Stock Market and Foreign Exchange Market in India: Are they Related?

Abstract

This article attempts to examine whether stock market and foreign exchange markets are related to each other or not. The study uses Granger’s Causality test and Vector Auto Regression technique on monthly stock return, exchange rate, interest rate and demand for money for the period April 1992 to March 2002. The major findings of the study are (a) there exists a unidirectional causality between the exchange rate and interest rate and between the exchange rate return and demand for money; (b) there is no Granger’s causality between the exchange rate return and stock return. Through Vector Auto Regression modelling, the study confirms that though stock return, exchange rate return, the demand for money and interest rate are related to each other but any consistent relationship doesn’t exist between them. The forecast error variance decomposition further evidences that (a) the exchange rate return affects the demand for money, (b) the interest rate causes exchange rate return change (c) the exchange rate return affects the stock return, (d) the demand for money affects stock return, (e) the interest rate affects the stock return, and (f) the demand for money affects the interest rate. Our results have implications for investors, policy makers and researchers.