Final Project Report

Foreign currency remittance and its impact

Submitted By:

Naveed

MBA Finance

Roll : 17018

Registeration no: 2113657

DEDICATED TO:

Holy Prophet

HAZRAT

MUHAMMAD

(P.B.U.H.)

&

My Beloved Parents

MR. & MRS. Khursheed

Abstract:

This paper reviews the main policy and analytical issues related to currency substitution in developing countries. The paper discusses, first, whether currency substitution should be encouraged or not; second, how the presence of currency substitution affects the choice of nominal anchors in inflation stabilization programs; third, the effects of changes in the rate of growth of the money supply on the real exchange rate; fourth, the interaction between inflationary finance and currency substitution; and, finally, issues related to the empirical verification of the currency substitution hypothesis.

ACKNOWLEDGEMENT:

I owe my gratitude to Almighty Allah for His blessings and kindness that I was able to accomplish the challenging task successfully and enthusiastically.

I am very lucky for having a brother whose critical evaluations have a great importance during the documentation of this thesis.

And finally I would like to thank all those persons who prayed for me and helped me in any context to fulfill the challenge to bring my experience into the words of internship.

Foreign Currency Introduction

Foreign exchange is the conversion of one country's currency into that of another. In a free economy, a country's currency is valued according to factors of supply and demand. In other words, a currency's value can bepeggedto another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value also may be fixed by the country's government. However, most countriesfloattheir currencies freely against those of other countries, which keeps them in constant fluctuation.The value of any particular currency is determined by market forces based on trade, investment, tourism, andgeo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of his or her home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency. IntroductionThe Foreign Exchange market is truly the largest exchange in the world. The amount of dollars traded on the Forex market on a daily basis is in the trillions. Most of this currency trading takes place between between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. However, individual traders are starting to get in the mix, using internet discount brokers such as Etrade to participate in the currency exchange market.

There is no central exchange or meeting place for the Forex. All trading is done over computer networks between traders in different parts of the world. Also, unlike the stock market, the foreign exchange market is open 24 hours per day, because it is a global market. A trader in Hong Kong may be exchanging currency with a trader in Australia while an American trader is sleeping.

There are several different markets within the Forex exchange system. First, there is the spot market. The spot market deals with trades that are based on the current values of currencies. One person trades a certain amount of currency with another trader in exchange for an equivalent amount of a different foreign currency. Spot trades take two days for settlement.

The other two types of foreign exchange markets are the forward and futures markets. In the forward market, the buyer and seller agree on an exchange rate and a transaction date is set for a specific time in the future, at which point the trade is executed regardless of what the rates are at that time. On the futures market, futures contracts are bought and sold based upon a standard contract size and maturity date. Futures trades take place on public commodities markets.

A currency quote is listed differently from a stock quote. Stocks are quoted in terms of price per share. Currency exchange prices are listed as either a direct quote or an indirect quote. A direct quote uses the domestic currency as the base and the foreign currency as the quote. An indirect quote works the exact opposite way.1. Inward Remittance - No Restrictions.2. Outward Remittances.3. Mode of Remittances.4. Prescribed Application Forms.5. Applications by Letters.6. Applications to be submitted to the State Bank only through an Authorized Dealer.7. Forwarding Applications to the State Bank.8. Processing of Approved Form etc.9. Permits for Recurring Remittances.10. Effecting Remittances against Permits.11. Period of validity of approval by the State Bank.12. Release of Foreign Exchange for Travel Abroad.13. Processing of Approvals given on one Authorized Dealer's Form by another Authorized Dealer.14. Reporting of Remittances.15. Cancellation of Outward Remittances.16. Cancellation of Inward Remittances.17. Utilization of Exchange for the purpose it is obtained.1.Inward Remittances.

The term 'inward remittance" means purchase of foreign currencies in whatever form and includes not only remittances by M.T., T.T., draft etc., but also purchase of travelers cheques, drafts under travelers letters of credit, bills of exchange, currency notes and coins etc. Debit to banks' non-resident Rupee accounts also constitutes an inward remittance. This chapter, however, does not cover purchase of foreign currency notes and coins which is dealt with inChapter XI.

2.Inward Remittance No Restrictions.

There is no restriction on receipt of remittances from abroad either in foreign currency or by debit to non-resident Rupee accounts of banks' overseas branches or correspondents. Authorized Dealers may freely purchase T.Ts, M.Ts, drafts, bills etc., expressed and payable in foreign currencies or drawn in Rupees on banks' non-resident Rupee accounts. There is also no objection to their obtaining reimbursement in foreign currency from their overseas branches and correspondents in respect of Rupee bills and drafts which are purchased by them under letters of credit opened by non-resident banks or under other arrangements.

3.Outward Remittances.

The term "outward remittance" means sale of foreign exchange in any form and includes not only remittances by T.Ts, M.Ts, drafts etc., but also sale of travelers cheques, travelers letters of credit, foreign currency notes and coins etc. Outward remittance can be made either by sale of foreign exchange or by credit to non-resident Rupee account of banks' overseas branches or correspondents. Authorized Dealers may sell foreign exchange for approved transactions only in accordance with the procedure outlined in this chapter. This chapter does not cover sale of foreign currency notes and coins which is dealt with inChapter XI.

4.Mode of Remittances.

Authorized Dealers should normally avoid issuing drafts in cover of outward remittances whenever remittance can be made by T.Ts, or M.Ts, etc. Where, however, the normal means of transfer is likely to result in unnecessary hardship or inconvenience to the remitter, drafts may be issued in the name of the beneficiaries of the remittance but such drafts should be crossed by the issuing bank as "Account Payee only".

5.Prescribed Application Forms.

(i)There are three types of application forms for outward remittances:

(a)Form 'I'is to cover remittance against imports (Appendix V-30)

(b)Form 'T-1'is to cover sale of exchange for travel (Appendix V-64)

(c)Form 'M'is to cover all other remittances (Appendix V-8)

(ii)Any person who wishes to purchase foreign exchange must lodge an application with an Authorized Dealer on the appropriate prescribed form duly supported by the requisite documents. On receipt, the application should be examined by the Authorized Dealer and if the Authorized Dealer is satisfied that the application is covered by the regulations and it is empowered to approve the remittance on behalf of the State Bank, it may effect the sale of foreign exchange. If the transaction requires prior approval of the State Bank, the application should be forwarded by the Authorized Dealer to the State Bank for consideration with comments under its stamp and signature.

6.Applications by Letters.

In some cases, applications are made by letters as it becomes difficult for the applicants to fully describe on the prescribed application form the purpose of purchase of foreign exchange particularly for travel abroad and for purposes other thanimport. In all such cases, letters should be accompanied by Form 'T-1' or 'M' as the case may be, duly filled in. If the remittance is permissible, the State Bank will return the form duly approved. In cases where remittance is required to be made in installments at periodical intervals, the State Bank may issue special permits authorizing remittances in the desired manner.

7.Applications to be submitted to the State Bank only through an Authorized Dealer.

All applications for foreign exchange should be forwarded to the State Bank through Authorized Dealers who should arrange their delivery to the State Bank through their own messengers or through post. All applicants who present their applications directly to the State Bank will be asked to resubmit them through an Authorized Dealer.

8.Forwarding Applications to the State Bank.

When submitting applications to the State Bank, Authorized Dealers should take all reasonable precautions to satisfy themselves as to the bonfires of the applicants. They should verify that the application form has been duly completed and signed by the applicant and then affix their stamp and signature thereon in token of their having examined the application and of having satisfied themselves that to the best of their knowledge and belief, the statements made in the form are correct and that full documentary evidence as required has been submitted. The applicant should also be advised that under Section 22 of the Act, it is an offence to give any information or make any statement which he knows or has reasonable cause to believe to be false or not true in any material particular.

9.Processing of Approved Form etc.

After receipt of approved forms or permits etc., from the State Bank, Authorized Dealers should see that the forms etc., have been approved by the authorized officers of the State Bank and that they bear its embossing seal. Authorizations which are signed by officers whose specimen signatures are not available with the Authorized Dealer, should be presented to the nearest office of the State Bank for authentication. It is also important that once a form has been approved by or on behalf of the State Bank, the Authorized Dealer should effect remittance only on behalf of the original applicant for whom the form has been approved and in favour of the beneficiary whose name appears in the approval. They must in no case accept instructions from third parties. In those cases where Authorised Dealers are empowered under the instructions laid down in this Manual to approve applications on behalf of the State Bank, they should ensure while approving the form that the applications are complete in all respects and that all the necessary documentary or other evidence as required has been submitted to and examined by them and that they have satisfied themselves as to the genuineness of the transaction.

10.Permits for Recurring Remittances.

(i)Permits (Appendix V-9) issued by the State Bank are of three types. In the first type of permits, the State Bank authorizes remittances up to a stated amount within a stated period which an Authorized Dealer may make on behalf of the permit holder. Remittances under such permits may be made during the period of validity of the permit in amounts as required by the applicant provided that the total of such remittances under the permit does not exceed the overall limit laid down in the permit.

(ii)The second type of permits covers remittances on a periodical (monthly) basis but the periodical (monthly) limits are not cumulative and remittances in all during any one period (month) must not exceed the prescribed rate laid down in the permit. If remittances are not made up to the full extent of the limit in any period (month), it is not permissible to carry forward unutilized balance in order to make larger remittances in subsequent periods.

(iii)The third type of permits allows remittances on a periodical (monthly) basis but the periodical (monthly) amount is sanctioned on a cumulative basis so that unutilized amounts for earlier periods (months) can be remitted in subsequent periods (months). Unutilized amounts may, however, be accumulated only within the validity of the permit and the entire unutilized balance of such permits will lapse after the last day of the validity of the permit. In such cases it is not permissible to make remittances in advance of the entitlements of the subsequent periods (months).

(iv)Requests for utilization of lapsed quotas should be forwarded by Authorized Dealers to the State Bank giving full reasons for non-utilization on due dates supported by suitable documentary evidence, wherever available.

11.Effecting Remittances against Permits.

In all cases where permits are issued by the State Bank, it will be in order for the Authorized Dealers to effect remittances against the permits subject to report onform 'M'. Authorized Dealers must state informthe number of the permit against which the remittance has been made and also certify that the remittance has been endorsed on the permit. The remittance must be endorsed on the reverse of the permit giving the amount and date of remittance under their stamp and signature. When the permit is exhausted, it should be returned to the State Bank by the Authorized Dealers along with theform 'M'on which the last remittance is reported. In all cases where the purpose for which the permit was granted ceases to exist and no further remittances are required or are permissible, the unutilized permit should be returned to the State Bank with an advice that the permit should be cancelled.

12.Period of validity of approval by the State Bank.

All Authorizations given by the State Bank are valid for a period not exceeding 30 days from the date of approval unless they are expressly approved as valid for a specified longer period or unless they have been revalidated for a further period. Similarly, permits issued by the State Bank is also valid for specified periods as stated on the permit. Authorized Dealers should not effect any remittance against approved forms, permits etc., which have been lapsed unless they have been duly revalidated.

13.Release of Foreign Exchange for Travel Abroad.

Foreign exchange is issued to the travelers against specific or general approval given by the State Bank. It may be drawn in any foreign currency equivalent to the sanctioned amount exclusively in the forms specified in paragraph 44 of Chapter XVII. In cases where a traveler desires to draw foreign exchange partly in foreign currency instruments and partly in foreign currency notes, Authorized Dealers will prepare two separate'T-1' forms. In the portion meant for their certificate, the Authorized Dealers will give on both the'T-1' formsa suitable indication as to the amounts of foreign exchange released in foreign currency instruments and notes. The'T-1' formswill be attached withSchedules E-3annexed to SummaryStatements S-1andS-6. In the case of sale of foreign exchange partly in foreign currency instruments and partly in foreign currency notes against specific approval issued by the State Bank, a photocopy of the State Bank's sanction will also be made. Authorized Dealers will give a suitable indication to this effect, both on the original sanction as well as its photocopy which will be attached with the relative'T-1' formsand surrendered to the State Bank along with the monthly returns of foreign exchange transactions.

14.Processing of Approvals given on one Authorized Dealers Form by another Authorized Dealer.

There may be instances where a traveler or a remitter might approach an Authorized Dealer for issue/remittance of foreign exchange against approved form'T-1'or 'M' bearing the identifying prefix and serial number of another Authorized Dealer. While releasing/remitting foreign exchange against such form'T-1'or 'M', Authorized Dealers should insert their own identifying prefix and serial number borne on one of the blank'T-1'or 'M' forms in their possession, and score out the prefix and serial number already appearing on approved form'T-1'or 'M' under proper authentication. The Authorized Dealers should, however, destroy that blank form'T-1'or 'M' whose serial number is so inserted by them.

15.Reporting of Remittances.

Authorized Dealers should submit to the State Bank along with the appropriate returns as laid down inChapter XXII, forms M,T-1and 'I' as the case may be, in cover of each remittance effected by them. Where remittances are approved by the State Bank, the approved forms should be submitted in original. Where approval is given by the State Bank by letter or through issue of permit, particulars of the letter or of the permit should be given on the appropriate form before submitting it to the State Bank with the returns.

16.Cancellation of Outward Remittances.

In the event of any outward remittance which has already been reported to the State Bank being subsequently cancelled, either in full or in part, Authorized Dealers must report the cancellation of the outward remittance as an inward remittance. The return in which the reversal of the transaction is reported should be supported by a letter giving the following particulars:

(a)The date of the return in which the outward remittance was reported.

(b)The name and address of the applicant.

(c)The amount of the sale as effected originally.

(d)The amount cancelled.

(e)Reasons for cancellation.

17.Cancellation of Inward Remittances.

In the event of any inward remittance which has already been reported to the State Bank, being subsequently cancelled either in full or in part, because of non-availability of the beneficiary, Authorized Dealers must report the cancellation of the inward remittance as an outward remittance on form 'M'. The return in which the reversal of the transaction is reported should be supported by a letter giving the following particulars:

(a)The date of the return in which the inward remittance was reported.

(b)The name and address of the beneficiary.

(c)The amount of the purchase as effected originally.

(d)The amount cancelled.

(e)Reasons for cancellation.

18.Utilization of Exchange for the purpose it is obtained.

Where any foreign exchange is acquired by any person other than an Authorized Dealer for any particular purpose or where any person has been permitted conditionally to acquire foreign exchange, the said person will not use the foreign exchange so acquired otherwise than for that purpose or fail to comply with the prescribed conditions. In cases where the foreign exchange so acquired cannot be used in full or in part for the purpose for which it was acquired or any of the conditions subject to which the foreign exchange was released cannot be complied with, the foreign exchange should immediately be surrendered to an Authorized Dealer.

Impact of Monetary Policy on the Volatility of Stock Market in Pakistan

Impact of Monetary Policy on the Volatility of Stock Market in Pakistan

This paper addresses the linkages between the monetary policy and the stock market in Pakistan. The estimation technique employed includes Engle Granger two step procedure and the bivariate EGARCH method. The results indicate that any change in the monetary policy stance have a significant impact on the volatility of the stock market. Thus contributing to the ongoing debate in the monetary policy rule literature regarding the proactive and reactive approach.

JEL code: G120, E430.

Keywords: Interest Rate, Stock Market, Monetary Policy.

1. Introduction

Financial sector in Pakistan has been experiencing the process of reforms since eighties. The two important outcomes of the financial sector reforms in Pakistan has been the opening up of the stock markets for foreign investors and adoption of market based instruments, such as interest rate, of monetary policy. Opening up of the stock markets resulted in a sharp increase in the inflows of portfolio investment [Fazal and Qayyum (2007)]. On one side such an investment helps in raising the investable funds and on other side it produced wild swings in the stock market. For example, the Karachi Stock (KSE)-100 Index increased to 2600 in 1995 but declined sharply to just 878 in 1998. From this low level it crossed 10 thousand marks in early 2005 and by May 2005 it had declined to around 7 thousand mark [Fazal and Qayyum (2007)]. It is argued that the volatility is high in the bullish market than in the bear market. The Repo rate as indicator of monetary policy these years has also shown volatility. Since 1995 the Repo rates have been fluctuating between 23.5 to 0.21.

Theoretically, monetary policy affects the stock prices through the wealth effect channel and the balance sheet channel as pointed out by Bernanke, Gertler and Gilchrist (1996), Bernanke and Gertler (1999) and Goodhart and Hofmann (2000). The traditional interest rate channel which implies that a tighter monetary policy leads to an increase in the interest rate that at which the firms future cash flows are capitalized causing stock prices to decline. While the easing of the monetary policy increases the overall level of economic activity and stock price responds in a positive manner as indicated by Cassola and Morana (2004). The traditional interest rate channel was also investigated by Bernanke and Blinder (1992), Thorbecke (1997) and Rigobon and Sack (2003). One third of the changes in the equity prices are associated with news on monetary policy (Fair, 2002).

However, there is no study available in Pakistan that has investigated the relationship between the stock prices and the monetary policy. The core objective of the study, therefore, is to explore the impact of monetary policy on the returns to stock market.

The study is arranged as follows. After this introductory part, section II overviews the stock market and the monetary policy developments in Pakistan. The section III elaborates the methodological framework. The data availability and preliminary data analysis is discussed in section IV. The cointegration analysis and EGARCH model results are presented in section V. The VI section concludes the study.

2.Overview of the Stock Market and the Monetary Policy Developments

The capital market in Pakistan is regulated by the Security and Exchange Commission of Pakistan (SECP) established in 1997 by replacing the Corporate Law Authority. There are three stock exchanges in Pakistan, namely the Karachi Stock Exchange (KSE), the Lahore Stock Exchange (LSE) and the Islamabad Stock Exchange (ISE). These are established on 1947, 1974, and 1997, respectively. The Karachi Stock Exchange (KSE) is the main and leading stock Exchange. The growth of the equity market during the decade of 1960s was due to industrialization policies pursued by the government of Pakistan. The decade of 1970s started with political turmoil and unrest in the eastern part of the country. The worsening domestic situation in the East Pakistan and war with India disaggregated Pakistan. The out come was the separation of former East Pakistan and emergence of new country Bangladesh. The Government of Pakistan has adopted the policy of nationalization of all types of private sector industries and financial institutions in 1973-74, which had completely eliminated private sector out of the country. The new government reversed and formulated the policy of denationalization of industries and financial institutions in 1985-86.

The decade of 1990s witnessed changes in the policies and functioning of the stock market. In the beginning of 1991 significant measures were taken including the opening of the market to international investors; removal of constraints to repatriation on investment proceeds, gains, and dividend; deregulation of economy and allowing commercial banks in the private sector; liberalization of foreign exchange restrictions and allowing Pakistanis to have foreign currency accounts. The market responded positively to liberalization measure and unprecedented increase in all indicators was observed in the first year of the opening of the market. The bullish trends were observed in the first year. In terms of its performance, the market was ranked third in 1991 [Husain and Qayyum (2006)]. Nevertheless in terms of listings the market deepened. The new companies (i.e., 86) were listed during the year that helped to increase the turnover of shares and market capitalization. The market improved significantly in terms of size and activity. As a result, the ratio of market capitalization to GDP increased from 7% to almost 18% in the first year of liberalization and further to 26% after two years. In 1995 Pakistani equities market collapsed due to domestic political crisis and a discouraging economic outlook. KSE established a `Defaulting Companies Counter in August 1997 for those companies which had committed various defaults under listing regulations of the Exchange. The KSE has shown improvement during 1997-98. Further, the Karachi Stock Exchange introduced a computerized trading system i.e. a KATS (Karachi Automated Trading System). Due to different measures the number of listed companies rose to 762 in 2000. In addition the listed capital and market capitalization are 229,314.8 million and 394,445.7 million respectively. On the other hand, the growth in activity indicated by trading value and turnover ratio was tremendous. Since late 90s the turnover ratio has been phenomenal and increased to almost 500% in 2003. As a result Pakistan ranks first in the world in terms of turnover ratio. The KSE has been among the best performing markets for the last two years.

Monetary Policy DevelopmentsThe State Bank of Pakistan has been established on July 1, 1948 as a central bank. The banking system had collapsed at the time of partition; SBP at first very carefully took measures to rehabilitate and expand the existent banking structure. These included the declination of the foreign banks offer to open branches in the interior of the country on the grounds that the local dominance of the most powerful financial sector of the economy is in the best interest of the new born country. The National Bank of Pakistan was thus established in 1949. To encourage the local banks to spread their branches into the interior of the country, the SBP provided clearing and cheap remittance facilities. A number of other specialized banks and were also set up namely Agricultural Development Finance Corporation in 1952 and Asian Development Bank in 1959 later merged into Agricultural Development Bank in 1961, Pakistan Industrial Finance Corporation in 1957 later on converted into Industrial Development Bank, Pakistan Industrial Credit and Investment Corporation in 1957, House Building Finance Corporation in 1952, National Investment Trust, Investment Corporation of Pakistan etc.

SBP has been using a selective credit control measures like the imposition of minimum margin requirements as an instrument of monetary policy. The interest rate was kept low during 19480-70 to contain rise in the public debt and to encourage larger expansion of the banking credit for financing the public and private investment. The SBP in addition to the use of moral suasion with the banks to encourage lending to the small parties used margin requirement as a tool. To restraint the growth of money supply the reserve ratios were used 1965. In addition a Quota System was introduced in August 1963, in respect of its advances to the scheduled banks against government securities. Under this agreement banks were assigned a quota every quarter equal to half of its statutory reserves with the state bank in the preceding quarter. The borrowing beyond this quota was subject to progressively high higher rates. In 1965 the quota was made more stringent by reducing the amount from 50 to 25 percent of the average statutory reserves and making it applicable it for all types of borrowing of the banks from SBP.

A comprehensive banking reforms was introduced in 1972 by the government with consultation of the new governor SBP. The emphasis was on the flow of the bank credit to priority sectors and small businessman in agriculture and industry through the creation of the National Credit Consultative Council. However, owing to the ineffectiveness of the reforms the SBP was nationalized in 1974. The system of the ceilings on the credit by the individual banks to private sector remained a really potent weapon to restrain growth of money and credit. Thus the monetary and credit policies were directed towards providing adequate credit to productive sectors in general and priority sectors in particular

As a result of Islamization of the economy, a compulsory zakat deduction of 2.5 percent was levied on saving accounts and other financial assets. The elimination of riba (interest) led to the switch of the NIT, ICP and SBFC to interest free operations. In 1981, profit loss sharing accounts were opened in commercial banks alongside the interest-bearing accounts. The capital was provided on the basis of profit and loss sharing (modarba) and mark-up (murahaba) basis in place of interest.

The beginning of the 90s witnessed the Banking Reforms II comprising of the market based policies of system and credit management. In 1992 the Prudential Regulations were introduced. This included introduction of public debt auctioning, abolition of credit ceiling and credit deposit ratio (CDR), phasing out of directed, concessionary credit and finally removal of cap on interest rates [Ashraf Janjua]. On February 1, 1992, the SBP extended a 3 day Repo facility for the Treasury Bills. The OMO, which SBP started on ad hoc basis in October 1991, supplemented by the changes in the discount rates and cash reserve requirements and issuance of T bills of different maturity in June 1998, facilitated in the management of the monetary and credit expansion. In 1999 the multiple exchange rate system was replaced by unified exchange rate by the SBP. From July 1, 2000, the integration of the exchange rate and the monetary policies took place.

The SBP gained autonomy in 90s with the reforms. In 2002, to strengthen the SBP autonomy, the State Bank of Pakistan Act, 1956, was amended. A section 9B was introduced which further clarified the role of Monetary and Fiscal Policies Coordination Board. To strengthen the SBP core banking capabilities and for creation of SBP Banking Services Corporation. The restructuring led to the formation of two subsidiaries. The SBP Banking Services Corporation in January 2002 and The National Institute of Banking and Finance (NIBAF) in January 1997. During the 19892000 period, monetary and credit policies mainly operated within the Annual Credit Plan (ACP). In December 2000, the Federal Investment Bonds were complemented with Pakistan Investment Bond.

During FY01, the monetary policy was initially tightened by increasing the discount rate twice from 11 to 12 percent and from 12 to 13 percent in September and October 2000 respectively and increasing the cash reserve requirement by 2 percent to effectively curb the depreciation of the rupee. Monetary policy witnessed an important transition in 2005, the focus of the monetary policy shifted on controlling inflation rather then reviving growth in the economy. The monetary policy was aggressively tightened in the second half of the fiscal year. In order to curb cost push inflation, SBP raised the discount rate (for the first time after June 2001) during April 2005, by 150 basis points. This rise in interest rates was supported by high liquidity absorptions through OMOs and a slow down in reserve money growth. This coupled with higher acceptance ratio in T-bill auctions during these months compared with initial nine months of the fiscal year, further drained inter bank liquidity and resulted in an increase in discounting activities.

3. Methodology

The study is based on time series econometrics. The financial time series, particularly stock market return, are not distributed normally; they generally are assumed to be highly Kurtic. The tests of skewness, Kurtosis and Jarque-Bera test of normality are used to analyse the non normality of the data. The Augmented Dickey Fuller (ADF) test of unit roots is used to test stationarity of the data (Dickey and Fuller, 1979, 1981). The volatility of the stock returns and the repo rate is also seen by plotting the data.

Engle and Granger (1987) two step method is used to test the existence of cointegrating relationship between the stock market prices and the money market rate. The first step estimates the long run equation and in the second step ADF test is applied on the residual from the cointegrating equation. The Engle-Granger two step method is

LRSt = + LRRt + t

(1a)

t = t-1 +1t-1 + 2t-2 + + pt-p + t

(1b)

where LSPIt is log of stock price index, LREPt is log of Repo rate, (t is residual from cointegrating equation and t is residual from the equation of ADF unit root test which is assumed to be white noise.

Because the tendency of stock prices to be negatively correlated with changes in the stock volatility, therefore, the relationship between the two markets, i.e., stock market and Repo market is estimated by utilizing ARCH-GARCH methods proposed by Engle (1982). The simple GARCH (p, q) model cannot capture the leverage effect. Keeping in view the importance of leverage effect in stock assets returns Bollerslev (1986) and Nelson (1991), amongst others, have developed the Exponential Generalised Autoregressive Conditional Heteroskedecity (EGARCH) model. Braun et al (1995), Kroners and Ng (1996, 1998), Henry and Sherma (1999) and Engle and Cho (1999) have extended Exponential Generalised Autoregressive Conditional Heterosckedecity (EGARCH) model into bivariate version. The model helps us in the estimation both static as well as dynamic forecast of the mean, forecast standard error and the conditional variance.

This paper applies a bivariate VAR-EGARCH model to investigate the relationship between the stock market and Repo rate. The VAR-EGARCH (p, q) model for the stock market is given in the following two equations;

(2a)

(2b)

Where i = 1, 2, .. , n and j = 0, 1, ..,m ( t(t-1 ~ N[ 0, ((s t)]

The equation (2a) is vector autoregressive (VAR) model of the conditional mean equation of returns on stock market assets (rst). It indicates that rst depends on the past values of stock returns (rst-i), the current and past values of Repo rate (rrt-j), the error correction term (ecst-1) representing the cointegrating relationship between the stock market prices and Repo rate, and the random variable. The random variable (i.e., t) is assumed to have zero mean and conditional variance. Hence the second equation of the model (i.e., 2b) represents the conditional variance of the stock market returns.

The exponential conditional variance of stock market returns (i.e., equation 2b) is dependent on the lagged value of innovation of the stock returns and the Repo rate returns, lag of conditional variance of stock market and the terms to capture asymmetric effect. The parameters s and s capture the last period forecast variance and stock market news effects, respectively. Further, the s allow asymmetry in effects of news from the stock market. The estimated parameter of GARCH term that is s indicates persistence of volatility in the stock market asset returns.

4.Preliminary Data analysisFor the analysis we use weekly data from 1st July 1998 to 27 May 2008. The data on stock index (i.e. KSE-index 100) are obtained from the Karachi Stock Exchange and the data on Repo rate is obtained from State Bank of Pakistan. The short run interest rate i.e. repo rate is used as the monetary policy instrument. The data on KSE-index 100 and repo rates is presented in fig 1. The figure 2 and 3 show volatility in the stock market returns and repo rates respectively.

Figure. 1. Stock Price Returns and Repo Rates (July 1998 May 2008)

Figure. 2. Volatility in Stock Price Returns (July 1998 May 2008)

Figure. 3. Volatility in Repo Rates (July 1998 May 2008)

The Fig. 1 traces the movements in the stock price index and the Repo rates over the period under analysis. As long as the Repo rates were declining the stock price index remained low. However, the upward movement of the Repo rates led to a sharp increase in the stock market returns.

The summary statistics from preliminary analysis are presented in Table 1. As can be seen in the table, the data are not normally distributed. Moreover, both the series show skewness. The ADF test of stationarity indicates that the series are not stationary and have a unit root problem. However, the first difference of both the stock market prices index and repo rate series are stationary. The ARCH test on the stock market prices index and the repo rate series confirms the existence of Autoregressive Conditional Heteroscedasticity (ARCH) in both the series. The Ljung Box Q statistics supports the null hypothesis of randomness in the data.Table 1: Preliminary Data Analysis: Summary Statistics.

INDEXRRRS

Mean5224.5166.7186860.005347

Median3105.1607.8150000.009741

Maximum15654.7917.840000.152012

Minimum774.74000.2-0.238895

Std. Dev4467.9874.0339270.042180

Skewness0.804339-0.022105-0.803208

Kurtosis2.2419142.1847527.014817

Jarque - Bera67.2039414.16489397.3608

Probability00.0008400

ADF Test-1.878484-8.538676-22.39739

Ljung Box14677.13552284.5554849.195208

Observations510510510

5. Empirical Results

Cointegration Analysis

The possibility of a long run relationship between the two series is investigated by applying Engle-Granger (1987) two step method. This helps us to determine whether an error correction term should be included in the EGARCH model or not. In the first step the stock prices are regressed on the repo rates. The results are presented below (t-statistics in parenthesis).

LRS = 6.612589 + 0.006121 T - 0.016951 LRR

(286.14) (95.92) (-1.82)

R-squared 0.95 F-statistics 4607.38 ADF -2.791505

In the second step, the presence of cointegration between the two variables is tested by applying the ADF test of unit roots on the residual obtained from the cointegration equation 1a. The Engle-Granger five percent critical value is (3.17). The results thus indicate the existence of a unit root test in the residual series, implying that the two series are not cointegrated for the period under analysis. This leads to the estimation of the EGARCH model without error correction term in the conditional mean equations.

EGARCH Model of Stock Returns

The bivariate EGARCH model is estimated by the Maximum Likelihood Method proposed by Bollerlov and Wooldridge (1992). The results are presented in the following equations.

(3a)

(3b)

The mean equation (3a) reveals that the returns to the stock market are not only affected significantly by its lag but the monetary policy in terms of the repo rates also plays a significant role in determining the returns to the stock market. Thus any increase (decrease) in the repo rates, indicating a monetary policy tightening (expansioning), decreases (increases) the returns to the stock market. The same is true for the variance equation (3b) whereby any increase (decrease) in the repo rates, indicating a monetary policy tightening (expansioning), enhances the volatility of the stock market with one week lag. Implying thereby that the monetary policy has a positive impact on the volatility of the stock market.

The parameter, indicate asymmetric impact of news on the stock market return. If it is negative, a negative innovation tends to reinforce the size effect, while a positive innovation tends to partial out. In case of Pakistan, it is positive and statistically significant. The positive and significant value implies that positive news tends to amplify the interest rate volatility more than the negative news.

The relative importance of the negative innovation to the positive innovation is 0.88, measured by the ratio -1+ / (1+). This ratio also considers the differing impact of a markets own innovation on the current conditional variance [Yang and Doong (2004)]. It reveals that the positive innovation in the stock market have a one time larger impact on volatility of the stock market returns than the impact of negative innovations in the stock market.

The sum of ARCH and GARCH coefficients is 1. If it is close to one, it reflects the persistence in the volatility shocks. The sum of ARCH and GARCH coefficients in case of Pakistan shows that the volatility shocks in the stock market returns have been very persistent and they die out rather slowly.

Based on the half-life of a shock, the life of volatility is measured as ln (0.5)/ ln (). It turns out to be almost 12 weeks. This implies that it takes almost twelve weeks for the stock market to regress halfway back to its steady state value [Mari G. Reyes (1996)].

The leverage effect is statistically significant in case of Pakistan. This implies that the past negative shocks increase current volatility more than do past positive shocks.

The monetary policy with one week lag enhances the volatility of the stock market returns.

News Impact Curve of Stock Market Returns

Given information up to current time, the news impact curve examines the relationship between the news and future volatility. The news impact curve plots news scenarios on the horizontal axis against the resulting volatility on the vertical axis. The curve shows that the conditional variance of the stock market returns reacts differently to equal magnitudes of negative and positive shocks. An increase in the stock market returns leads to more uncertainty when compared to a decrease of equal magnitude.

6.Conclusion

In an economy there are several paths and channels through which monetary policy can effect the real activity of the economy. The traditional transmission mechanisms of the monetary policy i.e. the credit and the money channel, have one thing common that they operate through the financial market. Most economists agree that the stock market price index, being one of the leading indicators in the developed economies, is affected by the monetary policy rules. Thus indicating that identifying the link between the monetary policy and the stock market is highly important to gain useful insight of the transmission mechanism of the monetary policy.

This paper addresses the linkages between the monetary policy and the stock market in Pakistan. The estimation technique employed includes Engle Granger two step procedure and the bivariate EGARCH method. The results indicate that in case of Pakistan the stock market is sensitive to the changes in the monetary policy.

References

Bernanke, B. and Kuttner, N. (2005) What Explains the Stock Markets Reaction to the Federal Reserve Policy?, The Journal of Finance, Vol. LX, 1221-1257

Bollerslev, T. (1986) Generalized Autoregressive Conditional Heteroscedasticity, Journal of Econometrics, 31

Cassola, N. and Morana, C. (2004) Monetary Policy nad Stock Market in the Euro Area. Jouirnal of Policy Modelling 26, 387 399.

Engle, R. F., and Granger, C. W. (1987) Cointegration and Error Correction: Representation, Estimating and Testing, Econometrica, 55, 251, 76

Engle, R. F. (1982) Autoregressive Conditional Heteroskedasticity and Estimates of the Variance of UK Inflation, Econometrica, Vol. 50, 987-1008

Fair, Ray C. (2002) Events that Shook the Market. Journal of Business, 75,713 731.

Goodhart, C., and Hofmann, B. (2000) Financial Variables and the conduct of Monetary Policy, Sveriges Riskbank Working Paper, No. 12.

Ioannidis, C. and Kontonikas, A. (2006) Monetary Policy and the Stock Market: Some International Evidence, University of Glasgow Working Paper, No. 2006_12.

Janjua, Asharf (2003), History of the State Bank of Pakistan 1977-1988, SBP.

Janjua, Asharf (2004), History of the State Bank of Pakistan 1988-2003, SBP.

Nelson, D. B. (1991) Conditional Heteroscedasticity in Asset Returns: A New Approach,Econometrica, Vol. 59, 347-370

Niazi, A. K. (2005) Monetary Policy in Historical Perspective (Pakistan Experience, 1978-2005),Pakistan Business Review, Vol. 8 (3), 3-43.

Niazi, A. K. (2007) Monetary Policy in Historical Perspective (Pakistan Experience, 1970-1978),Pakistan Business Review, Vol. 8 (4), 3-40.

Patelis, Alex. D. (1997) Stock Return Predictability and the Role of Monetary Policy, The Journal of Finance, Vol. 52(5), 1951-1972.

Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other isinfluenced by numerous fundamental and technical factors. These include relative supply and demand of the two currencies, economic performance, outlook for inflation,interest rate differentials, capital flows, technical support and resistance levels, and so on. As these factors are generally in a state of perpetual flux, currency values fluctuate from one moment to the next. But although a currencys level is largely supposed to be determined by the underlying economy, the tables are often turned, as huge movements in a currency can dictate the economys fortunes. In this situation, a currency becomes the tail that wags the dog, in a manner of speaking.

STATE BANK OF PAKISTAN

Statistics & DWH Department

COUNTRY-WISE WORKERS' REMITTANCES

(Provisional)

(Million US Dollar)

Jul-AprApril ItemAprilMarch

AmountYoY growth (percent)

201520152014FY15FY14FY13FY15FY14

2.U.K.174.47164.28166.07 1,845.30 1,798.37 1,611.11 2.6111.62

3.Saudi Arabia519.68489.70415.09 4,565.42 3,806.41 3,371.59 19.9412.90

4.UAE395.69411.24233.973,384.302,522.982,312.0134.149.12

Dubai245.95228.04107.00 1,853.76 1,247.82 1,015.85 48.5622.84

Abu Dhabi144.441,640.581,577.461,311.8514,969.6612,897.9111,569.7216.0611.48 Cash

Sharjah5.161.USA233.85199.69206.15 2,105.49 2,028.47 1,819.85 3.8011.46

Other0.140.080.12 1.06 1.26 1.37 -15.87-8.03

5.Other GCC Countries190.59196.07169.671,751.221,527.401,331.6714.6514.70

Bahrain35.9836.5935.60 308.32 266.22 236.08 15.8112.77

Kuwait63.7662.1756.57 617.35 558.29 511.08 10.589.24

Qatar32.6836.0528.50 283.05 274.60 267.13 3.082.80

Oman58.1761.2649.00 542.50 428.29 317.38 26.6734.95

6.EU Countries26.8725.9836.37298.89355.36297.69-15.8919.37

Germany6.034.92 7.03 64.78 70.58 71.51 -8.22-1.30

France1.741.61 2.83 20.83 29.03 30.33 -28.25-4.29

Netherland0.420.27 0.42 2.86 3.60 4.61 -20.56-21.91

Spain3.082.79 5.74 39.18 65.87 43.84 -40.5250.25

Italy2.302.18 2.66 25.82 27.34 29.31 -5.56-6.72

Greece0.950.82 1.27 11.88 12.05 8.92 -1.4135.09

Sweden0.980.77 1.14 9.87 12.67 11.25 -22.1012.62

Denmark0.651.16 1.89 10.89 20.10 20.76 -45.82-3.18

Ireland10.4011.07 13.09 108.99 111.39 74.46 -2.1549.60

Belgium0.320.39 0.30 3.79 2.73 2.70 38.831.11

7.2.021.66 2.07 22.98 25.16 31.91 -8.66-21.15 Norway

8.Switzerland1.861.89 2.29 25.56 24.91 25.62 2.61-2.77

9.14.7213.33 14.18 144.73 130.09 129.62 11.250.36Australia

10.Canada10.9810.49 11.72 134.72 134.86 150.66 -0.10-10.49

11.Japan0.750.71 0.65 6.27 5.33 4.47 17.6419.24

12.Other Countries69.1062.42 53.62 684.78 538.57 483.52 27.1511.39

II.0.000.000.000.000.000.090.000.00Encashment and Profit in Pak.Rs. of Foreign Exchange Bearer Certificates (FEBCs) & Foreign Currency Bearer Certificates (FCBCs)

1,640.581,577.461,311.8514,969.6612,897.9111,569.8116.0611.48TOTAL

(Provisional)

MONTH-WISE WORKERS' REMITTANCES(Million US Dollar)

Monthly Cash Inflow (including FEBCs & FCBCs)FY15FY14FY13YoY growth (percent)

FY15FY14

1,649.391,404.691,204.7117.4216.60July

1,328.711,240.141,258.987.14-1.50August

1,716.591,284.221,135.4233.6713.11September

1,383.131,348.001,365.102.61-1.25October

1,320.621,130.411,017.8316.8311.06November

1,583.231,384.941,134.7014.3222.05December

1,378.191,245.971,089.6410.6114.35January

1,391.761,209.771,028.3815.0417.64February

1,577.461,337.891,119.1517.9119.55March

1,640.581,311.851,215.9025.067.89April

14,969.6612,897.8811,569.8216.0611.48Jul-Apr

1,496.971,289.791,156.9816.0611.48Monthly average for period July-Apr

Watch

Embed

ActualPreviousHighestLowestDatesUnitFrequency

4346.004287.004695.00906.002002 - 2015USD MillionQuarterlyNSA

This page provides - Pakistan Remittances - actual values, historical data, forecast, chart, statistics, economic calendar and news. Content for - Pakistan Remittances - was last refreshed on Sunday, May 31, 2015.

Pakistan TradeLastPreviousHighestLowestUnit

Balance of Trade-188772.00-161481.006457.00-280964.00PKR Million[+]

Exports202874.00196553.00275483.0051.00PKR Million[+]

Imports391646.00358034.00472228.0096.00PKR Million[+]

Current Account778.00-770.001418.00-4213.00USD Million[+]

Current Account to GDP-1.10-2.104.90-8.50percent[+]

External Debt62649.0063960.0066490.0033172.00USD Million[+]

Terms of Trade54.4152.2494.8349.17Index Points[+]

Remittances4346.004287.004695.00906.00USD Million[+]

Gold Reserves64.4764.4365.4364.39Tonnes[+]

Crude Oil Production96.0098.0098.0050.00BBL/D/1K[+]

Foreign Direct Investment2816.402665.303184.302099.10USD Million[+]

RemittancesReferencePreviousHighestLowestUnit

Brazil1909.90Dec/141943.906411.001909.90USD Million[+]

France39.00Feb/1545.0087.0022.00EUR Million[+]

Germany-881.00Feb/15-863.00-601.00-1228.00EUR Million[+]

India12293.40Nov/1411673.5112293.405999.10USD Million[+]

Indonesia2147.00Nov/142103.002194.001202.00USD Million[+]

Italy131.00Nov/14153.00203.0097.00EUR Million[+]

Mexico2257.86Mar/151842.512637.71248.06USD Million[+]

Netherlands48.00Feb/1448.00171.000.00EUR Million[+]

Russia5081.00Nov/144790.005728.001359.00Million USD[+]

Spain1271.00Feb/141349.001610.00252.00EUR Million[+]

Turkey66.00Mar/1546.00574.0043.00USD Million[+]

Impact of Foreign Exchange rate on stock prices

1(Management Sciences, Foundation University Institute of Engineering & Management Sciences, Pakistan)

Abstract: Foreign exchange fluctuations have been found in the literature review to have an impact on the

stock market return and the fluctuations in the stock prices. This research uses the cointegration technique to

analyze the impact of USD to PKR exchange rate on the stock return market in Pakistan. The stock market

return has been studied by KSE 100 Index. The results show that a relationship between the two variables exists

in the short run in Pakistan.

Keywords Exchange Markets, stock prices, Pakistan

I. Introduction

Stock market return is one of the most relevant and most important metric for the management and the

shareholders of the organizations. The study on the factors that impact the share prices is flocking the research

databases mostly because the theorist and the applicants want to optimize the management processes and thus

provide a guaranteed and stabilized performance of the stock. One factor that impacts the return on stocks and

the interest of investors in the stock is the foreign exchange rate.

Foreign exchange return is also important in the context of macroeconomic management of a country

meaning to say that if a relationship between the foreign exchange rate and the stock market return is found to

exist, then the government has the opportunity to manage the exchange rate and thus the return on the stock

market. Moreover, through the establishment of this relationship, the investors will be able to get another

element of predictability in the fluctuations of stock market returns.

II. Literature Review

As far as the existence of literature on market returns and forecasting stock returns is concerned, the

amount is found to be considerably high (Ferreira and Santa-Clara, 2011). A number of factors have been of

interest when it comes to forecasting stock market return for example the macroeconomic variables, the

corporate actions and finally the measure of risk and the studies find that there is a predictable component in

stock market return that the investors can find and use to stabilize their returns to a greater extent. Certain

critique however exists to the researches and the forecasting models that exist. For example Goyal and Welch

(2008) studied the out of sample performance of a list of apparent predictors of stock market return and find the

historical mean to have a better out of sample performance in predicting the stock market returns than the

traditional regressions used for forecasting purposes. So what Goyal and Welch (2008) are saying is that the use

of traditional predictive regression models would not have helped the investor in either attaining valuable

information regarding the stock return patterns or to make profits on time.

Bermer and Hiraki (1999) say that there has been a lot of interest shown by interest to know whether

there exists a predictable component in the short term stock return or not. One of the reasons for this interest is

that the researchers want to either confirm or reject the assumed rationality of individual investors and the

efficiency of the stock market. Those who do have faith in the rationality of investors and efficiency of the

market, seek to study the short term return patterns of the stock in order to give evidence on the subtle market

microstructure issues.

For the purpose of assessing the expected returns, uncertain changes in the investment opportunity have

been found to play a strong role in ascertaining the demand of the asset by the potential investors (Cox, Ingersoll

and Ross, 1985). In this regards, Chiang and Doong (1999) says that financial volatility is a factor that needs to

be considered significantly for exaplining the stock returns.

III. Exchange Rate

As far as quantifying the expectation of the exchange rate are concerned, Marey (2004) says on the

basis of a survey data that long term expectations are not only heterogeneous but are also not effectively

described by the rational expectations. In his own research, Marey (2004) tried to investigate the level of

plausibility of standard exchange rate expectations mechanism which in an artificial economy are found to be

favored by heterogeneous traders, the research concludes that adaptive expectations market exhibits more serial

correlation because it bandwagons the expectations market. Secondly, the extrapolative expectations market

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sometimes generates extreme returns and thus cannot be empirically plausible and finally, the regressive

expectations market reproduces stylized facts of empirical quarterly exchange rates.

Tsen (2011) says that the real exchange rate has been found to play an important role in the investment

determination and the international trade systems as the appreciation of real exchange rate can lead to retarded

exports, a change in the amount of debt payment that needs to be done and a growth of inflow of foreign direct

investment. The economies overall can be affected by the changes in the exchange rate.

For this research however, the impact of exchange rate changes on the stock returns has been considered.

IV. The Impact of Exchange Rate Changes on the Stock Returns

The relationship with the US dollar and the Stock Exchange Index has been studied by Wu et al (2012)

who have focused their research on the Philippine Stock Exchange. According to the authors, such a research

can actually help in guiding the government of countries to macro manage the investor returns on the stocks and

thus in effect control the inflow of foreign direct investment into the country. Focusing further on the issue,

Bahani-Oskooee and Sohrabian (2006) use the granger causality technique along with the co integration

technique to analyze the results of exchange rates and stock prices by using the S&P 500 index. The results

show that not only the relationship exists only in the short run, it is also bidirectional. Moving on, Branson

(1983) discusses his stock oriented model of exchange rates and emphasizes on the fact that the exchange rates

serve to equate the supply and demand for assets including the stocks and the bonds. Yau and Nieh (2008) note

that even though the existence of a relationship is often signified by the researchers between the stock exchange

returns and the exchange rates, the length and the direction of the relationship is often an element of further

debate. Interestingly, using the granger causality and the relationship between the financial assets and exchange

rates of USA and Japan, Yau and Nieh (2008) find that there is no short term causal relationship between the

two however in the long run a positive relationship has been found to exist.

Kim (2003) uses the error correction technique and the co integrating system to investigate whether a

long term relationship exists between the exchange rates and the stock prices in the United States. The data set

used is the S&P 500 which yields that there is a negative relationship that exists for the stock returns in USA

with the value of the dollar. Finally, Lin (2012, p. 161) analyzes the comovement of the exchange rates and the

stock prices in the Asian markets and finds that

Results have suggested that the comovement between exchange rates and stock prices becomes

stronger during crisis periods than during tranquil ones, in terms of long-run co-integration and short-run

causality, which is consistent with contagion or spillover between exchange rates and stock prices during the

former type of period.

This means that the government when trying to control the crisis period should try to stimulate growth

and keep investment attractive.

V. Methodology

In order to test our hypothesis monthly KSE 100 index data from Karachi Stock Exchange (KSE) was

obtained from 1998 to 2009. Returns of index were calculated by using following formula:

(1)

Further monthly Real exchange rates (EXT) were obtained from IFS CD Rom from 1998 to 2009.

Real exchange rate was proffered in order to investigate change that is purely due to exchange rate itself and not

contaminated by inflation. The analysis period was confined from 1998 to 2009 primarily due to nonavailability

of the former prior to 1998. Further the IFS CD ROM was updated to give exchange rate

information till June 2010. Since we wanted to obtain data yearly, six months data in 2010 was unavailable.

Thus we decided to calculate variables from 1998 to 2009, where complete yearly information was available.

Our sample was time series and it has inherent problems of non-stationarity that leads to spurious

regression. Thus we conducted stationarity tests using Phillip Peron(PP) tests for stationarity. The results of PP

are more robust than Augmented Decke fuller test for stationarity (Gujrati, 2003). Thus after we were confirmed

that data is stationary, we will check for co integration and also vector error correction test cannot be conducted

until there is a long term affiliation between variables. The co integration tests will reveal whether there exist a

long term relationship between stock market returns and real exchange rates. Once the co integration tests

confirm long term relationship, we will conduct vector error correction model. After that we will run ordinary

least square regression using following equation to see if short term impact exist or not.

(2) D(MRET) = C(1)*( MRET(-1) + 1*EXT(-1) + 2*@TREND(1) + C ) + C(2)*D(MRET(-1)) +

C(3)*D(EXT(-1)) + C(4)*D(MRET(-2)) + C(5)*D(EXT(-2)) + C(6)

The portion of the model in parenthesis is co integrating while the rest of the equation is comprised of error

correction term. Our variable of interest are C(3) and C(5). These are error correction terms representing

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previous months change in exchange rates. Thus we will check if they have impact on returns by using Wald

Test under following hypothesis;

H0: Exchange rate change has no impact on Market returns in short term.

H1: Exchange rate change has impact on Market Returns in short term.

Significant p-values of less than .05 will indicate that we will accept H1. This acceptance will lead us to

believe that in short term exchange rate fluctuations will impact stock market returns.

VI. Results and Discussion:

Unit root test was conducted using Phillip Peron test for stationarity. The test was conducted under all

assumptions i.e. with intercept, without intercept but trend and without intercept and trend. The results for both

variables are summarized in tables 1.1 and 1.2.

Table 1.1: Unit Root Test for Market Returns

ASSUMPTIONS PHILIPS PERRON TEST

STATISIC

CRITICAL VALUES

1% 5% 10%

Intercept -11.3802 -3.477 -2.8817 -2.5774

Trend and intercept -5.107754 -4.263 -3.4426 -3.1457

NO intercept and No trend -4.826372 -2.5804 -1.9422 -1.6169

Table 1.2: Unit Root Test for Change in Exchange Rate

ASSUMPTIONS PHILIPS PERRON TEST

STATISIC

CRITICAL VALUES

1% 5% 10%

Intercept -7.840877 -3.477 -2.8817 -2.5774

Trend and intercept -7.81797 -4.0245 -3.4417 -3.1452

NO intercept and No trend -7.413119 -2.58 -1.9421 -1.6169

The results indicate that both variables are stationary under all three assumptions at level. This indicates that

problem of non stationarity does not exist in our series and our series has constant variance. This helps us in

predicting out of sample relationship and robustness is ensured. Further, since our variables are stationary at

same level, we can safely check our variables for long term relationship. Thus after unit root we will carry out

co integration tests to check for long term relationship.

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6.1 Co integration Test

Co integration test was conducted under all assumption. The result are summarized in table 1.4

The results indicate that Akiake information criteria is lower in case of assumption which indicates that

equations are quadratic in nature and have trend and intercept. Further Schwarz criterion is also indicating that

results of the former are correct. Thus we will carry the co integration test assuming trend and intercept in

quadratic form for establishing long term relationship. The test result under this assumption is as follows:

6.2 Johansen Co integration Test Summary

Table 1.5

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The results indicate that Null hypothesis that indicates no long term relationship exists is rejected by significant

p-value of 0.000. Thus the results clearly indicate that long term relationship exists in between exchange rate

and market returns. Thus after establishing long term relationship, we will see whether exchange rate has short

term impact on market returns. Thus we will use the co integrating equation and check it for Vector Error

Correction.

6.3 Vector Error Correction Model (VECM)

The results of VECM are summarized in table 1.6

Table 1.6

The results indicate that the intercept of co integrating equation is negative and significant. This validates the

long term relationship. The coefficients of exchange rates with lag 1 and 2 are significant that indicates the

impact of short run exchange rate movements of previous 1 and 2 months respectively has significant impact on

Pakistani stock market returns. However we have t-values of the error correction terms and no p-values. Thus to

obtain p-values and to further confirm short run impact of exchange rate on market return, we will following

VECM equation and conduct Ordinary Least square Analysis at 95% confidence interval:

(3) D(MRET) = C(1)*( MRET(-1) + 13.3428963975*EXT(-1) - 5.38602779704e-05*@TREND(1) -

0.0229364536928 ) + C(2)*D(MRET(-1)) + C(3)*D(EXT(-1)) + C(4)*D(MRET(-2)) + C(5)*D(EXT(-

2)) + C(6) + C(7)*@TREND(1)

6.4 OLS Results:

The OLS results are summarized as follows;

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Table 1.7 (VECM regression)

The results of OLS regression indicates that C(3) and C(5) which are the co-efficient of short term change in

exchange rate has significant impact on change in market return where C(6) is the co-efficient of the system

equation. However, to further test the existence of impact of exchange rate change, we will conduct Wald test

using following hypothesis:

C(3) = C(5) = 0 , the null hypothesis assumes that short term exchange rates have no significant impact on

market returns.

Table: 1.8

The p-values of .000 indicate that we will reject null hypothesis and accept the alternate. Thus we can safely say

that exchange rates have short term impact on market returns.

VII. Conclusion

The study was conducted in an effort to understand the impact of exchange rate on stock market

returns. The primary purpose of the study was to understand short run sensitivity of returns to changes in

exchange rate. The reason for this is because in Pakistan, investments in stock exchanges are short term and

most of investors liquidate their stocks within year. VECM analysis was conducted that indicates that exchange

rates have significant impact on stock market returns. The results indicate that in the short run, market correct

itself to the changes in exchange rate to be in equilibrium. This finding has implications for government and

industry. An appreciation of Pakistani rupee will cause the returns to rise and vice versa. Thus if there is,

fluctuations in rupee, the exchange rate will adversely affect the change in market returns. Thus for a stable

stock market, exchange rate has to be maintained in a favorably territory.

The perceived impact of corporate social responsibility on credit rating company

www.iosrjournals.org 51 | Page

Impact of Foreign Exchange rate on stock prices

Abstract: Foreign exchange fluctuations have been found in the literature review to have an impact on the

stock market return and the fluctuations in the stock prices. This research uses the cointegration technique to

analyze the impact of USD to PKR exchange rate on the stock return market in Pakistan. The stock market

return has been studied by KSE 100 Index. The results show that a relationship between the two variables exists

in the short run in Pakistan.

Keywords Exchange Markets, stock prices, Pakistan

I. Introduction

Stock market return is one of the most relevant and most important metric for the management and the

shareholders of the organizations. The study on the factors that impact the share prices is flocking the research

databases mostly because the theorist and the applicants want to optimize the management processes and thus

provide a guaranteed and stabilized performance of the stock. One factor that impacts the return on stocks and

the interest of investors in the stock is the foreign exchange rate.

Foreign exchange return is also important in the context of macroeconomic management of a country

meaning to say that if a relationship between the foreign exchange rate and the stock market return is found to

exist, then the government has the opportunity to manage the exchange rate and thus the return on the stock

market. Moreover, through the establishment of this relationship, the investors will be able to get another

element of predictability in the fluctuations of stock market returns.

II. Literature Review

As far as the existence of literature on market returns and forecasting stock returns is concerned, the

amount is found to be considerably high (Ferreira and Santa-Clara, 2011). A number of factors have been of

interest when it comes to forecasting stock market return for example the macroeconomic variables, the

corporate actions and finally the measure of risk and the studies find that there is a predictable component in

stock market return that the investors can find and use to stabilize their returns to a greater extent. Certain

critique however exists to the researches and the forecasting models that exist. For example Goyal and Welch

(2008) studied the out of sample performance of a list of apparent predictors of stock market return and find the

historical mean to have a better out of sample performance in predicting the stock market returns than the

traditional regressions used for forecasting purposes. So what Goyal and Welch (2008) are saying is that the use

of traditional predictive regression models would not have helped the investor in either attaining valuable

information regarding the stock return patterns or to make profits on time.

Bermer and Hiraki (1999) say that there has been a lot of interest shown by interest to know whether

there exists a predictable component in the short term stock return or not. One of the reasons for this interest is

that the researchers want to either confirm or reject the assumed rationality of individual investors and the

efficiency of the stock market. Those who do have faith in the rationality of investors and efficiency of the

market, seek to study the short term return patterns of the stock in order to give evidence on the subtle market

microstructure issues.

For the purpose of assessing the expected returns, uncertain changes in the investment opportunity have

been found to play a strong role in ascertaining the demand of the asset by the potential investors (Cox, Ingersoll

and Ross, 1985). In this regards, Chiang and Doong (1999) says that financial volatility is a factor that needs to

be considered significantly for exaplining the stock returns.

III. Exchange Rate

As far as quantifying the expectation of the exchange rate are concerned, Marey (2004) says on the

basis of a survey data that long term expectations are not only heterogeneous but are also not effectively

described by the rational expectations. In his own research, Marey (2004) tried to investigate the level of

plausibility of standard exchange rate expectations mechanism which in an artificial economy are found to be

favored by heterogeneous traders, the research concludes that adaptive expectations market exhibits more serial

correlation because it bandwagons the expectations market. Secondly, the extrapolative expectations market

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sometimes generates extreme returns and thus cannot be empirically plausible and finally, the regressive

expectations market reproduces stylized facts of empirical quarterly exchange rates.

Tsen (2011) says that the real exchange rate has been found to play an important role in the investment

determination and the international trade systems as the appreciation of real exchange rate can lead to retarded

exports, a change in the amount of debt payment that needs to be done and a growth of inflow of foreign direct

investment. The economies overall can be affected by the changes in the exchange rate.

For this research however, the impact of exchange rate changes on the stock returns has been considered.

IV. The Impact of Exchange Rate Changes on the Stock Returns

The relationship with the US dollar and the Stock Exchange Index has been studied by Wu et al (2012)

who have focused their research on the Philippine Stock Exchange. According to the authors, such a research

can actually help in guiding the government of countries to macro manage the investor returns on the stocks and

thus in effect control the inflow of foreign direct investment into the country. Focusing further on the issue,

Bahani-Oskooee and Sohrabian (2006) use the granger causality technique along with the co integration

technique to analyze the results of exchange rates and stock prices by using the S&P 500 index. The results

show that not only the relationship exists only in the short run, it is also bidirectional. Moving on, Branson

(1983) discusses his stock oriented model of exchange rates and emphasizes on the fact that the exchange rates

serve to equate the supply and demand for assets including the stocks and the bonds.

that even though the existence of a relationship is often signified by the researchers between the stock exchange

returns and the exchange rates, the length and the direction of the relationship is often an element of further

debate. Interestingly, using the granger causality and the relationship between the financial assets and exchange

rates of USA and Japan, Yau and Nieh (2008) find that there is no short term causal relationship between the

two however in the long run a positive relationship has been found to exist.

Kim (2003) uses the error correction technique and the co integrating system to investigate whether a

long term relationship exists between the exchange rates and the stock prices in the United States. The data set

used is the S&P 500 which yields that there is a negative relationship that exists for the stock returns in USA

with the value of the dollar. Finally, Lin (2012, p. 161) analyzes the comovement of the exchange rates and the

stock prices in the Asian markets and finds that

Results have suggested that the comovement between exchange rates and stock prices becomes

stronger during crisis periods than during tranquil ones, in terms of long-run co-integration and short-run

causality, which is consistent with contagion or spillover between exchange rates and stock prices during the

former type of period.

This means that the government when trying to control the crisis period should try to stimulate growth

and keep investment attractive.

V. Methodology

In order to test our hypothesis monthly KSE 100 index data from Karachi Stock Exchange (KSE) was

obtained from 1998 to 2009. Returns of index were calculated by using following formula:

(1)

Further monthly Real exchange rates (EXT) were obtained from IFS CD Rom from 1998 to 2009.

Real exchange rate was proffered in order to investigate change that is purely due to exchange rate itself and not

contaminated by inflation. The analysis period was confined from 1998 to 2009 primarily due to nonavailability

of the former prior to 1998. Further the IFS CD ROM was updated to give exchange rate

information till June 2010. Since we wanted to obtain data yearly, six months data in 2010 was unavailable.

Thus we decided to calculate variables from 1998 to 2009, where complete yearly information was available.

Our sample was time series and it has inherent problems of non-stationarity that leads to spurious

regression. Thus we conducted stationarity tests using Phillip Peron(PP) tests for stationarity. The results of PP

are more robust than Augmented Decke fuller test for stationarity (Gujrati, 2003). Thus after we were confirmed

that data is stationary, we will check for co integration and also vector error correction test cannot be conducted

until there is a long term affiliation between variables. The co integration tests will reveal whether there exist a

long term relationship between stock market returns and real exchange rates. Once the co integration tests

confirm long term relationship, we will conduct vector error correction model. After that we will run ordinary

least square regression using following equation to see if short term impact exist or not.

(2) D(MRET) = C(1)*( MRET(-1) + 1*EXT(-1) + 2*@TREND(1) + C ) + C(2)*D(MRET(-1)) +

C(3)*D(EXT(-1)) + C(4)*D(MRET(-2)) + C(5)*D(EXT(-2)) + C(6)

The portion of the model in parenthesis is co integrating while the rest of the equation is comprised of error

correction term. Our variable of interest are C(3) and C(5). These are error correction terms representing

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previous months change in exchange rates. Thus we will check if they have impact on returns by using Wald

Test under following hypothesis;

H0: Exchange rate change has no impact on Market returns in short term.

H1: Exchange rate change has impact on Market Returns in short term.

Significant p-values of less than .05 will indicate that we will accept H1. This acceptance will lead us to

believe that in short term exchange rate fluctuations will impact stock market returns.

VI. Results and Discussion:

Unit root test was conducted using Phillip Peron test for stationarity. The test was conducted under all

assumptions i.e. with intercept, without intercept but trend and without intercept and trend. The results for both

variables are summarized in tables 1.1 and 1.2.

Table 1.1: Unit Root Test for Market Returns

ASSUMPTIONS PHILIPS PERRON TEST

STATISIC

CRITICAL VALUES

1% 5% 10%

Intercept -11.3802 -3.477 -2.8817 -2.5774

Trend and intercept -5.107754 -4.263 -3.4426 -3.1457

NO intercept and No trend -4.826372 -2.5804 -1.9422 -1.6169

Table 1.2: Unit Root Test for Change in Exchange Rate

ASSUMPTIONS PHILIPS PERRON TEST

STATISIC

CRITICAL VALUES

1% 5% 10%

Intercept -7.840877 -3.477 -2.8817 -2.5774

Trend and intercept -7.81797 -4.0245 -3.4417 -3.1452

NO intercept and No trend -7.413119 -2.58 -1.9421 -1.6169

The results indicate that both variables are stationary under all three assumptions at level. This indicates that

problem of non stationarity does not exist in our series and our series has constant variance. This helps us in

predicting out of sample relationship and robustness is ensured. Further, since our variables are stationary at

same level, we can safely check our variables for long term relationship. Thus after unit root we will carry out

co integration tests to check for long term relationship.

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6.1 Co integration Test

Co integration test was conducted under all assumption. The result are summarized in table 1.4

The results indicate that Akiake information criteria is lower in case of assumption which indicates that

equations are quadratic in nature and have trend and intercept. Further Schwarz criterion is also indicating that

results of the former are correct. Thus we will carry the co integration test assuming trend and intercept in

quadratic form for establishing long term relationship. The test result under this assumption is as follows:

6.2 Johansen Co integration Test Summary

Table 1.5

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The results indicate that Null hypothesis that indicates no long term relationship exists is rejected by significant

p-value of 0.000. Thus the results clearly indicate that long term relationship exists in between exchange rate

and market returns. Thus after establishing long term relationship, we will see whether exchange rate has short

term impact on market returns. Thus we will use the co integrating equation and check it for Vector Error

Correction.

6.3 Vector Error Correction Model (VECM)

The results of VECM are summarized in table 1.6

Table 1.6

The results indicate that the intercept of co integrating equation is negative and significant. This validates the

long term relationship. The coefficients of exchange rates with lag 1 and 2 are significant that indicates the

impact of short run exchange rate movements of previous 1 and 2 months respectively has significant impact on

Pakistani stock market returns. However we have t-values of the error correction terms and no p-values. Thus to

obtain p-values and to further confirm short run impact of exchange rate on market return, we will following

VECM equation and conduct Ordinary Least square Analysis at 95% confidence interval:

(3) D(MRET) = C(1)*( MRET(-1) + 13.3428963975*EXT(-1) - 5.38602779704e-05*@TREND(1) -

0.0229364536928 ) + C(2)*D(MRET(-1)) + C(3)*D(EXT(-1)) + C(4)*D(MRET(-2)) + C(5)*D(EXT(-

2)) + C(6) + C(7)*@TREND(1)

6.4 OLS Results:

The OLS results are summarized as follows;

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Table 1.7 (VECM regression)

The results of OLS regression indicates that C(3) and C(5) which are the co-efficient of short term change in

exchange rate has significant impact on change in market return where C(6) is the co-efficient of the system

equation. However, to further test the existence of impact of exchange rate change, we will conduct Wald test

using following hypothesis:

C(3) = C(5) = 0 , the null hypothesis assumes that short term exchange rates have no significant impact on

market returns.

Table: 1.8

The p-values of .000 indicate that we will reject null hypothesis and accept the alternate. Thus we can safely say

that exchange rates have short term impact on market returns.

VII. Conclusion

The study was conducted in an effort to understand the impact of exchange rate on stock market

returns. The primary purpose of the study was to understand short run sensitivity of returns to changes in

exchange rate. The reason for this is because in Pakistan, investments in stock exchanges are short term and

most of investors liquidate their stocks within year. VECM analysis was conducted that indicates that exchange

rates have significant impact on stock market returns. The results indicate that in the short run, market correct

itself to the changes in exchange rate to be in equilibrium. This finding has implications for government and

industry. An appreciation of Pakistani rupee will cause the returns to rise a[1] Bahmani-Oskooee, R. and Sohrabian, A. (1992). Stock prices and the effective exchange rate of the dollar. Applied Economics,

Vol. 24 (4), pp. 193-207

[2] Bremer, M. and Hiraki, T. (1999). Volume and individual security returns on the Tokyo Stock Exchange, Pacific Basin Finance

Journal, Vol. 7 (3-4) pp. 351 370.

[3] Chiang, T. and Doong, S. (1999). Empirical analysis of real and financial volatilities on stock excess returns: evidence from Taiwan

industrial data, Global Finance Journal, Vol. 10 (2), pp. 187 200.

[4] Cos, J., Ingersoll, J. and Ross, S. (2985). An intertemporal general equilibrium model of asset prices, Econometrica, Vol. 53, pp.

363 384.

[5] Ferriera, M. and Santa-Clara, P. (2011). Forecasting stock market returns: The sum of the parts is more than the whole, Journal of

The authors are thankful to Saghir Pervaiz, Umad Mazhar and Ejaz Bajwa for the data.

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