Dynamics of exchange rate and stock price volatility: Evidence from India

• Published date: 01 February 2021
• Author: Arjunan Vadivel
• Date: 01 February 2021
• DOI: http://doi.org/10.1002/pa.2144

ACADEMIC PAPER

Dynamics of exchange rate and stock price volatility: Evidence

from India

Arjunan Vadivel

Department of Economics, Arignar Anna

Government Arts and Science College,

Karaikal, Pondicherry, India

Correspondence

Arjunan Vadivel, Department of Economics,

Arignar Anna Government Arts and Science

College, Karaikal, Pondicherry, India.

Email: arjunavadivel@gmail.com

The article examines causal relationship between exchange rate and stock price

volatility. We use daily data from February 2, 2015 to August 30, 2019 to estimate

variables employed in ARCH/GARCH, and cross correlation. It gives a feedback that

effect between the conditional mean and variance of exchange rate and stock price

volatility. The stock market has brought more capital inflow rupee that appreciate

while capital moves out of the monetary system rupee depreciate. The Reserve Bank

of India has a policy to encourage and to bring huge inflows instead of outflows.

1|INTRODUCTION

Since 2003, the Indian stock market had grown fast rate comparethan

other emerging market economies which has brought more capital

inflows into India. All-time high the Bombay Stock Exchange Market

(SENSEX) has stoodat 42,000 in January 16, 2020. While all-time low

SENSEX has indicated 29,235 on March 18, 2020. Still it continues to

bring more capital inflows inside the country. The cross border capital

movements are due toforeign institutional investment(FII); not due to

trade flows. Also the balance of trade has brought a very minimum

amount of capitals into the economy. The behavior of stock markets

depends on market equilibrium (demand and supply of market partici-

pants). Barberisand Huang (2001) suggested tradershave earned more

profit in terms of capital gain (risk seeking) when share price increases

consistently upward. Afterward, the market participants havelost their

capital gains which explains risk-averse the markets have moved out

equilibrium as the participants expected. If the traders have previous

information on share price (increased index) they will be investing fur-

ther. Otherwise, the share price will be decreased and they will move

out of the markets. The implication of the share market volatility must

be wide whetherrisk-seeking or risk-averseHe and Ng (1998).

Dornbusch and Fisher (1980) studied on “goods market approach”

which informs volatility of exchange rate affect the goods market and

stock price. The results of goods markets occur when exchange rate

depreciation (against the dollar) trader export more; the Reserve Bank

of India (RBI) accumulates more foreign exchange reserves. India's

commodity is sold lesser price than foreign goods. If a rational con-

sumer picks lesser price commodity that product will be sold more.

Therefore, the trader would have made profit out of his trade. If the

share markets have shown positive signal for further trades, it would

bring more capital inflows into the financial markets. The money mar-

ket is added extra money to create spill of money market. Since 1993,

the RBI exchange rate has followed a managed float with a base on

quantum of currencies to build a strong relationship between stock

prices and exchange rates (USD/INR).

Stock prices and exchange rate is highly volatile from rest of the

markets. The markets are based on demand and supply of financial prod-

ucts, always not in equilibrium. The traders and academician try to under-

stand to control the volatility of both markets. In addition, traders make

profit (loss) with in the time bound as both markets volatility accommo-

date. To instigate, we have opportunity to estimate the causal relation-

ship between exchange rate and stock price volatility. Cheung and

Ng (1996), Hoshikawa (2008) offered a two-step method as collect con-

ditional mean and variance of exchange rate and stock price volatility.

2|REVIEW OF LITERATURE

In retrospect of the numerous literatures have come up to support

relationship between exchange rate and stock price. For instance,

Dornbusch and Fisher (1980) studied the currency movements affect

the international competitiveness and balance of trade positions. The

real output of the country affects currency value and future cash

flows of companies. According to Frankel (1983), there was negative

relationship between stock price and exchange rate. The results were

based on the portfolio balance approach model. Further Gavin's (1989)

study on the monetary approach makes clear that exchange rate and

stock price is influenced by each other.

Received: 20 February 2020Accepted: 17 March 2020

DOI: 10.1002/pa.2144

J Public Affairs. 2021;21:e2144.wileyonlinelibrary.com/journal/pa© 2020 John Wiley & Sons, Ltd1of5

https://doi.org/10.1002/pa.2144