The relationship between stock returns and foreign exchange rates continues to draw attention from both economists and practitioners, for theoretical, empirical and portfolio management reasons. The continued interest arises from the fact that they both play crucial roles in influencing the development of a country’s economy and its financial markets. The relationship between stock returns and foreign exchange rates is also frequently utilised for predicting the future trends of each other by investors.
The evolution of this present regime of floating exchange rate can be traced back to the early 1970s, and since then, the foreign exchange market has grown to become one of the largest, and by far the most liquid financial market in the world. According to the Bank for International Settlements (BIS), the daily global average turnover of the foreign exchange market as at April 2013 was about US$5.3 trillion.
This large trading volume coupled with the long trading hours and borderless geographic distributions present new opportunities and risks in the financial market.
The London market accounts for about 40.9 percent of this daily trading volume, followed by the New York, Tokyo, Singapore, and Hong Kong markets, which account for about 18.9 percent, 6.2 percent, 5.3 percent and 4.7 percent, respectively (as reported by BIS).
From the viewpoint of an international investor that is seeking higher returns and/or diversification, knowledge about the dynamic relationships between the stock market and the foreign exchange market is invaluable. Previous empirical works have established that there are two components to an asset return. One stems from price appreciation, while the other component is as a result of the performance of the currency the asset is denominated in. For a cross-border investor, investing in an asset also invariably means investing in the asset’s currency of denomination; thus, the net future value of such investments will be determined by the performance of the foreign equity, and the performance of the home currency relative to the foreign currency.
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Theoretically, two main approaches to the relationship between the stock market and the foreign exchange market have been established: the ‘flow oriented’ approach (Dornbusch & Fischer, 1980), and the ‘stock oriented’ approach (Frankel 1983, Branson, 1983).
The flow-oriented approach posits that FX rate changes affect international competitiveness and trade balance. Hence local currency depreciation works to strengthen the competitiveness of domestic companies as their exports will be cheaper in international trade. As a result, the flow-oriented approach claims a positive linkage between equity prices and the FX rate. Going by the structure of the Nigerian economy, this relationship is unlikely to hold as export of domestically-produced goods is an exception to the rule rather than the norm. Few companies will benefit from a devalued currency since most of their production inputs are imported. Export from Nigeria is dominated by just one commodity, the crude oil, which is denominated in USD.
The ‘stock-oriented’ approach on the other hand suggests a negative relationship between the stock market and the FX market with the causality flowing from the stock market to the FX market. This approach considers an internationally diversified portfolio, and suggests that the FX rate dynamics function to balance the demand and supply of domestic and foreign financial assets. Thus in this approach, increase in domestic equity prices will lead to an appreciation of the domestic currency since investors’ demand for domestic currency increases in order to purchase domestic equities.
We empirically investigate this relationship in Nigeria using the daily NSE-ASI data and the daily NGN/USD interbank exchange rate over the last five years. We also included dummy variables to capture the two different capital control regimes during this period. Since there are at least two co-integrating relationships among the variables employed, a Vector Error Correction Model (VECM) was a better fit rather than a Vector Autoregressive model (VAR).
Our results are quite interesting. Our granger-causality test suggests there is dual causality between the NSE-ASI and the NGN/USD exchange rate. This implies there is likelihood that they both lead each other. The results from our VECM regression show a strong and significant negative relationship between stock returns and FX rates, with one day lag. This is consistent with the stock-oriented approach, which suggests that increase in prices of domestic assets will lead to interest from investors which will engender stronger naira due to high demand for the local currency. The capital control dummy is also negative and significant, which suggests that the tighter the restriction on movement of capital, the lower the ability of each variable to predict the other.
This result has implications for policymakers and portfolio managers. The direction of equity prices provides some information on the likely direction of the exchange rate.
This can help policymakers be proactive rather than reactive as there are usually early warning signals of impending events. For the portfolio managers, this is another tool that could help in predicting the returns on their assets.
Olugbenga A. Olufeagba