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the effect of exchange rate on interest rate and stock returns

Introduction:

Interest rate can be defined as The rate which is paid by the borrowers for the use of money
which they have lend from the lender for a certain period of time or interest rate is the rate
which being charged by the lender or paid by the borrower for the use of money or in simple
words interest rate is the cost of the borrowed money. Interest rate targets are an important
tool of any countrys monetary policy. When dealing with variables like investment,
unemployment and inflation, interests rate targets are taken into account. In any country the
interest rate is controlled by Central Bank.

Exchange rate is the rate between two countrys currencies; it is the rate at which one countrys
currency will exchange for another country currency. Exchange rate can also be defined as the
value of one country currency in terms of another country currency or in simple words it can be
define as the conversion of one country currency into another country currency. Exchange rate
is also known as foreign exchange rate or the currency exchange rate. There are various factors
that influence the exchange rate; some of these factors are interest rate, inflation and policies
of the state and the economy in each country. Exchange rate plays a significant role in every
countrys economy. Any abrupt change in the exchange rate can affect the countrys imports
and exports.

Exchange rate and interest rate has an important role in the economy. These two variables i-e
interest rate and exchange rate are the significant macro economic variables of the economy.
Both of these variables play a vital role in the economy and their importance cannot be ignored
by the businessmen, corporations and invertors.

Exchange rate and interest rate cannot be controlled because these variables can change
rapidly. Due to this rapid change in the interest rate and the exchange rate, the stock market
observes high fluctuations in the prices of the stocks

It is analyzed in this paper that both of these macroeconomic variables, interest rate and
exchange rate has an effect on the prices of the stocks. The exchange rate has a positive
relationship with the prices of the stocks; while on the other hand, interest rate has a negative
but insignificant relationship with the prices of the stocks

Hypothesis:
Ho= Exchange rate and interest rate has no impact on the stock returns
H1= Exchange rate and interest rate has an impact on the stock returns

Research Objectives:


Scope of the Study:



Limitations:


Scheme of the Study:
The research consist of the following Chapters
Chapter 1: Introduction
Chapter 2: Literature review
Chapter 3: Methodology
Chapter 4: Analysis
Chapter 5: Conclusion
Chapter 6: Reference















LITERATURE REVIEW:
Exchange rate and interest rate plays a significant role in every countrys economy. These two
variables are the Major macro economic variables of every economy. As these two variables
plays a significant role in the stock returns, so many researchers have studied the effect of
interest rate and exchange rate on the returns of the stocks.
Different macroeconomic variables like GDP, interest rate, exchange rate, money supply and
current account has a significant role in the market capitalization of the stocks (Kurithara,
2006).
Franck and Young (1972) are among the first researchers who studied the relationship between
exchange rate and the stock returns. In their study they used exchange rates of six different
countries and they found no relationship between these two financial variables.
Solnik (1987) in his study used various variables such as exchange rate, interest rate and
changes in inflationary expectation, and studied the impact of these variables on the prices of
the stocks. In his study he used monthly data of nine different western markets (U.S., Japan,
Germany, U.K., France, Canada, Netherlands, Switzerland and Belgium) and found that
exchange rate have a positive but insignificant influence on stocks market as compared to the
other two variables i-e interest rate and the change in the inflationary expectations.

Raoof (2010), studied the effect of exchange rate on Pakistani stock exchange. Exchange rate is
an important macroeconomic factor of any countrys economy. He used the data of exchange
rate and stock returns from Karachi stock exchange 100 index from year 1998 to 2009. He used
a simple multiple regression model to study the dependency of exchange rate on stock returns.
The results showed that due to the variations in the exchange rate there was a significant
influence of exchange rate on the stock returns.
Olongunde (2006) conducted a research in Nigeria and he stated that: The interest rate has an
affirmative influence on the market Capitalization of the stocks. He used ordinary least square
regression model (OLS) for his research findings.
Doong (2005) conducted a research on 6 Asian countries i-e Thailand, Malaysia, South Korea,
Taiwan, Indonesia and Philippines. He studied the relationship between exchange rate and
equity returns, and he found that there is a negative relation between equity return and
exchange rate. Further he found in his study that variables, exchange rate and stock prices
correlated with each other, while applying Granger causality test in their research. They also
found that among six selected countries, in four countries (Indonesia, Thailand, Korea and
Malaysia) there was a negative significant relationship between exchange rate and the stock
returns, excluding the other two countries i-e Taiwan and Philippines.
Kaul (1990) showed in his study that estimated inflation is negatively interlinked with real
economic activities, and on the other hand it has a positive relationship with the stock market
returns. To find this relations ship Kaul used the Fama Proxy Hypothesis (1981) in his study.
Hsing (2004) conducted a study to find the relationship between interest rate and prices of the
stock and he concluded that there is an inverse relationship between prices of the stock and
interest rate. In his study Hsing used Vector Auto Regression Model (VAR) to find the relation
between prices of the stock and interest rate. For his study he used variables like real interest
rate, exchange rate and the stock market index.
Further, Arango (2002) in his studies concluded that there is an inverse relationship between
prices of the shares and the interest rate. He conducted this study in Colombia and for this
purpose he collected his data from Bogota stock market, Colombia. He also measured the effect
of monetary policy on interbank borrowing interest rate and concluded that the monetary
policy does have an effect on the interbank borrowing interest rate.
Zhou (1996) conducted a study and he found that the long term interest rate affects the
dividend ratio. Furthermore he also found in his study that the variation of the long term yield
of the bond was highly correlated with the stock market. A simple regression model was used
by Zhou in his study to find out the relationship between the prices of the stock and the rate of
interest.
According to Aydemir (2009) there is an inverse relationship between exchange rate and the
stock market indices. Further in his studies he also found that there was a negative relationship
between exchange and national hundred services and industrial indices, and later in his studies
he also found that there was also a negative relationship between exchange rate and the stock
market indices. The data used in this study was taken from 2001 to 2008.
M and Ghazi (2009) conducted a study to find out the relationship between exchange rate and
interest rate. To find out this relationship they took the sample of fifteen countries including
Chile, Australia, Bangladesh, Germany, Colombo, Canada, Italy, Japan, Jamaica, Malaysia,
Mexico, Philippines, South Africa, Spain and Venezuela. The data was collected from these
countries was from 1998 to 2003 on monthly basis. Among fifteen countries, in only six
countries they found that there was a negative relationship between the stock returns and the
interest rate. Further in their study the researchers suggested that by controlling the interest
rate, the stock exchange could get high benefits.
Another study was conducted by Irndoust and Hatemi (2002) in Sweden for finding out the
relationship between the stock prices and the exchange rate, and they found in their study that
the exchange rate and stock prices moves in one direction. For the purpose of this study the
researcher collected the data of the stock prices from 1993 to 1998. Granger Model was used
by the researchers for the analysis of the data.
Charles (2008) conducted a research in Ghana to check the effect of barter rate on equity
market. In his research used various variables like foreign exchange rate, inflation treasury bills
rate, and money supply and trade deficit as an independent variables. The model which was
used in the research was Exponential Generalized Autoregressive Conditional Hetroskedasticity
(EGARCH). The model showed that there exist a positive relationship between consumer price
index and the stock market. Further in his research he found that whenever there is an increase
in the inflation rate then volatility in the prices of the stock also increases. Later in the research
he concluded that there is a significant relationship between the macroeconomic variable and
the returns of the stocks.
Banerjee and Adhikary (2008) conducted a study in Bangladesh. The model which was applied
in this study was Vector Error Correction Model (VECM), and twenty three years data was on
monthly basis i-e from 1993 to 2006. By analyzing the results of the study the researchers
concluded that there is a cause and effect relationship which exists between interest rate,
exchange rate and equity market on the long term basis and there is no relationship that exists
between these variables (interest rate, exchange rate and equity market) on the short term
basis.
Another study was conducted by Rashee and Muhammad (2002) with the aim to find the long
run and short run relationship between the exchange rate and the stock prices. The study was
conducted in four south Asian countries i-e India, Pakistan, Srilanka and Bangladesh. The data
collected regarding these countries was from 1994 to 2000. In order to find the relationship
between the exchange rate and the stock prices, Granger Causality Model was used in the
study. Further in the study the results indicated that in Bangladesh and Srilanka there was an
inverse relationship that existed between the stock prices and exchange rate. While in Pakistan
and India there was no relationship between stock prices and exchange rate on the long term
basis.
Prices of the stocks are usually interpreted as the present value of the future cash flows of the
firm; respond to exchange rate changes and from the link among future income, interest rate
and current investment and consumption choices. Innovation in the stock market on the other
hand affects total demand via wealth and liquidity, thereby affecting money requirement and
rate of exchange (Gavin, 1989).
Frank and Young (1972) have also made an attempt in their study to determine a link between
stock prices and the exchange rate. In their study they used the data of six countries exchange
rates, but when they analyzed their results, they found that there was no relationship between
these two financial variables.
Solnek (1987) conducted a study in nine European countries including Belgium, France, Canada,
United Kingdom, United States, Germany, Switzerland, Japan and Netherland. He wanted to
analyze the impact of variables like exchange rate, change in inflationary prospects and interest
rate on the stock prices. When Slonek analyzed the data from these countries so he found
positive but insignificant influence on the United States stock market compared to change in
inflationary expectations and interest rate.
Sonen and Hnniger (1988) conducted their own research to analyze the relationship between
the exchange rate and the prices of the stocks. For finding out this relationship the used the
data of stock prices and effective exchange rate. The data was used from 1980 to 1986 on
monthly basis. When they analyzed the data they found a negative relation between value of
the U.S Dollar and change in the prices of the stocks.
Aggarwal (1981) conducted a research to analyze the relationship between value of the U.S
Dollar and the prices of the stocks and they noticed that prices of the stocks and the value of
the U.S Dollars were absolutely related and this relationship was stronger in the short run
rather than in the long run. The results of his research were based on a relationship between
the changes in the prices of the stocks and the value of the U.S Dollars. To find the relationship
between the value of the U.S Dollars and the prices of the stocks, the researcher used the data
of effective exchange rate and U.S stock price data for the period of 1974 to 1979 on the
monthly basis.
Mohsin and Amare (2000) also worked on finding out the relationship between the prices of
the stock and the exchange rate. The results of the study showed that there was a very week
relationship between equity market and exchange rate. To find out this relationship the
researcher used a method called Non Liner Least Square Method. From the results of the study
the researchers concluded that depreciation in the countrys currency causes its market shares
to increase, while an appreciation in the countrys currency would cause its market share to
decrease. To analyze this relationship the researchers included the data of nine Asian countries
naming Hong Kong, Taiwan, Singapore, Malaysia, Japan, Thailand, Korea, Indonesia and
Philippines. They included the data of these countries for the period of January 1980 to June
1998, and this data was used on the monthly basis.
Mohd Thas Thaker, Rohilina, Hassama and Amin (2010) conducted a research in Malaysia with
the aim to find a relationship of stock prices with various macroeconomic variables like
exchange rate, Money supply and inflation. To find this relationship they collect the data of
stock prices from the Kuala Lumpur composite index (KLCI). They collected the data in two
intervals, in first interval they collected the data before the economic crisis i-e from 1987 to
1995 and in the second interval they collected the nine year data after the economic crises i-e
from 1999 to 2007. The data was collected on the monthly basis. The researchers used
consumer price index (CPI) as an alternate to the inflation, the exchange rate of US Dollar was
used and the internal currency was used for the supply of money. The various tests and models
that were used by the researchers to analyze the data were Co integration Test, Unit Root Test,
Error Correction Model, Granger Causality Test, Impulse Response Test, and the Variance
Decomposition Test. From these the researchers concluded that there was a positive
relationship between the consumer price index (CPI) or inflation and the prices of the stocks on
the long term basis, while there was a negative relationship between stocks index and the
supply of the money.
Another research was conducted by Pilinkus (2009) in a Europen country called The Republic of
Lithuania. Form his research he concluded that some of the macroeconomic variables were
working as the leading indicator for the stocks price index, while for some variables the stocks
price index was working as the leading indicator. For this research the researcher collected the
data of the stock prices from the Lithuanian stock exchange. Further more in his study the
researcher also found that there was a strong relationship between the stock market returns
and macroeconomic variables in The Republic of Lithuania.
Kutty (2010) conducted a research in Mexico in order to examine the relationship between
exchange rate and the prices of the stock. The tests that were used by the researchers to find
the relationship between stock prices and exchange rate are the unit test and Co integration
test, while Granger Causality Test was only done to find the relationship among these variables
(stock prices & exchange rate) on the short term basis. For this research the data was collected
from the Dow Jones for the period of 1989 to 2006 on weekly basis. The Data of the
international monetary market was used for the US dollar. When the models were applied and
the data was analyzed the results indicated that there was a short term relationship, and there
was no long term relationship between the variables. Further analysis of the data indicated that
the prices of the stock were influenced by the exchange rate.
Another study was conducted by Manish Kumar (2008) with an attempt to find the relationship
between exchange rate and the prices of the stock. Unit Root Test and Co Integration tests
were applied by the researcher to find run relationship between the exchange rate and the
prices of the stocks, while and Non Linear Granger Causality Test were conducted by the
research to find the dynamic relationship between the stock prices and the exchange rate. For
this study the data was collected from the S&P CNX Nifty and the US Dollar exchange rate was
used on daily basis. Ten year data was used i-e from the period of 1999 to 2009. When the data
was analyzed so the results indicated that there was no long run relationship between the stock
prices and the interest rate, while the further analysis of the results indicated that there was
non liners Granger causality between the exchange rate and the prices of the stock.