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Exchange Rate Volatility: Impact on Industry Portfolios in Indian Stock Market

K N Badhani*, Rajani Chhimwal** and Janki Suyal***


This study examines the interaction between changes in the exchange rate of Indian Rupee and returns on different BSE-based indices representing the firms of different sizes and industries. In absolute sense, the returns on all the stock portfolios are found to be positively correlated with the external value of Indian Rupee. However, the analysis with an extended market model of asset pricing shows that the indices of export-oriented industries are negatively associated with change in exchange rate, after making the adjustment for market trend. Among them, IT, technology and knowledge-based sectors show high sensitivity towards exchange rate fluctuations. On the other hand, the indices of financial sector and import-intensive industries show a positive association with the exchange rate of rupee. The Vector Autoregression (VAR) model shows one-way causality running from stock prices to exchange rate. This suggests that the portfolio rebalancing activities of Foreign Institutional Investors (FIIs) have a more important role in the dynamic interaction between stock prices and exchange rate.

Introduction
The implementation of flexible exchange rate regime, full convertibility of rupee in current account, and a gradual move towards full capital account convertibility have raised the volatility of exchange rate, and the issue of exchange rate exposure has become quite important for the corporate world. The volatility of the exchange rate of Indian Rupee in respect to US Dollar during recent periods has caused anxiety in many quarters of the economy, particularly export-oriented sectors such as IT and Business Process Outsourcing (BPO). Since, any impact on competitiveness and profitability of a firm affects the future value of its expected cash flow which, in turn, gets reflected in the market price of the its stock, this study makes an attempt to evaluate the impact of exchange rate fluctuations in the stock prices of different industry-specific portfolios. Economic theories suggest that under a floating exchange rate regime, exchange rate appreciation reduces the competitiveness of local industries in international market. It is likely to have a negative effect on the domestic stock market. Conversely, in an import-oriented economy, exchange rate appreciation may have a positive effect on the stock market as it helps to lower the input costs. The objective of the study is to examine the sensitivity of different industry-specific and size-sorted stock portfolios towards changes in exchange rate. For this purpose, the study uses daily data of exchange rate and different Bombay Stock Exchange (BSE) indices
* ** Associate Professor, Institute of Rural Management Anand (IRMA), Anand 388001, India. He is the corresponding author. E-mail: badhanikn@yahoo.co.in Research Scholar, Department of Commerce, DSB Campus, Kumaun University, Nainital 263002, India. E-mail: renu_3feb@yahoo.co.in

*** Lecturer, Department of Economics, Government P G College, Agastyamuni, Rudraprayag, India. E-mail: janki_suyal@yahoo.co.in Exchange Rate Volatility: Impact on Industry 2009 The Icfai University Press. All Rights Portfolios Reserved. in Indian Stock Market 33

representing different firm-size and industries. The results indicate that in absolute sense, an appreciation in exchange rate of rupee has a positive impact on stock prices in general. However, in relative sense, there is a negative impact of appreciation in the external value of Indian Rupee on the stock prices of export-oriented industries such as Information Technology (IT), technology and knowledge-based industries.

Review of Literature
After the end of Bretton Woods agreement in 1970, more and more countries adopted flexible exchange rate regime. Increasing globalization led to the gradual abolition of foreign exchange controls in the emerging economies together with tremendous increase in cross-border flow of goods and capital. Adoption of flexible exchange rate regime has increased the volatility of foreign exchange markets and the risk associated with foreign investments. Therefore, the academicians as well as the investment managers have started taking great interest in studying the interaction between stock and foreign exchange markets, as the stock market serves as a composite indicator of the value of investments in an economy. This interaction can be examined at different levelsat firm-level, at industry-level and at aggregate market level. The flow-oriented model of Dornbusch and Fischer (1980) postulates that a change in exchange rate affects a firms operational exposure, its competitiveness in the international market and, consequently, its share prices. At macro level, the impact of exchange rate fluctuations on stock market depends on the relative importance of international trade in the economy and the nature of trade imbalances of the country. Ma and Kao (1990) find that the currency appreciation negatively affects the domestic stock market for an export-dominant country and positively affects the domestic stock market for an import-dominant country. The portfolio balancing model (Branson, 1983; Frankel, 1983; and Smith, 1992), on the other hand, suggests that the excessive foreign investment flow induced by booming capital market increases the demand for local currency, which leads to appreciation of the currency. Since the pay-off of foreign investors depends on changes in exchange rate as well as changes in stock prices, they are likely to revise their portfolios according to their expectation about future changes in exchange rate and stock prices. These expectations, in most of the cases, are based to extrapolations of the past trends and the feedback trading behavior exhibited by investors. When, on the basis of the past trends, the foreign investors expect an appreciation in local currency, they increase their investment in the local market; consequently, the stock prices go up due to the increase in demand. Similarly, when stock price movements show an upward trend, the foreign investors may increase their investment flows in the country which pushes up the exchange rate. Therefore, past changes in exchange rate are likely to cause changes in stock prices and past changes in stock prices are likely to affect the changes in exchange rate. While the portfolio balancing hypothesis postulates a short run bidirectional (feedback) causality arising out of temporary excessive liquidity or illiquidity in the stock and forex markets, a unidirectional causality running from exchange rate to stock prices is implied in the flow-oriented model. In flow-oriented model, the correlation between exchange rate and
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stock prices may be positive or negative depending on the nature of trade imbalances of the country, while the portfolio balancing model suggests a positive correlation between them. The empirical evidences are rather mixed. Some studies report a positive correlation between exchange rate and stock prices (e.g., Aggarwal, 1981; Roll, 1992; and Chiang et al., 2000), while some report a negative relationship (Soenen and Hennigar, 1988; Friberg and Nydahl, 1999; and Gao, 2000). There are also some studies which report no relationship between them (e.g., Chow et al., 1997). While some studies find long run cointegration between exchange rate and stock prices (e.g., Bahmani-Oskooee and Sohrabian, 1992; and Smyth and Nandha, 2003), others find no cointegration between them (Rapp et al., 1999; and Morley and Pentecost, 2000). The results of the studies also differ regarding the direction of causality between the variables. For example, Bahmani-Oskooee and Sohrabian (1992) report bidirectional causal relationship between stock-prices and exchange rate in the US, while Abdalla and Murinde (1997) report unidirectional causality running from exchange rate to stock prices for India, Korea and Pakistan. Ma and Kao (1990) attribute the differences in results to the nature of the trade imbalances in the country, whereas Morley and Pentecost (2000) argue that the exchange rate control and central banks intervention in foreign exchange market may be responsible for a theoretically inconsistent relationship between stock market and foreign exchange market. At micro level, the conceptual relationship between stock prices of a firm (or firms in an industry) and exchange rate is also based on the argument of the competitiveness. The sensitivity of a firms economic value or its share prices towards changes in exchange rate is referred to the firms exchange rate exposure (Hekman, 1983). The changes in exchange rate affect a firms value because future cash flows of the firm will change with exchange rate fluctuations. Shapiro (1975) argues that the firms exposure should be related to the proportion of export sales, the level of foreign competition and the degree of substitutability between local and imported factors of production. Adler and Dumas (1984) show that even firms whose entire operations are domestic may be affected by exchange rates, if their input and output prices are influenced by exchange rate movements. Marston (2001) demonstrates that the net foreign revenues of a firm are the main determinant of a firms exchange rate exposure. He also argues that the exposure is a function of the firms own elasticity of demand and the cross elasticity of demand with its competitors. Bonder et al. (2002) show that the firms with high elasticity of demand have higher exchange rate exposure, while the firms with inelastic demand can successfully pass on the price changes to consumers. Since a firms export sales is understood to be the most important determinant of its foreign exchange exposure, most of the studies have focused on this factor. However, results of these studies again portray a mixed picture. Jorion (1990) shows that the level of foreign sales is the main determinant of exchange rate exposure of the US multinational firms. However, Amihud (1994) in the US and Dominguez and Tesar (2001) in eight non-US countries find no relationship between foreign sales and exposure in the sample firms. Another characteristic of a firm which is likely to have a significant implication for its exchange rate exposure is its size. Size is likely to be associated with exposure in several ways. First, large firms are likely to have more foreign activities relative to small firms; therefore,
Exchange Rate Volatility: Impact on Industry Portfolios in Indian Stock Market 35

size serves as a proxy of a firms foreign activities. Big firms are likely to have more exchange rate exposure than the small firms. Second, firm size is also often used as a proxy for the amount of information available to the market regarding firms operations. Large firms are more closely monitored by analysts, therefore, their stock prices are likely to adjust to new information rapidly when compared to stocks of small firms. The market inefficiency argument predicts that large firms have higher contemporaneous exposure, while the stocks of small firms show a lagged effect for exchange rate exposure (Griffin et al., 2002). However, as Allayannis and Ofek (2001) show, the use of foreign currency derivatives reduces the exposure and large firms are more likely to use derivatives for hedging. Therefore, these firms may be successful in reducing their exposure to some extent. Studies analyzing the relationship between size and exposure show mixed results. He and Ng (1998) and Bonder and Wong (2003) show that large firms have more exposure than small firms in the US and Japan. Conversely, Dominguez and Tesar (2001) argue that the exposure varies little with firm size (Muller and Verschoor, 2006). In India, most of the studies on the interaction between stock market and foreign exchange market have taken up the issue at macro level (Bhattacharya and Mukherjee, 2003 and 2006; Muhammad and Rasheed, 2003; and Badhani, 2005 and 2006). Most of these studies concluded that in India, causality runs from exchange rate to stock prices and the flow of foreign portfolio investment serves as an important intervening variable. These findings can be explained with the help of portfolio balancing model. The present study aims to extend this analysis further. Since in an industry, the firms have more homogeneous mix of inputs and outputs, it is more likely that the firms of the same industry will have more similar exposures than the firms from different industries (for country arguments, Williamson, 2001). Therefore, this study examines exposure at the industry level following Dogan and Yalacin (2007). For this purpose, the industry-specific indices were used. An attempt has also been made to examine the size-effect on exposure using the indices representing the firms with varying market capitalization size.

Data and Methodology


This study uses 16 BSE-based stock indices. Out of these, six represent different combinations of the size of the firms market capitalization, while the remaining ten indices represent different industries. The indices at BSE were constructed using value weighting system and free-float methodology. The study covers a period of more than seven years, i.e., from January 2000 to March 2007. However, in case of a few indices, the actual sample period may differ due to nonavailability of the data. Table 1 provides the details of the indices included in this study and their sample periods. The dollar-rupee exchange rate is used to represent the external value of the rupee. The exchange rate has been obtained from the Reserve Bank of Indias database and converted into rupee denomination from the dollar denomination. The daily closing values of all the indices are log transformed and differenced to obtain the return on index (Rit). The change in exchange rate (Ext) is also obtained using the same method. The stationarity of the data at level as well as at the differenced form is evaluated using the Augmented Dickey-Fuller (ADF) and the Phillips-Parron (PP) unit root tests.
36 The Icfai Journal of Applied Finance, Vol. 15, No. 6, 2009

Table 1: List of the Indices Included in the Study


Index Sensex BSE 100 BSE 200 BSE 500 Mid-Cap Small-Cap Auto Metal Consumer Durables FMCG Bankex Oil and Gas IT Capital Goods Healthcare TECK Sample Period 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 11/4/2005 to 31/3/2007 11/4/2005 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 1/1/2002 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 3/1/2000 to 31/3/2007 31/1/2002 to 31/3/2007

Since these tests are sensitive to lag-length selection, we use Akaike Information Criterion (AIC) for choice of the lag length. The results (Table 2) show that the indices possess unit root at level but can be removed while differenced. Therefore, the returns on indices and change in exchange rate are stationary and suitable for econometric modeling. When data series are integrated of the same order, there is a possibility that the series may be cointegrated. Cointegrated time series are associated with each other with a long run equilibrium relationship. Engle and Granger (1987) show that if two or more variables are cointegrated, the relationship between them must be modeled in the form of an error correction model, at level rather without differencing. Valuable information is lost if these are modeled simply in differenced form without accounting for their equilibrium relationship. On the other hand, if variables are not cointegrated, they must be included in an econometric model only after making them stationary through differencing. Therefore, testing the cointegration among variables is an important step of time series modeling. As discussed earlier, previous studies do not provide conclusive evidence on the issue whether stock prices and exchange rates are cointegrated or not. Therefore, we examine the pair-wise cointegration between stock price indices and exchange rate, using Johansens test (Johansen, 1988; and Johansen and Juselius, 1990). The Johansens test is sensitive towards specification of intercepts and trends in the Vector Autoregression (VAR) equation. Following Pantula principle, we used the test with five possible combinations of the specifications of these
Exchange Rate Volatility: Impact on Industry Portfolios in Indian Stock Market 37

38

Table 2: Unit Root Tests


ADF Test At First Difference At Level PP Test At First Difference

Variable

At Level

With Constant With Constant With Constant With Constant With Constant With Constant With Constant With Constant Without Trend and Trend Without Trend and Trend Without Trend and Trend Without Trend and Trend 1.56 1.81 2.12 2.10 2.08 2.30 2.59 3.16 2.26 1.82 8.09** 7.10** 7.91** 7.96** 8.77** 7.20** 7.86** 7.33** 7.49** 2.76 2.28 4.76** 1.23 3.57* 3.73* 2.25 7.33** 7.03** 8.52** 7.68** 7.80** 7.10** 7.97** 6.93** 7.32** 0.88 1.55 0.17 1.61 6.54 1.80 0.30 3.25 4.53 7.38** 7.41** 0.60 8.40** 8.54** 0.42 4.92** 5.03** 7.79 5.31** 5.41** 4.30 11.87 12.65 7.75 15.72 5.83 5.70 15.51 7.60 8.23 3.38 14.98 5.70 7.25 7.94** 8.21** 1.03 5.85 7.99** 8.25** 1.01 5.91 8.06** 8.35** 1.06 4.90 7.94** 8.25** 1.59 3.70 1701.28** 1743.69** 1737.26** 1736.21** 424.97** 392.89** 1814.97** 1829.05** 1976.21** 1673.12** 1048.47** 1665.03** 1722.05** 1887.99** 1612.25** 1577.68** 2032.32** 1625.33** 1681.34** 1679.75** 1677.05** 417.23** 384.87** 1761.52** 1814.86** 1894.27** 1649.64** 1046.89** 1632.18** 1679.66** 1804.90** 1569.83** 1491.24** 1981.94**

Sensex

1.16

BSE 100

0.80

BSE 200

0.47

BSE 500

0.51

Mid-Cap

1.64

Small-Cap

2.16

Auto

0.38

Metal

0.32

Consumer Durables

0.24

FMCG

0.65

Bankex

0.09

Oil and Gas

0.99

IT

3.30*

Capital Goods

1.53

Healthcare

0.51

TECK

1.47

Exchange Rate

1.31

The Icfai Journal of Applied Finance, Vol. 15, No. 6, 2009

Note:

**

p < 0.01; p < 0.05.

deterministic terms. However, the results fail to reject the null hypothesis of no cointegration between stock price indices and exchange rate, in general. Therefore, data is used at their first-difference (i.e., Rit and Ext) rather than at level for further analysis. First, we measure the contemporaneous sensitivity of returns on market capitalization based indices. For this purpose, we use Adler and Dumas (1984) model with some modifications. Adler and Dumas (1984) measured the sensitivity of stock returns towards changes in exchange rate using a simple bivariate regression model with Gaussian error term. However, the conditional heteroskedasticity, often found in financial data, may affect the results. Therefore, we allow a conditional variance for the error term in our model. More specifically, we use the following bivariate regression model with GARCH (1, 1) error term:
R it i i Ex t it

it u it h it u it ~ N (0,1)
2 h it i a i it b i h it

...(1)

where Ext is the change in exchange rate. The results of this analysis are presented in Table 3. A similar model is used to estimate the sensitivity of industry-specific portfolios and the results are presented in the first column of Table 4. However, a drawback of this analysis is that some macroeconomic factors may be correlated with both exchange rate changes and stock returns and therefore, the obtained association using Equation (1) may be spurious. Following Bonder and Wong (2003), we include market-return (Rmt) in Equation (1) to control the effects of such macroeconomic factors. The revised equation becomes an extended market-model, (or a two-factor model) of asset pricing. More precisely, we use the following regression:
R it i i Ex t i R mt t

it u it h it u it ~ N(0,1)
2 h it i a i it b i h it

...(2)

Table 3: Sensitivity of Different Market Indices Towards Exchange Rate


Index Sensex BSE 100 BSE 200 BSE 500 Mid-Cap Small-Cap
Note:
**

Constant

Coefficient t 1.38 1.24 1.34 1.42 1.72 1.39

0.0004910 0.0004686 0.0004956 0.0005239 0.0011144 0.0010243


*

1.41556 1.51315 1.57205 1.58647 1.20754 1.11188

t 4.94** 5.13 5.16 5.26 3.81


** ** ** **

Adjusted R2 0.0329 0.0334 0.0372 0.0385 0.0402 0.0258

3.19**

p < 0.01; p < 0.05. 39

Exchange Rate Volatility: Impact on Industry Portfolios in Indian Stock Market

40

Table 4: Sensitivity of Industry Index Portfolios Towards Change in Exchange Rate


After Adjusting for Market Return Based on BSE Sensex Based on BSE 500 F-test 6.63** 9.89** 2.19 0.00 18.90** 7.66** 9.06** 4.22** 2.52* 3.30** 19.08** 4.89* 11.16** 0.370 0.007 0.100 0.490 0.210 1.010 0.450 0.160 0.790 0.220

Before Adjusting for

Portfolio t-test 5.49** 5.22** 0.57 0.27 0.05 0.60 0.43 0.70 0.61 0.26 0.60 3.24** 2.71** 4.05** 0.48 1.45 2.96** 4.42** 4.08** 5.05** 4.76** 3.14** 5.40** 5.32** 3.69** 0.33 3.04**

Market Return

t-test

t-test 2.14* 2.09* 0.04 0.77 3.40** 1.65 4.42** 3.59** 1.56 4.14**

F-test 3.01 4.77* 0.00 0.32 11.30** 2.67 22.14** 11.47** 1.58 9.84**

Auto

1.41

Metal

1.91

Consumer Durables

1.45

FMCG

1.08

Bankex

1.92

Oil and Gas

1.60

IT

1.32

Capital Goods

1.79

Healthcare

1.20

TECK

1.34

The Icfai Journal of Applied Finance, Vol. 15, No. 6, 2009

Note: ** p < 0.01; * p < 0.05.

However, Equation (2) is likely to be affected by the problem of multicolinearity as change in exchange rate (Ext) and return on market portfolio are also correlated. Therefore, the use of usual t-test may not be valid to evaluate the statistical significance of i. To solve this problem, we may reestimate Equation (2) without including the Ext term. Then, this restricted model becomes a simple market model of asset pricing. Now, the significance of i can be evaluated by comparing the results of Equation (2) and its restricted (or nested) equation with the following F-test.
F

1 R n 2
2 UR

2 2 RUR RR

...(3)

is the R2 obtained from Equation (2), and R2 is the R2 obtained from the restricted where R2 UR R version of this equation after dropping out Ex t term. The test statistic follows the F-distribution with df of 1 and n2 for numerator and denominator respectively. The choice of appropriate market portfolio has a crucial importance in the estimation of Equation (2). In India, most of the studies use BSE Sensex as a proxy for market portfolio for verities of empirical studies. Following this convention, we also use the BSE Sensex to represent the market portfolio. However, the BSE Sensex represents only the large stocks, and the past studies show that size of the firm is an important determinant of the exchange rate exposure. Therefore, use of the BSE Sensex as the proxy for market portfolio may cause some biases in the estimates. To overcome this problem, we use a broad-based indexBSE 500as an alternative proxy for market portfolio. The results obtained, based on this analysis, are presented in Table 4. Next, the study takes up the issues of delayed reaction, causality and the dynamic relationship between the changes in exchange rate and stock returns. For this purpose, we estimate the following VAR model:
X t A 0 A 1 X t 1 ............. A k X t k t

...(4)

where X is the vector of n indigenous variables, A0 is the n-order vector of intercepts, k is the order of VAR (i.e., the number of lagged terms included in the model), A1......Ak are n n order matrices of the coefficients and t is the vector of Gaussian white noise. For the six market indices this model is estimated using two variablesthe change in exchange rate and return on stock index (taking the six indices one by one). Therefore, the value of n in this case is 2. On the other hand, the VAR models for industry-specific indices are estimated with two alternative specifications(i) without including a market index in the VAR, and (ii) including a market index in the VAR. The second specification is used to ensure that the causality shown by the first specification is not indirectly caused by market and is specific to industry. The BSE Sensex is used as a market index for this purpose. Thus, first specification includes two variables (n=2), while the latter specification includes three variables (n=3). Another important issue in the construction of a VAR model is the choice of the order of the VAR or the number of the lags included in the model. We have uniformly used two lags in the VAR models.
Exchange Rate Volatility: Impact on Industry Portfolios in Indian Stock Market 41

The individual coefficients of a VAR model are difficult to interpret. Therefore, generally, the summary statistics of the models are reported. One of the important summary statistics is the Granger causality test based on Wald test. Table 5 reports these results. Table 5: VAR Models Granger Causality (Block Exogeneity Wald Test: 2 Distribution) (VAR Order-02)
A. VAR Models for Market Indices Market Index BSE Sensex BSE 100 BSE 200 BSE 500 BSE Mid-Cap BSE Small-Cap H0: Change in Stock Index Does Not Cause Change in Exchange Rate 8.96* 9.01
*

H0: Change in Exchange Rate Does Not Cause Change in Stock Index 3.92 2.42 2.32 1.85 0.86 0.72

8.78* 8.62* 0.89 0.93 B. VAR Models for Industry Indices H0: Change in Stock Index Does Not Cause Change in Exchange Rate

H0: Change in Exchange Rate Does Not Cause Change in Stock Index Before Including Market Index in VAR 1.32 1.66 0.84 6.83 4.07 1.81 3.76 10.04** 0.52 0.91
*

Stock Portfolio

Before Including Market Index in VAR 8.24* 4.61 4.77 3.19 4.38 6.56 4.67 2.02 2.10 6.39*
*

After Including Market Index in VAR 2.66 0.07 0.08 5.05 0.56 0.74 0.08 2.46 1.44 0.43

After Including Market Index in VAR 1.41 1.25 0.38 5.54 4.18 1.82 2.21 9.21** 0.33 0.81

BSE Auto BSE Metal BSE Con. Dur. BSE FMCG BSE Bankex BSE Oil-Gas BSE IT BSE Capital Goods BSE Healthcare BSE TECK
Note:
**

p < 0.01; p < 0.05.

Results and Discussion


Firm Size and Exchange Rate Exposure
Table 3 presents the exchange rate exposure of different stock indices, which represent firms of different capitalization size. The BSE Sensex is based on 30 largest stocks traded at the BSE.
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Similarly, BSE 100, BSE 200 and BSE 500 represent the largest 100, 200, 500 stocks respectively. The BSE Mid-cap and BSE Small-cap indices represent the mid-cap and small-cap stocks. Theory suggests that large firms are more sensitive to changes in exchange rate. However, the large firms are also capable of managing their exposure effectively; therefore, the relationship between exposure and firm size is not perfectly linear. The exposure coefficient (i) obtained with Equation (1) is the highest for BSE 500 companies (1.59), followed by BSE 200 companies (1.57). For Sensex , which includes the 30 biggest companies according to their market capitalization, the exposure coefficient is 1.42. In keeping with the conceptual proposition, the exposure coefficient is lower for small size companies. The exposure coefficient of the BSE Mid-cap index is 1.21 and that of the BSE Small-cap index is 1.11. All the coefficients are positive, which implies that the exchange rate of rupee and stock prices tend to move in the same direction. When rupee appreciates, the stock prices also move up and vice versa. In all the cases, the coefficients are statistically significant at 0.01 level (based on t-statistics). The average adjusted R2 is about 0.035, which implies that the changes in exchanges rate explain about 3.5% of the variability in stock returns.

Exchange Rate Exposure of Industry-Specific Indices


Table 4 presents the exchange rate exposure of ten industry-specific indices. First, we estimate the exposure coefficient i using Equation (1). All the coefficients are positive, implying that the exchange rates of rupee and stock prices of all the industry-specific indices tend to move in the same direction. Even the indices representing export-oriented industries such as IT, technology and knowledge-based (TECK), show positive exposure coefficients. All the coefficients are statistically significant. However, the exposure coefficient obtained using Equation (1) may be spurious, as it may include the impact of some macroeconomic variables which affect both the stock prices and the exchange rate. Therefore, we include the return on market portfolio as an additional regressor to isolate the impact of the changes in exchange rate on industry-specific portfolios (Equation (2)). The BSE Sensex and BSE 500 have been used alternatively as the proxy of market portfolio. The significance of the exchange rate exposure coefficients i has been tested using restricted F-test procedure as presented in Equation (3). The results presented in Table 4 show that the IT stocks show the highest sensitivity towards changes in exchange rate after making adjustment for market returns. The exposure coefficient of BSE IT index is 0.70 when the BSE Sensex is used as a proxy of market portfolio, and 1.01 when the BSE 500 is used as a proxy. In both the cases, the F-test reveals that the impact of exchange rate on returns is statistically significant. IT stocks are followed by TECK stocks in terms of sensitivity towards change in exchange rate. The exposure coefficient of the BSE TECK index is 0.60 when BSE Sensex is used as market proxy and 0.79 when BSE 500 is used as market proxy. The negative exposure coefficients for these two indices indicate that there is a negative association between the changes in exchange rate and stock prices of the export-oriented companies such as IT and TECK industries. On the other hand, the remaining eight industry-specific indices show positive exposure coefficients. Among them, the indices representing capital goods and banking sector show higher and statistically significant sensitivity to changes in exchange rate. Capital goods industry is
Exchange Rate Volatility: Impact on Industry Portfolios in Indian Stock Market 43

predominantly an import-oriented industry. On the other hand, the foreign exposure of financial companies depended on the mix of their foreign exchange dominated assets and liabilities. Conceptually, a positive exposure for financial companies is likely when their foreign exchange liabilities exceed their foreign exchange dominated assets. The BSE Metal index also shows a positive sensitivity to change in exchange rate, which is significant at 0.01 level when the BSE Sensex is used as market proxy, and at 0.05 level when BSE 500 is used as market proxy. The impact of change in exchange rate is found significant at 0.01 level on two other indicesBSE Auto and BSE Oil and Gaswhen BSE Sensex is used as market proxy. Similarly, in BSE Healthcare index, the impact is found significant at 0.05 level only when BSE Sensex is taken as a proxy of market portfolio. Consumer durables and FMCG indices do not show any significant exchange rate exposure.

The Dynamic Interaction Between Change in Exchange Rate and Stock Returns
So far, the study has considered only contemporaneous relationship between changes in exchange rate and stock prices. However, the relationship between these variables may exist across the time. The lead and lag relations may arise either out of delayed reaction of one of the variables or due to causality of one variable on the other. To explore this possibility, we construct the VAR model as presented in Equation (4). The results of Granger causality test (Block Exogeneity Wald test) based on the estimated VAR models are presented in Table 5. The results show that the returns on market indices representing the firms of different capitalization size are not caused by changes in exchange rate (Table 5A). These results are consistent with the spirit of the efficient market hypothesis. Theory suggests that the price discovery process, in the case of small stocks, may be inefficient. Therefore, these stocks may show a delayed reaction to changes in exchange rate. However, we do not find any significant delayed reaction of returns on BSE Mid-cap and BSE Small-cap indices towards changes in exchange rate. However, the VAR model suggests the causality running from stock returns to changes in exchanges rate, particularly for the indices representing large stocks (i.e., BSE Sensex, BSE 100, BSE 200 and BSE 500). No such causality is found in the case of mid-cap and small-cap indices. The causality of stock returns on changes in exchange rate can be explained with the help of portfolio balancing hypothesis. Since the FIIs in India are known to follow positive feedback trading (Badhani, 2006), the flow of portfolio investment increases in response to the rising stock prices. This pushes up the demand for the Indian Rupee and, consequently, its external value. Since FIIs are more interested in investing in large capitalization firms, the causality is more robust from these stocks to exchange rate in comparison to that from the indices representing mid-cap and small-cap companies. The VAR models for industry-specific indices have been constructed with two alternative specificationswith and without including returns on market index (BSE Sensex) in the model. Causality runs from index returns to change in exchange rate in the case of three indices, viz., auto, oil and gas, and TECK (Wald statistics are significant at 0.01 level), but this disappears when return on market index is included in the model. Therefore, this observed causality is just a reflection of causality of stock market returns on change in exchange rate and cannot be attributed to a specific industry. In two casesFMCG and Capital goods
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causality runs from change in exchange rate to index returns. In the case of FMCG, this causality is significant at 0.05 level and disappears when return on market index is included in the model. However, in the case of capital goods industry, this causality appears robust as it is significant at 0.01 level and does not disappear after controlling for market effect.

Conclusion
The study examines the contemporaneous and dynamic relationship between changes in exchange rate and returns on stock indices representing the firms of different size and industries. Before making adjustment for common market trend in stock returns, the returns on all the industry-specific indices show a positive correlation with changes in exchange rate. This implies that in absolute sense, the appreciation in exchange rate of rupee does not adversely affect the stock prices of any industry, whether import- or export-oriented; rather stock prices, in general, move in the same direction that the exchange rate is moving. However, when we make adjustment for common market trend in stock returns (using an extended market model of stock returns) and measure the relative exposure of specific industry index, we observe that there is a negative association between changes in exchange rate and returns of export-oriented industries. The BSE IT index shows the highest sensitivity to exchange rate, followed by the BSE TECK index. On the other hand, returns on BSE capital goods index and BSE bankex show a positive association with changes in external value of the rupee. The stock indices, in general, do not show a lagged effect of change in exchange rate, except for BSE capital goods. This observation is consistent with the concept of efficient market hypothesis. However, the exchange rate shows a lagged reaction to changes in stock prices, particularly those of the large-cap companies. This reaction is likely to be caused by portfolio rebalancing by FIIs.

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