Investigate the Effects of Foreign Exchange (FX) Rate Changes on Stock Returns

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Table of contents

ACKNOWLEDGEMENTii

DECLARATIONiii

CHAPTER 01: INTRODUCTION1

Background of the Study1

Aims and Objectives of the Study2

Outline of the Study3

CHAPTER 02: LITERATURE REVIEW5

Exchange Rate and Exchange Rate Risk8

Corporate Exchange Rate Exposure10

Exchange Rates and Firm Values11

Macro and Microeconomic Implications of Currency Exposure11

Theoretical Framework12

Empirical Evidence14

Critiques on the Empirical Evidence18

REFERENCES22

CHAPTER 01: INTRODUCTION

Background of the Study

It is a common belief that as the financial market becomes increasingly more globalised, FX exchange rate and interest rate should have a higher degree of impact on the stock return. Therefore, theoretically, there should exist a strong correlation between these rates and the stock return. The reason is mainly due to the fact that FX exchange rate will create a chain reaction when a firm value their assets and liabilities under multicurrency. Since the return from a foreign asset investment is comprised of the return on the foreign asset and the exchange rate fluctuation due to the fact that investing in foreign stock markets entails exposure to exchange rate risk. The rate will then have impact on the measurement when the firm prepare their financial reports (Heckerman, 1972, Hekman, 1985). This may show a complete different image of their performance as the purchasing power will be different according to different FX rates and lead to competitive advantages or disadvantages in the global marketplace, and thus ultimately affect their share price and their cash flow. Therefore, it is crucial for firm to have efficient multicurrency portfolio management strategies. This variable has great impact on a firm's profitability yet it is not controllable by the firms.

In the past, there have been numerous research studies focusing on the relationship between FX exchange rate and the stock return. However, those literatures provided conflicted findings regarding the dynamic linkage between FX and stock markets. While there are some findings document a significant exchange rate exposure for multinationals (Bartov and Bodnar, 1994), there are also some suggesting that FX rate changes offer little or no predictive power for stock returns volatility (Jorion, 1990, Jorion, 1991). A related body of work provided strong empirical support for the idea of strong and time varying correlations across financial markets of the same type (Longin and Solnik, 2001), while the correlations between two different financial market such as stocks and bonds is less strong (Garcia and Tsafack, 2011).

The possible impacts of the FX rate changes that can have on the stock returns is the ...