[Investigate the effects of foreign exchange (FX) rate changes on stock returns of financial institutions]

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ACKNOWLEDGEMENT

I would take this oPPortunity to thank my research supervisor, family and friends for their support and guidance without which this research would not have been possible.

DECLARATION

I, [type your fuLL first names and surname here], declare that the contents of this dissertation/thesis represent my own unaided work, and that the dissertation/thesis has not previously been submitted for academic examination towards any qualification. Furthermore, it represents my own opinions and not necessarily those of the University.

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ABSTRACT

We use univariate and multivariate GARCH-type models to investigate the properties of conditional volatilities of stock returns and exchange rates, as well as their empirical relationships. Taking three European Stock markets and two popular US dollar exchange rates as case study, our results show strong evidence of asymmetry and long memory in the conditional Variances of all the series considered. In multivariate settings we find that bilateral relationships between stock and foreign exchange markets are highly significant for France and Germany. Moreover, both the univariate FIAPARCH and bivariate CCC-FIAPARCH models provide more accurate in-sample estimates and out-of-sample forecasts than the other competing GARCH-based specifications in almost all cases. Finally, there is evidence to support the suitability of the FIAPARCH model in forecasting portfolio's market risk exposure and the existence of diversification benefits between stock and foreign exchange markets.

TABLE OF CONTENTS

ACKNOWLEDGEMENT2

DECLARATION3

ABSTRACT4

CHAPTER 1: INTRODUCTION6

Background of the Study6

Aims of the Study7

Objectives of the Study7

CHAPTER 2: LITERATURE REVIEW9

Foreign Exchange Effect on Stock Return9

Foreign Exchange and Interest Rate Effect10

Increase in interest rate11

Decrease in interest rates11

Rules11

Empirical Evidences12

Econometric Approach15

Related Literature Critique19

Exposures of stock prices and cash flows to exchange rate risk21

CHAPTER 3: MODEL FRAMEWORK24

Uni-variate GARCH, FIGARCH and FIAPARCH models24

Bivariate GARCH, FIGARCH and FIAPARCH model26

CHAPTER 4: DATA29

CHAPTER 5: EMPIRICAL RESULTS33

Estimates of Univariate GARCH-Type Models33

Estimates of Bivariate GARCH-type models35

Forecasting Evaluations37

Risk Management and Portfolio Diversification40

CHAPTER 6: DISCUSSION ANALYSIS44

Dynamic Effects with Lagged Values of Exchange Rate Changes44

Business Cycles: Expansions and Contractions46

Sector Analysis48

Asymmetric Effect50

CHAPTER 7: CONCLUSION51

REFERENCES53

APPENDIX60

CHAPTER 1: INTRODUCTION

Background of the Study

It is a common belief that as the financial market becomes increasingly more globalised, FX exchange rate and interest rate should have a higher degree of impact on the stock return. Therefore, theoretically, there should exist a strong correlation between these rates and the stock return. The reason is mainly due to the fact that FX exchange rate will create a chain reaction when a firm value their assets and liabilities under multicurrency. Since the return from a foreign asset investment is comprised of the return on the foreign asset and the exchange rate fluctuation due to the fact that investing in foreign Stock markets entails exposure to exchange rate risk. The rate will then have impact on the measurement when the firm prepare their financial reports(Heckerman, 1972, Hekman, 1985). This may show a complete Different image of their performance as the purchasing power will be Different according to different FX rates and lead to competitive advantages or disadvantages in the global marketplace, and thus ultimately affect their share price and their ...