The exchange rate and stock price

Chapter TWO

2.1 ) Introduction

This chapter aims at showing basic theories on the foreign exchange exposure and an overview of Indian economic system and its stock market. The chapter besides play a cardinal function in constructing the foundation for the whole research, if this chapter is non decently taken into consideration, than the remainder of this thesis may non be understood profoundly. This chapter is divided in to three parts which are as follows:

2.2 ) Overview of foreign exchange exposure

In 1971, to favor the market-determined foreign exchange rates, the fixed foreign exchange rate systems were abolished, which was administrated by the Bretton Woods system under the supervising of IMF. Further, the dislocation of Bretton Woods System resulted in debut of fluctuating exchange rates, and the effect of this increased the volatility in the markets around the universe and increased rising prices and volatility in oil and stock prices4.

4 Anuradha Sivakumar and Runa Sarkar. ( 2007 ) .

Now, different states fallow different exchange rate systems. Having a fixed exchange rate system by a state and where in the state tries to fallow a pecuniary policy which is inconsistent with the holes rates could take to currency crisis. On the other manus, holding a floating exchange rate will let in detecting the economic dazes easy, but the disadvantage of holding a floating exchange rate system is that it may exhibit high volatility which could consequence on the economic growing of the state. So the above account makes it clear that, each exchange rate has its ain advantages and disadvantages. 15

Before traveling in front to analyze the assorted exchange rate exposure and the relationship between exchange rate and stock monetary values, first Lashkar-e-Taiba ‘s hold a expression at the some of the exchange rate systems as classified by Alan C. Shapiro. ( 2008 ) .

Monetary brotherhood: ( 39 ) *5

5 * Indicates the figure of states that fallow such exchange rates

Is a zone where there is no separate legal stamp, in other words where a individual pecuniary policy exists with a individual currency or currencies, which are perfect replacements and go around freely. This class is besides known as exchange agreements with no separate legal stamp.

Free float: ( 47 ) *

This exchange rate is besides known as pure float, where the exchange rate is market determined which does non affect public sector intercession. The interaction in the currency supply and demands will find the free-market exchange rate. The economic growing, monetary value degree alterations and the involvement derived functions in bend will consequence on the supply and demands of currency, so any alterations in these economic parametric quantities, the market participants consequently will set the current and expected future currency demands.

Currency board agreements: ( 8 ) *

States which intend to train their cardinal bank are following this sort of pecuniary government, here the exchange rate is fixed to an ground tackle currency, their exist an statute law committedness to interchange domestic currency to specific foreign currency at a fixed exchange rate

Fixed nog: ( 44 ) *

Where the currency is paged with other currency or basket of currencies at a fixed rate, where the currency fluctuates within the narrow border.

Pegged exchange rate within horizontal sets: ( 6 ) *

The value of currency is maintained within a present set, where through intercessions end points are defined, this sort of governments allows to blend market 16

Determined rate with stabilised exchange rate intercessions in a regulation based system

Crawling nog: ( 4 ) *6

*Indicates the figure of states that fallow such exchange rates

Is a regulation based system to change the par value where little sums of periodical accommodations are made in currency value at a fixed pre-announced rate.

Managed float: ( 33 ) *

Where exchange rate are determined in the foreign exchange market, the agreement provides off to blend market-determined rate with stabilising intercession regulation. Here states will actively step in in the foreign exchange market so, as to cut down the economic uncertainness.

Euro country is one of the best illustrations for stiffly fixed exchange government, where in the Euro is the individual currency for its member states. However against all other currencies, Euro itself is an independently floating currency. States like Ecuador and Panama are another best illustration for stiffly fixed exchange government that uses the US dollar as their official currency. States like Cameroon, Chad, Mali, Niger, Senegal and others in the Cardinal African France ( CFA ) zone are besides uses a individual common currency called France. On the other manus 47 states fallow independent drifting currencies, most of these states are developed states such as Australia, Canada, Japan, US, UK, new Zealand, Sweden and Switzerland ( Alan C. Shapiro. ( 2008 ) . However, some emerging states like Brazil, Indonesia, Korea, Mexico, Philippines and Thailand are the unwilling participants included in the natation currencies class, who tries to keep a fixed exchange rate but the market place forces them to drift their currencies. On June 1993, the Reserve Bank of India announced that Indian currency will be allowed to drift, before it was pegged with US dollar. But grounds show that RBI have been step ining to a great extent in the direction of the exchange rate government by increasing the currency modesty, therefore the currency government of India could be said to be managed drifting 17

2.2.1 ) Concept of foreign exchange exposure

Adler and Dumas ( 1983 ) separate the currency hazard and currency exposure by proposing that, a currency hazard is non hazardous because devaluation is likely to go on. If we know the magnitude and timing of the currency fluctuation than there would be no hazard at all. The most of the person ‘s or a house ‘s debt are denominated in a strong currency so the currency does non go hazardous, on the other manus a weak currency compared with a strong currency would be less hazardous. Statistical measures are used to place the currency hazard, which summarize the chance that the existent value of a currency will differ on a given hereafter day of the month from its original awaited value. A currency hazard is non the same as the currency exposure ; a currency exposure could be said as the grade to which a company or an economic system is affected from the fluctuation in the exchange rates ( Davis, Coates, Collier and Hongden, 1992 ) .

The exposure from exchange rate comes in two forms- economic exposure which includes dealing and operating exposure and another one is the interlingual rendition exposure. Understanding these exposures is of importance as they helps in understanding the construct of exchange exposure.

Transaction exposure is the any future losingss or additions, that may originate from the minutess which are already been entered and are denominated in foreign currency. For case, say an UK transnational house sells $ 1 million worth of goods on a three months recognition to a US client. At the clip of dealing, the bill will be $ 1 million, if the bill is issued in dollar. Hence, on the adulthood day of the month, the UK house will have 1 million dollar, which it has to change over in to lbs at the topographic point rate, but an exchange rate may non be the same at that clip. Now suppose if the dollar appreciated against lb, so the UK house will do net income as it will have more lbs, or frailty versa. During the Asiatic crisis, 1997-98 most of the US exportation houses received 80 % less hard currency flow if their bill was in Asiatic currencies ( Kim, K. , 2003 ) . 18

Operating exposure: it ‘s an exposure for a house from the currency fluctuation towards its hereafter operating hard currency flow. The minute a house invest in serving a market which is capable to foreign competition or involves in international activities, it faces the operating exposure than comes the dealing exposure when the houses committednesss leads to prosecute in gross revenues and purchase in foreign denominated currency.

Translation exposure: is besides known as accounting exposure or balance sheet exposure, where if a company keeping assets and liabilities, returns and disbursals in foreign currency denomination and when the fiscal statements for foreign operations are translated to place currency and if the exchange rate fluctuates from the old coverage period, than the consequences could be said as foreign exchange additions or losingss. An illustration for interlingual rendition exposure- in 1996, due to losingss from foreign net incomes interlingual renditions, IBM company ‘s main fiscal officer made an proclamation that the company ‘s net incomes for 2nd one-fourth were declined by $ 25 per portion, investors reacted severely by selling their IBM portions which made the company portion monetary values to farther autumn.

In decision, we can state that, houses need to hold a proper direction over these exposures or else they could be lay waste toing to houses and can convey immense losingss. Hence, cognizing the relationship between fluctuating exchange rate and stock monetary values could assist houses in fudging against exchange exposures.

2.3 ) Relation between exchange rate and stock monetary values

Stock monetary value are considered as an index of existent economic activity and to detect their major determiners, many theories have been developed, among them ; pecuniary theory supports the being of the relation between the stock monetary value and exchange rate. The indirect attack for set uping the relation between these two is by sing some of the common pecuniary variables like rising prices, involvement rate and money supply which influences of the stock monetary value and every bit good as exchange rate. In this portion of the chapter we will try to analyse the direct and indirect attacks which set up the relationship between these two. 19

2.3.1 ) indirect relationship between exchange rate and stock monetary value

To link indirect relationship with stock monetary value and exchange rate, we will be discoursing four of import hypotheses:

  • The expected rising prices hypothesis:

Harmonizing to this hypothesis, both the stock monetary value and exchange rate will be affected by a alteration in the rising prices of a specific state. An increasing rising prices leads to depreciation of currency value as the high rising prices reduces the demand for domestic currency, this is other manner around, and that means when rising prices rate falls down it boost up the demand for domestic currency taking to its grasp.

Again, rising prices rate have besides important impact on stock monetary value. The former has through empirical observation proved that stock monetary values hedge against rising prices. However, empirical consequences by Fama ( 1980 ) , and Geske & A ; Roll ( 1983 ) , show that, there is a negative relationship between the stock monetary value and exchange rate. Therefore, the relationship between the stock monetary value and exchange rate is equivocal all though they are indirectly linked by rising prices it is because of deficiency of grounds on the reaction of stock monetary value to rising prices alterations.

2. The Keynesian hypothesis:

If all the monetary values in the economic system dual, the buying power will be reduced that means the same nominal measure of money will no longer be able to purchase the same goods, so we can state that money is valued in footings of what it can purchase. John Maynard Keynes a British economic expert therefore constructed the undermentioned money demand equation

Md /P =F ( I, Y )

Where ; M is the nominal stock of money and P is the monetary value degree. This equation states that the demand for existent money balances Md /P is a map of involvement rate ( I ) and existent income ( Y )

Harmonizing to this hypothesis, in the foreign exchange market the increasing involvement rates will increases the demand for domestic currency, which finally will take to grasp of domestic currency. where as in stock market the addition in existent involvement rate 20

should take to take down the stock monetary values, this is because the increasing involvement rates consequences in lifting price reduction rates and puts economic activates under depression ( Manabu Asai. ( 1999 ) .

3. The existent activity hypothesis:

Harmonizing to the existent activity hypothesis, the domestic currency will appreciate, if there is an expected rise in the existent activity. Two grounds could be related to this ; foremost, the increasing demand for domestic currency will automatically impact the exchange rate and secondly, the higher existent rate linked with a greater money demand would do an incipient capital influx.

4. The hazard premium hypothesis:

Harmonizing to this hypothesis, an proclamation of unexpected addition in money will hold following affect:

  • Increase or diminish in short term rates
  • Long term rates will increase
  • Stock monetary values will fall, but the domestic currency value would non hold any affect.

2.3.2 ) direct relationship between stock monetary value and exchange rate

In the old subdivision an indirect links between stock monetary value and exchange rate were analysed or discussed, in the current subdivision a more direct attack will be fallowed an effort will be made to discourse the direct consequence of altering exchange rate on the stock monetary value and vice-versa.

How the exchange rate affects the stock monetary values:

With the universe economic systems opening up fare more than in the yesteryear, the house ‘s assets & A ; liabilities and hard currency flows are more espoused to the consequence from altering exchange rate. Harmonizing to Bordnar and Gentry ( 1993 ) , an grasp of the domestic currency means lower sum of currency needed to buy a unit of foreign currency. In general, this is good for import sector but hurts the export sector as the grasp reduces the foreign demand and hard currency flows of exporters. 21

For import sector their net incomes additions from grasp of place currency because it reduces the place currency cost of goods. To understand this more clearly Lashkar-e-Taiba ‘s see the undermentioned figure

Import oriented house ‘s net incomes

Export oriented house ‘s net incomes

Demand for goods

Domestic currency

Import oriented house ‘s net incomes

Export oriented house ‘s net incomes

Demand for goods

Domestic currency

Figure 1: currency fluctuation effects

Beginning: Writer ‘s ain Compilation

From the above figure it ‘s clear that when domestic currency appreciates, the demand for domestic goods will diminish which will impact the export oriented houses and import oriented houses will be benefited when the foreign currency deprecates as their cost of goods will be reduced.

Finally, when houses has foreign denominated assets, the motions in exchange rates would impact on the value of their retention assets for case, say a house has foreign investings with the current and future hard currency flows denominated in foreign currency, so the place currency value of this watercourse of hard currency flows depends on the exchange rates, here the value of foreign denominated assets will increase when the place currency depreciated. In decision, we can state that altering exchange rates will consequence on the net incomes of the houses, so this would automatically reflect on the portion monetary values of the house. 22

How the stock monetary value impact the exchange rate:

On the other manus fluctuating stock monetary value can hold an consequence on the exchange rate. This could be inferred by trusting on the portfolio attack to interchange rate finding. The critical portion of portfolio theoretical accounts of exchange rate finding is the construct that, all the wealth of an person is allocated among the alternate assets which includes foreign and domestic money every bit good as foreign and domestic securities. It is normally hypothesized that there is an reverse relation between the domestic and foreign involvement rates with the demand for the domestic money or in other words domestic every bit good as foreign involvement rates determines the demand for the domestic currency, where as the demand for domestic ( foreign ) securities has a positive relation with domestic ( foreign ) involvement rates and negative relation with foreign ( domestic ) involvement rates. In this context, the function of exchange rate is to equilibrate the demand and supply of assets. Therefore, there will be alteration in the equilibrium exchange rate if there is any alteration in the demand and supply of assets. Now consider that the domestic stock monetary value additions highly, this will ensue in an addition in domestic wealth. Sing the portfolio attack, which states that the increased wealth will ensue in addition for the demand for money and so does the involvement rate additions, this high involvement rate attracts foreign capital influx which would consequences in grasp of domestic currency value.

2.4 ) Overview of Indian currency governments and Indian stock market

The intent of this subdivision is to familiarize the reader with the some of the facts and figure of Indian economic system and its currency government and stock market, which will be used as samples in our analysis on the relation between stock monetary value and exchange rate. First we will hold a expression at the Indian economic development and so on its currency government and eventually on its stock market.

India, after opening its economic system to the universe market, it has undergone terrible alterations, it has besides seen an unbelievable growing in some of its economic activities. The economic growing of the state was 9.8 % in 2007/08 but was 23 lag to 7.4 % in 2008 ; the accelerator for the recent economic growing is due to increase in the industrial production, roar in the IT sector and addition of FDI activities. In the twelvemonth 2004 the FDI was $ 4.11 billion which in the twelvemonth 2008 was recorded as $ 12.35 billion as matching addition of 73.35 % in FDI. For the twelvemonth 2007, the fabrication, industrial and service sectors all together amounted to 77 % of the GDP of India. The part of Indian export towards the GDP was amounted to US $ 127 billion and the import figure were US $ 132 Billion for the twelvemonth 2008 ; the portfolio investing of India was amounted to US $ 7.1 billion in 2008 ( Indian Economy 2009 ) . Due to the addition in the oil monetary values the rising prices rate had increased to 12 % . The SENSEX ( BSE index ) in the current planetary downswing has besides experienced high volatility and instability. The Indian Rupee in the recent convulsion has fallen greatly from 39 rupee per $ in the beginning of 2008 to 44 rupee per $ by the terminal of 2009 and reached the lowest of 49 rupee per $ by the mid 2009. In our empirical survey, we have considered Indian rupee against US dollar, as US is one among the biggest trading spouse for India and furthermore many research workers have used rupee exchange rate against per US dollar in their empirical analysis7.

7 Ajayi and Mougoue ( 1996 ) , Ashok Banerjee and Sahabed Sarkar. ( 2006 ) , Golaka ( 2003 ) .

Traveling on to the history of Indian exchange rate government, from 1947 to till 1975 INR ( Indian rupee ) was pegged with the British lb. Indian rupee was briefly pegged to US dollar after the prostration of Bretton Woods Systems on August 1971, but by the terminal of 1971, the rupee returned to be pegged with lb until 1975. From September 1975 boulder clay 1991, the Indian currency was pegged to a basket of currency which was non disclosed. Between the old ages 1991-1993 the Indian currency government went through many alterations, this was the period of passage towards openness of Indian economic system ( Jaykumar V, 2005 ) . After the 1993, the Indian exchange rate government is considered to be managed float.

Finally talking on the Indian stock market, its dynamic alterations have mostly affected on the economic growing on India. After the independency the Indian stock market has seen an unbelievable growing, but the market was truly boosted 24 up after the fiscal sector reforms of India which facilitated influx of FDI. Over the past few old ages, the universe has witnessed a significant addition in the stock market trading with greater stableness. More specifically, by supplying more liquidness to market participants and by being more transparent in its trading activities, Indian stock market has become more easy accessible. Talking on the history of Indian stock market ; the working of stock exchanges started in 1875. Bombay Stock Exchange and National Stock Exchange are the lone two markets in India that facilitates exchange of securities ( K.S. Chalapati Rao, 2002 ) . In 1990, BSE For the first clip reached 1000 Markss and by the terminal of 2008 it reached 16000 Markss. Since the 1990, due to the beginning of fiscal deregulating in India, the Indian stock market has witnessed several alterations housemans of its trading forms, processs and fiscal invention ( that is new merchandises and services ) but these has besides made the stock market to be more highly volatile. Harmonizing to the study on Indian stock markets investors have about lost $ 6 trillion between the old ages 2006-08 due to high volatility in stock monetary values ( K. J Somaiya ) . ( 2008 ) .

2.5 ) Decision

In this chapter, the research worker emphasises on researching some of the of import constructs of foreign exchange exposure. The chapter foremost familiarise the reader to assorted exchange rate systems that are followed by different states ; this portion of the chapter gives a general thought on the construct of exchange rates. Than we move on to foreign exchange exposure by explicating what is exposure and different sort of exposure. Once the exchange rate exposure construct is understood the chapter than explores the direct and indirect links between the exchange rate and stock monetary values and eventually the chapter provides a brief position on Indian economic system, its currency government and on its stock market. This chapter besides acts as a foundation for our research. 25