International Journal of Economics and Finance Vol.1, No. 1, February 2009

Editor IJEF
2009 International Journal of Economics and Finance  
The aim of this paper is to examine the interaction between stock prices and exchange rates in Australia. During the period of the study, the value of the stock market increased by two-thirds and the Australian dollar exchange rate appreciated by almost one-third. The empirical analysis employed provides evidence of a positive co-integrating relationship between these variables, with Granger causality found to run from stock prices to the exchange rate during the sample period. Although
more » ... y prices have not been included, the significance of the results lends support to the notion that these two key financial variables interacted in a manner consistent with the portfolio balance model, that is, stock price movements cause changes in the exchange rate. This challenges the traditional view of the Australian economy as export-dependent, and also suggests that the Australian stock market has the depth and liquidity to adequately compete for both domestic and international capital against other larger markets. Portfolio balance approaches, or 'stock oriented' models developed by Branson et. al. 1977 postulates the opposite to flow models, that is, that movements in stock prices can cause changes in exchange rates via capital account transactions. The buying and selling of domestic securities in foreign currency (either by foreign investors or domestic residents moving funds from offshore into domestic equities) in response to domestic stock market movements has a flow through effect into the currency market. Although the literature on this subject has examined the relationship Vol. 1, No. 1 International Journal of Economics and Finance 4 between stock prices and exchange rates in various economies, the results have been mixed in terms of the evidence as to which of the above models is most applicable to, or prevalent within an economy. Ramasamy and Yeung (2005) suggest that the reason for these divergent results is that the nature of the interaction between stock and currency markets is sensitive to the stage of the business cycle and wider economic factors, such as developments or changes in market structures within an economy. So the period of time in which the interaction between stock and currency markets is observed is critical to the end result. This observation is a key platform on which the current study of the interaction between stock prices and exchange rates in Australia is developed given the high degree of co-movement between Australian stock prices and the Australian dollar exchange rate during the period of the study. This positive relationship is intriguing given the traditional importance of export earnings to the growth profile of the Australian economy. Indeed, this view of the economy lends itself to the flow oriented model, whereby exchange rate appreciation would be expected to cause stock prices to fall. This is also consistent with the conclusions of Mao and Ka (1990), who found that an appreciation in the currency of export-dominant economies tends to negatively influence the domestic stock markets of those economies. Reinforcing this view is the fact that the Australian stock market lacks the depth and liquidity of other larger markets in Asia, Europe and North America. Hence, rises in stock prices here would not normally be expected to result in an appreciation in the value of the Australian dollar as the portfolio balance model postulates, and as is observed by the trends in these variables during the said period. The results of this study has value for policy makers and market practitioners in that it sheds light on the nature of the strong co-movement between stock prices and the Australian dollar. Indeed, any evidence that stock price movements are found to Granger cause movements in the Australian dollar exchange rate would certainly challenge the traditional view that Australian financial markets reflect the economy's traditional commodity base. Section 2 examines the economic theory surrounding stock and currency market interactions, and also reviews the literature on the interaction between stock prices and exchange rates. Section 3 reviews the data used in the analysis and describes the hypotheses which underpin the study. Section 4 details the methodology employed in the study, and section 5 describes the results of the analysis. Section 6 provides concluding comments. Theory and Literature Review Classical economic theory hypothesises that stock prices and exchange rates can interact. The first approach is encompassed in 'flow oriented' models (Dornbusch and Fisher 1980), which postulate that exchange rate movements cause stock price movements. In the language of Granger-Sim causality, this is termed as 'uni-directional' causality running from exchange rates to stock prices, or that exchange rates 'Granger-cause' stock prices. This model is built on the macro view that as stock prices represent the discounted present value of a firm's expected future cash flows, then any phenomenon that effects a firm's cash flow will be reflected in that firm's stock price if the market is efficient as the Efficient Market Hypothesis suggests. One of the earliest distinctions of how exchange rates affected stock prices was according to whether the firm was multinational or domestic in nature (Franck and Young 1972). In the case of a multinational entity, changes in the value of the exchange rate alter the value of the multinational's foreign operations, showing up as a profit or loss on its books which would then affect its share price. Flow oriented models postulate a causal relationship between exchange rates and stock prices. Clearly, the manner in which currency movements influence a firm's earnings (and hence its stock price) depends on the characteristics of that firm. Indeed, today most firms tend to be touched in some way by exchange rate movements, although the growing use of derivatives, such as forward contracts and currency options, might work to reduce the manner in which currency movements affect a firm's earnings. In contrast to flow oriented models, 'stock oriented' or 'portfolio balance approaches' (Branson et. al 1977) postulate that stock prices can have an effect on exchange rates. In contrast to the flow oriented model -which postulate that currency movements influence a firm's earnings and hence causes change in stock prices -stock oriented models suggest that movements in stock prices Granger-cause movements in the exchange rate via capital account transactions. The degree to which stock oriented models actually explain real world stock and currency market reactions is critically dependent upon issues such as stock market liquidity and segmentation. For example, illiquid markets make it difficult and/or less timely for investors to buy and sell stock, while segmented markets entail imperfections, such as government constraints on investment, high transactions costs and large foreign currency risks, each of which may discourage or hinder foreign investment (Eiteman et. al. 2004). It is clear from this theoretical review that there are various ways by which stock and currency markets can interact. This makes empirical analysis of the degree and direction of causality between stock prices and exchange rates particularly interesting and has provided the motivation for several studies in examining the interaction between stock prices and exchange rates. Although theory such as the flow and portfolio models and the money demand equation International Journal of Economics and Finance February, 2009 5 hypothesise that a relationship should exist between exchange rates and stock prices, the evidence provided by the literature on this subject matter has been mixed. A study by Aggarwal (1981) provided some evidence in support of the flow model. This study examined the relationship between exchange rates and stock prices by looking at the correlation between changes in the US trade-weighted exchange rate and changes in US stock market indices each month for the period 1974 to 1978. The study found that the trade-weighted exchange rate and the US stock market indices were positively correlated during this period, leading Aggarwal (1981) to conclude that the two variables interacted in a manner consistent with the flow model. That is, movements in the exchange rate could directly affect the stock prices of multinational firms by influencing the value of its overseas operations, and indirectly effect domestic firms through influencing the prices of its exports and/or its imported inputs. Soenen and Hennigar (1988) found a significant negative correlation between the effective value of the US dollar and changes in US stock prices using monthly data between the period from 1980 to 1986. While this finding is in contrast to Aggarwal (1981), who found a positive correlation, it still provides evidence in support of the flow model. While the above studies focussed exclusively on the United States, a later study by Ma and Kao (1990) examined the relationship between exchange rates and stock prices in six industrialised economies, including the UK, , the authors tested the degree of stock price reaction to exchange rate changes in each of the above jurisdictions. Their findings were consistent with the flow model, leading the authors to conclude that the relationship between exchange rates and stock prices hinged on the extent to which an economy depended on exports and imports. These early studies were useful in establishing a foundation for further studies on the interaction between exchange rates and stock prices, but they were limited in that they only applied simple regression analysis to establish a correlation between the variables, or only tested the 'reaction' of one variable to changes in the other. Bahmani-Oskooee and Sohrabian (1992) were one of the first to utilise tests of causality in examining the relationship between stock prices and exchange rates in the US context. They also used a much longer time period (15 years) and also utilised tests of co-integration. Co-integration techniques allow one to establish if the variables share a long-run relationship, as the interactions uncovered by the Granger (1969), Sim (1972) method are intrinsically short-run in nature. Using monthly data of the US S&P 500 index and the effective exchange rate of the US dollar, the authors employed an autoregressive framework, finding that US stocks and the exchange rate shared a dual or bi-causal relationship (i.e. changes in the exchange rate effected stock prices and vice versa) in the sample period, 1973 to 1988. These results would seem to affirm both the portfolio and flow models. Meanwhile, the co-integration test (carried out using the methodology outlined by Engle and Granger 1987) found little evidence that the variables shared any relationship in the long-run. A study by Ajayi et al. (1998) examined the relationship between exchange rates and stock prices among developing and developed nations. Like Bahmani-Oskooee and Sohrabian (1992) and Yu Qiao (1997), Ajayi et al. (1998 used Granger-Sim causality to examine the relationship between movements in the stock price indexes and movements in the exchange rates. Importantly, the findings of Ajayi et al. (1998) appeared to have uncovered a consistency in the relationships between stock prices and exchange rates among developed economies, which were in accordance with the portfolio model. On the contrary, the patterns of causality among the emerging Asian economies examined were mixed. No significant causal relationships were detected in Hong Kong, Singapore, Thailand or Malaysia. Notably, this result is again in contrast with those of Yu Qiao (1997), which found uni-directional causality from exchange rates to stock returns in Hong Kong, although the findings of Ajayi et al. (1998) are consistent with those of Yu Qiao (1997) in that neither study found a relation between stock prices and exchange rates for Singapore. Ajayi et al. (1998) attributed the difference in their findings between developed and emerging economies to structural differences between the currency and stock markets of each. Specifically, the authors suggest that markets are likely to be more integrated and deep in advanced economies, and that emerging markets tend to be much smaller, less accessible to foreign investors and more concentrated. The authors also made note of wider risks such as political stability and the legislative environments which might make investment in emerging markets less attractive. Hence, the study concluded that activity in emerging stock markets tends to portray wider macroeconomic factors less strongly than in developed markets and as a result, these markets tend to have weaker linkages to the currency market. While most literature in this context had previously focussed on developed markets or on comparisons between developed and emerging markets, the Asian financial crisis of the late 1990s sparked interest in the interaction between currency and stock markets solely in developing markets. Indeed, the Asian crisis was characterised by plunging currency and stock markets within South East Asia. Granger et al. (2000) was one such study which focussed on this region. It examined the interaction between stock and currency markets in Hong Kong, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore, Thailand and Taiwan, all of which were effected by the crisis. The empirical results showed that, with the exception of Singapore (where exchange rate changes led stock prices as per the flow Vol. 1, No. 1 International Journal of Economics and Finance 6 model), all countries displayed little evidence of interaction between currency and stock markets during the first period. In the second period, the exchange rate in Singapore again led its stock market, while the reverse (as per the portfolio model) was evident in the cases of Taiwan and Hong Kong. The contrasting results across the body of literature regarding this issue suggest that there is no underlying or intrinsic causal relationship between exchange rates and stock markets across jurisdictions. Rather, the differing causal relationships uncovered through empirical analysis implies that the interaction between currency and stock markets are influenced by the business cycle and different economic structures present within individual countries, meaning causality between the two financial variables is sensitive to the time period in which the analysis is undertaken. This view is confirmed by Ramasamy and Yeung (2005), who suggest that causality is unique within jurisdictions, within specific time periods and is even sensitive to the frequency of data utilised. In their study, the authors examined the degree of exchange rate and stock price causality in the same nine Asian economies studied in Granger et al. (2000), but during the period 1 January, 1997 to 31 December, 2000 -the entire period of the Asian currency crisis. The empirical results of Ramasamy and Yeung (2005) differ from those of Granger et al. (2000). While Granger et al. (2000) found a bi-causality for Malaysia, Singapore, Thailand and Taiwan, Ramasamy and Yeung (2005) found that stock prices lead exchange rates for these countries. On the other hand, Granger et al. (2000) found that stock prices lead exchange rates for Hong Kong, but a bi-causality was detected by Ramasamy and Yeung (2005). The current study on the interaction between exchange rates and stock prices in the Australian context differs from previous work in a number of ways. Firstly, it employs a current data set. Secondly, it does not seek to postulate the existence of some underlying causal relation between stock prices and exchange rates as early studies on thus subject have sought to. Rather, recognising the robust and changing dynamics between these variables, this study examines how these variables interacted during the sample period. This is done specifically with a view to challenging the traditional export-dependent view of the Australian economy which lends itself to the flow oriented model of stock price and exchange rate interaction. Hence, the focus is on ascertaining the significance of the strength and direction of the influence of Australian stock price movements on the Australian dollar exchange rate in the study period. Given the importance of both equity and currency markets to the functioning of an economy, the empirical results provide useful information to market practitioners and policy makers on the interaction between stock prices and exchange rates. Data and Hypotheses This study examines the interaction between Australian stock prices and the Australian-USD exchange rate from 2
doi:10.5539/ijef.v1n1p0 fatcat:jrt42fuonvdtdmps2ym6gxs5ty