BBA-LLB (HONS.

)/ SEMESTER II
ECONOMICS RESEARCH PAPER SUBMISSION: 18th JUNE, 2021

TITLE:
A comparative study on impact of exchange rates on stock market in India and
USA

SUBMITTED BY:
KINJAL BHARDWAJ
SAP: 81022019101
(D027)

SUBMITTED TO:
PROF. PARINAAZ MEHTA
NMIMS, SCHOOL OF LAW
(DEEMED TO BE UNIVERSITY)

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Table of contents
INTRODUCTION .......................................................................................................................... 3

Objectives .................................................................................................................................... 5

Hypothesis................................................................................................................................... 5

LITERATURE REVIEW............................................................................................................... 6

VARIABLES .................................................................................................................................. 8

Exchange Rate............................................................................................................................ 8

Stock Market ............................................................................................................................... 8

RELATION BETWEEN EXCHANGE RATE AND STOCK MARKET .................................... 9

DATA INTERPRETATION AND ANALYSIS .......................................................................... 12

CONCLUSION............................................................................................................................. 16

BIBLIOGRAPHY......................................................................................................................... 18

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INTRODUCTION

The exchange rate and stock market are the two fundamental financial markets in the world. These
two markets are playing key role in an international business all over the world. It is necessary to
understand the relationship between the both markets so that the investors may be able to invest in
a better way by taking the minimum risk.

Stock market return is one of the most relevant and most important metric for the management and
the shareholders of the organizations. The study on the factors that impact the share prices is
flocking the research databases mostly because the theorist and the applicants want to optimize the
management processes and thus provide a guaranteed and stabilized performance of the stock. One
factor that impacts the return on stocks and the interest of investors in the stock is the foreign
exchange rate. Foreign exchange return is also important in the context of macroeconomic
management of a country meaning to say that if a relationship between the foreign exchange rate
and the stock market return is found to exist, then the government has the opportunity to manage
the exchange rate and thus the return on the stock market. Moreover, through the establishment of
this relationship, the investors will be able to get another element of predictability in the
fluctuations of stock market returns.

The impact analysis of macroeconomic variables on stock market is a focus for economists since
19th century. Macroeconomic fundamentals and stock market volatility do play an important role
in determining and forecasting the future position of an economy as a whole. In this study, one of
the macroeconomic variables, exchange rate, is studied along with Indian Stock Market (BSE
Index). The linkage between exchange rate and stock market index is considered as one of the
important contributors to predict the growth/ business cycle of any economy. This dynamic linkage
between exchange rate and stock market has been analyzed considering 15 years of data (from
2010 to 2016) on exchange rate and stock market index related to Indian Economy. A stock index
or stock market index is a measurement of the value of a section of the stock market. It is computed
from the prices of selected stocks (typically a weighted average). It is a tool used by investors and
financial managers to describe the market, and to compare the return on specific investments. The

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main focus of the researchers is to find out the impact of exchange rate fluctuation on stock market
volatility to predict the economic scenario.

In the context of economic development, Stock market plays a crucial role for every country.
Amount of savings an economy has, contributes one of the robust factors for boosting economic
growth. The more is the percentage of investment out of savings, the faster an economy reaches to
sustainable development for long run. The main purpose of channelizing savings into investment
is return. Higher amount of investment leads to higher return and vice versa. This return or profit
can again be channelized into further investment to reach the goal of economic development of a
country.

International Trade, on the other hand, also facilitates an important role in shaping the structure of
an Economy by varying the exchange rate. Two broadly categorized exchange rates- Nominal and
real can be taken into account in this regard. While the nominal exchange rate takes into
consideration the amount of domestic currency which can be sold to purchase one unit of foreign
currency, real exchange rate tells how much domestic goods and services can be exchanged with
foreign goods and services. The real exchange rate equation measures (Nominal exchange rate x
domestic price/foreign price). The rise in the exchange rate causes an economy to import more
which means revaluation of domestic currency and vice versa. Taking stock market and exchange
rate together, we can say, in stock market, if the interest rate is low, foreign investors sell their
assets and they will liquidate their investments. The liquidation of investment gives a sudden or
external supply shock of the foreign currency in the determination of equilibrium exchange rate
schedule. As there is now more supply of foreign currency at a given demand, the domestic
currency gets appreciation and foreign currency faces depreciation or devaluation.

Domestic investors invest more in domestic market when there is an increase in prices of assets
which in turn increase the demand for local currency and also increase the behavior of selling the
foreign assets. The increase in demand of local currency will force the interest rates to become
higher which will ultimately attract the foreign investors to invest and gain maximum benefit. The
exchange rate of local currency will appreciate against that of foreign currency and shows negative
relationship as also suggested by Portfolio Balance approach. While, Traditional approach

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advocates that there is a positive relationship between stock market and exchange market and the
causality runs from exchange rate to stock market. It suggested that a positive relationship between
stock prices and exchange rates exists when local currency depreciates and local firms become
more competitive which leads to an increase in their exports. This will result in an ultimate increase
in stock prices. In addition to above two approaches, there exists another approach i.e., Asset
Market approach which propose that there is no interaction or very weak association between the
exchange rate and stock market. This is due to the reason that both the variables may be driven by
different factors. The current international financial system and its ever increasing importance with
the passage of time have brought many researchers to study the relationship between stock market
and exchange rate.

The present study is an endeavor to analyze the relationship between stock prices volatility and
exchange rates movement in India and USA. The analysis on stock markets has come to the fore
since this is the most sensitive segment of the economy and it is through this segment that the
country’s exposure to the outer world is most readily felt.

Objectives

▪ To examine the role of exchange rate in the stock markets of India and USA.
▪ To examine the influencing role of exchange role on stock market.
▪ To examine the relationship between the two variables.

Hypothesis

H0-Exchange rate significantly influences the stock market of a country.

H1- Exchange rate does not significantly influence the stock market of a country.

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LITERATURE REVIEW

According to the study of Franck and Young (1972), there is no significant interaction between
the stock market and exchange rate. An association was examined by Bhattacharya and Mukherjee
(2003) between the stock prices and financial sector of currency exchange in India and found no
significant integration. Nonlinear Least Square method used by Ong and Izan (1999) to find the
relationship between stock prices and exchange rates. They found a very weak association between
the US stock market and exchange rates. While, Soenen and Henniger (1988) found a significantly
negative relationship between the value of US dollar and stock prices by using monthly data on
stock prices and effective exchange rates for the period 1980-1986. Jorion (1990) determines
significant differences across industries by considering the impact of exchange rate on US
multinational firms. The developed countries have experienced less exposure of exchange rate
movements as compared to developing or emerging countries.

A bidirectional relationship exists between the two variables. Both variables have little or more
impact on each other. Yu (1997) conducted the study by using daily data for the period 1983-1994
on three Asian countries Hong Kong, Tokyo and Singapore. He brought the facts that a
bidirectional relationship exists in Tokyo while Singapore market has unidirectional relationship
i.e., changes in exchange rate to changes in stock prices. Abdalla and Murinde (1997) investigated
the relationship between the two variables in four Asian countries for the period 1985-1994 by
using co integration approach in the long run and come up with the conclusion that no causality
exists in Pakistan and Korea while supported its presence in India and Philippines. Ajayi et al.
(1998) found a unidirectional relationship from stock market to foreign exchange market on
developed economies and no consistent relationship in developing economies. Pan et al. (2001)
examined that exchange rates are significantly correlated with stock markets in seven Asian
countries by using the data for the period 1988-98.

The relationship between exchange rate and stock market may vary. It may be different depend
upon the geographical area, economic conditions, relations with international world, domestic
conditions etc. The inconsistency in the results between the different countries might be due to the
trade volume, equity, economic relations, risk assessment etc. The direction of the impact of both
variables may not be estimated as it may be unidirectional, bidirectional or multidirectional.

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Rittenberg (1993) investigated the relationship between stock price and exchange rate in Turkey
by applying Granger causality tests and found that there is a unidirectional relationship that runs
from price level changes to exchange rate changes but there is no reverse relation exists. Bahmani-
Oskooee and Sohrabian (1992) also apply Granger causality tests to find the relationship between
stock market and exchange rate for the period 1973- 1988. They investigated that a dual and
bidirectional relationship exists between stock prices and exchange rates in the short run without
further examining it in the long run. Granger et al., (2000) found that there is a strong relation
between the two variables and in some case, it was unidirectional with negative interaction while
bidirectional in the others.

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VARIABLES

Exchange Rate
As far as quantifying the expectation of the exchange rate are concerned, Marey (2004) says on
the basis of a survey data that long term expectations are not only heterogeneous but are also not
effectively described by the rational expectations. In his own research, Marey (2004) tried to
investigate the level of plausibility of standard exchange rate expectations mechanism which in an
artificial economy are found to be favored by heterogeneous traders, the research concludes that
adaptive expectations market exhibits more serial correlation because it bandwagons the
expectations market. Secondly, the extrapolative expectations market sometimes generates
extreme returns and thus cannot be empirically plausible and finally, the regressive expectations
market reproduces stylized facts of empirical quarterly exchange rates.

Tsen (2011) says that the real exchange rate has been found to play an important role in the
investment determination and the international trade systems as the appreciation of real exchange
rate can lead to retarded exports, a change in the amount of debt payment that needs to be done
and a growth of inflow of foreign direct investment. The economies overall can be affected by the
changes in the exchange rate. For this research however, the impact of exchange rate changes on
the stock returns has been considered.

Stock Market
According to Tetlock (2007) and Van Rooij et al. (2011), the stock market is defined as consisting
of the primary and secondary markets. Under this definition, new issues (IPOs) are initially offered
by companies and this is the primary market, whereas any later trading is the secondary market.
According to Singh (2010) stock price is influenced by many factors, some of which are specific
to company, sector and the environment in which a firm conducts its business. Stock price is also
dependent upon macroeconomic factors, domestic and international factors, market sentiments,
expectations about future economic growth, political or social events, monetary and fiscal policies
of countries.

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RELATION BETWEEN EXCHANGE RATE AND STOCK MARKET

According to Patosa & Cruz (2013) exchange rate is priced like other assets and determined by the
expectations of foreign investors, who give regard to fluctuations in exchange rates in the future,
interest rate differential among countries, inflation rate, current account deficit, political and
economic conditions, trade relations between countries, and the external debt of the country. It has
been also being proposed that exchange rate fluctuations impose a risk to the import and export of
the country, however, this is dependent upon whether the country is export or import dominant. In
support of this, Ozturk (2007) stated that volatility in the exchange rate has a significant impact on
the level of international trade as an increase in exchange rate leads to increased risk and
transaction costs, which are both associated with the volatility of the exchange rate; ultimately this
leads to a lowering international trade within the economy. Macroeconomic factors are the external
factors that impact the general environment rather than particular environments. Through focusing
research on to stock prices, there is a secondary effect of studying the macro environment when
measuring stock performances. Such macro factors include inflation rate, interest rate, GDP rate
and exchange rate (Hong and Stein, 2007). Among these variables, Lobo (2000) has studied the
behavior of stock prices with respect to the macro variable of interest rate. In which he found that
interest rate is inversely related with stock prices. It was suggested that this finding arose because
the rate of interest is the rate of borrowing money in order to invest in assets, which can also be
used as a discounting rate to find the valuation of future cash flows generated by these assets; this
creates an inverse relationship among these variables.

Many researchers and analysts who found the association between the inflation rate and stock
prices have also studied the behavior of other macro variables. It has been found that there is a
significant relationship between inflation rates and stock prices. Increases in stock price lead to a
decrease in the rate of inflation (Rano, 2011). Such an indirect relation between inflation rate and
stock prices exists, because whenever there is a decline in the inflation rate, the interest rate also
declines which ultimately results in a rise of stock prices (Fornell et al., 2006). Such indirect results
appear on stock prices due to unsteady living expenditure. The foremost variable of this research
has also been found as a factor for consideration when studying the performances of the stock
market. It was identified in Muhammad and Rasheed (2003), that the association between

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exchange rate and stock prices is insignificant in the case of South Asian countries (i.e. Pakistan,
India, Bangladesh, and Sri Lanka). Nevertheless, they found a two-way direction between the two
variables in Sri Lanka and Bangladesh.

The exchange rate value in a specific country, at a particular point in time, influences the prices in
the stock market. An increase in exchange rate suggests an appreciation in national currency,
therefore enhancing of profits of an organization. High profits for a corporation lead to increased
stock prices. It is identified that the association between exchange rate and stock prices is only
observed in the short-term (Farooq et al., 2004) and (Agrawal et al., 2010). Moreover, there is no
such interconnection found on a long-term basis between these two variables. In contrast to this
Muhammad et al. (2002), stated that there are different variables that influence exchange rate, such
as positive or negative news. Furthermore, it has been described that the factors that affect
fluctuations in stock market prices are different and include political condition, industry growth,
etc. According to Adjasi et al. (2008), the association between currency rate and stock market
prices are understood through various theories on exchange rates, including the flow-oriented
model and stock oriented model. The stock-oriented model suggests that stock prices and exchange
rate are related; a change in stock prices alters the exchange rate of a particular nation. A positive
increase in stock prices serves as a trigger to attract investors in foreign markets (Phylaktis, and
Ravazzolo, 2005). Which leads towards the high demand of local currency and results in an
appreciation of the exchange rate. The research gap is defined as areas that have not been covered
in past studies (Zikmund et al., 2012). It has been observed in past studies that there are different
factors that affect exchange rates such as gross domestic product, inflation level, interest level, and
other macroeconomic indicators. Furthermore, it has been discussed that there is an
interconnection between exchange rate and stock market prices. Moreover, there were various
studies that have clearly identified and justified association of these two research variables. Hence,
the current study fulfils this gap by focusing on identifying an association between exchange rate
and stock market prices in South Asian economies.

A popular example of the correlation between forex and shares is the FTSE 100 stock index and
British pound sterling. The index is impacted by the direction of the national currency because a
lot of the listed companies have international operations, so a large portion of their profits are made
in US dollars or other currencies. If sterling weakens then the dollar revenues are worth more and

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the FTSE 100 is likely to rise as the companies on the index become more valuable. However, it
is important to remember that the forex market is extremely volatile, so any impact upon the stock
market tends to lag. Also, until a company releases its earnings report we can’t fully understand
the extent to which currency movements have impacted upon their operations and share prices.
Even though the correlation between exchange rates and the stock market does exist, it can be
difficult to use as an indicator for share price movements.

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DATA INTERPRETATION AND ANALYSIS

In statistics, a correlation coefficient is used to quantify the connection between two variables. The
correlation indicates the degree of a linear relationship between the X and Y variables. Correlation
coefficients come in a variety of shapes and sizes. Karl Pearson's Coefficient of Correlation is a
widely used mathematical approach for determining the degree of relationship between linearly
linked variables using a numerical representation. The correlation coefficient is denoted by the
letter "r."

INDIA

Correlation between the Indian rupee exchange rate and the stock market index from 2001 to 2013,
with the exchange rate on the X-axis and the stock market index on the Y-axis.

Years Exchange rate Stock market value

2001 47.19 1059.05

2002 48.61 1093.5

2003 46.58 1879.75

2004 45.32 2080.5

2005 44.1 2836.55

2006 45.31 3966.4

2007 41.35 6138.6

2008 43.51 2959.15

2009 48.41 5201.05

2010 45.73 6134.5

2011 46.67 4624.3

2012 53.44 5905.1

2013 56.57 6304

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 INDIA
Series1 Linear (Series1)

18,000.00
16,000.00
14,000.00
12,000.00
10,000.00
8,000.00
6,000.00
4,000.00
2,000.00
0.00
0 10 20 30 40 50 60

Exchange rate Stock market index

Exchange rate 1
Stock market index 0.281251 1

Methodology: Secondary Data

Findings: Therefore, the nature of correlation between exchange rate of India and its stock market
index is positive but weak (r= 0.281251). It implies that both the variables are ever increasing
however, there isn’t any significant influence of either on either variable. This concludes that the
foreign exchange rate doesn’t affect India’s stock market.

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USA

Correlation between the US dollar exchange rate and the stock market index from 2001 to 2013,
with the exchange rate on the X-axis and the stock market index on the Y-axis.

Years Exchange rate Stock market value

2001 47.19 10,021.57

2002 48.61 8,341.63

2003 46.58 10,453.92

2004 45.32 10,783.01

2005 44.1 10,717.50

2006 45.31 12,463.15

2007 41.35 13,264.82

2008 43.51 8,776.39

2009 48.41 10,428.05

2010 45.73 11,577.51

2011 46.67 12,217.56

2012 53.44 13,104.14

2013 56.57 16,576.66

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 USA
Series1 Linear (Series1)

18,000.00
16,000.00
14,000.00
12,000.00
10,000.00
8,000.00
6,000.00
4,000.00
2,000.00
0.00
0 10 20 30 40 50 60

Exchange Rate Stock market index

Exchange Rate 1
Stock market index 0.51077 1

Methodology: Secondary Data

Findings: Therefore, the nature of correlation between exchange rate of USA and its stock market
index is positive and moderate (r= 0.51077). It implies that both the variables are ever increasing
however, there isn’t any influence of either on either variable. This concludes that the foreign
exchange rate doesn’t affect USA’s stock market considerably.

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CONCLUSION

The relationship between exchange rates and stock prices has instigated a widespread debate in
the empirical literature since both variables have an essential role in many macroeconomic
fundamentals and investment decisions. The basic theory is that when the domestic stock market
rises, it gives investors’ confidence that the country’s economy is also rising, leading to increased
interest from foreign investors and demand for the domestic currency. Conversely, if the stock
market underperforms, confidence falters and foreign investors take their funds back to their own
currencies.

The analysis has given an importance on analyzing two-time series data after taking the normalized
value of two variables. The study suggests to the Indian stock investors to invest in Indian stock
market for long run to get higher return and to avoid the short term fluctuation in the interpretation
behind this is that if there is depreciation of rupee against dollar, price level increases. Investors
sell their financial assets because of higher profit in the situation of price hike. The mass selling
of financial assets leads to a fall in SENSEX value at a particular point of time. For long run, the
result is opposite showing a positive correlation between them. For long term investors in India, it
is profitable to keep their assets and not to sell frequently because if Rupee depreciates against
dollar, there will be higher exports.

Export oriented promotion leads to change the economic scenario of developing country, like
India. Increased export will call for more production, more employment, less current account
deficit, increase in percentage of GDP. Competitiveness and quality of production will also
improve. This actually contributes to higher level of National Income, savings and Investment.
The increased investment will amount to higher value of SENSEX. Hence, in short run, the
correlation between currency value and SENSEX may be negative, but, in due course of time, the
correlation is positive. The analysis of the two data done in the paper for India and USA also
portrays there is no significant influence of foreign exchange rates on the stock markets of the two
countries however, it also observed that the influence of exchange rate on the stock market index
is comparatively more in the case of USA than India.

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In an incomplete stock market, to induce risk-averse investors to invest in the market, some risk
premium would be required to compensate for the probable risks they face. It is noted that
traditional arbitrage theory regards risk premium as an arbitrage gain that implies the nonlinearity
in asset return dynamics. In addition, structural changes in asset returns may also occur as the firms
involved make obvious adjustments based on the external economic environment and public
policy. As USA’s economy opens up and grows rapidly, the US Dollar continues to appreciate.
For USA’s changing capital markets, it would undoubtedly be mismodeled to utilize a traditional
linear model for estimation. This is why the viewpoint of nonlinearity has continuously been
emphasized, and why empirical studies increasingly tend to focus on employing nonlinear models
to estimate economic and financial variables.

Compared with stock markets in other countries, USA’s stock markets are still in the nascent stages
of development. However, with the infusion of more foreign capitals into the country, USA’s stock
markets will undertake an important role in the international asset portfolio in the future. It is
imperative, therefore, that the government has comprehensive investment policies in place. The
study provides novel results that market investors with proper investment strategies and the
government with accurate policy-making to perform risk control management in advance.

While looking at specific examples can be a great way to see the two markets interact with each
other, it is important to remember that there is no guarantee these patterns will be repeated over
time. Using a single data point, especially one as prone to change as the relationship between forex
and stocks, can be extremely risky. Traders and investors should consider multiple indicators when
they are making decisions about what to trade and when to trade it. The forex market can be an
interesting factor to consider when looking at stocks, but alone it is not enough to provide an
accurate assessment of market movements, and vice versa.

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BIBLIOGRAPHY

▪ Suriani, S., Kumar, M. D., Jamil, F., & Muneer, S. (2015). Impact of exchange rate
on stock market. International Journal of Economics and Financial Issues, 5(1S).
▪ Zhao, H. (2010). Dynamic relationship between exchange rate and stock price:
Evidence from China. Research in International Business and Finance, 24(2), 103-
112.
▪ Gavin, M. (1989). The stock market and exchange rate dynamics. Journal of
international money and finance, 8(2), 181-200.
▪ MARKET, F. O. S. (2018). Impact of exchange rate fluctuation on stock market
volatility-a study to predict the economic Scenario In India. International Journal of
Pure and Applied Mathematics, 118(18), 4309-4316.
▪ Jorion, P. (1991). The pricing of exchange rate risk in the stock market. Journal of
financial and quantitative analysis, 363-376.
▪ Nath, G. C., & Samanta, G. P. (2003). Relationship between exchange rate and stock
prices in india-an empirical analysis. Available at SSRN 475823.
▪ MARKET, F. O. S. (2018). Impact of exchange rate fluctuation on stock market
volatility-a study to predict the economic Scenario In India. International Journal of
Pure and Applied Mathematics, 118(18), 4309-4316.
▪ Patel, S. (2012). The effect of macroeconomic determinants on the performance of
the Indian stock market. NMIMS Management Review, 22.
▪ Görg, H., & Wakelin, K. (2002). The impact of exchange rate volatility on US direct
investment. The Manchester School, 70(3), 380-397.

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