Relationship between Stock Market and Foreign Exchange Market in India

Abstract

The present study examines the relationship between stock market and foreign exchange market in India for the period April 1994 to July 2009. The approach employs Engle Granger Test and Johanson Test of cointegration, Granger Causality Test, Vector Auto Regression and Vector Error Correction Model. The research suggests that there exists a bi-directional causality between Stock Market and Foreign Exchange Market. However, after including the effect of interest rate and money supply, the direction of causation is not clear. Although there exists a significant long-term relationship between the two markets as suggested by VAR and VEC model. The implications of the above results points to the following: the foreign currency brought by FIIs need to be monitored and channelised through government intervention, as the rate of FII flows into the country would be governed by the performance of the domestic equity market and/or foreign investor’s expectations about its performance. Also, the markets are informationally inefficient and thus, there exists the scope of abnormal profits. But there is a need to stabalise the frequent ups and downs in the domestic stock market, with more focus on regaining investors’ confidence in the equity market.