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Relationship Between Exchange Rate and Stock Prices
Exchange rates are very critical since they ensure the supply and demand for assets is adequately balanced. Whenever domestic stock prices rises, it subsequently leads to a rise in demand for domestic assets. In order for local investors to buy more domestic assets, they will require to sell more foreign assets, thus leading to appreciation of local currency (Allayannis et al 2001). In the event that there is an increase in wealth caused by an increase in prices for domestic assets, there is a tendency for the demand in money by investors to rise as well, subsequently raising local interest rates. Consequently, this will lead to appreciation of domestic currency since it will create appeal for foreign investors and capital. Furthermore, a rise in foreign demand for local assets is another platform that can stir a negative relationship due to an increase in stock prices (Yin 2000).
On his part, Gavin postulates that successful stock market has a positive effect on aggregate demand. If this is massively sufficient, expansionary monetary or contractional fiscal policies which target the interest rates and the real currency exchange rate will be neutralized. In some instances, policy formulators advocate for a cheaper currency in an aim to boost the export sector. The link between the two markets is a tool that can predict the direction of the exchange rate (Cesari et al). Further, this can benefit multinational firms in management of their exposure to international contracts and exchange rate risks, thus stabilizing their earnings as currency, mostly grouped with other assets in investment funds’ portfolios (Simkovic).
A clear understanding about the connection existing between currency exchange rates and other assets in a portfolio is essential for the performance of the fund. Further, the full understanding of the stock price to currency exchange rate relationship may prove helpful in foreseeing a crisis. According to Khalid and Kawai, the link between the stock and currency markets stirred the Chinese Financial Crisis in 2003. It is said that the sharp depreciation of the Renminbi subsequently triggered depreciation of other currencies in the region. This led to the collapse of the stock markets as well. Existence of such relationship between the two markets necessitates a preventive action before the crisis spreads and affects other economic sectors.
In regard to trade effect, Ozbay (2009) explains that exchange rate policies affect both exporters and importers. When the domestic currency depreciates, the domestic consumers are likely to deny purchasing the imported goods which are more expensive in term of domestic currency. Otherwise, depreciation of domestic currency makes local products more attractive than the imported goods due to lower prices in term of domestic currency. As a result, the demand for the imported products will decrease, leading the decrease in the importer firm’s shares in stock market. In the opposite, production of the exporter company will increase, hence increasing the prices for shares.