Relationship between FII, Stock Market and Exchange Rate

Rupal Chowdhary, Shubhangi Jore and Shuchi Sharma

(December 2008)

The study of this paper is between the following economic factors: Foreign Institutional
Investors/Investment, the Stock Market movement and performance and the Exchange Rate
movement. Through the study the researchers try to analyze the possible relations between the
above mentioned factors. In order to understand any possible relationship between the factors,
the statistical tool used by the researchers is the Granger non-causality test developed by Toda
and Yamamoto in 1995. Through the study the researchers try to find out the existence of any
causal links between stock market returns and FII and exchange rates. There have been various
studies trying to establish the causal link between stock market returns and various macro
variables. These studies were generally through the various techniques such as CAPM, APT and
the Present Value Model. Various research data in the past establishes a causal link between the
stock market returns and exchange rate.

Through the paper the researchers investigate the interaction between 3 important variables: the
stock market prices, exchange rates and the FII. The study establishes bidirectional causality
between FII and the S&P NIFTY. The study also establishes causality from the stock prices to
the exchange rate, i.e. changes in stock prices affect changes in FII. Also, in the Indian scenario,
there is causality from exchange rates to FII, i.e. changes in exchange rate affect changes in FII.
The study proposes that a stringent control on exchange rate variability would enable better FII
inflows.

Aggregate Economic Variables and Stock Markets in India

Shahid Ahmed, International Research Journal of Finance and Economics (2008)

The study investigates the nature of the causal relationships between stock prices and the key
macro economic variables representing real and financial sector of the Indian economy for the
period March, 1995 to March, 2007 using quarterly data. These variables are the index of
industrial production, exports, foreign direct investment, money supply, exchange rate, interest
rate, NSE Nifty and BSE SENSEX in India. Johansen`s approach of co-integration and Toda and
Yamamoto Granger causality test have been applied to explore the long-run relationships while
BVAR modeling for variance decomposition and impulse response functions has been applied to
examine short run relationships. The results of the study reveal differential causal links between
aggregate macro economic variables and stock indices in the long run. However, the revealed
causal pattern is similar in both markets in the short run. The study indicates that stock prices in
India lead economic activity except movement in interest rate. Interest rate seems to lead the
stock prices. The study indicates that Indian stock market seems to be driven not only by actual
performance but also by expected potential performances. The study reveals that the movement
of stock prices is not only the outcome of behavior of key macro economic variables but it is also
one of the causes of movement in other macro dimension in the economy.

Causal relationship between stock market and exchange rate, foreign

exchange reserves and value of trade balance: a case study for India
Basabi Bhattacharya and Jaydeep Mukherjee of Jadavpur University
The researchers investigate the existence of a causal relation between the stock market and
various macroeconomic aggregates such as exchange rates, the foreign reserves and the balance
of payment in any economy. The study is basically conducted with Indian scenario and context
in mind. The study focuses on the key changes that have been introduced into the Indian
financial architecture post 1991. 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. The study analyses the relationship between
stock prices and foreign sector macroeconomic variables in India with implications on efficiency
of Indian stock market. Along with the newer relationships operating in the markets, newer
econometric techniques are also being introduced and applied. This paper makes use of the latest
available econometric techniques and examines efficiency of Indian stock market in terms of the
relationships mentioned above. The research also studies the existence of informational
efficiency in the Indian stock markets. Informational inefficiency in stock market implies on the
one hand, that market participants are able to develop profitable trading rules and thereby can
consistently earn more than average market returns, and on the other hand, that the stock market
is not likely to play an effective role in channeling financial resources to the most productive
sectors of the economy.
Stated in Granger jargon, there exists informational efficiency if there is a unidirectional lagged
causal relationship between macroeconomic variable and stock prices cannot be determined.
By applying the techniques of unit–root tests, co integration and the long–run Granger non–
causality test recently proposed by Toda and Yamamoto (1995), we test the causal relationships
between the BSE Sensitive Index and the three macroeconomic variables, viz., exchange rate,
foreign exchange reserves and value of trade balance using monthly data for the period 1990-91
to 2000-01. The results suggest that there is no causal linkage between stock prices and the three
variables under consideration. It may be concluded that Indian stock market is approaching
towards informational efficiency at least with respect to three macroeconomic variables, viz.
exchange rate, foreign exchange reserves and trade balance.

Stock market and macroeconomic behavior

Sangeeta Chakravarty, Institute of Economic Growth

This paper reexamines the relationship between stock price and some key macro economic
variables in India for the period 1991-2005 using monthly time series data. The researcher tries
to analyze the performance and response of a stock market that is deregulated and exposed to the
various market risks. In the study it is stated that, financial economics provide a number of
models that helps to examine the relationship The return on stocks is highly sensitive to both
fundamentals and expectations. The latter in turn is influenced by the fundamentals which may
be based on either rational or adaptive expectation models, as well as by many subjective factors
which are unpredictable and also non quantifiable. Empirical studies indicate that once the
financial deregulation takes place, the stock market becomes more sensitive to both domestic and
external factors. Domestic factors are related to domestic economic conditions and external
factors are those related to stock prices in global economy, the interest rate and the exchange
rate. The Famma Theory of efficient market hypothesis suggests that stock markets are efficient
because they reflect the fundamental macroeconomic behavior. The term efficiency implies that
a financial market incorporates all relevant information(including macroeconomic fundamentals)
in the market, in which case the outcome is the best possible under the circumstances.

Famma and French (1989) and Poterba and Summers (1988) have shown that the U.S. stock
returns have a mean reverting tendency and can be predictable to some extent .Similar results
have been found by MacDonald and Power (1991) that U.K. stock returns have a mean
reverting-tendency and so can be predicted. the efficient market hypothesis holds in US market,
and there was significant linkage between US stock market on one hand and real economic
variables, such as, GDP, industrial production, inflation and unemployment on the other hand.

The study uses Granger non causality test procedure developed by Toda and Yamamoto(1995).
The results of the study indicate that index of industrial production and inflation Granger cause
stock price but stock price does not cause either of the two so the causation is unidirectional. The
causal relation between stock price and money supply is unidirectional as stock price Granger
cause money supply but money supply does not. On the other hand there is no causal relation
between stock price and exchange rate. Similarly there is no causal linkage between gold price
and stock price.

Investigating causal relations by econometric models and cross spectral

methods
C. W. J. Granger, Econometrica, 1969

On some occasion there is a difficulty to decide the direction of causality between two related
variables and also whether feedback is occurring or not. Testable definitions of causality and
feedback are proposed and illustrated by use of simple two-variable models. The important
problem of apparent instantaneous causality is discussed and it is suggested that the problem
often arises due to slowness in recording information or because a sufficiently wide class of
possible causal variables has not been used. It can be shown that the cross spectrum between two
variables can be decomposed into 2 parts, each relating to a single arm of feedback situation.
Measures of causal lag and causal strength can then be constructed. A generalization of this
result with the partial cross spectrum is possible.

DEVELOPMENTS IN THE STUDY OF CO INTEGRATED ECONOMIC

VARIABLES
C. W. J. Granger, 1986

In sophisticated level of economic theory lies the belief that certain pairs of economic variables
should not diverge from each other by too great an extent, at least in the long-run. Thus, such
variables may drift apart in the short-run or according to seasonal factors, but if they continue to
be too far apart in the long-run, then economic forces, such as a market mechanism or
government intervention, will begin to bring them together again. Examples of such variables are
interest rates on assets of different maturities, prices of a commodity in different parts of the
country, income and expenditure by local government and the value of sales and production
costs of an industry. In some cases an economic theory involving equilibrium concepts might
suggest close relations in the long-run, possibly with the addition of yet further variables.
However, in each case the correctness of the beliefs about long-term relatedness is an empirical
question. The idea underlying co integration allows specification of models that capture part of
such beliefs, at least for a particular type of variable that is frequently found to occur in
macroeconomics. Since a concept such as the long-run is a dynamic one, the natural area for
these ideas is that of time-series theory and analysis.
This paper has attempted to expand the discussion about differencing macro-economic series
when model building by emphasizing the use of a further factor, the 'equilibrium error', that
arises from the concept of co integration. This factor allows the introduction of the impact of
long run or 'equilibrium' economic theories into the models used by the time-series analysts to
explain the short-run dynamics of economic data. The resulting error-correction models should
produce better short-run forecasts and will certainly produce long-run forecasts that hold together
in economically meaningful ways. If long-run economic theories are to have useful impact on
econometric models they must be helpful in model specification and yet not distract from the
short-run aspects of the model.

Integration and Efficiency of Stock and Foreign Exchange Markets in India

Dr. Alok Kumar Mishra & Dr. M. Thomas Paul
The research is initiated with the consideration of investor’s perception that various financial
markets may or may not be correlated to each other. Further, the issue mentioned is that, how far
the return of one market will enable the investor to predict the return in another market.
This research attempts to examine the integration and efficiency of Indian stock and foreign
exchange markets. The study employed Time series ordinary least square regression, Unit Root
test, Grangers causality test, Vector Auto Regression techniques on monthly data of stock return
and exchange rate return for the period spanning from February 1995 to March 2005.
Both the stock indices return (Rsensex and Rnifty) are near normal whereas exchange rate return
is not normal and more peak. The stock return and exchange rate return are positively related.
The policy implication of this above result of the positive relation between stock return and
exchange rate return for the foreign investors in India should be further studied. From the
Granger’s causality test, it is found that there is no causality for the return series of stock indices
and exchange rate except return Nifty and return exchange rate.

Relation between stock prices and exchange rates: evidence from south asian
countries
Naeem Muhammad and Abdul Rasheed, Karachi University
This paper examined the long-run and short-run association between stock prices and exchange
rates for four South Asian countries for the period January 1994 to December 2000. The
researchers employed monthly data and applied co integration, error correction modeling
approach and standard Granger causality tests to examine the long run and short-run association.
The results show no long run and short-run association between stock prices and exchange rates
for Pakistan and India. No short-run association was also found for Bangladesh and Sri- Lanka.
However, there seem to be a bi-directional long-run causality between these variables for
Bangladesh and Sri Lanka. The results suggest that in South Asian countries stock prices and
exchange rates are unrelated (at least in the short-run), therefore, investors cannot use
information obtained from one market (say stock market) to predict the behavior of other market.
Moreover, authorities in these countries cannot use exchange rate as a policy tool to attract
foreign portfolio investment; rather they should use some other means to do this (e.g., use
interest rates, reduce political uncertainty, improve law and order situation, produce conducive
investment climate etc.).