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Impact of
Asymmetric impact of exchange exchange rate
rate changes on stock returns: changes on
stock returns
evidence of two de facto regimes
Walid M.A. Ahmed 147
Department of Management, Ahmed bin Mohammed Military College,
Doha, Qatar Received 21 February 2019
Revised 29 June 2019
27 September 2019
30 October 2019
Accepted 11 November 2019
Abstract
Purpose – This study focuses on Egypt’s recent experience with exchange rate policies, examining the
existence of spillover effects of exchange rate variations on stock prices across two different de facto regimes
and whether these effects, if any, are asymmetric.
Design/methodology/approach – The empirical analysis is carried out using a nonlinear
autoregressive distributed lag modeling framework, which permits testing for the presence of short- and long-
run asymmetries. Relevant local and global factors are also included in the analysis as control variables. The
authors divide the entire sample into a soft peg period and a free float one.
Findings – Over the soft peg regime period, both positive and negative changes in EGP/USD exchange
rates seem to have a significant impact on stock returns, whether in the short or long run. Short-term
asymmetric effects vanish in the free float period, while long-term asymmetries continue to exist. By and
large, the authors find that currency depreciation tends to exercise a stronger influence on stock returns than
does currency appreciation.
Practical implications – The results offer important insights for investors, regulators and policymakers.
With the domestic currency depreciation having a negative impact on stock prices, investors should
contemplate implementing appropriate currency hedging strategies to abate depreciation risks and, hence,
preserve their expected rate of return on the Egyptian pound-denominated investments. In the current post-
flotation era, the government could pursue a flexible inflation targeting monetary policy framework, with a
view to both lowering the soaring inflation toward an announced target rate and stabilizing economic growth.
The Central Bank of Egypt (CBE) could adopt indirect monetary policy instruments to secure tightened
liquidity conditions. Besides, the CBE could raise policy rates to incentivize people to keep their money in local
currency-denominated instruments, instead of dollarizing their savings, thereby relieving banks of foreign
currency demand pressures. Nevertheless, while being beneficial to the country’s real economy on several
aspects, such contractionary monetary measures may temporarily impinge on stock market performance.
Accordingly, policymakers should consider precautionary measures that reduce the potential for price
distortions and unnecessary volatility in the stock market.
Originality/value – To the best of the authors’ knowledge, the current study represents the first attempt to
explore the potential impact of exchange rate changes under different regimes on Egypt’s stock market, thus
contributing to the relevant research in this area.
Keywords Egypt, Stock prices, Breakpoint unit root tests, Exchange rate regimes,
Nonlinear ARDL model, Asymmetry effects
Paper type Research paper

1. Introduction
Given its close association with monetary and fiscal policies, the exchange rate policy has Review of Accounting and
always been a key concern for governments, practitioners and academics worldwide. In an Finance
Vol. 19 No. 2, 2020
pp. 147-173
© Emerald Publishing Limited
1475-7702
JEL classification – G02, G12, G14, G15 DOI 10.1108/RAF-02-2019-0039
RAF increasingly integrated world economy, countries use exchange rate policy as an effective
19,2 mechanism for cushioning external shocks. The degree of effectiveness hinges, among other
factors, on exchange rate stability. Central banks strive to maintain a broadly stable
currency environment to provide a favorable economic outlook, while keeping inflation rates
under control at least in the long run. As indicated by Reinhart and Rogoff (2004), the choice
of exchange rate regime has profound implications permeating multiple aspects of
148 macroeconomic performance. Hence, developing countries, in particular, choose the most
suitable regime by exploring the consequences of such regime on various macroeconomic
and financial fundamentals, and Egypt seems to be a good case in point.
Throughout its recent economic history, Egypt has experimented with several exchange
rate regimes, with a view to establishing macroeconomic stability and promoting
sustainable growth. Over the period 1960-1990, the Central Bank of Egypt (CBE, hereafter)
maintained a de jure peg against the US dollar at a rate of EGP 0.348 per US$1. However,
there had been some instances where the CBE intervened by devaluing the Egyptian pound,
suggesting that the then-exchange regime had been practically a de facto adjustable peg.
The domestic currency had experienced a dramatic depreciation against the US dollar,
plummeting from EGP 0.348 in January 1960 to EGP 3.138 by the end of 1990. As part of the
country’s wide-ranging economic reform program launched in 1991, the CBE had
abandoned the de jure fixed regime in favor of a managed floating one. This action induced
a further depreciation of the home currency from about EGP 3.138 in January 1991 to EGP
3.850 by the end of 2000. During the period January 2001-December 2002, a crawling peg
system with three hefty devaluations had been implemented. Subsequently, the CBE had
announced a de jure floating regime in January 2003, in an attempt to curb mounting
inflation pressures. Egypt’s currency had undergone a series of gradual devaluations from
around EGP 5.850 in January 2003 to EGP 8.925 in March 2016. Regardless of the CBE’s
officially declared exchange rate regime, the IMF’s Annual Report on Exchange
Arrangements and Exchange Restrictions (AEAER) of 2017 classifies Egypt as pursuing a
de facto soft peg (stabilized and crawl-like arrangements) from January 2013 to 3 November
2016. Owing to a serious hemorrhage of foreign currency reserves, the de jure float had
turned out to be untenable. On November 3, 2016, the government announced the
liberalization of the currency regime, a move marking a new chapter in the country’s history
of exchange rate systems.
On the other hand, financial markets are not in isolation from exchange rate fluctuations.
There is considerable empirical evidence supporting the existence of return and volatility
spillover effects from currency markets to equity markets (Ahmed, 2014; Andreou et al.,
2013; Bahmani-Oskooee and Saha, 2018; and references therein). Glen (2002) assesses stock
market performance prior to and after currency devaluations, using a sample of 24
devaluation events in 18 emerging market countries. The results reveal that such events
have a significant negative effect on stock returns in the period preceding the event.
However, returns in the aftermath of the devaluations vary across countries and firms.
Chortareas et al. (2012) document that the floating of the Turkish lira and Egyptian pound
exchange rates in 2001 and 2003, respectively, generate abnormal volatility and abnormal
returns in their respective stock markets. Balcilar et al. (2014) indicate that the bilateral US
dollar exchange rate movements could steer international investors to or away from the US
dollar-denominated investments, thus reflecting changes in investors’ risk appetite.
In this respect, a recent stream of research (Bahmani-Oskooee and Saha, 2018; Salisu and
Ndako, 2018; Tiryaki et al., 2019) stresses the importance of considering the potential for
nonlinearity in the relationship between stock and foreign currency markets. These studies
indicate that the effects of currency appreciation and depreciation on stock market
performance are unlikely to be symmetrical in terms of magnitude and sign. Generally, Impact of
market participants pay more attention to negative news than to positive news. Reboredo exchange rate
et al. (2016) find asymmetric downside and upside risk spillovers from currency returns to
stock returns and vice versa, for a group of emerging economies. Sikhosana and Aye (2018)
changes on
document asymmetric bidirectional spillover effects between the volatility of real exchange stock returns
rates and the volatility of stock returns in South Africa. Based on data from the USA, Sim
and Zhou (2015) establish that equity returns respond asymmetrically to positive versus
negative oil price shocks.
149
Motivated by the above discussion, we examine the presence of spillover effects of
exchange rate changes on domestic stock returns across two different de facto regimes and
whether these effects, if any, are asymmetric. More explicitly, taking Egypt’s recent
experience with exchange rate systems as a case study, we empirically address the
following issues:

Do exchange rates affect stock prices? and if so, in which direction?

Is this effect, if any, asymmetric?

Do the nature and magnitude of this effect, if any, differ between soft peg and free
float regimes?

We contribute to the existing literature in different directions. First, to our best knowledge,
this study is the first attempt to explore the potential impact of exchange rate changes under
different systems on stock prices. Thus far, no empirical analysis addressing the above-
mentioned issues has been carried out in the Egyptian context, a lacuna in the literature that
we seek to fill. Second, regulatory barriers to capital mobility and foreign portfolio
investment activities in Egypt’s financial markets have been dismantled since 1992, thus
providing foreign investors with complete access to all existing financial assets.
Nonetheless, due to successive depreciations in the Egyptian pound, potential gains are
more likely to be offset by exchange rate losses when converted back to an investor’s home
currency. Consequently, the practical implications derived from our analysis could be of
interest to portfolio managers and multinational corporations challenged with measuring
and managing currency risk exposure in Egypt. Third, although our analysis takes an
Egyptian-centric view, the implications could also prove useful to other emerging market
countries, which mull over floating their currencies and may experience economic
circumstances akin, more or less, to those of Egypt. For instance, the IMF’s Annual Report
on Exchange Arrangements and Exchange Restrictions (AEAER) of 2017 indicates that
Tunisia, Malaysia and Czech Republic abandon crawl-like, other managed and stabilized
exchange-rate arrangements, respectively, in favor of a free float regime. Other developing
countries, such as Morocco, Sudan and Sri Lanka, are in the process of floating their
respective currencies, within a comprehensive economic agenda. Over the years, these
nations appear to have made strides toward improving their respective financial and
economic systems, similar to Egypt’s case. Still, exchange rate variations may influence
asset prices to different degrees depending, among other factors, on the magnitude of the
former’s pass-through effects and the speed of the latter’s adjustment. As such, our results
may equip policymakers and financial stability practitioners in these countries with a
deeper understanding of the transmission and amplification mechanism of exchange rate
shocks to capital markets. This, in turn, could help the concerned authorities put in place
appropriate strategies to preserve capital market resilience and financial stability.
The evidence from this study suggests that, over the soft peg regime period, both positive
and negative changes in the bilateral exchange rates of the Egyptian pound versus the US
RAF dollar have a substantial influence on domestic stock returns, whether in the short or long run.
19,2 Short-term asymmetric effects of exchange rates die off in the free float regime period, while
long-term asymmetries continue to exist. Overall, currency depreciation tends to exert a
stronger impact on stock returns than does currency appreciation. Our results lend support for
the “negative bias effect”, a key tenet in psychology (Kanouse and Hanson, 1971; Peeters, 1971).
From here on, the study proceeds as follows. Section 2 succinctly reviews prior literature and
150 develops the hypotheses to be tested. Data description and basic statistics are given in Section 3,
while the econometric methodology is outlined in Section 4. Section 5 presents the findings. The
penultimate section checks the robustness of the results, and the final section concludes.

2. Literature review and testable hypotheses

2.1 Prior research
Over the years, the association between foreign exchange and stock markets, across
different regions of the globe, has inspired a wealth of research activity and invigorated
intellectual debate. On the theory side, there are two key approaches explicating the
interplay between exchange rates and stock prices, with their respective conclusions being
at opposite poles. The first one is the goods market theory, proposed by Dornbusch and
Fischer (1980), whereas the second one is the portfolio balance theory, developed by Frankel
(1983) and Branson and Henderson (1985). The goods market theory posits a causal effect of
exchange rates on stock prices. The portfolio balance theory, on the other side, posits a
negative correlation between stock prices and exchange rates expressed in a direct quotation
form (i.e. the domestic price of one unit of a foreign currency), where variations in the former
influence the latter’s movements via portfolio rebalancing (foreign capital inflows and
outflows).
On the empirical front, despite the fact that research on the interdependence structure of
equity and exchange markets is abundant, there is still no clear answer on the nature,
magnitude, and direction of influence. On the one hand, numerous studies reveal significant
reciprocal price and/or volatility transmission effects between the two markets. In one of the
pioneering studies in this category, Bahmani-Oskooee and Sohrabian (1992), using data
from the USA, find bidirectional causality between exchange rates and stock prices.
Tule et al. (2018) investigate the transmission mechanism of returns and shock spillover
effects between the Nigerian foreign exchange and stock markets. After accounting for
structural breaks, the results point to the absence of mean spillovers in either direction and
the presence of positive bidirectional shock spillovers. Based on linear VAR models and
Markov switching VAR (MS-VAR) models, Roubaud and Arouri (2018) document
significant nonlinear interrelations between the US real stock price, the real effective
exchange rate of the US dollar, the real Brent oil prices and the economic policy uncertainty
index, especially during highly volatile periods. Using data from Hong Kong, Singapore,
South Korea and Taiwan, Yang (2017) document bidirectional causality between stock
prices and exchange rates, though feedback from the former’s shocks to the latter’s changes
is greater than the other way round. Lin and Fu (2016) report evidence of bidirectional panel
causality effects, whether in the short or long run, for a sample of four Asian economies,
namely, Japan, South Korea, Singapore and Taiwan.
On the other hand, a spate of studies suggests a unidirectional effect of either market on
the other, where the dominant market varies across countries and over time. For instance,
Fowowe (2015) finds a unidirectional causal relationship from exchange rates to domestic
stock prices in Nigeria, and an independence relationship in South Africa. Abdalla and
Murinde (1997) demonstrate causal effects of exchange rates on stock prices for the
emerging markets of India, Korea and Pakistan. Naresh et al. (2018) document that
appreciation of local currencies of BRICS countries (Brazil, Russia, India, China and South Impact of
Africa) versus the US dollar leads to an increase in their respective stock indices, and vice exchange rate
versa, lending support to the flow-oriented theory. Leung et al. (2017) investigate the
volatility spillover effects between the equity markets of New York, London and Tokyo and
changes on
their exchange rates from 2001 to 2013. The results reveal that all exchange rate volatilities stock returns
have a positive influence on the volatility of equity markets, with the pair JPY/USD- Nikkei
225 being the only exception. In a similar spirit, Delgado et al. (2018) establish that changes
in the exchange rate of the Mexican peso against the US dollar have a negative and 151
statistically significant impact on the Mexican stock market index.
In contrast, Tsagkanos and Siriopoulos (2013) document a causal link running from stock
returns to exchange rate changes for the EU (US) in the long (short) run. Ahmed (2014)
investigates the existence of first and second moment interdependencies between stock and
foreign exchange markets of Egypt prior to and during the popular uprising of 2011. He finds
significant mean and volatility transmission effects from the equity market to the foreign
exchange counterpart in both subperiods. The results of Kanas (2000) reveal the presence of
volatility spillovers from stock returns to exchange rate changes for the USA, the UK, Japan,
France and Canada. Using a panel of 32 OECD countries, Salisu and Ndako (2018) test the
validity of the portfolio-balance theory. The results suggest that stock prices have a negative
effect on exchange rates for the full OECD sample, the euro area, and the non-euro area.

2.2 Hypotheses development

The main argument of this study is that the dynamics of positive and negative exchange rate
changes are likely to have asymmetric effects on the behavior of Egypt’s stock market (EGX,
hereafter), no matter which exchange rate regime is in place. Thus, the adoption of either a soft
peg or free float exchange rate policy is unlikely to alter the nature of the stock price–exchange
rate nexus. Two principal premises underlie this argument. First, foreign portfolio investors
have full access to local financial securities, they can freely enter and exit the market, and they
can conveniently repatriate their earnings back home without restrictions. Under these
circumstances, encouraging signs of market upturn are expected to allure foreign investors to
trade in the EGX, thereby strengthening the national currency against other foreign currencies.
On the contrary, the sudden reversal of foreign capital, as a result of, for example, adverse
domestic shocks, is likely to plunge Egypt’s economy into a currency crisis, which, in turn, may
inevitably send equity prices into a tailspin. Ioannidis and Kontonikas (2006) indicate that stock
markets tend to serve as a potent transmission mechanism of exchange rate movements,
because stock prices are connected with the real economy through their impact on consumption
spending (wealth effect channel) and investment spending (balance sheet channel). Based on
the above discussion, we propose the following hypothesis:

H1. Stock returns are related to exchange rate variations, irrespective of the currency
regime in force.
Second, the separate effects of domestic currency appreciation and depreciation on the EGX
may not be identical. This premise has its base in the theoretical rationale for the so-called
“psychological bias of negativity” (the negativity bias effect), which is expounded in the
psychology literature (Kanouse and Hanson, 1971; Peeters, 1971). This cognitive
phenomenon refers to the human tendency to assign more weight to negative pieces of
information than to positive ones of equal magnitude. In the finance literature, the
asymmetric effects of positive and negative news shocks have been extensively explored in
various contexts. Veronesi (1999) develops an intertemporal rational expectations
equilibrium model of asset pricing, in which investors are inclined to overreact to negative
RAF news in favorable times, but underreact to positive news in adverse times. Using data for 24
19,2 countries, Bahmani-Oskooee and Saha (2018) document the presence of asymmetric
exchange rate exposure of stock returns, mostly over short-term horizons.
In the Egyptian case, there have been several sharp currency depreciations, particularly
during the soft peg regime period. Hence, it is expected that stock prices exhibit different
reactions to episodes of currency depreciation and appreciation. According to this
152 discussion, we put forward the following hypothesis:

H2. Stock returns react asymmetrically to positive and negative exchange rate changes,
regardless of the currency regime in place.

3. Data and preliminary analysis

3.1 Basic data
Our data set contains closing stock index levels of EGX100 as well as the Egyptian pound/US
dollar (EGP/USD, hereafter) exchange rates, covering the period from 6 January 2014 to 9 August
2018. EGX100 is a major benchmark index designed to measure the performance of the top 100
shares of the EGX in terms of liquidity and activity. Daily exchange rates are expressed as the US
dollar price of one unit of the Egyptian pound, so that a decrease in the exchange rate is indicative
of a depreciation of the domestic currency against the US counterpart, and vice versa.
In conducting our empirical analysis, we use the de facto classifications of the IMF’s
AEAER. Reinhart (2000) and Calvo and Reinhart (2002) point out that, due to fear of
floating, some emerging economies officially announce a free float, while their actual regime
is nothing but some type of a managed peg. In practice, Egypt seems to be no exception to
this phenomenon. Based on the IMF’s classification, the CBE pursued a soft peg system
(stabilized and crawl-like arrangements) from January 2013 to November 3, 2016, but
switched to a free float onwards. Thus, we split the full sample into two subsamples, where
November 3, 2016 (i.e. the date on which the soft peg system was abandoned) is taken as the
cutoff point. In this sense, the first one runs from January 6, 2014 to November 2, 2016,
representing the soft peg period. The second one extends from 4 November 2016 up to the
end of the sample, making up the free float period. Both stock index and exchange rate
returns are computed as the logarithmic difference between two consecutive values.
Figure 1 displays the time trend of EGX100 and EGP/USD price levels series over the
entire sample. As shown in Figure 1 for the soft peg period, recurring up-and-down swings
are clear in the trend path of EGX100 in 2014-2015, followed by a generally downward
movement in 2016, while the evolution of the EGP/USD rates points to somewhat short-lived
pegs, followed by sporadic, yet at times, massive devaluations in the Egyptian currency. As
for the free float period, the stock market started progressively to come off its earlier bottom
EGX100 EGP/USD

2,400 0.16
Soft peg period Free float period Soft peg period Free float period
0.14
2,000

0.12
1,600
0.10
Figure 1.
1,200
Evolution of EGX100 0.08

index and EGP/USD 800

0.06
levels over the sample
period 400 0.04
2014 2015 2016 2017 2018 2014 2015 2016 2017 2018
level, hitting peaks in the first half of 2018. After flotation, the behavior of the EGP/USD Impact of
rates appeared remarkably stable. Indeed, the perceived stability of the Egyptian pound exchange rate
against the US dollar and its favorable consequences on foreign portfolio investments could
possibly be a major contributing factor to the stock market rally.
changes on
stock returns
3.2 Control variables
In view of the process of financial liberalization across the globe, both domestic and global 153
influences seem to be major sources of stock price variations (Bekaert and Harvey, 1995;
Foerster and Karolyi, 1999). Therefore, we explore the potential effect of exchange rates on
stock returns, using a multivariate framework that controls for a range of relevant factors.
Our control variables include domestic market liquidity, short-term interest rates, volatility
of domestic returns, world stock markets and oil prices. The choice of those market-specific
and global macroeconomic fundamentals is motivated by empirical evidence on the
determinants of equity market behavior. For instance, Ze-To (2016) documents a positive
relationship between asset liquidity and future cross-sectional equity returns on the London
stock exchange. Based on panel data for 49 emerging markets, Lehkonen and Heimonen
(2015) demonstrate that market liquidity tends to have a positive effect on returns. Assefa
et al. (2017) find that variance of local returns is a valid proxy for omitted risk factors in
emerging markets, while Bilson et al. (2002) report similar results for both emerging and
developed markets. Wu et al. (2018) find that interest rates are negatively related to stock
returns in the Taiwan stock market. The results of You et al. (2017) indicate that real interest
rates have asymmetric negative effects on Chinese stock markets across quantiles. There
exist many studies that use a trivariate framework to investigate the interplay between oil
prices, exchange rates, and equity prices. For instance, Narayan and Narayan (2010) show
that movements in oil prices and exchange rates have positive effects on the Vietnamese
stock market in the long, rather than, short run. For the Indian market, Kumar (2019)
considers nonlinearity and asymmetry in the causal linkages between oil prices, exchange
rate and stock prices. The results suggest a bidirectional nonlinear relationship between oil
prices and both foreign exchange and stock markets, but a unidirectional nonlinear
causality from exchange rates to stock prices. He also finds that one-month lagged positive
and negative shocks in oil prices exert positive (negative) effects on exchange rates (stock
prices), with positive shocks being stronger than negative ones.
To capture domestic market liquidity, the turnover ratio, defined as the value of all
stocks traded on a given day scaled by that day’s total market capitalization, is adopted. We
use domestic interbank seven-day offered rate as a proxy for short-term interest rates, since
it reflects the intended monetary policy stance in Egypt. The global equity market portfolio
and world oil prices are proxied by the MSCI ACWI ex Egypt IMI Index[1] and Brent crude
oil, respectively. The popular range-based volatility estimator of Rogers and Satchell (1991)
is deployed to produce ex post estimates of domestic returns variability. Under the
assumption that asset or index price observations follow a geometric Brownian motion with
a non-zero drift, this estimator uses the information available about the Opening (Ot), High
(Ht), Low (Lt) and Closing (Ct) prices observed on a trading day t, and is given by:
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
     
d Ht Ht Lt Lt
VOLrt ¼ ln ln þ ln ln (1)
Ot Ct Ot Ct

Our data set comes from different sources. We collect local stock market data from Egypt
Information Dissemination Company (EGID), a premier authorized distributor of the EGX’s
RAF trading data and market information, while we obtain interbank interest rates from the CBE
19,2 website. The EGP/USD exchange rates are from OANDA Corporation, a world-class
provider of currency exchange information. Global stock market index data are sourced
from the MSCI Barra database. Spot prices of Brent crude oil are in US dollar per barrel,
retrieved from the US Energy Information Administration (EIA) website. All data series are
filtered so that only daily observations in common with those of EGX100 index series are
154 used in the analysis. This time alignment yields 554 and 346 observations for the first and
second subperiods, respectively.

3.3 Summary statistics

Panels A and B of Table I provide descriptive statistics and diagnostic test results for the
soft peg and free float regime periods, respectively.
A number of remarks can be drawn from Table I. First, average daily returns on EGX100
index and oil are negative in the first subperiod, but they become positive and of sizable
magnitude during the second subperiod. Second, movements in the EGP/USD exchange
rates reveal average daily depreciation of about 0.044 per cent and 0.016 per cent over the
first and second subperiods, respectively. Third, in the first subperiod, interest rates and oil
are skewed to the right of their respective means, but the other variables are skewed to the
left. In the second subperiod, the distributions of domestic returns and market liquidity
become positively skewed. It is also evident that percentage changes in EGP/USD have the

Variables Mean SD Skewness Kurtosis J-B test Q-Stat (10) test

Panel A: Soft peg period

Y 0.025 1.306 1.102 7.892 663.504*** 41.476***
FRX 0.044 0.439 12.782 192.336 8.4E þ 5*** 112.820***
MLQ 0.081 2.121 0.071 189.853 8.1E þ 4*** 137.571***
INT 0.006 0.106 6.247 68.672 1.1E þ 4*** 12.664
VOL 0.009 0.379 0.105 5.806 182.491*** 178.591***
WMP 0.002 0.945 1.676 13.612 2.8E þ 3*** 14.230
OIL 0.154 2.709 0.479 6.210 258.572*** 19.138**
Panel B: Free float period
Y 0.233 1.059 0.192 4.656 41.563*** 37.873***
FRX 0.016 0.950 1.905 56.149 4.1E þ 4*** 50.721***
MLQ 0.035 0.088 0.343 25.399 7.2E þ 3*** 79.001***
INT 0.006 0.228 2.569 25.975 7.9E þ 3*** 31.324***
VOL 0.007 0.400 0.238 6.114 142.655*** 106.071***
WMP 0.070 0.591 1.752 17.029 3.0E þ 3*** 28.937***
OIL 0.128 1.891 0.034 4.803 46.764*** 7.345

Notes: This table lists univariate descriptive statistics for all variables over both sample periods. It also
reports test results of normality and serial correlation. Y is the benchmark stock index of the Egyptian
market, EGX100, while FRX represents the nominal EGP/USD exchange rate. MLQ, INT, and VOL denote
domestic control variables that include market liquidity, short-term interest rates, and volatility of stock
returns, respectively. WMP and OIL represent global control variables, including the MSCI ACWI ex Egypt
Investable Market Index (IMI) and Brent crude oil prices, respectively. Y, FRX, WMP, and OIL are
transformed into percentage changes, whereas MLQ, INT, and VOL are levels differenced. J-B is the
standard Jarque-Bera test examining the null hypothesis of a Gaussian distribution. Q-Stat (10) is the Box-
Table I. Ljung statistic testing the null hypothesis of no residual serial correlation up to the tenth lag order. ***and
Descriptive statistics **indicate rejection of the corresponding null hypothesis at the 0.01 and 0.05 significance levels,
for all variables respectively
largest negative skewness of 12.782 and 1.905 over the first and second subperiods, Impact of
respectively. Fourth, the Jarque–Bera test strongly rejects the null of normality for all series exchange rate
at the 1 per cent significance level. Fifth, with the exception of interest rates and world
market returns (oil) in the first (second) subperiod, all the series exhibit linear time-
changes on
dependence up to ten lags, as confirmed by the statistical significance of the corresponding stock returns
Box-Ljung test statistics at the 5 per cent level or better.
In this regard, since the analysis involves several regressors, a multicollinearity problem
may arise. To check this possibility, we run the parametric Pearson’s correlation test[2]. A
155
perusal of the correlation matrices reveals very weak associations, where correlation
coefficients for all possible independent variable pairs do not exceed 0.078 and 0.179 over
the soft peg and free float regime periods, respectively. Furthermore, with few exceptions, all
pairwise associations fail to reach statistical significance at standard levels. Therefore,
concerns about multicollinearity are unwarranted.

4. Econometric methodology
4.1 Unit root test with structural breaks
As a prerequisite for proper statistical inference, we initially verify the order of integration
of the individual data series. For this purpose, classical unit root tests, such as the
Augmented Dickey–Fuller (ADF) test (Dickey and Fuller, 1979, 1981) and the Dickey–Fuller
Generalized Least Squares (DF-GLS) test (Elliot et al., 1996), could be used. However, as
indicated by Perron (1997) and Leybourne and Newbold (2003), these tests often tend to
erroneously favor the unit root null against the alternative of trend stationarity when there
are structural breaks in the data generating process (DGP) of a series. It is well documented
in the literature (Hansen, 2000; Stock and Watson, 1996) that most economic and financial
variables undergo abrupt structural changes across time due, for instance, to new policy
measures, geopolitical developments, economic recession, or currency devaluations. To
overcome such drawbacks, we rely on the two-break minimum Lagrange Multiplier (LM)
unit root procedure of Lee and Strazicich (2003). In addition to determining the presence and
location of structural shifts endogenously rather than exogenously, the LM unit-root test
captures level and/or trend shifts under both the null and alternative hypotheses. Hence,
contrary to its conventional peers, this test is invulnerable to the spurious rejection of the
non-stationarity null when the DGP contains breaks.

4.2 Nonlinear autoregressive distributed lag framework

As highlighted in the Introduction section, local and global factors may have a bearing on
stock market dynamics. Hence, we conduct our analysis in a multivariate setting to reduce
the possibility of omitted variable bias. Domestic market liquidity, short-term interest rates,
volatility of domestic returns, world stock markets and oil prices are considered as potential
determinants of the EGX100 behavior as follows:

Yt ¼ f ðFRXt ; MLQt ; INTt ; VOLt ; WMPt ; OILt Þ (2)

where Y is the benchmark stock market index EGX100, FRX is the EGP/USD exchange
rates, MLQ is the market turnover ratio as a proxy for aggregate liquidity, INT is the short-
term interest rates, VOL denotes local return volatility, WMP is the global equity market
portfolio, and OIL is the Brent crude oil prices. The logarithmic model version of the above
function, augmented with a time trend variable T and a set of structural break dummy
variables DMi (i = 1,. . ., k; where k is the number of breaks), is specified as follows:
RAF X
k
In Yt ¼ C þ #t T þ h i DMi þ a1 In FRXt þ a2 In MLQt þ a3 In INTt
19,2 i¼1

þ a4 In VOLt þ a5 In WMPt þ a6 In OILt þ « t (3)

In this respect, evidence that the integration order of the variables concerned is either I(0) or I
156 (1), as shown by the results of the LS unit root test in Table II, provides strong grounds for
validating the use of the autoregressive distributed lag (ARDL) approach of Pesaran et al.
(2001) in our analysis. Within the framework of symmetric ARDL, we rewrite equation (3) as
follows:

X
k X
p X
q1
D In Yt ¼ C þ #t T þ h i DMi þ ˆ i D In Yti þ a1;i D In FRXti
i¼1 i¼1 i¼0

X
q2 X
q3 X
q4
þ a2;i D In MLQti þ a3;i D In INTti þ a4;i D In VOLti
i¼0 i¼0 i¼0

X
q5 X
q6
þ a5;i D In WMPti þ a6;i D In OILti þ f ECTt1 þ « t
i¼0 i¼0
(4)

where p denotes the lag order of the regress and qi indicates the lag order of the i-th
regressor, ECTt represents the estimated error correction term, f is the speed of adjustment
coefficient. A negative and statistically significant value of f implies cointegration between
the regressand and its forcing variables in the model. Pesaran et al. (2001) show that an error
correction representation, which captures both short- and long-term dynamics in a single
statistical model, can be derived by substituting the lagged error term ECTt1 with a linear
combination of lagged-level variables, as follows:

X
k X
p X
q1
D In Yt ¼ C þ #t T þ h i DMi þ ˆ i D In Yti þ a1;i D In FRXti
i¼1 i¼1 i¼0

X
q2 X
q3 X
q4
þ a2;i D In MLQti þ a3;i D In INTti þ a4;i D In VOLti
i¼0 i¼0 i¼0

X
q5 X
q6
þ a5;i D In WMPti þ a6;i D In OILti þ b 1 ln Yt1
i¼0 i¼0

þ b 2 ln FRXt1 þ b 3 ln MLQt1 þ b 4 ln INTt1 þ b 5 ln VOLt1

þ b 6 ln WMPt1 þ b 7 ln OILt1 þ « t (5)

The estimated coefficients on first differenced variables (a1;i , . . ., a6;i ) provide short-run
effects on equity returns, while the coefficient estimates on lagged variables in levels ( b 2 ,
. . ., b 7 ), normalized on b 1 ; give long-run effects. Equation (5) assumes that the potential
impact of positive and negative exchange-rate changes on returns are symmetric, which
 Significant breaks Test statistic Estimated break dates
Impact of
Variables TB1 TB2 exchange rate
changes on
Panel A: Soft peg period
Y 2 3.288 [5] 2015:03:09 2016:01:19 stock returns
DY 2 18.989*** [3] 2014:06:10 2015:07:08
FRX 2 4.647 [5] 2015:09:29 2016:02:08
DFRX 2 12.529*** [2] 2015:09:30 2016:02:01 157
MLQ 1 9.393*** [3] 2015:11:03 –
DMLQ 1 22.098*** [2] 2014:08:13 –
INT 0 1.671 [3] – –
DINT 1 5.871** [2] 2016:03:17
VOL 1 13.406*** [1] 2014:06:04 –
DVOL 1 21.042*** 0 2016:07:26 –
WMP 2 3.569 [4] 2015:06:08 2015:12:22
DWMP 1 5.799** 0 2015:12:06 –
OIL 0 0.902 [3] – –
DOIL 1 12.324*** [8] 2015:10:20 –
Panel B: Free float period
Y 1 3.501 [1] 2018:03:28 –
DY 1 14.539*** 0 2018:03:09 –
FRX 1 6.749*** [5] 2017:03:30 –
DFRX 1 8.717*** [8] 2017:02:27 –
MLQ 0 0.337 [6] – –
DMLQ 2 19.228*** [1] 2017:07:20 2018:02:14
INT 0 1.054 [8] – –
DINT 1 11.232*** [6] 2017:04:09 –
VOL 2 18.328*** [1] 2017:03:07 2018:06:07
DVOL 2 28.662*** 0 2017:02:08 2017:08:21
WMP 1 5.794** [3] 2018:01:30 –
DWMP 1 8.746*** [8] 2018:05:31 –
OIL 2 3.495 [8] 2017:03:02 2017:08:16
DOIL 1 5.805** [3] 2017:06:07 –

Notes: This table displays the results of Lee and Strazicich’s (2003) LM unit root test with two endogenous
structural changes in both the intercept and the slope of the trend function. In case of no significant
breakpoints are detected in the series, results of the conventional ADF unit root test are reported instead.
All variables are log-transformed. D is the first difference operator. The optimal lag orders for the minimum
LM and ADF unit root tests are based on the Akaike Information Criterion, with a maximum number of 10
augmented lags, and are given in squared brackets. Critical values for the LM unit root test rely on the Table II.
relative location of the breaks. Critical values for the one- and two-break tests are sourced from Lee and Results of two/one-
Strazicich (2003). Obtained from MacKinnon (1996), the ADF critical values, with constant and trend, are
3.975 and 3.985, for the first and second periods, respectively, at the 0.01 significance level. Values given break minimum LM
in squared brackets represent number of augmented lags. *** and ** indicate statistical significance at the and ADF unit
0.01and 0.05 levels, respectively root tests

might be counterintuitive and even questionable. Indeed, it stands to reason that the effect of
currency appreciation on stock markets is unlikely to be the same as that of currency
depreciation, whether in terms of magnitude or in terms of sign. To investigate the
asymmetric exchange rate risk exposure of stock returns, we use the nonlinear ARDL
framework proposed by Shin et al. (2014), in which both short- and long-term asymmetries
are explored through positive and negative partial sum decompositions of the regressor of
interest. As such, two new time-series variables (i.e. In FRXtþ and In FRXt Þ capturing
episodes of the Egyptian pound appreciation and depreciation, respectively, are extracted
RAF from the underlying DlnFRX series, where D In FRXt  In FRX0 þ In FRXtþ þ
19,2 In FRXt : The variable representing currency appreciation (depreciation), In FRXtþ
(In FRXt Þ; is generated by replacing negative (positive) changes in DlnFRX with zeros.
Partial sum component processes are defined as follows:

X
t X
t
In FRXtþ ¼ D In FRXiþ ¼ max ðD In FRXi ; 0Þ (6)
158 i¼1 i¼1

X
t X
t
In FRXt ¼ D In FRXi ¼ min ðD In FRXi ; 0Þ (7)
i¼1 i¼1

Based on this decomposition, the long-run equilibrium relationship described in equation (3)
can be expressed in terms of positive and negative partial sums as follows:

X
k
In Yt ¼ C þ #t T þ h i DMi þ aþ þ  
1 In FRXt þ a1 In FRXt þ a2 In MLQt
i¼1

þ a3 In INTt þ a4 In VOLt þ a5 In WMPt þ a6 In OILt þ « t (8)

Moreover, as shown in Shin et al. (2014), equation (8) can be rewritten in an error correction-
modeling format with asymmetric short-run dynamics as follows:

X
k X
p X
q1
D In Yt ¼ C þ #t T þ h i DMi þ ˆ i D In Yti þ aþ þ
1;i D In FRXti
i¼1 i¼1 i¼0

X
q2 X
q3 X
q4
þ a 
1;i D In FRXti þ a2;i D In MLQti þ a3;i D In INTti
i¼0 i¼0 i¼0

X
q5 X
q6 X
q7
þ a4;i D In VOLti þ a5;i D In WMPti þ a6;i D In OILti
i¼0 i¼0 i¼0

þ b 1 ln Yt1 þ b þ þ  
2 In FRXt1 þ b 2 In FRXt1 þ b 3 ln MLQt1

þ b 4 ln INTt1 þ b 5 ln VOLt1 þ b 6 ln WMPt1 þ b 7 ln OILt1 þ « t

(9)
Pq1
where aþ 
1;i and a1;i are the asymmetric distributed lag coefficients. aþ
1;i gauges the
i¼0 Pq2
cumulative short-run effects of home currency appreciation on stock returns, while a1;i
i¼0
gauges the cumulative short-run effects of depreciation. If aþ 
1;i and a1;i are of the same size
and same direction, then it can be deduced that stock returns respond symmetrically to
currency appreciations and depreciations in the short run.  b þ 
2 = b 1 and  b 2 = b 1 are the
normalized coefficients related to positive and negative long-run exchange rate exposure,
respectively.
5. Results Impact of
5.1 Unit root test results exchange rate
Prior to conducting the bounds testing approach to cointegration, we subject all the time
series to unit root testing to ensure that none of them follows an I(2) process. Initially, the LM
changes on
unit-root procedure of Lee and Strazicich (2003) allowing for two endogenous structural stock returns
breaks in the level and trend is executed. If the test statistics prove significant for only one
breakpoint, the same procedure allowing for a single break, rather than two, is performed. If
there is still no significant breakpoint in the series, the conventional ADF unit root test is in 159
place to check for stationarity or lack thereof. Panels A and B of Table II present the test
results for the first and second subperiods, respectively.
Concerning the soft peg period, the results in Panel A of Table II suggest rejection of
the unit root null for measures of market liquidity and volatility of local returns at the 1
per cent significance level, implying that both variables are level stationary, I(0). The rest
of the variables have a unit root in levels, but not in first differences, which means that
they are first-difference stationary, I(1), at least at the 5 per cent level. The results also
highlight the relevance of structural break unit root tests, since the vast majority of the
variables display level and trend shifts during this subperiod. The only two exceptions
are the level series of short-term interest rates and oil prices, for which the ADF unit root
test is used.
In the free float period, the results in Panel B of Table II fail to reject the existence of a
unit root in levels, but not in first differences, for EGX100 index, market liquidity, interest
rates, and oil prices, at the 5 per cent level or better, suggesting that these variables are
integrated of order one. On the other hand, the level series of EGP/USD rates, volatility of
local returns, and world stock market index are integrated of order zero, given their
respective test statistics provide evidence against the null of nonstationarity at the 5 per cent
level or better. Furthermore, no significant breakpoints are detected for the level series of
market liquidity and interest rates. Consequently, the ADF unit root test is used to
determine whether they are stationary or not. The remaining series, whether in levels or first
differences, seem to experience significant structural breaks during the free float regime
period.
Given that EGX100 index series are found to suffer from structural changes in either
subperiod, it is important that we account for these breaks by explicitly modeling them
in the relationship under examination. In this regard, Koukouritakis et al. (2014)
indicate that the presence of structural shifts in the DGP of a series is likely to distort
inferences from cointegration analysis and error correction models. Accordingly, we
augment the nonlinear autoregressive distributed lag (NARDL) model with two and one
break dummy variables for the first and second subperiods, respectively. For the soft
peg period, DM2014 and DM2015 denote the first and second breaks that occurred on 10
June 2014 and 8 July 2015, respectively, while, for the free float period, DM2018
represents the only identified break dated on 9 March 2018. These dummies are equal to
zero before the corresponding breakpoints of EGX100 index returns and one
subsequently.

5.2 Nonlinear cointegration test results

After establishing that the order of integration of each time-series variable is an I(0) or I(1)
but not I(2), we examine the presence of a long-run level relationship between the variables,
using the bounds testing procedure of Pesaran et al. (2001). To this end, the Wald F-statistic
is performed to test the joint significance of lagged variables in levels, where the null of no
cointegration ðH0 : b 1 ¼ b þ 
2 ¼ b 2 ¼ b 3 ¼ b 4 ¼ b 5 ¼ b 6 ¼ b 7 ¼ 0Þ is tested against the
RAF alternative of cointegration ðH1 : b 1 6¼ b þ 
2 6¼ b 2 6¼ b 3 6¼ b 4 6¼ b 5 6¼ b 6 6¼ b 7 6¼ 0Þ.
19,2 Besides, we use the Banerjee et al. (1998) t-test to assess the statistical significance of the
coefficient estimate on the lagged-level regressand, where the null of no cointegration ðH0 :
b 1 ¼ 0Þ is tested against the alternative of cointegration ðH1 : b 1 < 0Þ: Both tests use
asymptotic upper- and lower-bound critical values, contingent on whether the variables
under consideration are I(1) or I(0), or a combination of both. Evidence of cointegration
160 (no cointegration) is detected only when either calculated test statistic lies above (below) its
corresponding upper-bound (lower-bound) critical value. If the F- or t-statistic falls in
between the bounds, the results are inconclusive. Panels A and B of Table III present the
F- and t-test results for the soft peg and free float periods, respectively.
As seen in Panel A, the computed F-test statistics exceed the upper-bound critical values,
thus providing evidence against the null of no nonlinear long-run linkage between the
variables at the 1 per cent significance level. The F-test results are corroborated by those of
the t-test, which consistently confirm the presence of nonlinear cointegration in the soft peg
period at the 1 per cent level. For the free float period, the results of either test in Panel B are
qualitatively the same as those in Panel A. The findings are broadly in line with those
documented in different countries. For example, the results of Lin and Fu (2016) suggest
panel long-run equilibrium relationships between the exchange rates and stock prices of
Japan, South Korea, Singapore and Taiwan. Salisu and Ndako (2018) find that exchange
rates and stock prices are nonlinearly cointegrated, using a panel of 32 OECD economies.

5.3 Asymmetry test results

Once a long-run level relationship has been detected, we proceed to examine the long- and
short-run asymmetry of exchange rate exposure, using standard Wald tests. Empirically,
the null of long-run symmetry ðH0 :  b þ 
2 = b 1 ¼  b 2 = b 1 Þ is tested versus the alternative of
þ 
long-run asymmetry ðH1 :  b 2 = b 1 6¼  b 2 = b 1 Þ: The existence of short-run asymmetry, on
the other hand, can be verified by weak- and strong-form tests. For the former, the null is
Pq Pq
aþ1;i ¼ a þ 
1;i , while for the latter, the null is a1;i ¼ a1;i , 8 i= 1,2,.,q. In either case,
i¼0 i¼0

F (Y| FRXþ , FRX , MLQ, INT, VOL, WMP, OIL)

Estimated model Panel A: Soft peg period Panel B: Free float period

F-statistic 51.077*** 27.013***

I(0) CV 3.728 3.728
I(1) CV 5.160 5.160
t-statistic 19.636*** 14.539***
I(0) CV 3.960 3.960
I(1) CV 5.490 5.490
Optimal lag structure (3, 3, 3, 0, 2, 1, 1, 1) (2, 2, 2, 0, 0, 0, 0, 1)

Notes: This table presents the results of NARDL bounds cointegration test with structural breaks in the
data generating process of the EGX100. The optimal lag selection is based on the Akaike Information
Criterion, with the maximum number of lags set at 10 days. The F-statistic tests the null hypothesis that all
Table III. the slope coefficients on the lagged variables in levels are jointly equal to zero. The t-statistic tests the null
hypothesis that the coefficient estimate on the lagged-level regressand is equal to zero. I(0) and I(1)
Bounds testing for represent the lower-bound and upper-bound critical values at the 0.01 significance level. The critical values
nonlinear are from Pesaran et al. (2001). ***indicates rejection of the null hypothesis of no cointegration at the 0.01
cointegration significance level, where both F-statistics and t-statistics lie above the upper-bound critical values
rejection of the null demonstrates that EGX100 reacts differently to currency appreciation Impact of
and depreciation. Panels A and B of Table IV report asymmetry test results for the first and exchange rate
second subperiods, respectively.
With respect to the soft peg period, the results in Panel A yield overwhelming evidence
changes on
against the null of long-run symmetry at the 1 per cent significance level. Likewise, the results stock returns
from the pairwise (strong-form) symmetry test and additive (weak-form) symmetry test
support rejection of the null of short-run symmetry at the 5 per cent level or better. One highly
plausible explanation for the finding of substantial asymmetric effects in both time horizons is 161
that daily changes in EGP/USD rates during most of this interval were negative and large in
magnitude (Figure 1). The results in Panel B demonstrate that long-term asymmetries continue
to exist in the free float period, with a significance level of 5 per cent. Interestingly, on the other
hand, short-term asymmetries vanish, since the results of both symmetry tests fail to achieve
statistical significance at conventional levels. Accordingly, the asymmetric impact of exchange
rate changes on stock prices during free float regime turns out to be of a permanent, rather than
temporary, nature. By and large, these findings parallel those of Bahmani-Oskooee and Saha
(2016), Cuestas and Tang (2017), and Roubaud and Arouri (2018).

5.4 Nonlinear autoregressive distributed lag estimation results

The parameter estimates and associated t-statistics of NARDL(p,qi) model for the soft peg
and free float periods are shown in Panels A and B of Table V, respectively.
5.4.1 Soft peg period. The upper part of Panel A of Table V displays the estimates of the
short-run dynamics. Two key remarks stand out. First, the coefficients of lagged
returns, D In Yti , bear a positive sign and statistically significant at standard levels,
suggesting that previous performance of EGX100 index stimulates current performance
levels. Second, there is evidence of contemporaneous positive and negative effects of EGP/
USD log changes on stock returns. It is worth mentioning that the corresponding coefficient
estimates on positive and negative change terms differ with respect to statistical
significance, effect size, and sign. The contemporaneous coefficient on currency
depreciation, D In FRXt , is highly statistically significant with a much larger magnitude
than is its counterpart on currency appreciation, D In FRXtþ . This pattern remains

Null hypothesis Panel A: Soft peg period Panel B: Free float period

Long-run asymmetry
b þ 
2 =b 1 ¼ b 2 =b 1 55. 236*** (0.000) 6. 217** (0.013)
Short-run asymmetry
aþ 
1;0 ¼ a1;0 16.340*** (0.000) 0.993 (0.321)
aþ 
1;1 ¼ a1;1 11.163*** (0.000) 1.897 (0.169)
aþ1;2 ¼ a 
1;2 5.088** (0.024) 0.432 (0.511)
aþ1;3 ¼ a 
1;3 15.798*** (0.000) –
Pq
þ
Pq 8.397*** (0.003) 1.581 (0.209)
a1;i ¼ a
1;i
i¼0 i¼0

Notes: This table reports the Wald test results on the long- and short-term asymmetric effects of exchange
rate exposure. The null hypothesis of long-run symmetry is defined as: H0 :  b þ 
2 = b 1 ¼  b 2 = b 1 : The null
Pq Pq
hypothesis of short-run symmetry is defined as either: (i) H0 : aþ 1;i ¼ a
1;i (weak-form symmetry test),
i¼0 i¼0 Table IV.
or (ii) H0 : aþ 
1;i ¼ a1;i , 8 i= 1,2,. ,q (strong-form symmetry test). P-values are given in parentheses.
***
and ** Long- and short-run
indicate rejection of the null of symmetry at the 0.01 and 0.05 significance levels, respectively asymmetry tests
RAF Panel A: Soft peg period Panel B: Free float period
19,2 Short- and long-run asymmetry imposed [equation (9)] Long-run asymmetry imposed [equation (10)]
Regressor Coefficient t-statistics Regressor Coefficient t-statistics

Short-run estimates
D In Yt1 0.181** 2.356 D In Yt1 0.202** 2.118
D In Yt2 0.054* 1.793 D In Yt2 0.299** 2.271
162 D In Yt3 0.509*** 4.252 D In FRX t 0.132* 1.758
D In FRX þt 0.233** 2.086 D In FRX t1 0.301*** 5.334
D In FRX þt1 0.304* 1.753 D In FRX t2 0.521** 2.064
D In FRX þt2 0.069** 2.274 D In MLQt 0.119* 1.693
D In FRX þt3 0.104* 1.808 D In INT t 0.554 1.308
D In FRX t 0.407*** 7.091 D In INT t1 0.266** 2.091
D In FRX t1 0.489*** 9.002 D In VOLt 0.394*** 7.882
D In FRX t2 0.221** 2.511 D In WMP t 0.221* 1.915
D In FRX t3 0.366** 2.213 D In WMP t1 0.366** 2.111
D In MLQt 0.433* 1.701 D In OILt 0.093* 1.841
D In INT t 0.316 1.459 D In OILt1 0.116*** 8.543
D In INT t1 0.493** 2.213 ECT t1 0.143** 2.527
D In INT t2 0.208** 2.440
D In VOLt 0.185*** 6.809
D In VOLt1 0.217** 2.187
D In WMP t 0.681 1.201
D In WMP t1 0.325** 2.520
D In OILt 0.076 1.409
D In OILt1 0.177** 2.321
ECT t1 0.073*** 5.193
Long-run normalized estimates
In FRX þt1 0.636** 2.099 In FRX þt1 0.477* 1.887
In FRX t1 1.506*** 6.843 In FRX t1 1.012*** 8.006
lnMLQt1 0.709* 1.876 lnMLQt1 1.134 1.542
ln INT t1 1.280** 2.277 ln INT t1 1.280* 1.783
lnVOLt1 1.087** 2.398 lnVOLt1 0.707*** 6.988
ln WMP t1 0.519 1.316 ln WMP t1 0.671*** 6.447
ln OILt1 2.874 0.732 ln OILt1 0.759** 2.381
Deterministic terms
DM2014 0.226*** 4.802 DM2018 0.471*** 3.884
DM2015 0.379* 1.923 T 0.289** 2.426
T 0.173** 2.077 C 0.087 1.309
C 0.168* 1.835

Notes: This table displays the estimation results of the NARDL models as specified in Eqs. (9) and (10).
ECT t1 is the error correction term coefficient. DM2014 ; DM2015 ; and DM2018 are dummies representing the
structural shifts detected in the regressand by the minimum LM unit root test. C is an intercept term and T
is a linear time trend. The optimal lag structure is identified according to the Akaike Information Criterion,
Table V. with the maximum number of lags set at 10 days. Long-run normalized coefficients (elasticities) are
NARDL Model computed as  b k = b 1 ; 8 k= 2,.,7. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10
estimation results levels, respectively

qualitatively unaltered over the three pairs of distributed-lag coefficients

þ þ þ
(i.e. a  
1;1 vs a1;1 ; a1;2 vsa1;2 ; and a1;3 vsa1;3 ). The respective coefficient signs imply that local
currency appreciation (depreciation) tends to push up (down) stock prices, across almost all
lags. Aloui (2007) reports similar evidence for Belgium and France during pre- and post-euro
adoption periods. The results of Adjasi et al. (2011) show that depreciation of the Tunisian Impact of
dinar dampens local stock returns. exchange rate
Concerning the effect of control variables in the short-term analysis, the coefficient
estimate on market liquidity, D In MLQt , carries a positive sign, but only at borderline
changes on
levels of significance, while lagged coefficients on interest rates, D In INTti , are stock returns
negatively signed and statistically different from zero at the 5 per cent level. This
implies that the EGX100 index displays a contemporaneous positive (lagged negative)
response to changes in aggregate market liquidity (interest rates). The coefficients of 163
domestic returns volatility, D In VOLti , are negative in sign and statistically
significant at the 5 per cent level or better.
The lagged coefficients of world market returns, D In WMPt1 , and oil price returns,
D In OILt1 , are positive and statistically significant at the 5 per cent level, implying that
both global factors exert delayed, rather than immediate, effects on domestic returns. The
error correction term, ECTt1 , has a negative sign and is significant at the 1 per cent level,
providing further evidence of the cointegrating relationship between stock returns and
explanatory variables. The coefficient estimate is 0.073, which indicates that the speed of
adjustment to long-run equilibrium is quite slow. That is, in the short run, roughly 7.3 per
cent of the last-period’s index disequilibrium is eliminated within one day by subsequent
index adjustments, while the full convergence to equilibrium level takes about 14 days (i.e. 1/
0.073).
The middle part of Panel A of Table V shows the estimated long-run elasticity of the
regressand with respect to each regressor. The coefficients pertaining to positive and
þ 
negative changes in EGP/USD rates, In FRXt1 and In FRXt1 , maintain their own signs
and remain significant at the 5 per cent and 1 per cent levels, respectively. The elasticity
results suggest that the EGX100 index reacts more strongly to currency depreciations
than to appreciations. For instance, a 10 per cent positive change in EGP/USD rates
increases stock returns by about 6.36 per cent, whereas if the Egyptian pound loses 10 per
cent of its value against the US dollar, then returns decline by around 15.06 per cent,
ceteris paribus. Overall, these results confirm the asymmetric impact of EGP/USD
exchange rate variations on stock prices, whether in the short or long run. The effects of
market liquidity, short-term interest rates, and volatility of domestic returns remain
relevant and statistically significant, whereas those of the world market portfolio and oil
prices cease to exist in the long run. This result may imply that, over long-term horizons,
country-specific factors play a more dominant role in explaining stock price changes than
do global macroeconomic factors.
The bottom part of Panel A shows that the break-dummy coefficients are
statistically significant at the 10 per cent level or better. Both have a negative sign,
suggesting that their corresponding break dates are associated with events that exert
negative effects on stock returns. The time trend is significant at the 5 per cent level
with a negative coefficient, which signifies that market returns tend to decline over the
soft peg period.
5.4.2 Free float period. Before turning to the short- and long-run parameter
estimates of NARDL(p,q i ) model, it is worth noting that the short-term asymmetry
of exchange rate exposure is statistically insignificant in the free float period, as
shown in Panel B of Table IV. To account for this result, the NARDL model in
equation (9) is re-estimated with a short-term symmetry condition imposed,
following the lines of Fousekis et al. (2016) and Badeeb and Lean (2018). This
procedure aims to circumvent any potential misspecification of the model.
Accordingly, the new model structure is:
RAF X
k X
p X
q1

19,2 D In Yt ¼ C þ #t T þ h i DMi þ ˆ i D In Yti þ a1;i D In FRXti

i¼1 i¼1 i¼0

X
q2 X
q3 X
q4
þ a2;i D In MLQti þ a3;i D In INTti þ a4;i D In VOLti
i¼0 i¼0 i¼0
164
X
q5 X
q6
þ a5;i D In WMPti þ a6;i D In OILti þ b 1 ln Yt1 þ b þ þ
2 In FRXt1
i¼0 i¼0

þ b
2

In FRXt1 þ b 3 ln MLQt1 þ b 4 ln INTt1 þ b 5 lnVOLt1

þ b 6 ln WMPt1 þ b 7 ln OILt1 þ « t (10)

For the above model, the AIC approach suggests an optimal lag order of (2, 2, 0, 1, 0, 1, 1)[3].
Panel B of Table V reports the parameter estimates and associated t-statistics of the
modified NARDL model.
The short-run estimation results are presented in the top part of Panel B. Several remarks
are worth noticing. First, autoregressive parameters are statistically significant at the 5 per
cent level, suggesting a clear pattern of persistence in the dynamics of stock returns. Second,
there is weak evidence that contemporaneous log changes in EGP/USD rates are negatively
related to stock returns, whereas lagged exchange rate effects seem to be of high importance
in terms of statistical significance and magnitude. Third, market liquidity has a positive
impact on returns, albeit the evidence is marginal. Fourth, the contemporaneous coefficient
on interest rates is not statistically significant at any standard level, while the one-period
lagged coefficient is different from zero at the 5 per cent level. Thus, the influence of interest
rates is lagged rather than immediate, which is consistent with the findings for the soft peg
period. Fifth, domestic volatility continues to have considerable negative effects on stock
returns, as shown by the significance of its corresponding coefficient. Sixth, global
macroeconomic factors preserve their short-term influence on the EGX100 index in the free
float period. Seventh, the error correction term coefficient is significant at the 5 per cent level
with a negative sign, thereby validating the presence of a long-run relationship between
stock returns and explanatory variables. The coefficient estimate is 0.143, which implies
that nearly 14.3 per cent of the last-period’s disequilibrium in equity prices is corrected
within a single day by current price adjustments, while the full adjustment to equilibrium
level is expected to take about seven days. Of note, the speed of stock price adjustment
during the free float period is almost twice as fast as that of the soft peg period.
The long-run normalized estimates are reported in the middle part of Panel A of Table V.
There is a marginally statistically significant positive effect of currency appreciation on
stock returns, whereas currency depreciation has a substantially negative effect on returns,
as revealed by the sign and statistical significance of its corresponding coefficient. As is the
case in the first subperiod, the EGX100 index is more sensitive to currency depreciations
than to appreciations. For example, a 10 per cent positive (negative) change in EGP/USD
exchange rates causes stock returns to rise (fall) by about 4.77 per cent (10.12 per cent),
ceteris paribus. This finding establishes the long-run asymmetric effect of EGP/USD
variations on stock market performance. The market liquidity proxy proves irrelevant for
explaining returns in the long run, while interest rates and local volatility remain relevant
and statistically significant. The short-run positive effects of the world market portfolio and
oil prices tend to hold on in the long run. Finally, as can be seen in the bottom part of Panel Impact of
B, the coefficient estimate on the break dummy, DM2018 ; is positive and significant at the 1 exchange rate
per cent level, implying that its corresponding break date is linked to certain events whose
influence on stock prices is favorable. The time trend coefficient is positive in sign and
changes on
significant at the 5 per cent level, which suggests a general tendency of market returns to stock returns
rise over the free float period.
Taken together, our results lend support for H1, which posits that stock returns are
sensitive to exchange rate variations, no matter which exchange rate regime is in force. 165
Additionally, the results are largely consistent with H2, which predicts that stock returns
respond asymmetrically to positive and negative changes of exchange rates, regardless of
the currency regime in place.

5.5 Diagnostic tests

Table VI displays residual diagnostics and stability tests that assess the goodness-of-fit of
the NARDL(p,qi) models.
Generally, the results indicate that the selected models in both subperiods conform to the
assumptions of residual normality, residual independence, and constant variance of the
residuals. More explicitly, the Jarque–Bera test statistics show that, for the soft peg period,
the residuals follow a Gaussian distribution, but for the free float period, there is weak
evidence of deviation from normality. The results from the LM and ARCH tests suggest that
their respective null hypotheses of residual independence and constant residual variance
cannot be rejected at the 1 per cent level. The Ramsey’s Regression Specification Error Test
(RESET) statistics are insignificant at the 5 per cent level, confirming that both models have
neither omitted variables nor incorrect functional form. This means that the functional form
adopted in either model is properly specified. To examine the stability of the short-run
dynamics and long-run parameters of the models, we apply the cumulative sum of recursive
residuals (CUSUM) test. As illustrated in Figure 2, the plot of the CUSUM of each model lies
within the critical boundaries of the 5 per cent confidence interval of parameter constancy,
implying that parameter estimates are structurally stable over the corresponding sample
period. Lastly, our regressors account for about 69 per cent and 61 per cent of the variation
of stock returns in the first and second subperiods, respectively, as shown by the adjusted
R2 values.

Test Panel A: Soft peg period Panel B: Free float period

x2N 1.554 (0.224) 4.904* (0.086)

x2SC ð10Þ 9.570 (0.478) 3.083 (0.979)
x2ARCH ð10Þ 5.322 (0.869) 8.587 (0.126)
x2RESET 0.606 (0.658) 2.139* (0.094)
CUSUM Stable Stable
Adjusted R2 0.69 0.61

Notes: This table shows results of some standard diagnostic and stability tests. x2N is the Jarque-Bera
normality test. x2SC is the Lagrange Multiplier (LM) test of residual serial correlation up to ten lags. x2ARCH is
the ARCH test for the presence of ARCH effects in the first 10 lags. x2RESET denotes the Ramsey’s Regression
Specification Error Test (RESET) for omitted variables/functional form. These diagnostics are distributed
as x2 , with different degrees of freedom. CUSUM is the cumulative sum of recursive residuals test used to Table VI.
assess constancy of the short-run dynamics and long-run parameters of the model. p-values are given in Residual diagnostics
parentheses; *indicates rejection of the corresponding null hypothesis at the 0.10 significance level and stability tests
RAF 6. Robustness checks
19,2 To evaluate the robustness of the findings, we conduct two investigations in this section.
Specifically, orthogonalized, rather than raw, interest rates are considered in the analysis.
Second, the potential role of Egypt’s prevailing political risk in the stock price–exchange
rate relation is examined. To conserve space, we confine the following discussions to the key
regressors of interest, i.e. positive and negative changes in exchange rates. Inferences are
166 made only when the newly estimated models pass diagnostic tests successfully[4].

6.1 Orthogonalized interest rates

Exchange rates and domestic interest rates provide vital channels, through which the effects
of monetary policy shocks are transmitted to capital markets, commodity prices, and the
real economy. It is widely believed that the dynamics of both factors are closely interrelated
[5]. Empirically, early works (Baxter, 1994; Edison and Pauls, 1993) find that interest rate
differentials are relevant for explaining exchange rate movements. Since short-term interest
rates are included in the specification described in equation (3), we perform a two-step
orthogonalization procedure to correct for potentially jointly determined covariates,
following Bekaert et al. (2016) and Smales (2014), among others. The first step is to regress
interest rate series on exchange rates and other possibly correlated controls as follows:

INTt ¼ a0 þ a1 FRXt þ a2 MLQt þ a3 VOLt þ a4 WMPt þ a5 OILt þ V?

t; INT
(11)

The residuals, V? t; INT , represent the portion of interest rates that is independent of (i.e.
orthogonal to) the regressors of equation (11). Second, the NARDL specifications given in
equations (9) and (10) are re-estimated using the orthogonalized interest rate series, V?t; INT ,
as a substitute for its non-orthogonalized counterpart. This exercise allows us to explore the
influence of exchange rate changes on stock returns, while avoiding the possibility of the
former being affected by interest rate variations.
To a great extent, the results based on orthogonalized and non-orthogonalized interest
rates are qualitatively alike. For the soft peg period, both positive and negative EGP/USD
log changes have statistically significant effects on market returns, over short- and long-
term horizons. Generally, the respective coefficients associated with negative change terms
are larger in magnitude than those related to positive change terms in both time scales. For
the free float period, log changes in EGP/USD rates are negatively correlated with stock
returns in the short run at conventional levels of significance. In the long run, both positive

CUSUM 5%Significance

80 60

60
40
40
20
20

0 0

–20
–20
Figure 2. –40
–40
CUMSUM parameter –60

stability test –80 –60

I II III IV I II III IV I II III IV IV I II III IV I II III
2014 2015 2016 2017 2018
and negative log exchange rate changes substantially affect stock returns, with the impact Impact of
of currency depreciation being stronger than that of appreciation. exchange rate
changes on
6.2 The role of political risk
In today’s globalized economies, political vicissitudes tend to be a further source of concern for
stock returns
policy makers, analysts and investors. The influence of political events (e.g. assassinations,
presidential elections, cabinet changes, terrorist acts, geopolitical conflicts) on asset price
movements is well established in the literature (Ahmed, 2018; Bekaert et al., 2016; and
167
references therein). The Egyptian case appears to be no exception, since its equity and foreign
exchange markets are likely to be vulnerable to the vagaries of political winds during the
sample period. The country’s political scene could inevitably confound the relationship between
stock prices and exchange rates. Therefore, to draw neat statistical inference, it is important to
examine this relationship in isolation from the potential effects of political uncertainty on
exchange rate changes. As a remedy, the analysis takes into account a political risk proxy, as a
further control variable, but only after verifying that it is uncorrelated with the EGP/USD
exchange rates. To do so, Egypt’s political risk ratings, obtained from the International Country
Risk Guide (ICRG) of the Political Risk Services Group (PRS), are orthogonalized with respect to
the EGP/USD exchange rates as follows:

PRt ¼ a0 þ a1 FRXt þ Z?
t; PR (12)

The residuals, Z? t; PR ; from the above auxiliary regression constitute an orthogonalized

political risk series, which is independent of the EGP/USD exchange rates. Next, to explore
the sensitivity of stock prices to exchange rate changes after controlling for political risk, the
following NARDL(p,qi) model is estimated:

X
p X
q1 X
q2
þ þ
D In Yt ¼ C þ ˆ i D In Yti þ a1;i D In FRXti DV1 þ a2;i D In FRXti DV2
i¼1 i¼0 i¼0

X
q3 X
q4
 
þ a3;i D In FRXti DV1 þ a4;i D In FRXti DV2
i¼0 i¼0

X
q5 X
q6 X
q7
? ?
þ a5;i D lnZti; PR DV1 þ a6;i D ln Zti; PR DV2 þ a7;i D In INTti
i¼0 i¼0 i¼0

X
q8 X
q9
þ a8;i D In VOLti þ a9;i D In WMPti þ b 1 ln Yt1
i¼0 i¼0

þ þ 
þ b 2 In FRXt1 DV1 þ b 3 In FRXt1 DV2 þ b 4 In FRXt1 DV1
 ? ?
þ b 5 In FRXt1 DV2 þ b 6 ln Zt1; PR DV1 þ b 7 ln Zt1; PR DV2

þ b 8 ln INTt1 þ b 9 lnVOLt1 þ b 10 ln WMPt1 þ « t (13)

where PR is a proxy for political risk, and DV1 and DV2 are dummy variables corresponding
to the soft peg and free float regimes, respectively. DV1 (DV2 Þ takes the value of unity when
a soft peg (free float) exchange rate regime is in force, and zero otherwise. The coefficient
RAF estimates a1 and a2 (a3 and a4 Þ capture the short-run response of stock returns to positive
19,2 (negative) EGP/USD rate changes over the soft peg and free float regimes, respectively,
while a5 and a6 reflect the short-term reaction of stock returns to political risk over the soft
peg and free float regimes, respectively. Similarly, the coefficients on the interaction terms
þ þ  
ln FRXt1 DV1 and ln FRXt1 DV2 ( ln FRXt1 DV1 and ln FRXt1 DV2 ) quantify the long-
run response of equity returns to positive (negative) EGP/USD changes over the soft peg
168 and free float regimes, respectively. The market liquidity and oil price variables are removed
from the above specification, due to their statistical insignificance. As the political risk series
is available only on a monthly basis, all regressors’ daily data are aggregated into monthly
averages, which, in turn, shrink the number of data points at hand. Accordingly, the
empirical analysis rather considers the entire sample period, and the maximum lag lengths,
p and qi, in equation (13) are set to one due to the finite sample size.
The results without and with controlling for political risk are somewhat qualitatively
consistent. For the soft peg regime, the coefficients associated with positive EGP/USD
rate changes are statistically indistinguishable from zero, while those related to negative
changes are significant over both horizons. The short- and long-run coefficients on
orthogonalized political risk are statistically significant and positively signed, implying
that lower levels of political risk (i.e. higher risk scores) tend to boost market returns. For
the free float regime, the coefficients on positive EGP/USD rate changes are only
marginally statistically significant, while those of negative changes are statistically
different from zero at the 5 per cent level or better, over the short and long run. The
coefficients pertaining to political risk maintain their positive signs but remain
statistically significant only in the long run. All in all, these findings demonstrate again
the asymmetric reaction of the Egyptian market to exchange rate variations, even after
controlling for political risk.

7. Summary and concluding remarks

Throughout its recent economic history, Egypt has adopted a variety of exchange rate
systems, which could, in one way or another, influence the dynamics of the domestic equity
market. Focusing on Egypt’s experience with exchange rate regimes, we explore the
existence of spillover effects of exchange rate variations on stock prices across two different
de facto regimes, and whether these effects, if any, are asymmetric. The sample is divided
into two subsamples, where 3 November 2016 (i.e. the date on which the soft peg system was
abolished) is taken as the cutoff point. The main findings are as follows. First, over the soft
peg regime, both positive and negative changes in EGP/USD exchange rates have a
significant impact on stock returns, whether in the short or long run. Nonetheless, currency
depreciation exerts larger effects than does currency appreciation. Positive (negative)
changes in EGP/USD rates tend to drive up (down) stock prices. Second, while short-term
asymmetries taper off in the free float regime, the long-term asymmetries continue to exist.
Again, the EGX100 index reacts more strongly to currency depreciations than to
appreciations. Third, interest rates and volatility of domestic returns appear to be key
factors explaining the performance of the EGX100 index. Fourth, the global market portfolio
and oil prices retain their short-term positive effects on the EGX across both regimes.
Taken together, our findings provide useful insights for investors mulling over adding
Egypt’s capital market vehicles to their internationally diversified portfolios, and for policy
makers tasked with monitoring economic and financial system risks. Given the substantial
sensitivity of the stock market to exchange rate movements, portfolio managers should be
attentive to the swings of the Egyptian pound exchange rates, in search of clues about the
future course of equity prices. Additionally, with the local currency depreciation having
negative effects on stock returns, investors must consider implementing appropriate Impact of
currency hedging strategies to abate depreciation risks and, hence, preserve their expected exchange rate
rate of return on the Egyptian pound-denominated investments.
On the other hand, the resolute decision to float the pound appears to have fulfilled some
changes on
of its ambitious goals, including bringing down the trade deficit through exports, combating stock returns
parallel market activities, alleviating foreign currency shortage, and promoting investor
confidence. These merits notwithstanding, the flotation decision has not been without pains,
169
as the high double-digit inflation has taken a heavy toll on Egypt’s economy. In this regard,
to mitigate inflationary pressures, the authorities concerned must implement appropriate
policy measures, such as raising interest rates, stabilizing fiscal policies, and draining
excess liquidity. More explicitly, the government could contemplate pursuing a flexible
inflation targeting monetary policy, which is intended to both lower the actual inflation
toward an announced target rate and to stabilize economic growth. The inflation targeting
framework entails that the CBE actively and pre-emptively adjusts monetary policy
instruments to counter soaring inflation levels. Fiscal stability can be accomplished by
simultaneously broadening government revenues and consolidating public expenditures.
An extensive fiscal consolidation program is vital to minimize debt service obligations,
which, in turn, will free up available funds for other basic public services (notably
infrastructure, health and education).
Another important implication of the results relates to the chief role that short-term
(policy) interest rates can play in the current post-flotation stage. Typically, positive
changes in interest rates result in positive effects on the local currency value. The CBE may
raise policy rates, with a view to incentivizing people to keep their money in local currency-
denominated investment vehicles. This tactic is expected to maintain the attractiveness of
domestic fixed-income investments, while enticing more foreign portfolio managers, whose
purchases will bid up the value of the Egyptian pound. Meanwhile, to soak up excess local
currency liquidity in the banking system, the CBE may adopt indirect monetary policy
instruments, such as standing overnight deposit facilities and variable-rate deposit auctions
with longer maturities, all of which will secure tightened liquidity conditions. On the
downside, such policy tactics are most likely to come at the expense of equities, since
interest-rate hikes could probably cause some flight out of stocks and into government
bonds and other fixed-income assets. Basically, stock pricing is a forward-looking process
that factors in expected discount rates and future dividends. With higher discount rates and/
or lower future cash flows, as monetary policy tightening implies, equity markets are
expected to fall. Still, the adverse knock-on effects could only be temporary, thanks to the
recent improvements in investor confidence and business environment. On their part, policy
makers should set up precautionary measures that lessen the possibility of price distortions
and unnecessary volatility in the stock market.

Notes
1. The MSCI ACWI ex Egypt Investable Market Index (IMI) accommodates 8,879 leading
constituents from 23 developed markets and 23 emerging markets around the world. The index is
designed to track the performance of large-, mid-, and small-cap stocks, covering nearly 99% of
the global equity investment opportunity set. In this index, Egypt is excluded from the emerging
markets sample.
2. Due to space limitations, correlation matrices are not presented herein, but are available upon
request from the author.
RAF 3. For model equation (10), the associated F- and t-test statistics indicate that the variables are
19,2 cointegrated in the long run. To conserve space, these results are not reported herein, but are
available upon request.
4. Due to space limitations, the corresponding tables showing the new parameter estimates and
diagnostic tests are not presented herein, but are available upon request from the author.
5. I would like to thank an anonymous reviewer for bringing this issue to my attention.
170

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Corresponding author
Walid M.A. Ahmed can be contacted at: Walid.Ahmed@abmmc.edu.qa

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