Assessing the Dynamic Linkage Between Exchange Rates and Stock Prices: Evidence from SAARC Countries

This study examines the dynamic relationship between exchange rate and the stock market price, using the evidence from four South Asian countries where the research gap has prevailed from a lesser number of studies and research has made little to no attempt in investigating the predicting power of the stock price using the exchange rate. By conducting time series analysis on the dynamic relationship between the exchange rate and the stock price in Sri Lanka, India, Pakistan and Bangladesh it was found that the variables are stationary at first difference. The insignificance of Johanson cointegration test results revealed that there is no long-term relationship between the variables in each country. Using the VAR estimates, the impulse response and variance decomposition has been tested to discover how each variable absorbs the shocks from the other variable. Granger causality test has shown that both Sri Lanka and India recorded bidirectional granger causal relationship, Pakistan showed unidirectional relationship whilst Bangladesh showed no causal relationship between the variables. Finally, the machine learning model revealed that the exchange rate can predict the stock price at 70.19% accuracy. Thereby, results of this study support that exchange rate and stock price in South Asian countries have a short-term significant relationship. Implication of this study could be used by the managers, policy makers and enterprises in diversifying the portfolios and obtaining maximum advantages from currency depreciation. However, this study also makes pre warning that if the direction has been changed due to the higher volatility of this relationship currency depreciation would bring negative implications on the stock prices. Therefore, policy makers should not solely depend on the exchange rate in making decisions. Further, as this study only covers the short-term impact, future studies are encouraged to assess the long-term relationship considering multiple aspects such as different exchange rates, other macroeconomic variables etc. to provide greater insights.