The Casual Relationship Between Exchange Rates and Stock Prices in Kenya

Abstract

At the least complicated level of economic theory lies the belief that certain pairs of economic variables should not diverge from each other by too great an extent, at least in the long-run. Thus, such variables may drift apart in the short-run or according to seasonal factors, but then economic forces, such as market mechanism or government intervention, will begin to bring them together again. Such variables include exchange rates and stock pnces. This study examines the causal relationship between foreign exchange rates and stock prices in Kenya from November 1993 to May 1999. The data set consists of monthly observations of the NSE stock price index and the nominal dollar exchange rates. The objective is to establish the causal linkages between leading prices in the foreign exchange market and the Nairobi Stock Exchange (NSE). These linkages have implications for policy makers, regulators, investors , financial intermediaries and the management of publicly owned companies in Kenya. This study employs cointegration and error-correction methodology. This statistical technique is not only simple to apply and relevant to analysing time series data, but also for ensuring stationarity and providing additional channels through which causality could emerge if two variables are cointegrated .. As a matter of procedure, we first tested for stationarity and the order of integration of the time series data. The empirical results show that foreign exchange rates and stock prices are nonstationary both in first differences and level forms, and the two variables are integrated of order one, in Kenya. Secondly, we tested for cointegration between exchange rates C'-1dstock prices in Kenya. The results show that the two variables are cointegrated. Thirdly, we used error-correction models instead of the classical Granger-causality tests since the two variables are cointegrated. to The empirical results obtained from the error correction model, over the period November 1993 to May 1999 indicate that exchange rates.G,ranger -causes stock prices in Kenya. There exists unidirectional causality from exchange rates to stock prices. Therefore, movements in exchange rates exert significant influence on stock price determination in Kenya.