International Journal of Statistics and Systems

ISSN 0973-2675 Volume 12, Number 1 (2017), pp. 167-174

© Research India Publications
http://www.ripublication.com

Cointegration and Causality among Stock Prices, Oil

Prices and Exchange Rate: Evidence from India

Dr. Nishi Sharma

Associate Professor, UIAMS

Punjab University, Chandigarh-160014, India.

Abstract

The paper examines the relationship among oil prices, stock prices and
exchange rate in Indian market. The results evidenced that data is stationary at
first difference order. Johansen co-integration suggests the possibility of at
most one co-integrating equation. It indicates investors cannot benefit from
arbitrage activities in the long run through diversifing the portfoio in these
markets. Granger causality and Wald statistics evidenced the absence of
Granger causality between Oil prices and Stock Prices as well as between
Exchange Rate and Oil Prices. Unidirectional causality flowing from Stock
Price to exchange rate was noticed but not vice versa. Since stock prices
Granger cause the exchange rate, participants in the foreign exchange market
can use information of stock prices to improve the forecast of exchange rates.

Keywords: Causality, Co-integration Exchange Rate, Oil Price and Stock

Price.

INTRODUCTION
Evolution of innovative sources of finance and gradual abolishment of capital inflow
barrier has proven to be promising to create a healthy environment for the growth of
capital market. Stock market absorbs all national as well as international innovations
very quickly and reflects them in the form of market swings. Since foreign exchange
rate plays a pivotal in the investment decision-making process, any change in
exchange rate also has significant implications for the stock market. Variation in
exchange rate influences the inflow and outflow of foreign investment that in turn
causes swings in stock market. Some researchers observed that change in the stock
price also affects exchange rate. The reason is that a rise in domestic stock prices
168 Dr. Nishi Sharma

leads to appreciation of the domestic currency and it turn affects the exchange rate.
Similarly shock in the oil price suggests a gradual transmission with the equity
market. Recent trend indicating linkage between oil prices and stock prices have
reignited research interest to explore any possible impact of oil price shocks over
stock market returns or vice versa. The effectiveness of innovations transmission from
one market to another market is required to be understood to ascertain whether there
is any possibility of risk minimization through portfolio diversification is unattainable
by holding assets in different markets or the integration of the market doesn’t permit
to enjoy the benefits of diversification. During recent few years there has been a great
turbulence in Indian stock market.
The changing conditions of practical world motivate the researchers to probe the
dynamic linkage of stock prices with different variables. In this context the present
paper investigates the lead-lag interaction and long-term relationship among stock
prices, stock prices and exchange rate in Indian market for the period.

LITERATURE REVIEW
The studies examining the impact of different micro and macro economic factors are
flocking the literature. Papapetrou (2001) analysed the daily stock prices of Greece
market to trace any evidence of impact of oil prices over equity market. The study
applied vector error correction and variance decomposition method. The findings of
the study revealed that the impact of negative oil prices on stock returns was extended
over four months. Bhattacharya and Mukherjee (2003) noted no significant
relationship between exchange rates and stock prices in Indian markets. Anoru and
Mustafa (2007) studied the relationship of oil market and stock market of US through
Johansen Bivariate Cointegration, Gregory-Hansen cointegration tests and error-
correction approach. Vector-error-correction Model (VECM) provided evidence of
causality from stock market returns to oil market and not vice versa. Gregory-Hansen
cointegration tests noticed that oil and stock markets are cointegrated.
Miller and Ratti (2009) also investigated the long-run relationship between oil prices
and stock market returns. The results reported a long-run relationship between the
variables. The stock market responded negatively to the increase in oil price in the
long-term. The effects of oil prices on stock prices in developed countries has been
examined by Ciner (2001), Yang and Bessler (2004), El Sharif et al (2005),
McSweeney and Worthington (2007), and Miller and Ratti (2009). Narayan and
Narayan (2010) examined the relationship between oil prices and Vietnam’s stock
prices with daily series from 2000 to 2008. The study found oil prices and exchange
rates have a positive and statistically significant effect on Vietnam’s stock prices in
the long-run and not in the short-run.
In context to stock prices and exchange rate Wu (2000) analysed the stock prices and
exchange rates of Singapore. The results revealed a unidirectional causality from
exchange rates to stock prices. Mansor (2000) investigated Malaysian markets. The
findings indicated short-run causal relationship from stock prices to exchange rates
but no long-term relation was observed between the two variables. Nieh and Lee
Cointegration and Causality among Stock Prices, Oil Prices and Exchange Rate 169

(2001) also reported no long run significant relationship between stock prices and
exchange rates in G-7 countries. The empirical analysis of four South Asian countries
namely Bangladesh, India, Pakistan and Sri-Lanka by Muhammad and Rasheed
(2003) portrayed no significant relationship between the variables for Pakistan and
India (neither in short-run nor in long-run). However the results indicated a
bidirectional relationship in case of Bangladesh and Sri-Lanka.
Dimitrova (2005) reported no existence of causality between exchange rates and
stock prices for UK and US for the period 1990-2004. Similarly Ozair (2006) also
couldn’t trace any evidence of causal linkage or Co-integration between exchange rate
and US stock market. The study of monthly data of Turkey from 1986 to 2006 proved
bidirectional causality between stock returns and exchange rates Sevuktekin and
Nargelecekenler (2007). Pekkaya and Bayramoglu (2008) also reported bidirectional
causality between exchange rate and stock prices of Istanbul Stock Index and S&P
500 in Turkey. Rjoub (2012) also reported Granger causality reflected the
bidirectional relationships between exchange rate and stock prices. Impulse response
results indicated the temporary nature of shocks. Exchange rate and Nigerian stock
market prices reflected bi-directional Granger causality (Umoru and Asekome 2013).
Sharma (2015) investigated the causal relationship of Indian sector with Exchange
Rates for a period of around 8 years from January 2007 to March 2015. Granger
Causality test highlighted bidirectional causal relationship between the exchange rate
and stock return for each sector except for Pharmaceutical sector and Media sector.

RESEARCH METHODOLOGY
The present study attempts to investigate the long term and short tem relationship
among stock prices, oil prices and exchange rate. BSE S&P Sensex has been taken as
a proxy of Indian stock market. Daily data has been collected for a period spanning
from 2011-16 to avoid the possible intervention of global financial crisis. The
logarithm value of all selected variables have been computed and examined for the
possible unit root in the series. Augmented Dickey Fuller test and Phillips Perron Unit
Root test have been conducted to examine the null hypothesis that ‘There is unit root
in the series. In other words, the data is not stationary in nature’.
As all the selected series found to be integrated of order one, Johansen Co-integration
test has been employed to check the possibility of long term relationship among the
variable. On the basis of two statistics viz., trace test statistics and maximum Eigen
value test statistics the test accept / reject following null hypotheses for both of the
tests are as follows:
 Null Hypothesis (Trace test): Number of distinct co integrating vector(s) is
less than or equal to number of co integration relations.
 Null Hypothesis (Maximum Eigen value): There is exactly ‘r’ number of co
integrating relations against the alternative of r + 1 co integrating relations.
170 Dr. Nishi Sharma

The Short-term relationship has been examined through Granger causality and was
confirmed by Block Exogeneity Wald Statistics. The test is helpful in ascertaining
whether one time series is useful in forecasting another or not.

FINDING AND ANALYSIS:

The descriptive statistics has been depicted through table 1. The results indicates that
all series have less than 3 kurtosis measure and non-zero skewness level. It indicates
the non-normality of the series. The same can be confirmed through Jarque Berra test.
The test statistics rejects the possibility of normality of data and the present data may
be assumed to be non-normal in nature.
Table 1: Descriptive Statistics
Particulars Stock Price Oil Price Exchange Rate
Standard Deviation 0.186082 0.322570 5.602381
Skewness -0.302098 -0.449436 0.527710
Kurtosis 1.625784 1.965524 2.346455
Jarque-Bera 115.9625 96.64450 79.29906
Probability 0.000000 0.000000 0.000000
Source: Author’s Calculation
Thereafter, it has been tested that whether data is stationary in nature or not. The data
is assumed to be stationary if it does not have unit root. To check the possibility of
unit root Augmented Dickey Fuller test has been conducted and the results have been
confirmed through Phillips Perron Unit Root Test (table 2). The test presumes the null
hypothesis of absence of any unit root in the data.
Table 2: Unit Root Test Statistics
Variable Test Original Level First Difference
Statistics Probability Statistics Probability
Stock Price ADF -1.73 0.418 -32.98 0.000
PP -1.72 0.418 -32.91 0.000
Oil Price ADF -1.14 0.700 -1.15 0.000
PP -1.15 0.698 -35.52 0.000
Exchange Rate ADF -1.75 0.407 -26.96 0.000
PP -1.71 0.4261 -35.61 0.000
Source: Author’s Calculation
The comparison of test statistics of all three variables demonstrates that we can’t
reject the null hypothesis and may presume that data is not stationary at level. To
remove the unit root, first difference of all series has been taken and both of the tests
have been conducted again. The results evidence that null hypothesis cannot be
accepted i.e. now the data has become stationary. Since all data series are integrated at
Cointegration and Causality among Stock Prices, Oil Prices and Exchange Rate 171

first level there is a possibility of co-integration among the variables. Johansen Co-
integration Test has been conducted to check out possible long term relation among
variables (table 3).
Table 3: Johansen Co-integration Test
Hypothesized Eigen Unrestricted Co-integration Rank Unrestricted Cointegration Rank
No. of CE(s) Value Test (Trace) Test (Maximum Eigenvalue)

Trace 0.05 Prob.** Max. 0.05 Prob.**

Statistic Critical Eigen Critical
Value Statistics Value

None 0.009927 22.92508 29.79707 0.2498 12.27117 21.13162 0.5211

At most 1 0.005420 10.65390 15.49471 0.2337 6.685186 14.26460 0.5270
At most 2 * 0.003221 3.968717 3.841466 0.0463 3.968717 3.841466 0.0463

Source: Author’s Calculation

Trace and Max-Eigen value test indicates the possibility of at most 1 co-integrating
equation among stock market index, oil price and exchange rate cannot be rejected.
So we may conclude that these series have long term integration among themselves.
To examine the direction of flow of causality among the variables during short term,
Granger causality test has been conducted. The idea of Granger causality that if one
variable X Granger-causes the other variable Y, we may assume that Y can be better
predicted using past values of both X and Y rather than using the past values of Y
alone. The null hypothesis of the test is that X does not Granger cause Y. The results
of Granger Causality have been reported in table 4.

Table 4: Granger Causality

Null Hypothesis F-Statistic Probability
Oil Prices does not Granger Cause Stock Prices 0.69029 0.5580
Stock Prices does not Granger Cause Oil Prices 2.36023 0.0699
Exchange Rate does not Granger Cause Stock Prices 2.49086 0.0588
Stock Price does not Granger Cause Exchange Rate 2.81408 0.0381
Exchange Rate does not Granger Cause Oil Prices 1.00753 0.3885
Oil Prices does not Granger Cause Exchange Rate 2.16337 0.0906
Source: Author’s Calculation
The results revealed the absence of Granger causality between Oil prices and Stock
Prices and also Exchange Rate and Oil Prices. Unidirectional causality flowing from
Stock Price to exchange rate was noticed but not vice versa. To give robustness in the
results of causality the process is repeated using VAR Granger Causality/Block
172 Dr. Nishi Sharma

Exogeneity Wald Tests (table 5). The optimal lag length is taken into consideration
using AIC information criterion.

Table 5: VAR Granger Causality/Block Exogeneity Wald Tests

Variable Excluded Chi-square Probability
Dependent variable: D(Stock Price)
D(Oil Price) 2.675898 0.2624
D(Exchange Rate) 4.628732 0.0988
All 6.289375 0.1786
Dependent variable: D(Oil Price)
D(Stock Price) 2.526617 0.2827
D(Exchange Rate) 4.133413 0.1266
All 5.807172 0.2140
Dependent variable: D(Exchange Rate)
D(Stock Price) 8.263665 0.0161
D(Oil Price) 5.609467 0.0605
All 13.41290 0.0094
Source: Author’s Calculation

The statistics of Block Exogeneity Wald Tests reports the unidirectional causality
flowing from stock prices to exchange rate. The results confirm the relationship as
exhibited by Granger causality Test.

CONCLUSION
The present study attempts to explore the dynamic linkage among stock prices, oil
prices and exchange rate with reference to India. Daily closing prices of S&P BSE
Sensex have been taken as proxy of stock prices. Similarly daily observations have
been taken for oil prices and exchange rate. The data was collected for a period
spanning 2011-16. The results evidenced that data is stationary at first difference
order. Johansen co-integration suggests the possibility of at most one co-integrating
equation. The cointegration of selected variables implies financial stability, since
they cannot deviate too far from the long-run equilibrium path. However investors
cannot benefit from arbitrage activities in the long run through diversification of their
portfoio in oil, equity and foreign exchange markets. Granger causality and Wald
statistics evidenced the absence of Granger causality between Oil prices and Stock
Prices and also Exchange Rate and Oil Prices. Unidirectional causality flowing from
Stock Price to exchange rate was noticed but not vice versa. Since stock prices
Cointegration and Causality among Stock Prices, Oil Prices and Exchange Rate 173

Granger cause the exchange rate, participants in the foreign exchange market can use
information of stock prices to improve the forecast of exchange rates.

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