Factors Affecting Exchange Rates Finance Essay

Exchange rates play a vital role in a country's level of trade, which is critical to every free market economy in the world. One very basic definition of exchange rates is the rates at which one unit of a country's currency can be exchanged into another one. As such, the observation of exchange rates is crucial and its one of the most watched, analysed and fluctuate economic variables. But exchange rates do matter on a smaller scale as well: they impact the real return of an investor's portfolio. Exchange rates for countries which operate under a flexible exchange rates system are determined through the foreign exchange rates also known as the FOREX. The forex market is believed to be the largest, most efficient and liquid financial markets. The forex market regroups international players through a network of computers that connect participants from across the globe.

2.1.1 Factors affecting exchange rates

Exchange rates vary within second, like any commodity, the mechanism of exchange rates operates through factor of demand and supply. It is essential to know the main factors that cause these instant movements in exchange rates are: Interest rate and Inflation It is important to note that exchange rates, interest rates and inflation are three highly correlated factors. The manipulation of interest rates by Central Bank of its 'benchmark' rates is reflected in the retail interest rates, that is, the price charged by banks or other financial institution in the business of lending money. Higher interest rates would boost up foreign investment by attracting investors seek higher return on investment. This will increase the demand for the domestic currency. Furthermore, if a country is underperforming, a measure to boost up consumption is by Central Bank to lower the interest rates thus making borrowing cheaper. https://fxtrade.oanda.com/learn/top-5-factors-that-affect-exchange-rates https://www.barclayswealth.com/international/foreign-exchange/currency-rates.htm# https://www.forexbite.com/trading-courses/fundamental/factors-that-affect-exchange-rate https://www.starfishfx.com/learn-forex-lesson-6 https://www.trading-point.com/foreign-exchange-prices https://www.investopedia.com/articles/basics/04/050704.asp#axzz2JBtSIgnn

2.2 Stock Market Index

Stock Index or Stock market index is a way of measuring or tracking the value of a section of a stock market. In general, the computation of stock indices is done by combining the prices of selected stock (weighted average). Indices can be calculated using two different methodologies: Price- weighted index: whereby only the price of the stock is used to calculate the value of the index. Dow Jones is an example of such index. Market-weighted index: use the market capitalization of companies for calculating the value of the index. It is the most broadly-used indexes today, such as S&P 500 and Hang-Seng indices. Stock Index is an important tool for investors or financial managers to make investment decision, for forecasting and assessing their returns on investment. Most widely followed stock indexes are from the US market, the S&P 500, Nasdaq and the Dow Jones. Other significant international stock markets indexes are Nikkei 225 (Japan),A FTSEA 100 (UK) and Hang Seng (Hong Kong).

2.3 Theoretical Review

There exist no theoretical consensus on the existence or the direction of any relationship between stock prices and exchange rates. But instead, classical economic theory hypothesis discuss the linkage between stock prices and exchange rates trough two models: 'flow oriented' model (Dornbusch and Fischer, 1980 and Gavin, 1989) and the 'stock-oriented' model (Branson, 1983 and Frankel, 1983). The flow oriented model assumes that important determinants of exchange rates are through a country's current account and balance of trade performance. Under this model, it is assumed that exchange rate affects the valuation of a firm through its competitiveness since it affects the cost of capital borrowed from overseas and also earnings made in foreign currencies. This in-turn influences real economic variables such as real income and output subsequently affects the current and future cash flows of companies and thus their stock prices. This goes in line with what had been discussed by Dornbuscher and Fischer which states that stock prices is defined as discounted present value of a firm's expected future cash flows; thereby any events affecting a firm's cash flow will be projected in the firm's stock prices. [1] As for the stock oriented models, as opposed to flow oriented model, stipulate that changes in stock prices cause changes in exchange rates through the use of financial account (capital account) transactions. Two distinct models can help in explaining the stock oriented model: the portfolio balance model and the monetary model. Under the portfolio model, it is assumed the investors diversified their portfolio as a measure of minimising risk by holding both domestic and foreign assets. As such, if prices of local assets increase, this will leads to an appreciation of the domestic currency. For instance, a rise (following a boom in the market) in the domestic assets prices will cause investors to demand more of local asset and subsequently selling foreign assets. This will lead to an increase in demand of local currency while increasing the supply of foreign currency causing a shift in the demand and supply of currencies which thereby induce an appreciation of the local currency. Another way of viewing this appreciation of the domestic currency following an increase in stock price; this will lead to an increase domestic wealth and hence demand for money, which in-turn raises the domestic interest rates. With higher interest rate, the domestic market is able to attract foreign capital, leading to an appreciation of the domestic currency. Thus, this establishes a positive causality linkage running from stock prices to exchange rates. The monetary model view exchange rates as being determine as a relative asset prices [2] , it assume that the current exchange rates reflects future expected exchange rates, which are affected by other factors than that of stock prices. Therefore under this model, stock prices and exchange rates should not show any linkage. [3] The relationship between stock prices and exchange rates can be examined in the case of an import-dominant country and export-dominant country. Ma and Kao (1990) (missing)

2.4 Empirical Review

During the past three decades, a large number of empirical studies tried to examine existence and direction of causality between Exchange Rates and Stock prices, using data of different stock indices as well as different time horizon. One of the earliest attempts in examining the nexus between exchange rates and stock prices was by Franck and Young (1972) who conclude that there was no significant interaction between the variables. Furthermore, studies at that time focuses on US market only and one of the most predominant studies was by Aggarwal (1981) which depicts the link between exchange rates and stock prices by analysing the correlation between the changes in the US trade-weighted exchange rates and changes in US stock markets indices using monthly data for the period 1974 to 1978. The study indicates a positive correlation during the period leading Aggarwal to conclude that the variables interacted in a manner consistent with the flow-model. In contrast, Soenen and Henigar (1988) reported strong negative interaction using monthly data of the U.S. dollar effective exchange rate and U.S. stock market index for the period 1980 to 1986. One study which provides a foundation for further studies was by Ma and Kao (1990), whereby they test the degree of stock prices reaction to exchange rates changes in different countries. The differences among countries were explained by the nature of their economies, specifically by the extent to which the economy depends on exports and imports. As per their research, an appreciating currency negatively affects the domestic stock market for a country with larger export sector and positively affects the domestic stock market for an import-dominant country. Earlier studies relating to the issue used mainly statistical techniques such as simple regression and correlation to establish any relationship between stock prices and exchange rates. These studies suffer from a serious limitation as they omit to recognize the fact that most financial variables are non-stationary. Since early nineties, researches started using advance econometrics tools to find a relationship between the variables and their assorted results. Bahmani-Oskooee and Sohrabian (1992) was the first to employ causality tests in the examination of any linkage between stock prices and exchange rates. They used co-integration to investigate the relationship between monthly data on S&P 500 index and US dollar effective exchange rate for the period 1973-1988. They showed bi-directional causality, at least in the short run. Their results affirm both stock-model and flow-model. As Ajayi and Mougoue (1996) search the relationship between exchange rates and stock indices for eight advanced economies using daily data from 1985 to 1991. According to results of study, there are significant short-run and long-run feedback relations between these two financial markets. An increase in stock price has a negative short-run effect as well as a positive long-run effect on domestic currency value. Also, currency depreciation has a negative both short-run and long-run effect on the stock market. Ajayi et al. (1998) take daily market indexes and exchange rates to investigate causal relations between stock returns and changes in exchange rates for seven advanced markets from 1985 to 1991 and eight Asian emerging markets from 1987 to 1991. The empirical results show that there is a unidirectional causality between the stock and currency markets in all the advanced economies while no consistent causal relations exist in the emerging economies. They explained the different results between advanced and emerging economies with the differences in the structure and characteristics of financial markets between these groups. Staverek (2005) investigated the causality between effective exchange rates and stock prices for eight EU countries and the USA. He employed vector error correction modelling, co-integration analysis and the standard Granger causality test. The results appear to be unidirectional and causality runs from stock prices to exchange rates, the causal relations for the period 1993-2003 were stronger than in 1970-1992. Additionally for old EU countries (Austria, France, Germany, UK) and for USA the causality was stronger than for new EU countries (Czech Republic, Hungary, Poland, Slovakia). Richards et al. (2009) depicts the interaction between stock prices and exchange rates in an Australian context. Their results were in consistent with the portfolio balance model, Granger causality runs from stock prices to the exchange rates. Very few researchers actually analyse the dynamics relationship between Stock prices and Exchange rates in Africa. Adjasi et al. (2011) is among the few to investigate the relationship between these variables in seven African countries. The analysis was made for the period 1992 to 2005 by using vector autoregressive (VAR) cointegration and impulse response analysis to determine the long- and short-run linkages between stock prices and exchange rates. Their findings were, whether in short run or long run, cointegration was found for Tunisia, where exchange rate depreciation drives stock prices down. Furthermore, Shocks induced by either stock prices or the exchange rate are more protracted in Ghana, Kenya, Mauritius and Nigeria than in South Africa and Egypt.

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