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ISSN : 2288-4637(Print)
ISSN : 2288-4645(Online)
The Journal of Asian Finance, Economics and Business Vol.2 No.3 pp.17-22

An Exponential GARCH Approach to the Effect of Impulsiveness of Euro on Indian Stock Market

Sahadudheen I*
*Lecturer in Economics, PG Department of Economics, Calicut University Centre, Kadmat, Union Territory of Lakshadweep, India.
July 2, 2015 August 4, 2015 August 10, 2015.


This paper examines the effect of impulsiveness of euro on Indian stock market. In order to examine the problem, we select rupee-euro exchange rates and S&P CNX NIFTY and BSE30 SENSEX to represent stock price. We select euro as it considered as second most widely used currency at the international level after dollar. The data are collected a daily basis over a period of 3-Apr-2007 to 30-Mar-2012. The statistical and time series properties of each and every variable have examined using the conventional unit root such as ADF and PP test. Adopting a generalized autoregressive conditional heteroskedasticity (GARCH) and exponential GARCH (EGARCH) model, the study suggests a negative relationship between exchange rate and stock prices in India. Even though India is a major trade partner of European Union, the study couldn’t find any significant statistical effect of fluctuations in Euro-rupee exchange rates on stock prices. The study also reveals that shocks to exchange rate have symmetric effect on stock prices and exchange rate fluctuations have permanent effects on stock price volatility in India.

JEL Classifications:E44, F31, F37, G01, G15.


 1. Introduction

Foreign exchange market and stock market are the most important constituents of a financial system. Foreign exchange market deals in foreign exchange and it is reflected in exchange rates, as stock market deals in shares of corporate and it is reflected by share prices. In recent years, the intellectual curiosity of researchers and investors has much focused to examine the ink between exchange rate and stock price. This is partly due to the advent of floating exchange rate regime, relaxation ofGovernment control over international trade and adoption of liberal policy regarding import and removal of restriction on foreign investment. Many factors, such as enterprise performance, dividends, stock prices of other countries, gross domestic product, exchange rates, interest rates, current account, money supply, employment, their information etc. have an impact on daily stock prices (Kurihara, 2006). Kim (2003) has reported that the unprecedented increases in the volume of world trade and free capital movements across the nations have increased the role of exchange rate in profitability and equity prices.

Exchange rate is one of the important and most confusing risk elements in the stock market. There is a common belief that, stock prices are significantly affected by ups and downs in the exchange rate. The variation in exchange rate affects the firm value and the firm value is reflected in its share prices. A booming stock market will attract foreign investment, and it will lead to the inflow of foreign exchange and the resulting rise in the value of domestic currency. The opposite also may happen in case of falling stock prices. In an open economy, the expectations of relative currency values influence the level of domestic and foreign interest rates, which in turn affect the present value of a firm’s assets. Similarly the firms and corporations use the foreign exchange market for a variety of purposes related to their operations such as payment for imports, conversion of export receipts, hedging of receivables and payables, payment of interest on foreign currency loans, placement of surplus funds and so forth. This suggests that exchange rates play a crucial role in the movement of stock prices.

2. Theoretical Explanations

The theoretical support for the impact of exchange rate onnstock prices is very strong. The impact of exchange rates onnstock prices can be explained with the help of two approaches,none is goods market approaches and another one is Portfolionbalance approach.

Goods market approach by Dombusch and Fischer suggestnthat changes in exchange rates affect the competitiveness of anfirm as fluctuations in exchange rate affects the value of thenearnings and cost of its funds as many companies borrow innforeign currencies to fund their operations and hence its stock price. A depreciation of the local currency makes exportingngoods attractive and leads to an increase in foreign demandnand hence revenue for the firm and its value would appreciatenand hence the stock prices. On the other hand, an appreciationnof the local currency decreases profits for an exporting firm becausenit leads to a decrease in foreign demand of its products.nWe can conclude from the above premises that appreciation innexchange rate is negatively related to the stock prices of thenexporting firm and positively related to stock price of importingnfirm.

Portfolio balanced approach stresses that exchange rate arendetermined by the fluctuation in the equity market and work undernthe demand and supply framework. An upward movingnstock market of the country grabs the attention of the foreign investorsnto invest in the stock and diversify their portfolios;nhence the upward movement brings more foreign currency tonthe country and increases the demand for the local currency,nwhich leads to appreciation of the local currency. On the othernside, when the stock market falls, the stocks lose its attractionnto be added in the portfolio. And the investors then sell outntheir stocks to avoid further losses this leads to lower demandnfor local currency and the local currency depreciates. As a resultnthe upward (downward) movement of the stock market ofncountry will lead to appreciate (depreciate) the exchange rate ofnthe country.

3. Literature Review

While both goods market and portfolio theory suggests thatnchanges in exchange rate can have an important impact on thenstock price, there is no conclusive empirical results hasnestablished. Some studies support negative association, whilensome studies support positive relation. The early studies, whichnexamined the stock price-exchange rate link shows no valid patternnof responses by stock prices to exchange rate (e.g., Ang &nGhallab, 1976; Franck & Young, 1972). This result may be attributednto the fixed exchange rate regime of Bretton Woodsnera. After the advent of floating exchange rate regime, the rolenof exchange rate in influencing macroeconomic and financialnvariables has been heightened.

Aggarwal (1981) was the first to examine the link betweennstock price and exchange rate and found a positive significantncorrelation between the two variables in U.S. On the other handnthe studies by Soenen and Hennigar (1988), Goodwin et al.n(1992), Ibrahim and Aziz (2003) and Kim (2003), suggested annegative link between the stock prices and the exchange rates.nAs a contrary to the above said studies Solnik (1987) and Ongnand Izan (1999) suggested that changes in exchange rates donnot have any significant impact over stock prices.

Enormous number of studies has been examined the causalnrelationship between exchange rate and stock price using grangerncausality technique. Some studies support a unidirectionalncausality from exchange rate to stock price; some studies fromnstock price to exchange rate and some studies support bidirec bidirectionalncausality. Most of the studies suggested a unidirectionalncausality from stock price to exchange rate. Bhmani et al.n(1992) examined both short run and long run relationship betweennstock price and exchange rate and found one way causalnrelationships from stock prices to exchange rates in short run,nand no causal relationship in the long run. Libly (1993) suggestedna unidirectional causality which moves from stock pricesnto exchange rate.

The study by Ajayi et al. (1998) reported a one way causalnrelation from the stock market to the exchange rate in Indonesianand the Philippines, while in Korea it runs in the oppositendirection. They couldn’t find any significant relation in HongnKong, Singapore, Thailand, or Malaysia. However, in Taiwan,nthey detected a two-way relationship. Granger, Huang and Yangn(2000) conducted a detailed study of the Philippine and SouthnKorean market and concluded that in Philippine the unidirectionalncausality exists between stock market and exchange rate,nand the direction of the causality is from stock price to exchangenrates. Mansoor (2000), found no long run relationshipnbetween stock prices and exchange rates, but found unidirectionalncausal relationship from stock prices to exchange rates innshort run. Hatemi-J and Irandoust (2002) suggested a unidirectionalncausality running from stock prices to exchange rates. Onnthe contrary to above study Yu (1997) detected a unidirectionalncausality from exchange rates to stock prices for Singapore, andnbidirectional causality for Tokyo Market during the period fromn1983 to 1994.

A detailed study made by Erbaykal and Okuyan (2007) forn13 developing countries suggested a unidirectional causality fromnstock price to exchange rates in the five countries, a bidirectionalncausality in the three economies and no relation found innremaining economies. Similarly Doong et al. (2005) studied thenrelationship between stock price and exchange rate for Asianncountries and detected bidirectional causality in Indonesia,nKorea, Malaysia, and Thailand.

A sizable number of studies have tried to examine the longnrun association using cointegration approach. Nieh and Leen(2001) examine the relationship between stock prices and exchangenrates for G-7 countries and find that there is nonlong-run equilibrium relationship between stock prices and exchangenrates for each G-7 countries. Similarly by taking 45nyears of U.S quarterly data, Ozair (2006) investigated the linknbetween stock prices and exchange rates and showed no causalnlinkage and no cointegration between these two financialnvariables.

The studies on the link between exchange rate and stocknmarket are relatively spheres in India and the existed studiesnshows mixed results. One of the earliest studies conducted bynAbdalla and Murinde (1997) detected a unidirectional causalitynfrom exchange rate to stock prices in India. Smyth and Nandhan(2003) also find a unidirectional causality running from exchangenrates to stock prices for India and Sri Lanka. On the contrary tonthe above result, Muhammad and Rasheed’s (2002) study onnthe exchange rates and stock price relationships for Pakistan,nIndia, Bangladesh and Sri Lanka shows no any significant relationnbetween exchange rates and stock prices in India. Similarly Bhattacharya and Mukherjee (2003) suggested that there is nonsignificant relationship between stock prices and exchange ratesnin India.

Even though, there are enormous studies focusing on exchangenrate and stock price relationships, to the best of ournknowledge, we find some drawbacks of existing works. Firstly,nno studies examined the effect of impulsiveness of euro exchangenrate on Indian stock market. Second, the studies thatnexamined the link between exchange rate and stock pricesnoverwhelmingly applied the traditional econometric tool ofnGranger causality test and cointegration. The studies with thenapplication of new financial econometrics model such asnGARCH and EGARCH model are hard to find.

The main objective of the paper is to examine the effects of impulsiveness of Euro-rupee exchange rates on two major stock price indices in India such as S&P NIFTY and SENSEX.

4. Data and Methodology

In order to examine the problem, the following secondary datanare used. We select rupee-euro exchange rates and S&PnCNX NIFTY and BSE30 SENSEX to represent stock price. Wenselect euro as it considered as second most widely used currencynat the international level after dollar. The data are collectedna daily basis over a period of 3-Apr-2007 ton30-Mar-2012. The daily data on rupee-euro exchange rates arencollected from Handbook of Statistics on Indian Economyn(, while the daily data on S&P CNX NIFTY andnBSE30 SENSEX are collected from the official website ofnNational Stock Exchange (NSE) and Bombay Stock Exchangen(BSE) respectively. The statistical and time series properties ofneach and every variable have been examined using the conventionalnunit root such as ADF and PP test. In order to check fornthe effect of impulsiveness of euro on Indian stock market, returnnon euro and stock price are used and employed GARCHnand EGARCH models.

The conventional econometric models keep the variance of the disturbance term as constant over time, but exchange rate and stock price series exhibit volatility clustering, some period a unusually high volatility followed by more tranquil periods of low volatility. There for in such cases it is clear that the assumption of constant variance is limiting and application of OLS method provides biased variance estimate; hence, inference based on OLS estimates will be misleading. So in such cases, it is better to examine not the unconditional variance but the conditional variance. For that we employ generalized autoregressive conditional heteroskedasticity (GARCH) of Bollerslev and exponential GARCH (EGARCH) of Nelson for daily data to investigate the link between exchange rate and stock price.

The returns on exchange rate and stock price can be calculated using the following formula,

Where yt and yt–1 are exchange rate and stock prices for the periods t and t-1. Let denotes greur, grnif and grsen be the daily returns on euro-rupee exchange rate, nifty and sensex respectively.

The general form of Mean and GARCH-M Equation can be written as

We can also consider alternative mean equation, which can be written as

The variance equation for both GARCH and GARCH-M model can be written as

The variance equation for the EGARCH model can be written as

5. Empirical Results

Table 1 gives a detailed descriptive statistics of all studynvariables. The mean shows the average returns, in which niftynhas highest returns followed by sensex among stock prices, euronhas also highest return. Sensex has highest volatility followednby nifty as indicated by the coefficient of variation which indicatesnthe highest standard deviation relative to the mean.nSimilarly, euro has the highest volatility.

<Table 1> Descriptive Statistics

Table 2 gives the correlation among the variables. As expected,nsensex and nifty has the highest positive correlation,nwhich is close to one. On the other hand both stock prices andna euro exchange rate is negative related.

<Table 2> Contemporaneous Correlation Coefficients


Table 3 shows a series of Augmented Dickey-Fuller andnPhilip-Perron unit root test results of daily return series; we arenable reject the null hypothesis of unit root at 1% level ofnsignificance. Thus, all series are stationary.

<Table 3> UnitRoot Test Results

All values are t statistics

At the first instance, we performed OLS regression on allnequations such as euro on sensex and euro on nifty and foundnthat the variable greur in both equations are significant at 5%nlevel. Then we checked the model for ARCH effect usingnLjung-Box Q-statistics for 5, 15 and 36 lags and also using LMntest. This indicates that we are able to reject the null hypothesisnof no ARCH effect in all models and we concluded thatnOLS regression models do suffer from ARCH effect.

As a further step, GARCH (1, 1), GARCH-M (1, 1) andnEGARCH (1,1) have been conducted using Maximum Likelihoodnmethod. The results of the effect of euro on both sensex andnnifty are presented in Tables 4 and 5. The mean equation ofnGARCH (1,1) shows a negative relation between euro and bothnstock price indices. More precisely, increase in rupee-euro exchangenrates have a negative effect on sensex and nifty. An10% depreciation of rupee against euro decreases the sensexnand nifty by 0.07% and 0.69% respectively. Regarding the effectnthe effect of euro on stock price is very low. Here for all thencases, we found that, the residual is free from autocorrelationnand ARCH effect.

<Table 4> Estimation Result-Effects of Euro on SENSEX

<Table 5> Estimation Result-Effects of Euro on NIFTY

The result form GARCH-M (1,1) is listed in the forth columnnof Tables 4 and 5, in all cases, the coefficient ζis found to beninsignificant which implies that the volatility in euro has no impactnon the euro itself. Both Q statistics and LM test suggestnthat, the residual is free from autocorrelation. The result fromnEGARCH model is reported in the final column of table 4 andn5. From the mean equations it is confirmed that euro is negativelynaffecting stock prices, but both the euro equations showninsignificant relations. Coming to the variance equation, the coefficientnγ, which measures the asymmetry, is found to be significantnat 1% level. This implies that shocks to euro rupee exchangenrate have an asymmetric effect on stock prices, whichnmeans positive and negative shocks have different effect onnstock prices in terms of magnitude. The volatility persistencenterm, λ, is positive and statistically significant at 5% level. Thencoefficient is close to 1, implying that shocks have permanentneffect on stock price volatility. The diagnostic check for autocorrelationnshows that the model is free from autocorrelation. Innshort the model is well fitted.

6. Conclusion

This paper empirically analyzed the impact of euro-rupee fluctuationsnon Indian stock prices. The study found that exchangenrate and stock price series exhibit volatility clustering, i.e. innsome period a unusually high volatility followed by more tranquilnperiods of low volatility. So GARCH and EGARCH model hasnbeen adopted. The major conclusions of the study are:

Firstly, an increase in rupee-euro exchange rates has a negativeneffect on sensex and nifty. A 10% depreciation of rupeenagainst euro decreases the sensex and nifty by 0.07% andn0.69% respectively. Regarding the effect, even though India is anmajor trade partner of European Union, we couldn’t find anynsignificant statistical effect of fluctuations in Euro-rupee exchangenrates on stock prices. This finding will be highly informativento both domestic and foreign investors and financialnanalysts to understand the direction of relationship between euronand stock prices.




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