Impact of Foreign Exchange Rate on Stock Market

Topics: Foreign exchange market, Stock market, Exchange rate Pages: 24 (7400 words) Published: April 22, 2012
Exchange Rate Volatility: Impact on Industry Portfolios in Indian Stock Market K N Badhani*, Rajani Chhimwal** and Janki Suyal***
This study examines the interaction between changes in the exchange rate of Indian Rupee and returns on different BSE-based indices representing the firms of different sizes and industries. In absolute sense, the returns on all the stock portfolios are found to be positively correlated with the external value of Indian Rupee. However, the analysis with an extended market model of asset pricing shows that the indices of export-oriented industries are negatively associated with change in exchange rate, after making the adjustment for market trend. Among them, IT, technology and knowledge-based sectors show high sensitivity towards exchange rate fluctuations. On the other hand, the indices of financial sector and import-intensive industries show a positive association with the exchange rate of rupee. The Vector Autoregression (VAR) model shows one-way causality running from stock prices to exchange rate. This suggests that the portfolio rebalancing activities of Foreign Institutional Investors (FIIs) have a more important role in the dynamic interaction between stock prices and exchange rate.

The implementation of flexible exchange rate regime, full convertibility of rupee in current account, and a gradual move towards full capital account convertibility have raised the volatility of exchange rate, and the issue of exchange rate exposure has become quite important for the corporate world. The volatility of the exchange rate of Indian Rupee in respect to US Dollar during recent periods has caused anxiety in many quarters of the economy, particularly export-oriented sectors such as IT and Business Process Outsourcing (BPO). Since, any impact on competitiveness and profitability of a firm affects the future value of its expected cash flow which, in turn, gets reflected in the market price of the its stock, this study makes an attempt to evaluate the impact of exchange rate fluctuations in the stock prices of different industry-specific portfolios. Economic theories suggest that under a floating exchange rate regime, exchange rate appreciation reduces the competitiveness of local industries in international market. It is likely to have a negative effect on the domestic stock market. Conversely, in an import-oriented economy, exchange rate appreciation may have a positive effect on the stock market as it helps to lower the input costs. The objective of the study is to examine the sensitivity of different industry-specific and size-sorted stock portfolios towards changes in exchange rate. For this purpose, the study uses daily data of exchange rate and different Bombay Stock Exchange (BSE) indices * ** Associate Professor, Institute of Rural Management Anand (IRMA), Anand 388001, India. He is the corresponding author. E-mail: Research Scholar, Department of Commerce, DSB Campus, Kumaun University, Nainital 263002, India. E-mail:

*** Lecturer, Department of Economics, Government P G College, Agastyamuni, Rudraprayag, India. E-mail: Exchange Rate Volatility: Impact on Industry Reserved. © 2009 The Icfai University Press. All Rights Portfolios in Indian Stock Market 33

representing different firm-size and industries. The results indicate that in absolute sense, an appreciation in exchange rate of rupee has a positive impact on stock prices in general. However, in relative sense, there is a negative impact of appreciation in the external value of Indian Rupee on the stock prices of export-oriented industries such as Information Technology (IT), technology and knowledge-based industries.

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After the end of Bretton Woods agreement in 1970, more and more countries adopted flexible exchange rate regime. Increasing globalization led to the gradual abolition of foreign exchange controls in the...
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