Journal of Business Finance & Accounting, 17(3) Summer 1990, 0306 686X $2.50
ON EXCHANGE RATE CHANGES AND STOCK PRICE REACTIONS CHRISTOPHER K , M A AND G . W E N C H I K A O "
INTRODUCTION
The volatility of exchange rate changes has increased significantly since the adoption of the floating rate regime in the early 1970s, As a result, more uncertainty has been introduced to the linkage between international equity markets. Considering the associated increase in risk for international investments, the choice of currency denomination adds an important dimension to the overall portfolio decision. The required rate of return of an investment should reflect both the domestic required rate of return and expected changes in the value of the currency in which the investment is denominated. The purpose of this paper is to examine stock price reactions to exchange rate changes. Under a floating rate regime, the required rate of return of stocks is shown to reflect two types of foreign exchange risks. First, the investment is inherently affected by the transaction exposure from foreign exchange rate changes. This is mainly due to gains or losses arising from the settlement of investment transactions stated in foreign currency terms. Second, the expected return is also determined by the economic exposure which is attributed to variations in firms' discounted cash flows when exchange rates fluctuate; Thus, the equilibrium relative stock price is related to both exchange rate levels and exchange rate changes. The rest of this paper is organized as follows: the second section reviews some related literature; the third section describes the theoretical foundation of the paper; the fourth section presents the corresponding hypotheses, the testing methodology and the empirical results; and the flnal section summarizes the paper, LITERATURE Numerous efforts have been undertaken to investigate the relationship in required rates of return in different equity markets, Agmon (1974) and Hillard • The authors are respectively, Associate Professor at Texas Tech University; and Assistant Professor in the Department of Finance, DePaul University, Chicago. This paper was completed when the first author was at the University of Toledo. Both authors acknowledge helpful comments from Ramesh P. Rao, Lawrence V. Conway, David Lindsiey, M.E. Ellis and participants of the Finance Research Seminar Series at the University of Toledo. This study was funded by grants from the Facutty Development Fund of the College of Business Administration and the Academic Challenge Grant of the University of Toledo. (Paper received November 1986, revised May 1988)
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(1976) identify various degrees of comovements between different international equity indices, Koveos (1983) and Panton, Lesseg and Joy (1976) show, instead, that the different degree of comovement is attributed to the lead-lag relationship between equity indices. As further demonstrated by Agmon and Lessard (1977), the same lead-lag relationship is the basis for benefits of international diversification. However, considering the treatment of the currency denomination simply as a means of exchange, the applicability of these results seems limited. On the other hand, examining the impact of exchange rate changes on stock markets, Franck and Young (1972) investigate the attribute of a multinational firm for which the stock return is sensitive to exchange rate changes. Crucial factors identified include the market mix, the input mix, exchange regulations of governments and accounting treatment of exchange gains and losses. Aggarwal (1981) explains the ex post, positive relationship between exchange rate changes and stock indices in terms of the relative competitiveness of international-traded goods. However, based on their assumption that investors only trade in domestic financial markets, the resulting empirical evidence in both studies understates the relationship between exchange rate changes and stock price movements. Furthermore, an exogenous foreign stock market clearly contradicts previous findings of comovements among different stock indices in the world exchange. The unstable relationship between exchange rate levels and stock market indices in different periods is, therefore, attributed to this under-specification,
MODEL In a simple, two-market world with perfect capital mobility, investors determine the portfolio weight as follows: where luj : E{R): i : Wg :
i)
(1)
weight of wealth invested in thejth asset; the expected return on the^th asset; investor's target return; and basic weight independent to expected return.
For every one dollar of wealth, equation (1) simply specifies the portfolio weight as the present value of expected future cash flows discounted at the investor's risk-adjusted target return i. For simplicity, investors are assumed to aflocate their wealth between two stock markets, i,e., the domestic stock market and the foreign stock market. Equations (2) to (5) demonstrate the allocation of wealth between two investment outlets:
(2) PfN*
(3)
EXCHANGE RATE CHANGES AND STOCK PRICE REACTIONS
,,i)*
443
- 0
(4)
i) - O
(5)
where * tu,, tuf
: in terms of foreigner's point of view; : weights of wealth invested in the domestic stock market and foreign stock markets; A^,, A'^* : numbersof shares outstanding in the domestic stock market and in the rest of the world; W : the total wealth denominated in the foreign currency; Si : the spot exchange rate in terms of foreign currency; *+ l) • the expected foreign stock return for the rest of the world; and the expected domestic return converted into the foreign currency.
Assuming the wealth is denominated in the foreign currency, equation (2) converts investment payoffs from the domestic market into foreign currency values. The portfolio weights in equations (4) and (5) depend on the difference between the expected rate of return and the target return i. In terms of the foreign currency, the expected holding period return from the domestic investment is:
For simplicity, we assume:
Hence, E{R,,,)*
= £(«,,,) + £(.,,,)
(6)
where e,+ i is the exchange rate appreciation. Equation (6) implies that returns of domestic investments for foreign investors depend on expected domestic returns and expected appreciation of the domestic currency. Transaction exposure of an investment is thus defined as changes in returns after the conversion of investment payoffs from one currency to another. Combining equation (2) through (6): rt, + p, + s, = w + E{R,,t)
- E{Rr.i)
+ £(«,,,)
(7)
where n, = ln(A^/Af,*), /), = ln{P/P^), w = \n{wjw*), s, = \x\S, and i n ' is the natural logarithm. Equation (7) specifies the (wealth) stock equilibrium condition, i,e,, the relative stock supply is equal to the relative stock demand. The equilibrium condition, in turn, depends upon the relative wealth position, the expected future return differentials between two equity markets, and the expected future appreciation of the currency denominated. Equation (8) below specifies the relative flow supply equation for two equities. It is assumed that (1) more new
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stocks are issued in the current period if the equity price for the next period is expected to fall, (2) more stocks are currently issued if stocks are denominated in a strong currency expected to depreciate in the future, and (3) it is more difficult to sell new stocks if an already large supply of stocks is outstanding. Hence, new issues in the current period are negatively related to the expected domestic return, expected currency appreciation and the outstanding supply of stocks: h, = a'
- &'{E{R,,,)
- E{RU,))
- e'E{e,,{)
- 0'n,
(8)
where 0 < a ' , /3', 6', ' < 1, Equation (8) may be further rearranged into the following: h, = a - /3[£(«,,,) - E{R*,^)] - eE(e,^,) - 4>rt,
(9)
w h e r e a = a'l{\ - 0 ' ) > 0 , /3 = ^'l{\ - 0,6 = 0 7 ( 1 - ') > 0; and 0 = 0 ' / ( l - ') > 0. Equations (10) and (11) below present the expected required rate of return for each stock market. It is assumed that the expected stock return reflects economic exposure of the domestic economy, i.e., the impact of changes in currency values to future cash flows. The cash flow of a typical economy is affected by exchange rate changes either through price competition in the worldwide product market, or through the cost impact of imported goods. On a micro basis, economic exposures of exchange rate changes are hypothesized as follows: A) Export sales will be negatively affected by the expected appreciation of the domestic currency. This is due to the relatively higher price of products in terms of the foreign currency in international markets. B) The importing firm will benefit from the appreciation of the domestic currency, since it results in lower import costs. Thus, the expected return on the stock market is determined in the following fashion: ,) = KR, + (1 - K)^E{e,,^) ) = KR; + (1 - K)rE{e,,^)
+ V, + 6,
(10) (11)
where v,, e, are white noises and 0 < K < 1. The first term in the right-hand side of equations (10) and (11) represents a random process generating the component of expected return which is independent from the foreign sector. Note that the impact of the expected exchange rate change on stock returns depends on both the importance of international trades in the domestic economy, 1 — K, and the degree of the trade imbalance, f. Let
where c is the cost elasticity, and s is the sales elasticity with respect to the
EXCHANGE RATE CHANGES AND STOGK PRIGE REAGTIONS
445
expected appreciation of the domestic currency. The net impact of the exchange rate change is determined by the relative importance of importing firms vs exporting firms within a given economy. Alternatively, the sign of f depends on the status of the trade imbalance, i.e., c > s: If the domestic economy is import dominant, then f < 0, c < s: If the domestic economy is export dominant, then f > 0. The second set of expectation scheme is the exchange rate movement of each currency. Specifically, the expected appreciation is assumed to follow an adaptive process: Eiet^O
= s, - s,_i + III
(12)
where /x, is a white noise. Substituting equations (10), (11) and (12) into the stock equation (7) and the flow equation (9), the system becomes the following two first-order differential equations: Pi =
1//C
\IK
with initial conditions: p{0) = p, n(0) = h. Solving the above system for p yields equation (13) (see Appendix A for derivation): Pi = a - 2{1 - K){UK)q \n{s/c){Si - ^,_,) -h q(i/K - 0)si
(13)
where a = p exp(Xi<) + (a + i3w - iu/K)q q = (l/X,)(exp(XiO - 1) > 0 and X] is the negative eigenvalue for the system.
METHODOLOGY
Hypotheses Equation (13) can be rewritten in the following fashion: \n{P/Pt) = a + bti{\nSi - \nS,_{) + dlnS,
(14)
where b = -2q{\lK){\ - /c) < 0; d = q{\lK - /3) > 0; and f, = \n{s/c), 5 0. The second term on the right-hand side of equation (14) represents the impact of economic exposure which the appreciation of currency would have on the domestic stock market. If the domestic economy is currrendy in a trade surplus
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with the rest of the world, the currency appreciation would discourage exports. This, in turn, would result in a depressed stock market composed of more exporting firms. On the other hand, for a domestic economy experiencing a trade deficit, the currency appreciation will lower import costs and impact stock markets favorably. As indicated from equation (14), the effect of exchange rate changes on stock market indices might be insignificant if the economy is less dependent on foreign trades, i.e., /c = 0. The third term demonstrates the impact of transaction exposure from exchange rate changes. It suggests that any investment denominated in a strong currency is preferred by investors. Note that there is an unambiguous positive impact from the exchange rate level on the stock market, regardless of the foreign dependence of the economy. Sample and Empirical Analysis
To test equation (14), monthly stock indices of six major industrialized countries and corresponding monthly exchange rates are gathered from the Exchange Rates and Interest Rates Tape provided by the Federal Reserve, United Kingdom, Canada, France, West Germany, Italy and Japan are chosen because of their less controlled foreign exchange markets and more mobile capital markets. The monthly merchandise exports and imports of the US with respect to each of these countries are gathered from Business Statistics. The sample period is from January 1973 to December 1983. Since the US stock market is the perfect substitute for the rest of the world,^ the foreign stock market index is a weighted average of all foreign stock indices, and the US exchange rate is the corresponding weighted average of dollar values with respect to foreign currencies. Consequently, all variables are first adjusted by the weight of the international trade with the US:
E i- 1
where 6
= (Export,, + Import,()/5] (Export^, + As implied from the model, the change of the currency value, e,, is further weighted by the dummy variable, f, which measures the degree of export/ import dominance at different points in time, i.e.. e! = \n{s/c),{\nS;
-
While \n{s/c) is not observable, we use the following proxy to weight the
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exchange rate change: 6
6
\n{s/c)i = ln(X; Export,/^ Import,,). i' - 1
i' • I
Eventually, the regression is conducted on the following relationship: ln{P/P;) = 0-1- be; + ds;. (15) In order to correct for the bias of multicollinearity between e,' and .f / , a twostep regression procedure is followed. First, s,' is regressed against e,'. The resulting residuals, which are independent to e/, are used to replace s,' in testing equation (15). Testing Results Table 1 reports the regression statistics of equation (15). The exchange rate level is positively related to the stock index relative at the one percent level, while the exchange rate change is negatively related at the five percent level. The entire model is significant at the one percent level. Table 1 The Regression Statistics for Equation (15): = a + be, -i- ds, \n{P/P;) =
-0.0933 0.7270?, + 1.1903.r, (-0.847a) (-0.379)" (0.276)*
F = 11.13*
fl-Square
= 0.148
a: The value in parenthesis is the standard error of the estimate. *: Significant at the 1 percent level. **: Significant at the 5 percent level.
The evidence suggests that if the investment is denominated in a strong currency, foreign investors expect to receive an ultimately higher rate of return after the payoff is converted into their own currency. Consequently, a high currency value generates a favourable transaction exposure and creates excess demands for domestic stocks. On the other hand, consistent with the classical theory of balance of payment, the expected change in a country's currency value tends to reverse the current status of the trade imbalance. The domestic stock market reacts favourably to the expected currency appreciation if the economy is import dominant. Conversely, an export dominant economy will lose its international competitive market power by the currency appreciation which results in a depressed economy. The estimated coefficients imply that stock indices are more affected by the exchange rate level than by the exchange rate change. It appears that investors
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are more sensitive to transaction exposure than to economic exposure. One possible explanation for the difference is that the US economy is not fully dependent on foreign trades. The domestic stock market is determined by the foreign sector to a lesser extent. In addition, there is some contract rigidity in international trades in terms of responding to exchange rate changes. The cost and sales adjustment are delayed by the contract period, and the change in relevant cash fiows is discounted in a future distant period. On the other hand, the greater importance of the transaction exposure is attributed to the relatively more open and mobile US capital market. As long as the investment is denominated in a foreign currency, all investors are invariably confronted with the transaction exposure.
GONGLUSION
This paper demonstrates two possible impacts of changes in a country's currency values on stock price movements. Primarily, the financial effect of exchange rate changes is the transaction exposure investors face if the underlying currency value is volatile. Since an investment becomes more attractive when it is denominated in a strong currency, high exchange rate levels are associated with favourable stock price movements. On the other hand, the economic effect from exchange rate changes suggests that, for an export-dominant country, the currency appreciation reduces the competitiveness of export markets and has a negative effect on the domestic stock market. Conversely, for an importdominated country, the currency appreciation will lower import costs and generate a positive impact on the stock market.
APPENDIX A UK
UK
e,,,)
-
W)IK'\
Solving for the eigenvalues of the system:
[
1//C-X,
UK
-0 then:
-/3-0
X, = (-(/3 + - 1/K) - J(0 + - XUf
The general solution for P(t) becomes: ^(0 = [^, + i
f'
JO
+ 4<^l/ic)(l/2) < 0,
EXGHANGE RATE GHANGES AND STOGK PRIGE REAGTIONS
449
where B, + B2 = 0/ " (2(1 " «) ln{s/c) + l)£(«,.^l) - W)/K = Kg X|.B, + X2B2 = —0s, + 0U1 + a + |8(«,.^l + M) = ^ h and
For the general solution of/'((): f ( 0 = (/I, + [X^Kg - /:,y[(>^2 - \)^imi
- exp(-X,O] exp(X,0
with P{0) = P, and solving for A^, therefore, A, = P. The final solution becomes: P(t) = exp(X|(X^ + A/ + A') - (A/ + W), where M = (X^Ko - /r,)/[X,(X2 - X,)] A^ = [-h(2{c
- s) + 1)M]/[X,(X2 - X,)] + M(3/[X,(X2 - X,)].
NOTES 1 The positive root of eigenvalues is dropped from the general solution for its destabilizing property. 2 In a two-market world with a budget constraint, investments in the US market world have to be a perfect substitute of investments to the rest of the world.
REFERENGES Aggarwal, R. (1981), 'Exchange Rates and Stock Prices: A Study of the US Gapital Markets under Floating Exchange Rates', Akron Business and Economic Review (Fall 1981), pp. 7—12. Agmon, T. (1974), 'The Relations Among Equity Markets in the United States, United Kingdom, Germany and Japan', bourne/ of Finance (September 1974), pp. 839—55. and D.R. Lessard (1977), 'Investor Recognition of Gorporate International Diversification', Journal of Finance (Septemher 1977), pp. 1049—55. Ayarslan, S. (1982), 'Foreign Exchange Rates and the Stock Prices of US Multinational Gorporations', M!rf-.<4//a«teyouma/o/Bu«nMj (Summer 1982), pp. 13—27. Bodenberg, D.W. (1978), 'Do Foreign Gurrency Fluctuations Affect Stock Prices?'. Paper presented at the University of Ghicago School of Business Seminar on Gorporate International Finance, 25 (April 1978). Franck, P. and A. Young (1972), 'Stock Price Reaction of Multinational Firms to Exchange Realignments', Financial Management (Winter 1972), pp. 66—73. Hillard, J.E. (1976), 'The Relationship Between Equity Indices on World Exchange',yourna/0/ finance (March 1976), pp. 415-32. Jacquillat, B. and B. Solnik (1982), 'Multinationals are Poor Tools for Diversification',yourna/ of Portfotio Management (Winter 1982), pp. 66-73. Koveos, P.E. and R.P. Ghang (1983), 'Gomovement of Equity Indices on World Exchanges: 1980-81', Working paper, Syracuse University (1983). Panton, D., V. Lesseg and O. Joy (1976), 'Gomovement of International Equity Markets: A Taxonomic Approach', Journal of Financial and Quantitative Analysis (September 1976), pp. 415-32. Sharma, J.L. and R.E. Kennedy (1977), 'A Gomparative Analysis of Stock Price Behavior on the Bombay, London and New York Stock Exchanges', yourna/ of Financial and Quantitative Analysis (September 1977), pp. 391-413. Solnik, B.H. (1974), 'An International Market Model of Security Price Behavior', Journal of Financial and Quantitative Analysis (September 1974), pp. 537—54.
