Introduction
As the modern day business sees the emergence of new capital markets with enhanced relaxation over foreign capital governance and raised flexibility of stock exchange rates, it is very important for academicians and industry experts to derive a relation between the foreign exchange rates and stock market fluctuations. This information is a key component for the international investors so that they can effectively diversify their investments with an adequate hedging strategy. Also, understanding the true nature of interrelation between the stock market and foreign exchange is also a must for the financial policymakers so that they can try to adapt with one on the basis of indications from the other (Morales, 2007).
This essay aims at analyzing the cointegration between the stock market and foreign exchange of the UK market so as to develop a straight causal relationship between the two entities.
Models for analyzing the cointegration between the UK stock and foreign exchange
The changes in the international currency exchange rates can definitely affect the performance of a country because a rise in exports can change the foreign exchange rates to such an extent that they can change the relative performance of domestic investment portfolios. The extent to which two countries are economically integrated is defined by the extent to which their trade relations are financially established and by the intertwined state of their national currencies (Kayani, Hui & Gulzar, 2015). Hence, the financial integration between two countries can be directly correlated to their economic integration which affects the performance of their mutual trades and affects the currency movement via those national companies whose performance gets directly reflected in the national stock exchanges, for example the economic integration between the UK and Poland markets (Kayani, Hui & Gulzar, 2015).
There are the ‘flow oriented’ models which state that the pace of a country’s currency movement leads to a direct impact on its international competitiveness and trade position in the international markets. A dynamic change of rising international trade levels causes a corresponding impact on the financial performance of the domestic companies which gets directly reflected in their stock prices and the stock exchange goes on a corresponding boom. This rise in the UK stock markets leads to a growth of the overall financial stability of nation which further increases its output and leads to better international trade. Thus, as per the ‘flow oriented’ model, the cointegration of foreign exchange on stock markets and flow of domestic capital might be effective in the long-term analysis (Morales, 2007).
Finally, in order to establish a long-term relationship between the two variables , the stock market and foreign exchange, the cointegration methodology of Johansen is used which builds a VECM model for conducting the tests between UK and Hungary (Alagidede, Panagiotidis & Zhang, 2010). The null hypothesis states that there is no long-term relation between the two vectors. At the end of test results for UK and Hungary, the null hypothesis could not be rejected which state that there can be no long-term cointegration between the two vectors (Alagidede, Panagiotidis & Zhang, 2010). Similar results were attained by using the Granger causality tests as well when both factors developed cointegration during the Asian financial crisis period but behaved independently in the post-crisis period. So, it is clear that an additional variable is required to set up a precise relationship between the two entities.
Conclusion
The results attained from various models are not in sync with each other. The theoretical models predict the direct causal relationship between the two factors for a long run but the quantitative analysis based models could not affirm the rejection of the null hypothesis which stated that there was no integration between the two factors. However, in the case of developed markets like UK and USA, their enhanced international trade systems reflect upon their stock exchanges when there is an economic crisis in the international markets and results in trade deficits globally. Thus, it can be concluded that more elaborate data analysis and use of other significant variables is required for effectively analyzing the cointegration between the UK foreign and stock exchange.
References
Alagidede, P., Panagiotidis, T. & Zhang, X.(2010). Causal Relationship between Stock Prices and Exchange Rates.University of Stirling. Stirling Economics Discussion Paper. Retrieved online from https://www.stir.ac.uk/media/schools/management/documents/workingpapers/SEDP-2010-05-Alagidede-Panagiotidis-Zhang.pdf
Kayani, M., Hui, X. & Gulzar, S. (2015). Dynamic Relationship between Stock Exchange and Exchange Rate: a Case of Emerging Economies in Context of GFC. AASRI International Conference on Industrial Electronics and Applications. Retrieved online from http://www.atlantis-press.com/php/download_paper.php?id=20586.
Morales, L.(2007).The Dynamic Relationship between Stock Prices and Exchange Rates: Evidence from FourTransition Economies. Conference paper. Dublin Institute of Technology. Retrieved online from http://arrow.dit.ie/cgi/viewcontent.cgi?article=1007&context=buschaccon
