, the
volume and speed of

their flows are just amazing. Trading in foreign exchange markets averaged $5.3
trillion per day in April

2013 (BIS Triennial Central Bank Survey 2013). This is up from $4.0 trillion in April
2010 and $3.3

trillion in April 2007. The most actively traded instruments in April 2013 were FX
swaps, at $2.2 trillion

per day, followed by spot trading at $2.0 trillion. Smaller banks accounted
for 24% of turnover,

institutional investors such as pension funds and insurance companies 11% and
hedge funds proprietary

trading firms another 11%. Trading with non-financial customers, mainly

corporations, contracted

between the 2010 and 2013 surveys, reducing their share of global turnover to only
9%. The US dollar

remained the dominant vehicle currency. The Euro was the second most traded
currency. The turnover

of Japanese Yen increased significantly from 2010 to 2013 and currencies like
Mexican Peso, Chinese

Renminbi entered the list of top 10 most traded currencies. Instruments covered in
FX market include

spot transactions, outright forwards, FX swaps, Currency swaps, OTC options, etc.

Due to over the counter nature of currency markets, there are rather a
many interconnected

marketplaces, where different currencies, instruments are negotiated. For that

reason, there is not a

single exchange rate but rather a number of different rates or prices

depending on which bank or investor is trading and the location of this one.
Trading is though increasingly concentrated in the largest

financial centers. In April 2013, sales desks in the United Kingdom, the United
States, Singapore and

Japan intermediated 71% of foreign exchange trading, whereas in April 2010 their
combined share was

66%. Currency trading happens continuously throughout the day, so when the
Asian trading session ends, the European session begins, followed by the North
American session and then coming back again to the Asian session. Like other Asian
emerging economies, Indian equity market has continued to grow and has seen the

relaxation of foreign investment restrictions primarily through country deregulation.

During the 1990s,
India has initiated the financial sector reforms by way of adopting international
practices in its financial

market. Parallel to this, the issuance of American Depository Receipts (ADRs) or

General Depository

Receipts (GDRs) has facilitated the trade of foreign securities on the NYSE, NASDAQ
or on nonAmerican exchanges. Over the years, Indian Rupee is slowly moving
towards full convertibility, which

has also had an impact in the Indian capital market as international investors have
invested about US

$15 billion in Indian capital market. The two-way fungibility of ADRs/GDRs allowed
by RBI has also

possibly strengthened the linkages between the stock and foreign exchange
markets in India.

DOLLAR EXCHANGE RATES

Depreciation in the value of the domestic currency (here, Indian Rupee)

against the foreign currency

(here, US Dollar) causes an increase in the exports, therefore the exchange rates
must have a negative

impact on the performance of the stock markets.

But, at the same time, depreciation in the domestic currency increases the
cost of imports which

indicates a positive relation between the two. Therefore, it becomes extremely

important to evaluate the

impact of exchange rate fluctuations on the Prices of NSE Indices.

The following chart depicts the changes in the exchange rates on an average basis
for six years starting

from January 2009- December 2014 in the sequence that year 1 displays 2009
values, year 2 displays

2010 values, and so on till year 6, i.e. 2014. The annual average of the
average monthly rates of

USD/INR stood at 48.26 (approx.), 45.58 in the year 2010, 46.87 in the year 2011,
53.37 in the year

2012, 58.89 in the fifth year and 61.15 in the last year. It can be observed that the
fluctuations in the

average exchange rates was nor very sharp.

Background and Literature Review

In an increasingly complex scenario of the financial world, it is of paramount

importance for the

researchers, practitioners, market players and policy makers to understand the

working the analysis of

dynamic andstrategic Interactions between stock and foreign exchange market

came to the forefront

because these two markets are the most sensitive segments of the financial system
and are considered as

the barometers of the economic growth through which the country's exposure
towards the outer world is

most readily felt. The present study is an endeavor in this direction. Before going to
discuss further

about the linkages between the stock and foreign exchange market, it is better to
highlight the evolutions

and perspectives that are associated with both the markets since liberalization in
the Indian context.

There are two explanations for which variable cause the other. The flow oriented
model approach as

described in Dornbusch and Fischer (1980) research show that currency movements
directly affect

international competitiveness. In turn, currency has an effect on the balance of

trade within the country.

As a result, it affects the future cash flows or the stock prices of firms. The counter
argument suggests

that taking a portfolio-balance approach (Dornbusch, 1976), where portfolio holders

should diversify to
eliminate firm specific risk, requires effective investments allocation including
currencies. As with other

financial instruments, currencies therefore are under the rules of supply and
demand for assets. In order

48.26166667

45.58475 46.87583333

53.36708333

58.89375 61.14666667

123456

Annual Average Exchange Rates

(USD/INR)*

Series1

for investors to purchase new assets they must sell off other less attractive asset in
their portfolio. In

other words buying and selling of domestic or foreign investments if less attractive.
As countries assets

become more valuable, interest rates begin to increase creating an appreciation of

domestic currency.

Although two valid explanations, no consensus has been made between the two. So,
this study attempts

to examine whether or not a causal relationship exists between exchange rates and
stock market.

relationships were determined for data between 2004 and 2012 in India. An

early attempt to examine the exchange rate and stock price dynamics was by
Franck and Young (1972)

who showed that there is no significant interaction between the variables. Soenen
and Hennigar (1988)

studied the same market but considered a different time period and contrast with
prior studies by

showing a significant negative relationship between stock prices and exchange

rates. Solnik (1987)

made a slightly different study and tried to detect the impact of several economic
variables including the

exchange rates on stock prices. He concluded that changes in exchange rates do

not have any significant

impact over stock prices. Nieh and Lee (2001) supported the findings of Bahmani
Oskooee and
Sohrabian (1992) and reported no long-run significant relationship between stock
prices and exchange

rates in the G-7 countries. Roll (1992) also studied the US stock prices and
exchange rates and found a

positive relationship between the two markets. Chow etal.

(1997) examined the same markets but found no relationship between stock returns
and real exchange

rate returns. They repeated the exercise with a longer time horizons and found a
positive relationship

between the two variables. Abdalla and Murinde (1997) employed co-integration
test to examine the

relationship between stock prices and exchange rates for four Asian countries
named as India, Pakistan,

South Korea and Philippines for a period of 1985 to 1994. They detected
unidirectional causality from

exchange rates to stock prices for India, South Korea and Pakistan and found
causality runs from the

opposite direction for

Philippines. Yamini Karmarkar and G Kawadia tried to investigate the relationship

between RS/$

exchange rate and Indian stock markets. Five composite indices and five spectral
indices were studied

over the period of one year: 2000. The results indicated that exchange rate has high
correlation with the

movement of stock market. Wu (2000) did a similar study using stock prices and
exchange rates of

Singapore and portrayed a unidirectional causality from exchange rates to stock

prices. Apte (2001)

13

investigated the relationship between the volatility of the stock market and the
nominal exchange rate of

India by using the EGARCH specifications on the daily closing USD/INR exchange
rate, BSE 30

(Sensex) and NIFTY-50 over the period 1991 to 2000. The study suggests that there
appears to be a

spillover from the foreign exchange market to the stock market but not the reverse.
In a recent study,

Bhattacharya and Mukherjee (2003) investigated Indian markets using the data on
stock prices and
macroeconomic aggregates in the foreign sector including exchange rate concluded
that there in no

significant relationship between stock prices and exchange rates.

Although theories suggest causal relations between stock prices and exchange
rates, existing evidence

on a micro level provides mixed results. Jorion (1990, 1991), Bodnar and Gentry
(1993), and Bartov and

Bodnar (1994) all fail to find a significant relation between simultaneous dollar
movements and stock

returns for U.S. firms. He and Ng (1998) find that only about 25 percent of their
sample of 171 Japanese

multinationals has significant exchange rate exposure on stock returns. Griffin and
Stulzs (2001)

empirical results show that weekly exchange rate shocks have a negligible impact
on the value of

industry indexes across the world. However, Chamberlain, Howe, and Popper (1997)
find that the U.S.

banking stock returns are very sensitive to exchange rate movements, but not for
Japanese banking

firms. While such findings are different from those reported in prior research,
Chamberlain et al.

attributed the contrast to the use of daily data in their study instead of monthly
data as used in most prior

studies.

On a macro level, the empirical research documents relatively stronger relationship

between stock price

and exchange rate. Ma and Kao (1990) find that a currency appreciation negatively
affects the domestic

stock market for an export-dominant country and positively affects the domestic
stock market for an

import-dominant country, which seems to be consistent with the goods market

theory. Ajayi and

Mougoue (1996), using daily data for eight countries, show significant interactions
between foreign

exchange and stock markets, while Abdalla and Murinde (1997) document that a
countrys monthly

exchange rates tends to lead its stock prices but not the other way around. Pan, Fok
& Lui (1999) used
daily market data to study the causal relationship between stock prices and
exchange rates and found

that the exchange rates Granger-cause stock prices with less significant causal
relations from stock

prices to exchange rate. They also find that the causal relationship have been
stronger after the Asian

crisis.

In the context of Indian economy, however, study in the similar direction is not
available, though the

issue is gaining importance in recent years. Like other Asian emerging economies,
Indian equity market

has continued to grow and has seen the relaxation of foreign investment restrictions
primarily through

14

country deregulation. During the 1990s, India has initiated the financial sector
reforms by way of

adopting international practices in its financial market. Parallel to this, the issuance
of American

Depository Receipts (ADRs) or General Depository Receipts (GDRs) has facilitated

the trade of

foreign securities on the NYSE, NASDAQ or on non-American exchanges. Over the

years, Indian

Rupee is slowly moving towards full convertibility, which has also had an impact in
the Indian capital

market as international investors have invested about US $15 billion in Indian

capital market. The twoway fungibility of ADRs/GDRs allowed by RBI has also
possibly strengthened the linkages between the

stock and foreign exchange markets in India. Pan et al. (2007) examined the
dynamic linkage between

exchange rate and stock price of seven east Asian Countries from 1988 to 1998 and
found out there is a bi-directional causal relationship for Hong Kong before the Asian
crisis. Also there is a uni-directional

causal relationship from exchange rates and stock prices for Japan, Malaysia and
Thailand and from

stock price to exchange rate for Korea and Singapore. Vygodina (2006) analysed
empirically the

exchange rates and stock price nexus for large cap and small cap stocks for the
period 1987 to 2005 in
USA and used Granger causality methodology. The study found out that there is
causality for large cap

stocks to exchange rate while there is no causality for small cap stocks to exchange
rate. Doong et al.

(2005) investigated the dynamic relationship between stock and exchange rate for
six Asian countries

over the period 1989 to 2003. The study found out that financial variables are not
cointegrated. The

results of Granger Causality test shows that bi-directional causality can be detected
in Indonesia, Korea,

Malaysia and Thailand. There is a significant negative relation between the stock
returns and the

contemporaneous change in the exchange rate for all the countries except Thailand.
Kaminsky and

Reinhart (2003) investigates the spillover effects of stock price returns and found
that US, Japan and

Germany markets plays an important role in the spillover relationships in the case of
Brazil, Thailand

and Russian crises. Muhammad and Rasheed (2002) examines the exchange rate
and stock price

relationship for Pakistan, India, Banglandesh and Srilanka using monthly data from
1994 to 2000. The

empirical results show that there is a bi-directional long-run causality between these
variables for only

Bangladesh and Sri Lanka. No associations between exchange rates and stock
prices are found for

Pakistan and India. Granger et al. (2000) found strong feedback relationships
between Hongkong,

Thailand, Thaiwan and Malaysia. They used daily data and sample period from
January 3, 1986 and

finished June 16, 1998. Furthermore, they found that the results are in line with the
traditional approach

in Korea, while they agree with the portfolio approach in the Philippines. Pan, Fok &
Lui (1999) used

daily market data to study the causal relationship between stock prices and
exchange rates and found

that the exchange rates Granger-cause stock prices with less significant causal
relations from stock

15
prices to exchange rate. They also find that the causal relationship have been
stronger after the Asian

crisis. Ajayi and Mougoue (1996) analysed the relationship between exchange rate
and stock prices in

eight advanced countries using an error correction model and found short and long
run feedback

between these two variables. Fama (1981) said that stock prices reflect these
variables such as inflation,

exchange rate, interest rate and industrial production. Later, Maysami and Koh
(2000) and Choi et al.

(1992) examined the impacts of the interest rate and exchange rate on the stock
returns and showed that

the exchange rate and interest rate are the determinants in the stock prices. Frank
and Young (1972)

investigated the relationship between stock prices and exchange rates by

employing six different

exchange rates and concluded no statistically significant underlying relationship.

Solnik (1987) gave

positive as well as negative relationship between real stock returns and real
exchange rate movements

for different time frames. Ma and Kao

(1990) found a negative relationship whereas Oskooe and Sohrabian (1992) claimed
bidirectional

Granger causality with no long-term relationship.

Most of the existing studies performed in Indian context found that the equity return
has a significant

and positive impact on the FII (Agarwal, 1997; Chakrabarti, 2001; and Trivedi &

Nair, 2003) but some also agree on bidirectional causality stating that foreign
investors have the ability

of playing like market makers given their volume of investments. (Gordon & Gupta
in 2003 and Babu

and Prabheesh in 2007). Griffin (2004) found that foreign flows are significant
predictors of returns for

Korea, Taiwan, Thailand and India.

Some researchers also point out a structural break in 1998-99 Asian crises when FII
went down, before

and after which drastically different results are expected. That's one reason why
current study analyzes
recent data since 1998. Rajput and Thaker state that no long run positive correlation
exists between

exchange rate and Stock Index in Indian context except for year 2002 and 2005. FII
and Stock Index

show positive correlation, but fail to predict the future value. Takeshi (2008) reports
unidirectional

causality from stock returns to FII flows irrelevant of the sample period in India
where as the reverse

causality works only post 2003. The structural break of 2003 as suggested by him
and some other

researchers was introduced in the current model and hence analyzed. A number of
researchers have

addressed the question of the relation between the levels of stock market returns
and exchange rate

changes. Studies have been undertaken both for broad market indices, industry
indices and individual

stocks. Representative examples are Bodnar and Gentry(1993), Bartov and Bodnar
(1994), Choi and

Rajan (1997), Jorion (1990,1991), Ma and Rao (1990), Apte (1997). By and large,
these investigations

have failed to discover significant relationship between stock returns and exchange
rate changes either at aggregate level such as a market or industry indices or at the
level of individual firms. There have also

been studies of dynamic linkages between stock returns and exchange rate changes
using the

cointegration framework. [Ajayi and Mougoue (1996)]. All these studies focus on the
first moments i.e.

relationship between mean stock returns and exchange rate returns.

In the literature, various theoretical reasons have been explained linking behavior of
stock prices and

key macro economic variables. For instance, Friedman (1988) suggests wealth
effect and substitution

effect as the possible channels through which stock prices might directly affect
money demands in the

economy. Friedman (1988) expected that the wealth effect will dominate and thus
the demand for

money and stock prices to be positively related. The theoretical basis to examine
the link between stock
prices and the real variables are well established in economic literature, e.g., in
Baumol (1965) and

Bosworth (1975). The relationship between stock prices and real consumption
expenditures, for

instance, is based on the life cycle theory, developed by Ando and Modigliani
(1963), which states that

individuals base their consumption decision on their expected life time wealth. Part
of their wealth may

be held in the form of stocks linking stock price changes to changes in consumption
expenditure.

Similarly, the relationship between stock prices and investment spending is based
on the q theory of

James Tobin (1969), where is the ratio of total market value of firms to the
replacement cost of their

existing capital stock at current prices. In retrospect of the literature, a number of

hypotheses also

support the existence of a causal relation between stock prices and exchange rates.
For instance, goods

market approaches (Dornbusch and Fischer, 1980) suggest that changes in

exchange rates affect the

competitiveness of a firm as fluctuations in exchange rate affects 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.

17

An alternative explanation for the relation between exchange rates and stock prices
can be provided

through portfolio balance approaches that stress the role of capital account
transaction. Like all

commodities, exchange rates are determined by market mechanism, i.e., the

demand and supply

condition. A blooming stock market would attract capital flows from foreign
investors, which may cause

an increase in the demand for a countrys currency. The reverse would happen in
case of falling stock

prices where the investors would try to sell their stocks to avoid further losses and
would convert their

money into foreign currency to move out of the country. There would be demand for
foreign currency in
exchange of local currency and it would lead depreciation of local currency. As a
result, rising

(declining) stock prices would lead to an appreciation (depreciation) in exchange

rates. Moreover,

foreign investment in domestic equities could increase over time due to benefits of
international

diversification that foreign investors would gain. Furthermore, movements in stock

prices may influence

exchange rates and money demand because investors wealth and liquidity demand
could depend on the

performance of the stock market. Economic theories suggest causal relations

between stock prices and

exchange rates; existing evidence also provides relatively stronger relationship

between stock price and

exchange rate. Ma and Kao (1990) find that a currency appreciation negatively
affects the domestic

stock market for an export-dominant country and positively affects the domestic
stock market for an

import-dominant country, which seems to be consistent with the goods market

theory.

Bahmani and Sohrabian (1992) found a bi-directional causality between stock prices
measured by the

Standard & Poor's 500 index and the effective exchange rate of the dollar, at least
in the short run. The

co-integration analysis revealed no long run relationship between the two variables.

Similarly, Abdalla and Murinde (1996) investigate interactions between exchange

rates and stock prices

in the emerging financial markets of India, Korea, Pakistan and the Philippines. The

In a recent paper Kanas (2000) has investigated volatility spillovers between stock
returns and exchange

rate changes. This is an important question. The variance of returns on a multi-

currency portfolio

depends on the variances of individual stock market returns, variances of the

exchange rates and their

pair-wise covariances4. If in addition, the stock market and exchange rate variances
are interconnected,

this would certainly affect the nonsystematic i.e. non-diversifiable risk of multi-
currency equity
portfolios and hence valuation of stocks by foreign investors which in turn has
implications for

extending the CAPM to a multi-country context. Eur and Resnick (1988) tried to
develop ex ante

portfolio selection strategies to realize potential gains from international

diversification under flexible

exchange rates. For the empirical analysis the Morgan Stanley Capital international
Perspective daily

18

stock index values for the United States and the other six countries were adopted.
The stock indices of

United States, Canada,

France, Germany, Japan, Switzerland, and the U.K. were value weighted and it was a
representative of a

domestic stock index fund. The data series were provided in both the United States
and the local

currencies for the period from December 3 1, 1979, through December 10, 1985.
Methods such as

correlation, variance and covariance have also been employed to know the changes
in stock market

across the countries.

The analysis reveals that exchange rate uncertainty is a largely nondiversifiable

factor adversely

affecting the performance of international portfolios. The authors have suggested

two methods such as

multi-currency diversification and hedging via forward exchange contracts for

reducing the exchange

rate risks.

Ma and Kao (1990) examined the stock price reactions to the exchange rate
changes. The authors have

studied the case of six developed countries namely United Kingdom, Canada,
France, West Germany,

Italy and Japan. Monthly stock indices and monthly exchange rates arc gathered
from the Exchange

Rates and Interest Rates Tape Provided by the Federal Reserve.

The sample period was from January 1973 to December 1983, and a two factor
model was adopted for

the empirical analysis.

The paper demonstrates two possible impacts of changes in a country's currency
value on stock price

movements. Firstly, the financial effects of exchange rate changes on the

transaction exposure.

Secondly, the economic effect from exchange rate changes suggests that, for an
export-dominant

country, the currency appreciation reduces the competitiveness of export markets

and has a negative

effect on the domestic stock market. On the other hand for an import dominated
country, the currency

appreciation will lower import costs and generate a positive impact on the stock
market.

Jorion (1991) examined the pricing of exchange rate risk in the United States (US)
stock market, by

using two-factor and multi-factor arbitrage pricing models. For the purpose of
empirical analysis,

monthly data are collected for a period ranging from January 1971 to December
1987. The data on the

trade-weighted exchange rate is derived from the weights in the

Multilateral Exchange Rata Model (MERM) computed by the International Monetary

Fund (IMF).

Monthly data on the Stock market return are collected from the University of
Chicago's Centre for

Research in Security Prices (CRSP) database. The study reveals that United States
(US) industries display

significant cross-sectional differences in their exposure to movements in the dollar.

However, the empirical results do not suggest that exchange rate risk is priced in
the stock market. The

conditional risk premium attached to foreign currency exposure appears to be small

and never

significant. Bartov and Bodnar (1994) re-examined the anticipated changes in the
dollar and equity

value. The period of study ranges from the fiscal year 1978 and runs through the
fiscal year 1989. The

authors have used the COMPUSTAT Merged-Expanded Annual Industrial File and Full
Coverage File

for fums that reported significant foreign currency gains or losses on their annual
financial statements.

The data on stock prices were collected either the

Centre for Research in Security Prices (CRSP) New York Stock Exchange (NYSE),
American Stock

Exchange (AMEX) Daily Return File or the National Association of Security Dealers
Automated

Quotation (NASDAQ) Daily or Master Files. The results of the study show that
contemporaneous

changes in the dollar have little power in explaining abnormal stock return. This
finding is consistent

with the failure of prior research to document a contemporaneous relation between

dollar fluctuations

and fum value and suggests that problems with sample selection technique are not
a complete

explanation for their failure. Choi and Prasad (1995) estimated a model of firm
valuation to examine the

exchange risk sensitivity of firm value. For the empirical analysis monthly time-
series of stock returns

were obtained from the University of Chicago Centre for Research in Security Prices
(CRSP) tapes and

COMPUSTAT database. The period of study was from January 1978 to December
1989. The nominal

exchange rate variable was the United States (US) dollar value of one unit of foreign
currency, where

foreign currency was the multilateral tradeweighted basket of ten major currencies
as published in the

Federal Reserve Bulletin. To summarize, even though the theoretical explanation

may seem obvious at times, empirical results have always been mixed and existing
literature is inconclusive on issue of causality. In this background, this study aims at
examining the dynamic linkages between foreign exchange of Indian Rupee and
stock market price index in India.

Research Methodology

Objectives

The broad objective of the study is to basically find out the two way relationship
between stock closing

price and foreign exchange rates. INR/$ is evaluated against SENSEX and NIFTY50.

Data Collection

Data is collected for Indian stock indices (SENSEX & Nifty 50) and the INR-USD
exchange rate from

1st January 2000 to 1st March 2016. Daily observations of SENSEX & Nifty 50 and the
INR-US dollar
exchange rate was gathered from historical data section of www.nseindia.com,
www.bseindia.com and

www.onada.com.
CONCLUSION

This research empirically examines the dynamic relationship between the volatility
of stock returns and

movement of Rupee-Dollar exchange rates, in terms of the extent of

interdependency and causality.

Following conclusions can be taken out from the above study:

x There is bidirectional relationship between SENSEX and foreign exchange rate

(INR/$).

x There is bidirectional relationship between Nifty 50 and foreign exchange rate

(INR/$).

x Changes in stock market will affect exchange rate and vice versa.

In this study, we examine the dynamic linkages between the foreign exchange and
stock markets for

India. While the literature suggests the existence of significant interactions between
the two markets, our

empirical results show that generally returns in these two markets are inter-related,
though in recent

years, the return in stock market had causal influence on return in exchange rate
with possibility of mild

influence in reverse direction. These results have opened up some interesting issues
regarding the
exchange rate and stock price causal relationship. In India, though stock market
investment does not

constitute a very significant portion of total household savings compared to other

form of financial

assets, it may have a significant impact on exchange rate movement as FII

investment has played a

dominant role. The results, however, are tentative and there is a need to undertake
an in-depth research to address the issue.

Appendix