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Borsa Istanbul Review 19-1 (2019) 15e23
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Full Length Article

Dynamics of the impact of currency fluctuations on stock markets in India:

Assessing the pricing of exchange rate risks
Smita Mahapatra*, Saumitra N. Bhaduri
Madras School of Economics, Chennai, Tamil Nadu, India
Received 3 March 2017; revised 2 April 2018; accepted 28 April 2018
Available online 21 July 2018

Abstract

This paper studies the dynamics of the impact of currency fluctuation on Indian stock market by assessing the pricing of exchange rate risk
during the period 2005e2016, specifically before and after financial crises. Estimating a two-factor arbitrage pricing model, using a random
coefficient model, the paper presents evidence that stock returns react significantly to foreign exchange rate fluctuations in the post-crisis period.
Particularly, during the last four years of our sample, 2012e2016, the exchange rate risk factor is becoming a prominent determinant of stock
returns, indicating that Indian investors are increasingly expecting a risk premium on their investment for their added exposure to exchange rate
risk. This is also further corroborated by the study by highlighting the fact that higher the foreign exchange exposure of industry, measured by
trade balance (net inflows), higher is their sensitivity to exchange rate risk (bS). A plausible reason for such premium could be the inadequate
hedging by Indian firms to mitigate the exchange rate risk.
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JEL classification: G01; G11; G12; G32

Keywords: Exchange rate risk; Arbitrage pricing theory; Stock returns; Risk premium; Hedging; Financial crisis

1. Introduction decades of which the most obvious example is the Asian

As the global economy is gradually regaining its balance
after the 2007e08 recession and the European financial crisis,
a gradual process of tightening monetary policy by the U.S.
and other large economies has been mounting pressure on the
currencies of some major EMEs (Emerging Market Econo-
mies). This had led to a sell-off in several currencies in early
2014 indicating a potential crisis in these countries that could
destabilize the ongoing global recovery process. Many EMEs
have been hit by currency crises over the past two to three
* Corresponding author. Madras School of Economics, Gandhi Mandapam
Road, Behind Government Data Center, Kottur, Chennai, Tamil Nadu, 600025,
India.
E-mail addresses: mahapatra.smita93@gmail.com (S. Mahapatra),
saumitra@mse.ac.in (S.N. Bhaduri).
_
Peer review under responsibility of Borsa Istanbul Anonim Şirketi.
financial crisis in 1997e1998.
The present study is focused on analyzing the impact of
such exchange rate fluctuations in recent years on the stock
market of one of the important emerging markets, India.
Specifically, the study examines the reaction of investors in
terms of changes in premium demands due to the added
exposure of risks associated with this kind of vulnerability.
For this analysis, the questions addressed are threefold:
First, whether the exchange rate fluctuations impact stock
markets such that it prices the exchange rate risk as a part of
the market premium. Secondly, how the shocks in foreign
exchange market affect this relationship. And finally, if the
currency crisis periods are more vulnerable to such changes in
investor sentiments.
The financial theory argues that in a well-developed
financial market, foreign exchange risk is a part of the un-
systematic risk that can be hedged away. According to the

https://doi.org/10.1016/j.bir.2018.04.004
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2214-8450/Copyright © 2018, Borsa Istanbul Anonim Şirketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND
license (http://creativecommons.org/licenses/by-nc-nd/4.0/).
16
S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23
modern portfolio theory, only risks that cannot be diversified
away (systematic risks) should be priced by the capital market
i.e., shareholders must be paid a premium for bearing such
risks. The exchange rate fluctuations can influence firm per-
formance in two ways: The direct impact could be on net
foreign monetary and real domestic assets of the firm. Indi-
rectly, it may affect aggregate demand, the cost of traded in-
puts, competing imported goods and inflationary expectations.
However, as these foreign exchange risks are perceived as
insignificant or diversifiable through active hedging, these
sources of risks should not be priced and hence should not
impact firms’ cost of capital. However, the more recent
Arbitrage Pricing theory proposed by Ross (1976) suggests
that if the economy can be represented by certain pervasive
factors, then these factors may be priced in the sense that in-
vestors will be willing to pay a premium to avoid these sources
of risk (Jorion, 1991). To date, a number of studies have
investigated the possible sources of exchange rate exposure
but not many have addressed the problem of empirically
measuring whether this exposure commands a risk premium in
the stock markets. The ones that have, are mostly centered
around developed economies.
In a pioneering study, Jorion (1991) examines such risk-
rewards on the US stock markets from the year 1971e1987
using a multi-factor framework of Arbitrage Pricing models.
The relation between expected returns and the sensitivity to
market and exchange rate movements is analyzed using a two-
factor model. The empirical results suggest that the uncondi-
tional risk premium associated with foreign currency exposure
appears to be insignificant and exchange rate risk is not priced
in the U.S. stock markets. On similar lines, the study by Chen,
Roll, and Ross (1986) finds that macroeconomic variables like
industrial production, expected and unexpected inflation, the
spread between long and short interest rates, and the spread
between high and low-grade bonds are sources of risk that are
significantly priced. Whereas market portfolio, oil price risks
and aggregate consumption are not priced in the stock mar-
kets. Sweeney (1986) conducted a comparable study using
interest rate changes (yield on long-term U.S. government
bonds) as the second factor instead of exchange rates. It was
empirically shown that most interest-sensitive stocks were in
the utility industries and there was reasonable evidence that
the interest factor was priced in the sense of APT (two-factor
model). Some studies find significant exchange rate risk using
conditional models. For example, De Santis and Gerard
(1998), using a parsimonious multivariate GARCH process,
have found that a significant fraction of the total risk premium
is generally represented by the premium for bearing currency
risk for four countries: Germany, Japan, the United Kingdom,
and the United States. A similar study by Choi et al., 1998
reports that ‘conditional currency risk’ plays a crucial role in
explaining the stock returns of firms in Japan. Patro, Wald, and
Wu (2002) uses a GARCH framework with a panel approach
and estimates a time-varying two-factor asset pricing model
for weekly equity index returns of 16 OECD countries. Using
the trade-weighted basket of exchange rates and the MSCI
world market index as risk factors, they report significant
_
currency risk exposures in country equity index returns.
Several other studies find significant foreign exchange expo-
sure using unconditional factor models on international data.
For instance, Roll (1992) as one of the three explanatory in-
fluences as per his inferences, documents that exchange rate
fluctuations explain a major portion of the variation in equity
index returns for developed countries. Ferson and Harvey
(1994) empirically examine multifactor asset pricing models
for the returns on eighteen developed markets. The factors
chosen, measure global economic risks and they conclude that
foreign exchange risk is one of the most crucial factors in
explaining international equity index returns.
Since developing countries have a very different institu-
tional framework and economic environment, it is important to
study this aspect of these economies, distinctly. For instance,
within EMs there are commodity exporters (Brazil, South
Africa, Russia) and Commodity Importers (India, China,
Turkey). Emerging markets like India, Brazil, Turkey, etc.
have been attracting enormous amounts of capital from in-
ternational investors over the past decade to give a boost to
their rapidly growing economies. However, unlike large
economies, EMEs are faced with a threat of ‘capital flight’ if
there is any instability detected in the economy by investors.
Further, the impact of global changes is not of the same in-
tensity in all emerging markets. It depends on upon factors like
the liquidity in the market and the access to international
markets. Some investors and analysts are suspicious of a
looming financial crisis in emerging markets while others
argue that the root cause of vulnerability in exchange rates lie
in structural problems in the domestic economies of the EMEs
rather than the effect of external shocks.
At an aggregate level, there are various studies showing a
relationship between exchange rate changes and stock returns.
For instance, Chun Mun (2008) examines the effect of fluc-
tuations in foreign exchange rates on international stock
market volatility and cross-market correlations between the
U.S. stock markets and the appreciating/depreciating local
currencies of the sample countries considered. These include
the Pacific-basin developing countries which depend, to a
great extent on international trade and equity flows through
FDIs for their economic growth. The Asian financial crisis
indicates the period of financial turmoil and fluctuations in
exchange rates. The observations made by the empirical
analysis suggested that fluctuating exchange rates significantly
contribute to a higher local equity market volatility and the
post-crisis contribution of exchange rate imbalance on the
U.S.-local market correlation was higher than what it was
before the crisis. On similar lines, Aquino (2005) investigates
the foreign exchange exposure faced by Philippine firms
around the Asian financial crisis period (1992e2001) and finds
that while stock returns were not impacted by exchange rate
fluctuations before the crisis, there was a significant impact of
the fluctuations in stock returns after the crisis i.e., after 1997.
The analysis was based on the two-factor APT model which is
the basis of the present study as well. The study also finds that
during the post-crisis period, investors started expecting a
premium on their investments for their added exposure to

S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23
exchange rate risk as perceived by them. Another interesting
study by Chkili and Nguyen (2014) investigates the dynamic
relationship between stock market returns and exchange rates
for the BRICS nations between the years 1997 and 2013 using
a regime switching model. The results from the Markov
Switching model applied on the data suggests that stock
markets have more influence on exchange rates during both
low and high volatility periods. Bailey and Chung (1995)
studies the impact of political and exchange rate risks on the
risk premiums reflected in equity returns of individuals from
Mexico and finds some evidence of equity market premiums
for exposure to these risks. Another interesting study by Han,
Xu, and Yin (2017) empirically investigates the impact of
investor attention on the movement of exchange rates for 9
countries. Google Search Volume of key terms such as “Dol-
lar”, “USD” etc. has been used as a proxy for ‘attention’. The
findings highlight that lagged investor attention significantly
influences currency returns although the effect is short term.
The results also demonstrate the reverse analogy that changes
in exchange returns have an impact on investor attention and
that too a long-lasting one.
Overall, these investigations suggest that the risk factors
that are essentially ‘priced’ by investors may vary across space
and time and hence the results and conclusions of these studies
cannot be generalized. The present study aims to fill the gap in
the literature by extending such analyses to the developing
world by focusing on India.
Two major financial crises in the last decade e The Global
Financial crisis (2007e08) and the Eurozone Debt crisis
(2010e11), that shook the world have brought about an
increasing interest among researchers to study about financial
markets with the backdrop of these crisis years and understand
the impact of such structural breaks. Several studies have sug-
gested that during crisis periods, there is an increased co-
movement of markets and a rise in exchange rate volatility
which in turn has significant implications for the risk manage-
ment strategies of international investors. A study along these
lines by P. Dua and Tuteja (2016) examines the financial
contagion and cross-market correlation between the stock and
currency markets of China, Eurozone, India, Japan and the US
during the two global crisis periods mentioned above. The re-
sults show significant contagion across the asset classes and
demonstrate the non-existence of the benefits of portfolio
diversification for stock markets as shocks after crises are
transmitted internationally. These findings make it important for
one to study the impact of any such shock or instability on the
perception of investors about their expectation on risk premiums
and stock returns during such crisis periods. Our sample,
therefore, is justified as it covers these years in particular.
In the light of currency crises and other such events in the
EMEs in the recent past, a country like India which is one of the
fastest growing economies in the world makes for an appropriate
choice for our study. Given the increasing openness of the Indian
economy, Indian companies can be substantially affected by
movements in the value of the currency. A strong evidence of
this relationship and the volatility spillover between the Indian
stock markets and foreign exchange markets has been examined
_
17
by Mishra, Malhotra, and Swain (2007). The results of the study
show that volatility in both markets is highly persistent and
predictable based on past innovations.
India had seen a near currency crisis situation in the year
2013 which was mainly caused due to two reasons. Firstly,
many EMEs including India were caught off guard with their
domestic currencies weakening against the US dollar when the
US Federal Reserve floated the possibility of a taper in May
2013 and tightening of monetary policy. The second reason
being that on the domestic front, the Rupee depreciation sit-
uation as a result of stagnant reforms and declining foreign
investments, was compounded by the government passing the
Food Security Bill in late 2013 as a populist pre-election
strategy. Thus, apart from a structural break due to the
global financial crisis of 2008, it is expected that the period
around 2013 which seems to be a high volatility exchange rate
regime also exhibits a risk that could affect investor sentiments
in India to some extent. The current study empirically shows
that currency risk is increasingly being perceived as a risk that
is priced by investors in the Indian stock markets in the recent
years post the global financial crisis in 2008.
The paper is arranged into four sections, the first of which
introduces the topic, purpose of the study and describes the
theoretical framework in which the analysis has been con-
ducted. Section 2 describes the model and hypothesis tested.
The third section on ‘Sample’ explains the construction of
variables along with their sources. This is followed by a sec-
tion on the ‘Methodology and Empirical Results’ of the
various statistical tests performed, and the final chapter con-
cludes the study with some important inferences.
2. Empirical model
The hypothesis of the study and details of the two-factor
APT model employed have been explained in this section.
We attempt to test the hypothesis that the exchange rate risk is
not priced as a premium by investors during low exchange rate
volatility regimes, however during (near) currency crisis pe-
riods foreign exchange rate risk essentially becomes a risk that
is priced in the stock markets.
The model for the analysis has been adopted from a study
by Jorion (1991) who has followed Ross's approach of Arbi-
trage Pricing Theory (APT).
The two-factor version of Ross (1976) APT implies a linear
relationship between expected returns and the sensitivity to
market and exchange rate movements:


E R~i ¼ d0 þ d1 bmi þ ds bsi ð1Þ
where.
Returns can be defined as nominal returns in excess of the
risk-free rate, Rit ¼ R*it  Rfi ,
bmi : ith stock's sensitivity to market movements and
bsi : ith stock's sensitivity to exchange rate movements.
In this model, the market excess return could be interpreted
as a transformation of the original factors which are not
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S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23
observable anyway. Since the market's sensitivity to exchange
s ¼ 0 by construction, this implies
rate movements bm

 
 
E Ri ¼ d0 þ E R~m  d0 bmi þ ds bsi
~ ð2Þ
Assuming stationarity, the rate of return on an asset at time
t can be statistically decomposed into an expected component
EðR ~ it Þ and an innovation,

 

R~it ¼ E R~it þ bmi R~mt  E R~mt þ bsi F~st þ ~εit ð3Þ
where, F ~st : residual of the regression of the exchange rate
movement against the rate of return on the stock market:


F~st ¼ R~st  g b 1 R~mt
b0 þ g ð4Þ
Given that there will be some correlation between the ex-
change rate and the market, one cannot simply use the ex-
change rate as the second factor. Without orthogonalization,
the second factor could appear to be priced because of a
nonzero correlation with a priced market.
Under rational expectations, substituting (2) in (3) yields:

 
R~it ¼ d0 1  bmi þ ds bsi þ bmi R~mt þ bsi F~st þ ~εit ð5Þ
This is the restricted model to be tested.
Exchange rate exposure orthogonal (statistically indepen-
dent) to the market, is priced if the coefficient ds is non-zero,
which would imply a rejection of the mean-variance efficiency
of the market.
The unrestricted equation is given by
R~it ¼ ai þ bmi R~mt þ bsi F~st þ ~εit ð6Þ
Given the restricted and unrestricted models, the cross-
section restriction is tested by a likelihood ratio test.
3. Data
The study uses secondary data for analysis. The dependent
variable in the test equation (6), ‘R~ it ’ is a series of returns
(excess of risk-free rate) on companies' common stocks. This
data was collected using Prowess which is a database of the
financial performance of Indian companies maintained by
Centre for Monitoring Indian Economy (CMIE). All the
companies listed in the S&P BSE 500 index have been
included in the analysis. The data on the monthly adjusted
closing prices for the period January 2005eJanuary 2016 were
collected for each of these 500 companies and fifteen portfo-
lios (number of companies in each portfolio given in paren-
thesis) were created based on the pre-defined sets given in
Prowess. The average of the company stock prices for each
month was taken as the portfolio averages on which monthly
returns were calculated. The portfolios are:
1. Food & agro-based products (26)
2. Textiles (16)
3. Chemicals and chemical products (78)
4. Consumer goods (21)
5. Construction material (24)
6. Metals and metal products (24)
7. Machinery (31)
8. Transport equipment (26)
_
9. Miscellaneous manufacturing (9)
10. Diversified (11)
11. Mining (6)
12. Electricity (15)
13. Services - other than financial (102)
14. Construction and Real Estate (32)
15. Financial Services (79)
For the variable, R ~ mt which is the market excess returns
series, data on the monthly closing prices were collected from
the official Bombay Stock Exchange (BSE) website. S&P BSE
500 index represents almost 93% of the total market capitali-
zation on BSE. It can be considered as a good proxy for the
market index since the underlying 500 companies cover all the
major industries of the economy and BSE is the oldest stock
exchange in India. The risk-free rate was calculated as the log
of ten-year bond yield monthly rate collected from RBI. The
exchange rate return series (R~ st Þ was calculated from the USD-
1
INR* monthly average currency rates collated from the RBI
website. The exchange rate can be defined as the domestic
currency price of a unit foreign currency. The second inde-
pendent variable used in the test equation is F ~ st , which is the
residual of the regression of the exchange rate movement
against the rate of return on the stock market.
‘Returns’, as the rate of change of each of the above vari-
ables were calculated as the natural log of the ratio of the
prices of one period to its previous period. The benefit of using
returns over prices is in ‘normalization’ (measuring all vari-
ables in a comparable metric) that it provides. If prices are
assumed to be distributed lognormally, then log returns will
follow a normal distribution and that is a major advantage
since most of the classical statistics presume normality.
The timeline for this study is between January 2005 and
January 2016 (Returns data begin from February 2005 since it is
calculated as a ratio of current to the previous time period). The
entire period of study has been divided into three sub-periods
with the purpose of accommodating the possible structural
breaks caused due to the financial crisis or near-crisis situations
that would help us comprehend whether and if so, then in what
way investors reacted to such relative instability (Table 1).
GDP growth rates depicted in Fig. 1, highlights the possible
structural breaks considered.
4. Methodology and Empirical Results
The market excess return series and exchange rate series have
been tested for stationarity using the ADF test. The correlation
between the excess market return series and the exchange rate
series is calculated to be 0.125 which is a reasonable explanation
to justify the use of the residuals of the regression between these
two variables in order to ensure orthogonality. Fig. 2 shows a
basic time series plot of the changes in exchange rate series to
1
It must be noted that using USD-INR as the exchange rate measure reflects
80% of the foreign exchange market in Inda. An alternative measure, INR
NEER which takes 36 currencies into account based on their weights, might
provide a broder base proxy and can be considered for future research.
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S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23 19

Table 1
Explanation of subsample periods.
Sub-period Feb 2005eDec 2007 Jan 2008eDec 2011 Jan 2012eJan 2016
Rationale Pre-crisis period of presumed The global financial crisis A near-crisis situation in FY 2012e13 with
overall economic stability and period with the initial plunge another plunge in GDP growth rate and a volatile
high GDP growth rates. in growth rate followed by gradual recovery. rupee value, followed by gradual recovery.

highlight the fluctuations in this variable in the period consid- Squares Seemingly Unrelated Regression estimation technique
ered. The substantial volatility of the exchange rates in the to simultaneously estimate the betas and pricing parameters.
speculated currency crisis years of 2008 and 2013 can be Due to the advantages that Random coefficient models
inferred on observing the line graph. provide, especially in terms of degrees of freedom and
The exchange rate exposure represented by the variable, F ~st simplified computation, the present study chooses to use this
is calculated first. The parameters, g ^
b 0 and g1 in equation (4) estimation technique. These models are called as random co-
are estimated using Ordinary Least Squares and the F ~st se- efficient models because they assume that the individual spe-
ries is constructed which is used as the second independent cific regression parameters are random, i.e. each represents a
variable in our final test equation (5). draw from a population. All the variants of these type of models
The Hausman test between random and fixed effects sug- are a particular case of the more general class of linear mixed
gested that a random effects model would fit the data better. effects models. Linear mixed effects models can be thought of
However, according to Hsiao and Pesaran (2004), “Conven- as extensions of linear regression models for the cases where
tional models do not allow the interaction of the individual data needs to be summarized in groups. In Swamy's Random
specific and/or time-varying differences in the included Coefficient linear regression model, rather than only the inter-
explanatory variables.” This was the rationale behind using cept varying across groups, all the coefficients are allowed to
Random Coefficient models for estimation with the kind of vary. The ‘xtrc’ function in the software Stata, that uses the
panel data we have. Aquino (2005) uses the Generalized Least Swamy Random Coefficient model (Swamy, 1970) has been
used to estimate the beta coefficients (bm and bs) in the unre-
stricted equation (6) which gives us the market and exchange
GDP Growth (Annual %) rate exposure coefficients for the fifteen industry portfolios. The
12
possibility of a non-linear relationship between stock returns
10 and foreign exchange exposure has been explored by including
% GDP growth rate

8 the quadratic term of exchange rate variable in the regression.

6
Our main findings remain invariant post such robustness test.
Most of the industry portfolios except for few industries such as
4
‘Electricity’, ‘Construction and Real Estate’ and ‘Financial
2 Services’, we do not observe non-linearity.
0 The coefficients across industries seem to be very different
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 in all the time periods. Most of the industries have recorded a
Year
significant negative exposure which might imply that these
industries tend to import a considerable portion of their factor
Fig. 1. Annual Growth Rate of GDP at Market Prices based on Constant
Rupee. Note: Based on official government statistics, the new base year is
inputs and are vulnerable to currency depreciation. On the
2011/12. The report was made using the data from the official website of the other hand, an industry like “Financial Services” shows a
Reserve Bank of India. significant positive exposure for the entire time period of
analysis and the second sub-period chosen. This indicates
export-oriented foreign operations and that the industry tends
Exchange rate fluctuaons to benefit from currency depreciation. A theoretical intuition
0.12 along these lines could be that higher sectoral import intensity
0.1 can influence the impact of exchange rate changes on national
Return on exchange rate

0.08
stock returns. To validate this hypothesis, the exchange rate
0.06
0.04
exposure (bs) for each industry portfolio was plotted against its
0.02 trade balance (Refer Fig. 3 in Annexure). Except for two
0 sectors (Financial services and Misc. manufacturing), it could
Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12

Aug-13

Aug-14
Feb-05

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10

Feb-11

Feb-12

Feb-13

Feb-14

Feb-15

-0.02
-0.04
be observed that industries with higher imports had a ‘sig-
-0.06 nificant’ negative exposure. Future research is needed to
Month
elaborate on this by using alternate measures of international
exposure.
Fig. 2. Exchange Rate Fluctuations (February 2005eJanuary 2016). Note:
Time series line plot of the exchange rate returns series to highlight the Tables 2e5 report the systematic risk and the exchange rate
fluctuations in the period considered. Monthly data on the USD-INR exchange exposure of the industry portfolios. The exposure coefficients
rates were obtained from the official website of Reserve Bank of India. reported, after projection on the market risk factor and the
20 _
S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23

Fig. 3. Exchange rate exposure of Industry portfolios with respect to their Trade Balance. Note: X axis e Trade Balance (Net Inflows) of each Industry portfolio (in
US billion $) for FY 2015e16. Y axis e Estimated Exchange rate exposure coefficient (bsi ) from the equation: R~it ¼ ai þ bm ~ s~
i Rmt þ bi F st þ ~
εit . *The highlighted
industries (shaded red) represent the portfolios that are significant at 5% los. Data Source: Trade data retrieved from ‘India's Foreign Trade 2015e16: An Appraisal’
report prepared by the Economic Division of Credit Analysis and Research (CARE).

exchange rate factor are denoted as bm and bs respectively. A
test of the joint significance was conducted using the Wald test
with the null hypothesis that coefficients are jointly equal to
zero, results of which have been reported below each table.
The null is rejected for the market return but not rejected for
exchange rate exposure when tested for the entire study period
(Feb 2005 to Jan 2016). For the first sub-period (Feb 2005 to
Dec 2007), the null is rejected for both, the market return
series and for exchange rate exposure. The results for the
second sub-period (Jan 2008 to Dec 2011) and the third sub-
period (Jan 2012 to Dec 2016) show that the null hypothesis
is rejected for the market return but not rejected for exchange
rate exposure (at 5% level of significance).
To statistically test the difference in exposure coefficients
across the industry portfolios, the t-statistics for equality of the
coefficients had been performed. The null hypothesis of equal
exchange rate betas is rejected for all the periods except the
first sub-period (Feb 2005 to Dec 2007). This implies that

Table 2
~ mt þ bs F
~ it ¼ ai þ bm R ~
Market and exchange rate exposure of industry portfolios. February 2005eJanuary 2016 (monthly data). Model: R i i st þ ~
εit .
S.No. Industry bm
i bsi
Coeff z-stat p-value Coeff z-stat p-value
1 Mining 1.0934 17.66 0.000 0.2889a 2.41 0.016
2 Food and Processing 0.8000 20.89 0.000 0.0709 0.67 0.506
3 Textiles 0.9743 18.12 0.000 0.1217 1.05 0.292
4 Chemical 0.8178 25.73 0.000 0.1503 1.50 0.135
5 Consumer 0.7433 16.01 0.000 0.1838 1.65 0.100
6 Construction material 0.9856 19.21 0.000 0.1765 1.54 0.122
7 Metal and metal products 1.0599 27.04 0.000 0.3879a 3.62 0.000
8 Machinery 1.0554 24.62 0.000 0.3633a 3.31 0.001
9 Transport Equipment 0.9676 21.12 0.000 0.1070 0.96 0.336
10 Misc. manufacturing 0.9097 18.04 0.000 0.1384 1.22 0.224
11 Diversified 1.0677 24.04 0.000 0.3469a 3.14 0.002
12 Electricity 1.3849 16.73 0.000 0.6579a 4.89 0.000
13 Construction and real estate 1.3747 24.95 0.000 0.6739a 5.80 0.000
14 Financial Services 0.6571 24.57 0.000 0.2588a 2.77 0.006
15 Services (other than financial) 0.9594 26.34 0.000 0.0348 0.33 0.741
Test for joint significance: chi2(1) ¼ 292.56 chi2(1) ¼ 3.18.
Prob > chi2 ¼ 0.0000 Prob > chi2 ¼ 0.0747.
a
Significance at 5% level. All coefficients are significant for the market coefficient, bim and are hence not marked for significance specifically.
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S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23 21

Table 3
~ mt þ bs F
~ it ¼ ai þ bm R ~
Market and exchange rate exposure of industry portfolios. February 2005eDecember 2007 (monthly data). Model: R i i st þ ~
εit .
S.No. Industry bm
i bsi
Coefficient z-stat p-value Coefficient z-stat p-value
1 Mining 1.1758 8.16 0.000 0.4366a 2.34 0.020
2 Food and Processing 0.8832 11.64 0.000 0.2902 1.42 0.155
3 Textiles 1.0924 11.01 0.000 0.3262 1.64 0.101
4 Chemical 0.8810 12.06 0.000 0.1248 0.61 0.544
5 Consumer 0.6929 6.36 0.000 0.1314 0.67 0.503
6 Construction material 1.0631 9.08 0.000 0.3536 1.83 0.068
7 Metal and metal products 1.0786 14.32 0.000 0.6704a 3.29 0.001
8 Machinery 0.9204 9.04 0.000 0.3192 1.61 0.107
9 Transport Equipment 1.0684 11.12 0.000 0.4122a 2.06 0.039
10 Misc. manufacturing 0.8371 8.91 0.000 0.2648 1.32 0.187
11 Diversified 1.1567 13.71 0.000 0.4386a 2.16 0.031
12 Electricity 1.3447 8.54 0.000 0.5096a 2.79 0.005
13 Construction and real estate 1.2532 10.38 0.000 0.5035a 2.62 0.009
14 Financial Services 0.5672 11.61 0.000 0.1184 0.63 0.531
15 Services (other than financial) 0.9005 9.58 0.000 0.3264 1.63 0.104
Test for joint significance: chi2(1) ¼ 153.27 chi2(1) ¼ 4.44.
Prob > chi2 ¼ 0.0000 Prob > chi2 ¼ 0.0352.
a
Significance at 5% level. All coefficients are significant for the market coefficient, bim and are hence not marked for significance specifically.

Table 4
~ mt þ bs F
~ it ¼ ai þ bm R ~
Market and exchange rate exposure of industry portfolios. January 2008eJanuary 2012 (monthly data). Model: R i i st þ ~
εit .
S.No. Industry bm
i bsi
Coefficient z-stat p-value Coefficient z-stat p-value
1 Mining 1.0811 16.87 0.000 0.3519 1.81 0.071
2 Food and Processing 0.7964 17.08 0.000 0.1081 0.62 0.533
3 Textiles 0.9914 0.69 0.000 0.2591 1.3 0.194
4 Chemical 0.8494 23.68 0.000 0.0906 0.60 0.549
5 Consumer 0.8009 15.04 0.000 0.2729 1.49 0.135
6 Construction material 0.9024 15.59 0.000 0.0239 0.13 0.899
7 Metal and metal products 1.1139 23.61 0.000 0.5337a 3.07 0.002
8 Machinery 1.0673 22.12 0.000 0.4232a 2.41 0.016
9 Transport Equipment 0.9266 17.80 0.000 0.0215 0.12 0.906
10 Misc. manufacturing 0.9938 14.07 0.000 0.3640 1.81 0.070
11 Diversified 1.0776 20.67 0.000 0.6169a 3.40 0.001
12 Electricity 1.3022 15.70 0.000 0.7721a 3.62 0.000
13 Construction and real estate 1.3676 20.04 0.000 0.8220a 4.13 0.000
14 Financial Services 0.6937 16.60 0.000 0.4586a 2.79 0.005
15 Services (other than financial) 1.0255 24.22 0.000 0.0926 0.56 0.576
Test for joint significance: chi2(1) ¼ 336.17 chi2(1) ¼ 2.32.
Prob > chi2 ¼ 0.0000 Prob > chi2 ¼ 0.1274.
a
Significance at 5% level. All coefficients are significant for the market coefficient, bim and are hence not marked for significance specifically.

relative stability of exchange rates is a feature of the first sub-
period while the others show variability in sensitivity to ex-
change rate fluctuations. The instability reported in the post-
crisis periods and the entire period indicates the importance
of the present study. It is evident that market exposure is
significant as the null of equal market betas is strongly rejected
in all the time periods considered. We thus focus on the pricing
of the exchange rate factor since a difference has been
observed in the time periods under consideration. Overall, it
can be said that sorting by industries generates a substantial
dispersion in exposure coefficients, which is an important pre-
requisite for pricing tests.
The final test equation (5) has been estimated by regres-
sion after plugging in the beta coefficient values obtained
from the previous estimation results of equation (6). The
restricted equation to be tested is a linear form equation with
four parameters d0, ds, bm s
i and bi . The beta coefficients
within the restriction, represented in square brackets in
equation (5) are treated as dependent variables. The values
for d0 and ds along with their statistics and p-values are re-
ported in Table 6.
The null hypothesis that the constant risk premium coeffi-
cient, representing the pricing of exchange rate exposure,
d0 ¼ 0 is rejected for all the periods considered. This implies
that the model in use accounts for the total differential in
excess returns across the different time periods.
The null hypothesis that ds ¼ 0 is rejected (at 5% signifi-
cance level) for the whole period (2005e2016) and for the
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S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23

Table 5
~ mt þ bs F
~ it ¼ ai þ bm R ~
Market and exchange rate exposure of industry portfolios. January 2012eJanuary 2016 (monthly data). Model: R i i st þ ~
εit .
S.No. Industry bm
i bsi
Coefficient z-stat p-value Coefficient z-stat p-value
1 Mining 0.9119 10.77 0.000 0.1476 1.17 0.241
2 Food and Processing 0.8193 9.22 0.000 0.0244 0.19 0.847
3 Textiles 0.8117 7.88 0.000 0.0168 0.13 0.896
4 Chemical 0.7086 9.99 0.000 0.0948 0.76 0.445
5 Consumer 0.7244 8.19 0.000 0.0292 0.23 0.817
6 Construction material 1.1812 12.34 0.000 0.2922a ¡2.29 0.022
7 Metal and metal products 0.8285 9.58 0.000 0.1451 1.15 0.250
8 Machinery 1.1805 13.75 0.000 0.2891a ¡2.29 0.022
9 Transport Equipment 0.9979 10.09 0.000 0.1337 1.05 0.296
10 Misc. manufacturing 0.7987 9.66 0.000 0.0634 0.50 0.614
11 Diversified 0.9366 9.25 0.000 0.0702 0.55 0.584
12 Electricity 1.3149 12.21 0.000 0.3651a ¡2.82 0.005
13 Construction and real estate 1.3437 17.40 0.000 0.4177a ¡3.34 0.001
14 Financial Services 0.7337 16.94 0.000 0.0529 0.49 0.627
15 Services (other than financial) 0.8193 13.06 0.000 0.0779 0.64 0.523
Test for joint significance: chi2(1) ¼ 185.96 chi2(1) ¼ 1.17.
Prob > chi2 ¼ 0.0000 Prob > chi2 ¼ 0.2784.
a
Significance at 5% level. All coefficients are significant for the market coefficient, bim and are hence not marked for significance specifically.

Table 6
~ mt þ bs F
~ it ¼ ½d0 ð1  bm Þ þ ds bs  þ bm R ~
Tests of Pricing of Exchange Rate Exposure. (Monthly data). Two Factor Model: R i i i i st þ ~
εit .
Factor Prices (t-statistics) [P>jtj] Test of Fit [p-value]
Period d0 ds c2
Feb 2005eJan 2016 0.0258696 a
0.0144305 a
0.95
(2.49) [0.013] (2.29) [0.022] [0.3302]
Feb 2005eDec 2007 0.0568258a 0.0025197 14.12
(-3.54) [0.000] (0.27) [0.787] [0.0002]
Jan 2008eDec 2012 0.0860055a 0.0143851 24.38
(4.12) [0.000] (1.67) [0.096]b [0.0000]
Jan 2012eJan 2016 0.0239179a 0.0213261a 7.23
(2.58) [0.010] (-2.05) [0.040] [1.0000]
Note: t-statistics between parentheses, marginal significance levels between brackets. d0 and ds are the pricing coefficients in the test equation. The chi-square
statistic tests the cross-sectional restrictions in the two-factor model.
a
Significant at the 5% level.
b
Significant at the 10% level.

latest sub-period (2012e2016). It is rejected (at 10% loss) for
the second sub-period i.e. between 2008 and 2012. The null is
not rejected for the first sub-period before any crisis which
shows that exchange rate risk was not priced in this period of
stability.
The chi-square goodness of fit statistic is computed using
the restricted and unrestricted models and reported in the last
column of Table 6. The likelihood ratio statistics for the entire
period and the most recent subperiod (2012e2016) suggest
that the model is reasonably well specified and seems to fit the
data in the periods in which the pricing coefficients are
significant.
The observations indicate that the results for the pricing
coefficients are significant for the periods considered post-
2008 which suggest that after the onset of the global finan-
cial crisis, there was a slight change in the perception of in-
vestors. In the last four years (2012e2016) however, the
exchange rate risk factor is becoming prominent as being
‘priced’ in the stock market. This essentially means that in-
vestors are progressively expecting a risk premium on
investments for their perceived added exposure to exchange
rate risk and it has become more prominent in the recent years.
5. Conclusion
The impact of foreign exchange fluctuations on stock
returns is increasingly becoming a prominent issue to in-
vestors, financiers and policymakers. The paper examines the
exposure of fifteen Indian industry groups (comprising the 500
firms listed in the S&P BSE 500 index) to the monthly USD-
INR exchange rate fluctuations for different time periods with
the overall period being eleven years from February 2005 to
January 2016. The analysis is done in the two-factor APT
framework.
Our choice of sample period also allows examining the
effect of exchange rates on stock markets and the overall
investor sentiment in India in the last decade which has not
been explored so far, in best of our knowledge. This is an
important aspect of the currency crisis that is seen imminent in
the forthcoming years and is affecting the investor
 _
S. Mahapatra, S.N. Bhaduri / Borsa Istanbul Review 19-1 (2019) 15e23
communities in EMEs gradually. Thus, it is expected that the
more recent the period under study, the greater the chances are
of capturing the change in investor sentiments. For a country
like India, that is going through a transitional phase in its
economy with its present government pushing for greater
foreign investments for boosting the country's industrial and
infrastructural growth, it is necessary to pay attention to how
the investors and the stock markets will react to these changes.
Empirical evidence suggests that investors are expectant of a
risk premium on their investment owing to the increased risk
exposure caused by exchange rate fluctuations, especially since
the last few years beginning from the crisis period. This implies
inadequate hedging by firms for the exchange rate risk and in the
larger macroeconomic sense, it displays market inefficiencies in
the stock market and/or foreign exchange market.
The study has qualitatively inferred from the results ob-
tained, that Indian investors now require compensation for
bearing exchange rate risk. However, the quantitative aspects
such as the difference between the risk premiums demanded
by investors in the various time periods are beyond the scope
of the present paper and are left for future research.
Conflict of interest
None.
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