An Empirical Study of Impact of Exchange Rate & Inflation Rate On Performance of Bse Sensex

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Spectrum:AJournalofMultidisciplinaryResearch
Vol.1Issue3,June2012,ISSN22780637
AN EMPIRICAL STUDY OF IMPACT OF EXCHANGE RATE

& INFLATION RATE ON PERFORMANCE OF BSE SENSEX
SAURABH SINGH*; DR. L.K TRIPATHI**; KIRTI LALWANI***
*Assistant Professor,
Altius Institute of Universal Studies,
Devi Ahilya Vishwavidyalaya,
Indore, M.P., India.
**HOD, School of Commerce,
***Assistant Professor,
School of Commerce,
ABSTRACT
PinnacleResearchJournals20
http://www.pinnaclejournals.com
The paper tries to examine the primary factors responsible for affecting Bombay Stock Exchange
(BSE) in India. Further this paper attempts to investigate the relative influence of the factors
affecting BSE and thereby categorizing them. It is a well known fact that dollar price or money
exchange rate and Inflation has a great influence on BSE Sensex therefore; this research
identifies the level of influence of exchange rate and rate of inflation on BSE Sensex. For
establishing the relationship Regression Analysis has been used by using SPSS. The results
suggest that Inflation Rate and Exchange Rate significantly affect the performance of BSE
Sensex.
KEYWORDS: Exchange Rate, Inflation, Regression Analysis, Stock Exchange.
______________________________________________________________________________
INTRODUCTION
A Stock Exchange forms an integral part of any nation. In many ways it is the barometer through
which the economy of a country is perceived by many people even though there are other
economic tools to judge the actual health of the economy. Stock exchanges are places through
which the public at large take part as investors. In India, the BSE has been attracting thousands
of investors each year. Worldwide, there are millions of transactions that take place every day.
Stock market is one of the major economic reflectors. Indian economy is currently emerging as a
global super power. Due to low labour cost and skillful manpower sectors like textile, garments,
manufacturing, banking and insurance has made a significant contribution to foster the growth
potentials of the economy but there are several factors which directly or indirectly affect the
performance of BSE Sensex such as inflation, exchange rate, IIP, crude oil, interest rate
structure, gold price etc.
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The movement of stock indices is highly sensitive to the changes in fundamentals of the
economy and to the changes in expectations about future prospects. Expectations are influenced
by the micro and macro fundamentals which may be formed either rationally or adaptively on
economic fundamentals, as well as by many subjective factors which are unpredictable and also
non quantifiable. It is assumed that domestic economic fundamentals play determining role in the
performance of stock market. However, in the globally integrated economy, domestic economic
variables are also subject to change due to the policies adopted and expected to be adopted by
other countries or some global events.
The common external factors influencing the stock return would be stock prices in global
economy, the interest rate and the exchange rate. For instance, capital inflows and outflows are
not determined by domestic interest rate only but also by changes in the interest rate by major
economies in the world. Recently, it is observed that contagion from the US subprime crisis has
played significant movement in the capital markets across the world as foreign hedge funds
unwind their positions in various markets. Other burning example in India is the appreciation of
currency due to higher inflow of foreign exchange. Rupee appreciation has declined stock prices
of major export oriented companies. Information technology and textile sector are the example of
falling stock prices due to rupee appreciation.
From the beginning of the 1990s in India, a number of measures have been taken for economic
liberalization. At the same time, large number of steps has been taken to strengthen the stock
market such as opening of the stock markets to international investors, regulatory power of
SEBI, trading in derivatives, etc. These measures have resulted in significant improvements in
the size and depth of stock markets in India and they are beginning to play their due role.
LITERATURE REVIEW
Varying evidences of causal links of stock returns and macro variables have been found in the
literature using various asset pricing specifications. In the literature, widely popular CAPM
has been severely challenged since returns can be predicted from other financial factors. This has
led to the development and testing of various alternative asset pricing specifications, such as the
Arbitrage Pricing Theory (APT) and Present Value Model (PVM). In the context of macro
dynamics of stock returns, APT assumes that returns are generated by a number
of macroeconomic factors. It allows multiple risk factors to explain asset returns. Chen, Roll and
Ross (1986) have argued that stock returns should be affected by any factor that influences future
cash flows or the discount rate of those cash flows. In an empirical investigation they found that
the yield spread between long and short term government bonds, expected inflation, unexpected
inflation, nominal industrial production growth and the yield spread between corporate high and
low grade bonds significantly explain stock market returns. An alternative way of linking
macroeconomic variables and stock prices is the discounted cash flow or present value model
(PVM). This model relates the stock price to future expected cash flows and the future discount
rate of the cash flows. Again, all macroeconomic factors that influence future expected cash
flows or the discount rate by which the cash flows are discounted should have an influence on
the stock price. The advantage of the PVM model is that it can be used to focus on the long run
relationship between the stock market and macroeconomic variables. In the literature, various
theoretical reasons have been explained linking behavior of stock prices and key macro
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economic variables. For instance, Friedman (1988) suggests wealth effect and substitution
effect as the possible channels through which stock prices might directly affect money demands
in the economy. Friedman (1988) expected that the wealth effect will dominate and thus the
demand for money and stock prices to be positively related. The theoretical basis to examine the
link between stock prices and the real variables are well established in economic literature, e.g.,
in Baumol (1965) and Bosworth (1975). The relationship between stock prices and real
consumption expenditures, for instance, is based on the life cycle theory, developed by Ando and
Modigliani (1963), which states that individuals base their consumption decision on their
expected life time wealth. Part of their wealth may be held in the form of stocks linking stock
price changes to changes in consumption expenditure. Similarly, the relationship between stock
prices and investment spending is based on the q theory of James Tobin (1969), where is the
ratio of total market value of firms to the replacement cost of their existing capital stock at
current prices. In retrospect of the literature, a number of hypotheses also support the existence
of a causal relation between stock prices and exchange rates. For instance, goods market
approaches (Dornbusch and Fischer, 1980) suggest that changes in exchange rates affect the
competitiveness of a firm as fluctuations in exchange rate affects the value of the earnings and
cost of its funds as many companies borrow in foreign currencies to fund their operations and
hence its stock price. An alternative explanation for the relation between exchange rates and
stock prices can be provided through portfolio balance approaches that stress the role of capital
account transaction. Like all commodities, exchange rates are determined by market mechanism,
i.e., the demand and supply condition. A blooming stock market would attract capital flows from
foreign investors, which may cause an increase in the demand for a countrys currency. The
reverse would happen in case of falling stock prices where the investors would try to sell their
stocks to avoid further losses and would convert their money into foreign currency to move out
of the country. There would be demand for foreign currency in exchange of local currency and it
would lead depreciation of local currency. As a result, rising (declining) stock prices would lead
to an appreciation (depreciation) in exchange rates. Moreover, foreign investment in domestic
equities could increase over time due to benefits of international diversification that foreign
investors would gain. Furthermore, movements in stock prices may influence exchange rates and
money demand because investors wealth and liquidity demand could depend on the
performance of the stock market. Economic theories suggest causal relations between stock
prices and exchange rates; existing evidence also provides relatively stronger relationship
between stock price and exchange rate.
Ma and Kao (1990) find that a currency appreciation negatively affects the domestic
stock market for an export-dominant country and positively affects the domestic stock market for
an import-dominant country, which seems to be consistent with the goods market theory.
Bahmani and Sohrabian (1992) found a bi-directional causality between stock prices measured
by the Standard & Poor's 500 index and the effective exchange rate of the dollar, at least in the
short run. The co-integration analysis revealed no long run relationship between the two
variables.
Similarly, Abdalla and Murinde (1996) investigate interactions between exchange rates and
stock prices in the emerging financial markets of India, Korea, Pakistan and the Philippines. The
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results of the granger causality tests results show unidirectional causality from exchange rates to
stock prices in all the sample countries, except the Philippines.
Ajayi and Mougoue (1996), using daily data for eight countries, show significant interactions
between foreign exchange and stock markets.
Abdalla and Murinde (1997) document that a countrys monthly exchange rates tend to lead its
stock prices but not the other way around.
Pan, Fok & Lui (1999) used daily market data to study the causal relationship between stock
prices and exchange rates and found that the exchange rates Granger-cause stock prices with less
significant causal relations from stock prices to exchange rate. They also find that the causal
relationship have been stronger after the Asian crisis.
Bodie [1976], Fama [1981], Geske and Roll [1983], and Pearce and Roley [1983], Pearce [1985]
document a negative impact of inflation and money growth on equity values. Many experts
however believe that positive effects will outweigh the negative effects and stock prices will
eventually rise due to growth of money supply (e.g., Mukherjee and Naka, 1995). They argue
that a change in the money supply provides information on money demand, which is caused by
future output expectations. If the money supply increases, it means that money demand is
increasing, which, in effect, signals an increase in economic activity. Higher economic activity
implies higher cash flows, which causes stock prices to rise.
Bernanke and Kuttner (2005) argue that the price of a stock is a function of its monetary value
and the perceived risk in holding the stock. A stock is attractive if the monetary value it bears is
high. On the other hand, a stock is unattractive if the perceived risk is high. The authors argue
that the money supply affects the stock market through its effect on both the monetary value and
the perceived risk. Money supply affects the monetary value of a stock through its effect on the
interest rate. The authors believe that tightening the money supply raises the real interest rate. An
increase in the interest rate would in turn raise the discount rate, which would decrease the value
of the stock as argued by the real activity theorists. The impact of real sector macro variables on
equity returns has been much more difficult to establish.
Their results show that there is no causal relationship between stock price and macro economic
variables like money supply, national income and interest rate but there exists a two way
causation between stock price and rate of inflation. As discussed above, literature reveals
differential causal pattern between key macro economic variables and stock prices. This
relationship varies in a number of different stock markets and time horizons in the literature. This
paper will add to the existing literature by providing robust result, which is based on more than
one technique, about causal links for the longer period, i.e., 2007-2012 monthly data.
OBJECTIVE OF STUDY
1. To find out the level of dependency of Sensex performance on Foreign Exchange Rate
2. To find out the level of dependency of Sensex performance on Inflation
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HYPOTHESIS
1. H0: Stock performance is not dependent on inflation.
H1: Stock performance has significant dependence on inflation.
2. H0: Stock performance is not dependent on foreign exchange rate.
H1: Stock performance has significant dependence on foreign exchange rate.
RESEARCH METHODOLOGY
For the purpose of the study three variables have been taken i.e. BSE Sensex, foreign exchange
and inflation. Out of these Sensex has been taken as Dependent Variable (DV) while foreign
exchange and inflation as Independent Variable (IV). For evaluating the degree of dependency of
Sensex on Exchange Rate and Inflation; Linear Regression has been used by using SPSS. The
representative variables used for the study are monthly values from the period April 2007 to
March 2012.
Regression model was used to derive the relationship and formula to compute the relationship is
given below.
y
1X1
2X2
Where,
Y -Return on Sensex
= intercept.
1 =slope of inflation
2 =slope of forex.
X1= inflation
X2= forex
The monthly returns of economic variables (in percentage) are determined as:
0
0
100
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Where:
Rt is monthly return of variables,
P1 is value of current month,
P0 is value of previous month
OUTPUT SUMMARY
MODEL SUMMARYB
Model
1
R Square
.533a
TABLE NO. 1
Adjusted R Square
.284
Std. Error of the Estimate Durbin-Watson
.258
7.4615492
2.294
a. Predictors: (Constant), ExchangeRate, Inflation

b. Dependent Variable: Return
ANOVAB
Model
Sum of Squares
TABLE NO. 2
df
Mean Square
Regression
1256.168
628.084
Residual
3173.459
57
55.675
Total
4429.627
59
Sig.
11.281
.000a

b. Dependent Variable: Return
COEFFICIENTSA
TABLE NO. 3
Unstandardized
Coefficients
Model
1
B
(Constant)
Std. Error
3.878
1.551
Inflation
-1.180
.551
ExchangeRate
-1.362
.388
Standardized
Coefficients
Beta
Collinearity
Statistics
t
Sig.
Tolerance
VIF
2.501
.015
-.249
-2.140
.037
.928
1.077
-.409
-3.512
.001
.928
1.077
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ANOVAB
Model
Sum of Squares
TABLE NO. 2
df
Mean Square
Regression
1256.168
628.084
Residual
3173.459
57
55.675
Total
4429.627
59
Sig.
11.281
.000a

a. Dependent Variable: Return
COLLINEARITY DIAGNOSTICSA
TABLE NO. 4
Variance Proportions
Model Dimension Eigenvalue Condition Index

1
(Constant)
Inflation
ExchangeRate
1.854
1.000
.09
.09
.04
.939
1.405
.04
.00
.88
.208
2.986
.87
.90
.08
RESIDUALS STATISTICSA
Minimum
Predicted Value
Maximum
TABLE NO. 5
Mean
Std. Deviation
-13.282711
9.755232
.847704
4.6142162
60
-16.0734119
18.4998703
.0000000
7.3339920
60
Std. Predicted Value
-3.062
1.930
.000
1.000
60
Std. Residual
-2.154
2.479
.000
.983
60
Residual
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FINDINGS AND INTERPRETATION OF RESULTS

1. From the Table No.1 it can be seen that Durbin-Watson (d) value is 2.294. The table
value of Durbin-Watson d statistic for k = 2 and n = 60 at 5% level of significance are:
dL = 1.514
du= 1.652
K = Number of Independent Variables

N = No. of variables
Interpretation: d > du , which indicates that there is no evidence of auto correlation
between the Independent Variable.
2. From the Table No.2 it can be seen that significance value = 0.00 at 5% level of
significance.
Interpretation: As p < 0.05, now the regression analysis can be applied.
3. From the Table No.3 it can be seen that value of VIF is 1.077.
Interpretation: Value of VIF less than 5 which indicates that there is no co-linearity
between the data.
4. TESTING OF HYPOTHESIS
From Table No. 3 it can be seen that:
For Inflation significance value is 0.037 which is less than the 0.05 level of
significance which means the hypothesis (H0) is rejected i.e. Stock performance is
not dependent on inflation and alternate hypothesis (H1) is accepted .i.e.
performance has significant dependence on inflation.
For Exchange Rate significance value is 0.01 which is less than the 0.05 level of
significance which means the hypothesis (H0) is rejected i.e. Stock performance is
not dependent on foreign exchange rate and alternate hypothesis (H1) is accepted
.i.e. performance has significant dependence on foreign exchange rate.
SUGGESTIONS
1. Exchange rate is complex variable that depends on a number of macroeconomic
variables.
2. We should also consider the aggregate influence of Interest rate, IIP, money supply,
central government policies etc. on exchange rate.
3. We can also include NSE (National Stock Exchange) with Sensex.
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4. Since exchange rate is very active variables, the data can be taken on daily basis.
5. We can also directly link the inflow or outflow of FII and DII on the stock exchange
value and consequently to exchange rate
6. We can also analyze the effect of major foreign stock exchange performances i.e. Dow
Jones industrial average etc. on Indian stock exchange
7. We can also analyze the effect of market sentiments on stock performances and finally on
exchange rate.
CONCLUSION
This research tries to find out the relationship between BSE Sensex and some other important
economical factors and got some interesting results related to this. Regression analysis has been
used to do the analysis based on monthly basis database of different economical factors. Finally
the result which came is that both exchange rate and inflation significantly affects the
performance of BSE Sensex, although it is only affecting by 28.4% but Sensex has significant
dependence on rate of inflation and exchange rate.
REFERENCES
1. Abdalla, I. S. A. and V. Murinde (1997), Exchange Rate and Stock Price Interactions in
Emerging Financial Markets: Evidence on India, Korea, Pakistan, and Philippines,
Applied Financial Economics 7, 25-35.
2. Abdalla, I. S. A. and V. Murinde (1996) Exchange rate and stock prices interactions in
emerging financial markets: Evidence on India, Korea, Pakistan and Philippines. Applied
Financial Economics, 7, 25-35.
3. Ando, A. and F. Modigliani (1963), The Life Cycle Hypothesis of Saving: Aggregate
Implications and tests, American Economic Review, Vol. 53, No. 1.
4. Ajayi, R. A. and M. Mougoue (1996), On the Dynamic Relation between Stock Prices
and Exchange Rates, Journal of Financial Research 19, 193-207.
5. Bahmani-Oskooee, M. and A. Sohrabian (1992). Stock Prices and the Effective
Exchange Rate of the Dollar, Applied Economics, 24, 4, 459-464.
6. Baumol, W. (1965), Stock Market and Economic Efficiency, Fordham University Press,
New York.
7. Bhattacharya B and Mukherjee J. (2002), Causal relationship between stock market and
exchange rate, foreign exchange reserves and value of trade balance: A case study for
India www.igidr.ac.in
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8. Bosworth, B.(1975), "The Stock Market and the Economy", Brookings Papers on
Economic Activity, Vol. 2.
9. Chen, N, R. Roll, and S. Ross (1986), Economic forces and the stock market, Journal
of Business 59, 383-403.
10. Friedman, M. (1988), Money and the Stock Market, Journal of Political Economy, 96,
2, 221-245.
11. Mukherjee, T.K. and A. Naka, (1995), Dynamic relations between macroeconomic
variables and the Japanese stock market: An application of a vector error correction
model, The Journal of Financial Research, 2, 223-237.
12. Mr. Rabjan Kumar : A Study of S&P CNX Nifty and Exchange Rate: With Special
reference to SMC Corporation Project, Department of International Business, School of
Management, Pondicherry University (India)
13. Fredric S. Mishkin, Monetary Policy Strategy, PHI Learning Pvt. Ltd.
14. Franco Modigilani, Frank J. Fabozzi (2009) Capital Markets: Institutions and
Instruments, PHI Learning Pvt. Ltd.
15. Dr. S, Guruswamy (2009) Capital Markets, Publisher: Tata McGraw-Hill Companies.
16. Historical
Data
of
BSE
Sensex
viewed
http://www.bseindia.com/histdata/hindices2.asp
on
April
15,
2012
17. US Dollar (USD) to Indian Rupee (INR) exchange rate history, viewed on April 15, 2012
http://www.oanda.com/currency/historical-rates/
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ANNEXURE
Month-Year
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
Apr-09
May-09
Jun-09
Jul-09
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Sensex Return % % Change in Inflation % Change in Exchange Rate

13872.4
6.122
2.57
-3.9261
14544.5
4.8448
2.69
-3.3146
14650.5
0.7291
2.69
-0.1295
15551
6.1464
2.36
-0.8859
15318.6
-1.4944
1.97
0.8335
17291.1
12.8765
2.76
-0.9909
19838
14.7295
3.54
-2.0594
19363.2
-2.3934
4.31
-0.2273
20287
4.7709
4.08
0.0466
17648.7
-13.005
4.28
-0.2868
17578.7
-0.3966
4.03
0.8712
15644.4
-11.004
3.98
1.547
17287.3
10.5013
3.94
-0.7473
16415.6
-5.0427
4.18
4.972
13461.6
-17.995
5.02
1.9288
14355.8
6.6422
5.6
0.053
14564.5
1.4543
5.37
0.3049
12860.4
-11.7
4.94
6.0357
9788.06
-23.89
3.66
9.4309
9092.72
-7.104
1.07
-0.2974
9647.31
6.0993
0.09
-0.8545
9424.24
-2.3123
0.03
0.2327
8891.61
-5.6517
0.24
0.0441
9708.5
9.1872
-0.38
4.9066
11403.3
17.4564
-0.74
-2.8061
14625.3
28.2551
-1.28
-3.2072
14493.8
-0.8985
-1.43
-1.5056
15670.3
8.117
-2.1
1.2104
15666.6
-0.0234
-1.48
-0.51
17126.8
9.3204
-1.29
0.4486
15896.3
-7.185
-0.18
-3.5237
16926.2
6.4791
1.84
-0.5162
17464.8
3.182
2.72
0.1113
16358
-6.3376
2.63
-1.2844
16429.6
0.4376
2.14
0.6277
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Mar-10
17527.8
Apr-10
17558.7
May-10
16944.6
Jun-10
17700.9
Jul-10
17868.3
Aug-10
17971.1
Sep-10
20069.1
Oct-10
20032.3
Nov-10
19521.3
Dec-10
20509.1
Jan-11
18327.8
Feb-11
17823.4
Mar-11
19445.2
Apr-11
19136
May-11
18503.3
Jun-11
18845.9
Jul-11
18197.2
Aug-11
16676.8
Sep-11
16453.8
Oct-11
17705
Nov-11
16123.5
Dec-11
15454.9
Jan-12
17193.6
Feb-12
17752.7
Mar-12
17404.2
Sources: www.bseindia.com
www.oanda.com
www.global-rates.com
6.6844
0.1765
-3.4973
4.4632
0.9457
0.5755
11.6743
-0.1833
-2.5513
5.0603
-10.636
-2.7519
9.0994
-1.5904
-3.3062
1.8515
-3.442
-8.3554
-1.3371
7.6046
-8.9328
-4.1464
11.2497
3.252
-1.963
2.31
2.24
2.02
1.05
1.24
1.15
1.14
1.17
1.14
1.5
1.63
2.11
2.68
3.16
3.57
3.56
3.63
3.77
3.87
3.53
3.39
2.96
2.73
2.87
2.65
-1.9234
-2.1351
2.8818
1.7633
0.631
-0.6699
-0.8595
-3.6207
1.5395
1.0186
0.4352
-0.3384
-0.3516
-1.609
0.624
0.607
-1.3586
1.6227
5.1889
3.9761
2.454
4.5434
-2.1372
-4.8653
2.6585

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SAJMR

AN EMPIRICAL STUDY OF IMPACT OF EXCHANGE RATE

Std. Error of the Estimate Durbin-Watson

a. Predictors: (Constant), ExchangeRate, Inflation

a. Predictors: (Constant), ExchangeRate, Inflation

a. Predictors: (Constant), ExchangeRate, Inflation

Model Dimension Eigenvalue Condition Index

a. Dependent Variable: Return

Std. Predicted Value

a. Dependent Variable: Return

FINDINGS AND INTERPRETATION OF RESULTS

K = Number of Independent Variables

From Table No. 3 it can be seen that:

Sensex Return % % Change in Inflation % Change in Exchange Rate

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