Currency Exposure in China

Currency exposure in China: Effect of exchange rate changes on stock market

Chapter: Data Analysis

The relationships between exchange rate and stock price are studied comprehensively by financial economists and practitioners. Theoretical links between stock prices and exchange rates have taken two forms. Dornbusch and Fischer (1980), firstly, suggest the “flow-oriented” models of exchange rates, which posit that changes in exchange rates affect international competitiveness and trade balances, thereby influencing real income and output. Stock prices, generally interpreted as the present values of future cash flows of firms, react to exchange rate changes and form the link among future income, interest rate innovations, current investment and consumption decisions. Gavin (1989) argues that the innovations in the stock market, on the other hand, affect aggregate demand through wealth and liquidity effects, thereby influencing money demand and exchange rates. Secondly, Branson (1983) and Frankel (1983) present the “stock-oriented” models of exchange rates, which view exchange rates as equating the supply and demand for assets such as stocks. This approach determines exchange rate dynamics by giving the capital account an important role. Since the values of financial assets are determined by the present values of their future cash flows, expectations of relative currency values play a considerable role in their price movements. Therefore, stock price innovations may affect, or be affected by, exchange rate dynamics.

Empirically, Jorion (1990), and Bartov and Bodnar (1994) fail to find a significant contemporaneous relation between U.S. dollar movements and stock returns for U.S. firms. Griffin and Stulz (2001) find that weekly exchange rate shocks have a negligible impact on the performance of industries for six industrialized countries. However, Aggarwal (1981) finds that U.S. stock prices and the trade-weighted dollar are positively correlated. Rather, Soenen and Hennigar (1988) find a strong negative correlation between U.S. stock indexes and a fifteen currency-weighted value of the dollar. Donnelly and Sheehy (1996) document a significant contemporaneous relation between exchange rate and the market value of large U.K. exporters. Still, some studies have focused on the interactions or the directions of causality between exchange rates and stock prices. Bahmani-Oskooee and Sohrabian (1992) show that there is bidirectional causality between stock prices measured by the S&P 500 index and effective exchange rates of the dollar. Ajayi et al. (1998) provide evidence to indicate unidirectional causality from the stock to the currency markets for advanced economies and no consistent causal relations in emerging markets. Chiang and Yang (2003)show that stock returns and currency values are positively related for nine Asian markets. Wu (2000)shows that Singapore-dollar exchange rates Granger cause stock prices. Ramasamy and Yeung (2002)examine the links between the foreign exchange and stock markets and their implications for capital controls in six Asian countries over the period 1995-2001 and find that there are inconsistent results for bivariate causality between stock prices and exchange rates. Pan et al. (2007) examine dynamic linkages between exchange rates and stock prices for seven East Asian countries, excluding China. Yau and Nieh (2009) investigate the exchange rate effects of the New Taiwan dollar against the Japanese Yen (NTD/JPY) on stock prices in Japan and Taiwan and find a long-term equilibrium and asymmetric causal ...