71 Stock Prices and Exchange Rates: Empirical Evidence from Kuwaits Financial Markets

Stock Prices and Exchange Rates:

Empirical Evidence from
Kuwaits Financial Markets
2009 IUP. All Rights Reserved.
Ahmed Alhayky* and Ndambendia Houdou**
* Ph.D. Candidate, Shanghai University of Finance and Economics, China; and is the corresponding author.
E-mail: alfanooce@hotmail.com
** Ph.D. Candidate, Shanghai University of Finance and Economics, China. E-mail: houdou04@yahoo.fr
Introduction
Most academic research has attempted to explain the relationship between stock prices and
exchange rate. It is theoretically apparent that the relationship between stock prices and
exchange rate has two basic approaches: flow-oriented and stock-oriented. First, the effect of
the exchange rate on the stock market (flow-oriented) approach states that depreciation of
exchange rate will increase competitiveness which leads to increase in domestic output
(expansion), which in turn is an indicator of an expansion economy and influence or boost
stock price. Second, the effect of the stock prices on the exchange rate (stock-oriented) states
that an increase in stock price attract capital inflows which increases the demand for domestic
currency and causes exchange rate to appreciate. Therefore, due to conversion process,
domestic stock price (which represents market return) is influenced by exchange rate
movements.
There are a number of empirical studies examining the relationship for various countries.
Although models and empirical methodologies vary widely, their study tends to focus on the
This paper uses the Error Correction Model (ECM) and the Granger causality
test to examine the long-run and short-run relationship between Kuwait's stock
prices and exchange rate, and determines the causal relationship between them
for the period June 2001-December 2008. Under the cointegration test, it is
found that there is long-run equilibrium relationship between Kuwait Stock
Price Index (STIDX) and exchange rates for United States Dollar (USD),
Japanese Yen (YEN), and British Pound (GBP), while there is no long-run
linkage relationship between STIDX and EURO. Next, based on the Granger
causality test, it is found that in the long run, there is a bilateral causality
between STIDX and GBP, STIDX and exchange rate YEN, and STIDX and USD.
Moreover, it is observed that in the short run, STIDX has no unidirectional or
bidirectional causality with exchange rate GBP. However, there is evidence of
only unidirectional causality from stock prices to exchange rate, which is
significant for YEN and USD.
The IUP Journal of Financial Economics, Vol. VII, Nos. 3 & 4, 2009 72
causal relationship, and therefore the Granger causality tests are often conducted. Some
researchers claim that exchange rate movements provide little or no explanation for stock
price (Jorion, 1990; Amihud, 1993; Bodnar and Gentry, 1993; Bartov and Bodnar, 1994;
Abdalla and Murinde, 1997; Ajayi et al., 1998; Bernard and Galati, 2000; and Smyth and
Nandha, 2003); while others argue that stock returns are affected significantly by exchange
rate fluctuations (Zietz and Pemberton, 1990; Roll, 1992; Ferson and Harvey, 1993; Granger
et al., 2000; Patro et al., 2002; and Hsing, 2004).
This paper aims at investigating the influence of exchange rate fluctuations on Kuwait
stock market volatility and measuring the response of Kuwait stock market to the major
exchange rates [i.e., United States Dollar (USD), Euro (EURO), British Pound (GBP), and
Japanese Yen (YEN)]. Therefore, this paper focuses on Kuwait Stock Market because Kuwait
represents a small open economy in the world.
Literature Review
Most of the empirical literatures examine the relationship between stock price and exchange
rate for various countries. These studies focus on correlation and causal relationship
between stock price and exchange rates by applying different methods. One of the earlier
studies that examined the relationship between stock price and exchange rate was done by
Franck and Young (1972). They concluded that there is no relationship between stock price
and exchange rate by applying this test on six different exchange rates. Another research
on the same topic was conducted by Aggarwal (1981). He tested whether change in USD
has relationship with stock price indices. He applied a simple regression and found that
there is a strong positive relationship between stock price and exchange rate in the short
run.
Solnik (1987) investigated the impact of several economic variables such as interest rate,
expected inflation and exchange rate on stock prices in nine industrialized countries. The
main conclusion drawn was that exchange rates had insignificant influence on stock prices.
Soenen and Hennigar (1988) used monthly data on US stock market index and USD
effective exchange rate for the period 1980-1986. They found a strong negative relationship
between these two financial variables. Due to inappropriate econometric regressions which
included spurious inferences, several more studies on the relationships between stock prices
and exchange rates appeared, using a variety of approaches (including variance ratio,
fractional integration, cointegration and error correction models). These studies almost
invariably tended to find evidence of relationship between exchange rates and stock prices.
Bahmani-Oskooee and Sohrabian (1992) used cointegration and Granger causality to test
the long-run relationship between stock prices and exchange rate. Based on monthly data for
the period 1973-1988 on the S&P 500 index and USD effective exchange rate, they concluded
that there was a dual causal relationship between the two variables in the short run, while there
was no evidence for the long run. Yu (1997) investigated on daily stock price indices and
exchange rates for three countries (Tokyo, Hong Kong and Singapore) for the period
1983-1994. He used Granger causality test to examine the possible interaction between these
73 Stock Prices and Exchange Rates: Empirical Evidence from Kuwaits Financial Markets
variables. He found that changes in stock prices were caused by changes in the exchange rates
for both Tokyo and Hong Kong. On the other hand, the change in exchange rates caused by
change in stock prices was found only in the Tokyo market. He also found strong long-run
relationships between stock prices and exchange rates for all three countries.
Another relevant research on the cointegration and causal relations between stock returns
and change in exchange rates in 16 advanced and emerging countries was presented by Ajayi
et al. (1998). They concluded that in all advanced countries there was unidirectional causality
between stock and currency, while no consistent causal relations were observed in emerging
countries. Li and Izan (1999) among others, investigated the relations between stock prices
and exchange rates using Nonlinear Least Square (NLS) method. Share price returns in US
claimed to reflect information transferred by movements in French Franc and Japanese YEN.
The results found a weak relation between US equity market and exchange rates which meant
that the share market return of a country would be affected by the depreciation of its currency
and vice versa.
The long-run relation between stock prices and exchange rates has been tested by Amare
and Mohsin (2000) for nine Asian countries. The study was conducted employing the
cointegration technique based on monthly data from 1980-1998. Singapore and Philippines
showed that there is a long-run relationship between stock prices and exchange rates.
Omission of important variables which causes bias was the reason for the lack of
cointegration between variables. Adding the interest rate to the cointegrating equation,
cointegration between stock prices, exchange rates and interest rates for six of the nine
countries was found.
Phylakits and Ravazzolo (2000) carried out a study in which they tested the long-run
relationships between stock prices and exchange rates by conducting cointegration and
multivariate Granger causality tests. They used monthly data from January 1980 to December
1998 for six Asian countries (Hong Kong, Indonesia, Malaysia, Philippines, Singapore and
Thailand). They concluded that stock prices and exchange rates were positively related. The
long-run co-movement of these stocks was temporarily affected by the financial crisis.
Kuwait Exchange Rate
The exchange rate plays an important role in connecting the domestic market with the world
markets. Every country seeks to adopt its own exchange rate regime which provides four
fundamental goals. First, maintain stable exchange rate which can attract Foreign Direct
Investment (FDI) and stabilize relative price by reducing uncertainty risk of the exchange rate.
Second, reduce inflationary pressure to protect domestic price. Third, retain external balance
which exists when balance of payment is close to zero. Fourth, maintain full employment
level, also called internal balance. However, countries face conflict between these goals.
In order to provide some flexibility, the Central Bank of Kuwait (CBK) pegged Kuwaiti
Dinar (KD) to weighted currency basket since March 1973. This regime provides some
stability for KD against the major currencies, especially against the main trading partners such
as US, Japan and Europe. Obviously, we can expect that the USD has the highest weight in
The IUP Journal of Financial Economics, Vol. VII, Nos. 3 & 4, 2009 74
the KD in order to provide stable income as oil export prices were denominated in dollar terms
and oil accounted for 94% of Kuwaiti export. Therefore, CBK aimed to target the inflation
rate and provide relative stable income till 2003.
As a step towards achieving full economic integration, Gulf Cooperation Council (GCC)
countries agreed to peg their currencies to US dollars as de jure before the end of the year
2002. This step required Kuwait to change its exchange rate regime. Therefore, in October
2002, Kuwait announced that the exchange rate of its currency would be pegged to the USD
in the beginning of 2003. During 2005-2007, USD depreciated by 25% against EURO. At the
same time, USD depreciated by 15% against Japanese YEN. The depreciation of the dollar
against major currencies drives inflation in dollar-pegged as prices of imports from non-dollar
bloc would rise when the dollar depreciated. The depreciation of dollar against EURO and
YEN led to depreciation of KD, against EURO and YEN. As a result, the weakness of dollar
affected the price level in Kuwait. The inflation target for CBK was 1.5%, but due to weakness
of dollar, Consumer Price Index (CPI) in Kuwait rose sharply to 4.11% in 2005 as compared
to 1.26% in 2004.
CBK used a variety of tools to pursue its tightening monetary policy for the last three
years through climbing its interest rates. As a result, during the month of May 2007, CBK
announced that KD exchange rate was to be pegged to a weighted basket of international
currencies of Kuwaits major trade and financial partner countries, as Kuwait did before
2003 in order to reduce the impact of the cost of imported inflation. CBK pointed out
that this move aimed at protecting the purchasing power of the national currency and
containing inflationary pressures in the local economy, after having exhausted all
attempts to absorb the adverse effects of USD depreciation against major currencies for
an extended period of time.
Methodology
In order to test the long-run relationship between stock prices and exchange rates, we use
Johansen (1988) and Johansen and Juselius (1990) bivariate cointegration test. In other words,
the purpose of this test is to find out if there is a long-run relationship between stock prices
and exchange rates. In order to apply this test, cointegration series should be of the same order
of integration. Therefore, to determine the order of integration we use Augmented Dickey
Fuller (ADF) and Pillips-Perron (PP) test. If these series are found to be of the same order of
integration, then we can apply the cointegration tests.
Equation (1) shows Johansen method in the form of Vector Autoregressive (VAR), with an
unrestricted Vector Error Correction (VEC) model in order to determine the cointegrating
vectors.
[
+ + A + = A

=
t t
K
i
t t
y y c y q t
1
1
1
...(1)
where t measures the influence of first differenced lags of the variable which could describe
the short-run variation. H can be interpreted as a long-run coefficient matrix which is a very
important item as it shows the long-run relationship between variables. The rank of matrix
75 Stock Prices and Exchange Rates: Empirical Evidence from Kuwaits Financial Markets
H assigns the number of independent cointegration vectors. According to the Granger
theorem, if the coefficient matrix H has reduced rank r < k, then there is k r matrices o and
| each with rank r where H = | o '
and
t
y |' is I(0). | is the cointegrating vector and o is a
speed of adjustment of the variables. Johansen (1988) and Johansen and Juselius (1990)
identify two Likelihood Ratio (LR) tests to test the cointegrating relationships among these
variables. The first test is trace of stochastic matrix H and test null hypothesis of exactly r
cointegrating vectors against the alternative r + 1 cointegration vectors. The second is
maximal eigen value of the stochastic matrix n and the null hypothesis is cointegrating
vectors is less than or equal to r against the alternative r + 1 cointegration vectors.
We apply Error Correction Model (ECM) if there is a cointegrating relationship
between stock prices and exchange rate. Otherwise, we apply Standard Granger causality
test if there is no cointegrating relationship between the variables. The ECM is as follows:
If Y and X are cointegrated, then there exist an error-correction representation of the form,
t i t i i t i t t
X Y Z Y
0 0 0 1 0 0
c o | o + A + A + + = A


...(2)
t i t i i t i t t
Y X Z X
1 1 1 1 1 1
c o | o + A + A + + = A


*
...(3)
where A is the first differenced operator AY
t
= Y
t
Y
t i
, o is a constant, c
t
are white noise errors
with constant mean, Z
t 1
and Z
*
t 1
are the lagged residuals obtained from the following
cointegration regressions:
Y
t
= a
0
+ b
0
X
t
+ Z
t
...(4)
X
t
= a
1
+ b
1
Y
t
+ Z
*
...(5)
Equations (2) and (3) show the ECM which can be used to draw conclusion about causality
between economic variables. According to the Standard Granger causality test, | shows the
long-run causality; while o shows the short-run causality. Therefore, long-run causality
between X and Y depend on |, if |
0
and |
1
coefficients are statistically different from zero this
indicates bilateral causality, but if |
0
and |
1
coefficients are not statistically different from
zero, it indicates independence.
Data
The data used in the study is monthly from June 2001 to December 2008, obtained from CBK.
The data includes monthly observations on Stock Price Index (STIDX), Exchange rate
between Kuwaiti Dinar and British Pound (GBP), exchange rate between Kuwaiti Dinar and
Euro, and exchange rate between Kuwaiti Dinar and Japanese Yen.
Empirical Result
We transformed all the time series into natural logarithm values as the first step. Thus, we
tested for unit roots in Kuwait stock indices and the exchange rate series to determine the
order of integration of these series. We used the ADF and PP test with and without trend
as recommended by Engle and Granger (1987). The result of ADF test for all variables is
The IUP Journal of Financial Economics, Vol. VII, Nos. 3 & 4, 2009 76
presented in Table 1. In order to determine the optimal length of appropriate lags for ADF
test, we used Schwartz Info. Criterion (SIC). According to our result, all variables are non-
stationary at level I(0). In order for the variables to be stationary, we differentiated the data,
as a result, all variables rejected the null hypothesis of unit root in the first differences
and it is significant at 5% level (Table 2).
Table 1: Results of ADF Unit Root Tests Applied to the Level of Stock Index
and Major Exchange Rate Series
Log STIDX 0.060500 1.792112 1.448114 Series has Unit Root
Log GBP 1.077658 1.286309 0.064176 Series has Unit Root
Log EURO 1.586473 2.388027 1.150155 Series has Unit Root
Log YEN 1.604365 1.646585 0.522481 Series has Unit Root
Log USD 1.589014 0.203846 2.458502 Series has Unit Root
No Constant
and No Trend
Conclusion
Constant and
No Trend
With Constant
and Trend
Series
Table 2: Results of ADF Unit Root Tests Applied to First Differences of Stock Index
and Major Exchange Rate Series
(1L) Log STIDX 6.277398 Series Stationary
(1L) Log GBP 6.218165 Series Stationary
(1L) Log EURO 6.651257 Series Stationary
(1L) Log YEN 8.057666 Series Stationary
(1L) Log USD 7.969913 Series Stationary
Critical Values at
5% Significance 3.410000 2.86000 1.95000
Level
No Constant
and No Trend
Conclusion
Constant and
No Trend
With Constant
and Trend
First Differences
Next, we apply the unrestricted Johansens cointegration test in order to see whether
Kuwait stock prices and major exchange rates are cointegrated by examining the long-run
relationship between these variables. According to Johansen (1997), the variables selected to
be included should be non-stationary to perform a cointegration test. Table 3 presents the
result of cointegration test with different lag orders. Table 3 shows that there is long-run
equilibrium relationship between Kuwait stock prices and exchange rates for USD, YEN,
EURO and GBP, while there is no long-run linkages relationship between Kuwait stock prices
and EURO. Cointegration tests are found to be sensitive to the choice of lag order. GBP shows
evidence of higher trace statistics where it is significant at 1% level.
We use the standard Granger causality to examine the causality for Kuwait stock exchange
and EURO. Table 4 shows the results of Granger causality test for different lag orders.
According to our results, the coefficients of both stock price index and EURO are not
77 Stock Prices and Exchange Rates: Empirical Evidence from Kuwaits Financial Markets
statistically significant in different lags which suggests that there is independent causality.
In other words, there is no statistically evident relationship between stock price and EURO.
The adjustment of short-run deviation from long-run equilibrium is corrected partially or
gradually through a series of adjustments. The above analysis shows that there is a long-run
relationship between STIDX, GBP, YEN and USD. In order to determine variables that Granger
causes short-run dynamics adjustment toward the long-run equilibrium, we use VEC model.
If |
0
are statistically different from zero, then it indicates causality from stock prices to
exchange rate, while |
1
indicates reverse causality from exchange rate to stock prices. F-test
is employed to examine the short-run causality. Therefore, short-run causality from stock price
to exchange rate depends on o
0
. If o
0
s are significant, this indicates a short-run causality,
otherwise not, while significance of o
1
s indicates a short-run causality from exchange rate to
stock price. Tables 5, 6 and 7 show these results.
Table 3: Result of Applied Cointegration Test (Trace Test Statistics)
Note: * and ** indicate significance at 1% and 5% levels respectively.
Exchange Rate L = 1 L = 2 L = 3 L = 4
GBP
Null Hypothesis
Alternative
Hypothesis
r = 0 r = 0 29.004** 22.301** 21.314** 22.504**
r = 1 r = 2 1.155 0.973 0.373 0.593
EURO
Null Hypothesis
Alternative
Hypothesis
r = 0 r = 0 19.022 18.556 15.011 17.725
r = 1 r = 2 6.162 5.795 3.409 3.667
YEN
Null Hypothesis
Alternative
Hypothesis
r = 0 r = 0 21.118* 23.771* 22.949* 20.403*
r = 1 r = 2 3.293 3.435 5.268 4.948
USD
Null Hypothesis
Alternative
Hypothesis
r = 0 r = 0 24.356* 24.306* 25.445** 22.289*
r = 1 r = 2 2.956 3.535 4.135 4.005
The IUP Journal of Financial Economics, Vol. VII, Nos. 3 & 4, 2009 78
Hypothesis Lag t-Statistic F-Statistic
STIDX GBP 1 3.591* 0.028
GBP STIDX 1 2.310** 0.667
STIDX GBP 2 3.506* 0.242
GBP STIDX 2 0.941 0.424
STIDX GBP 3 2.328** 0.199
GBP STIDX 3 2.945* 0.374
STIDX GBP 4 3.031* 0.140
GBP STIDX 4 2.147* 0.235
Table 5: Vector Error Correction Models (Long and Short-Run Causation): GBP
Note: * and ** indicate significance at 1% and 5% levels respectively.
Hypothesis Lag t-Statistic F-Statistic
STIDX YEN 1 2.725* 4.348***
YEN STIDX 1 4.404* 0.893
STIDX YEN 2 3.128* 1.338***
YEN STIDX 2 3.662* 0.232
STIDX YEN 3 3.085* 1.303***
YEN STIDX 3 2.921* 0.125
STIDX YEN 4 4.098* 1.217***
YEN STIDX 4 1.755*** 0.735
Table 6: Vector Error Correction Models (Long and Short-Run Causation): YEN
Note: * and *** indicate significance at 1% and 10% levels respectively.
Hypothesis Lag F-Statistic p-Values
STIDX EURO 1 1.77505 0.17577
EURO STIDX 1 2.96193 0.05715
STIDX EURO 2 1.22759 0.30509
EURO STIDX 2 1.56560 0.20409
STIDX EURO 3 0.95495 0.43710
EURO STIDX 3 1.11211 0.35689
STIDX EURO 4 0.52155 0.75921
EURO STIDX 4 1.44168 0.21929
Table 4: Result of Applied Granger Causality Tests: EURO
79 Stock Prices and Exchange Rates: Empirical Evidence from Kuwaits Financial Markets
There are long-run bilateral causalities between STIDX and GBP (Table 5), STIDX and
exchange rate YEN (Table 6), and STIDX and USD (Table 7). In the short run, STIDX has no
unidirectional or bidirectional causality with exchange rate GBP. While, we found there is
evidence of only unidirectional causality from stock prices to exchange rate which is
significant for YEN and USD.
Hypothesis Lag t-statistic F-statistic
STIDX USD 1 3.103* 2.940**
USD STIDX 1 3.230* 0.657
STIDX USD 2 3.399* 5.654*
USD STIDX 2 2.774* 1.870
STIDX USD 3 3.396* 3.434**
USD STIDX 3 3.216* 0.138
STIDX USD 4 4.512* 1.940***
USD STIDX 4 2.287** 0.105
Table 7: Vector Error Correction Models (Long and Short-Run Causation): USD
Note: *, ** and *** indicate significance at 1%, 5% and 10% levels respectively.
Conclusion
This paper examined the long-run and short-run association between stock prices and
exchange rates for four Kuwait STIDX and exchange rates by using cointegration and ECM
models and Granger causality tests for the period June 2001-December 2008. Cointegration
tests show that there is long-run equilibrium relationship between Kuwait STIDX and
exchange rates for USD, YEN, and GBP; while, there is no long-run linkages relationship
between Kuwait STIDX and EURO. The empirical results based on the Granger causality test
suggests that in the long run, there is a bilateral causality between STIDX and GBP, STIDX
and exchange rate YEN, and STIDX and USD. Moreover, we found that in the short run, STIDX
has no unidirectional or bidirectional causality with exchange rate GBP; while, we found
evidence of only unidirectional causality from stock prices to exchange rate which is
significant for YEN and USD.
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