On the Relationship Between Stock Return Essay

4054 Words May 26th, 2011 17 Pages
On the Relationship between stock return and exchange rate: evidence on China

Yaqiong Li a b , Lihong Huang b a b

The Business School, Loughborough University ,UK

College of Mathematics and Econometrics, Hunan University, Changsha ,Hunan ,China

Abstract The purpose of this paper is to investigate the relationship between RMB exchange rate and A-share stock returns in China, in particular in Shanghai stock market. We find that both stock returns and RMB nominal exchange rate are integrated of order 1. The Engle–Granger cointegration test is then performed, suggesting that there is not a long-run equilibrium relationship between stock returns and RMB exchange rates at 5% significance level. However, there is strong evidence
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This paper employs daily data and considers a more recent sample period after Chinese exchange rate reform. The relationship between stock returns and foreign exchange rates has drawn much attention of economists, for theoretical and empirical reasons, because they both play crucial roles in influencing the development of a country’s economy. In addition, the relationship between stock returns and foreign exchange rates has frequently been utilized in predicting the future trends for each other by investors. Macroeconomic fundamentals are seen by economists as providing the robust media to link stock returns and foreign exchange rates. Among all the monetary models of exchange rate determination, money supply, interest rate, return level, and inflation are taken into account to

predict the exchange rate movement. See e.g. Frenkel (1976), Bilson (1978), Dornbusch (1976), Frankal (1979), Dornbusch and Fisher (1980), and Hooper and Monton (1982). Branson, et al.’s (1977) portfolio-balance model further incorporates assets of portfolios to describe the “stock-oriented” exchange rate movement. Among empirical studies, Meese and Rogoff (1983), Wolff (1988), Baillie and Selover (1987), and Ghartey (1998) have found certain relationships among macro-fundamentals and exchange rates, whereas the empirical evidence for the relationships among macro-fundaments and stock returns are found in Bailay

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