Journal of Financial Economic Policy

Linkages between Thai stock and foreign exchange markets under the floating regime
Komain Jiranyakul

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Linkages between Thai stock

and foreign exchange markets
under the floating regime
Komain Jiranyakul

Thai stock and

foreign exchange
markets
305

School of Development Economics,

National Institute of Development Administration, Bangkok, Thailand

Downloaded by Universiti Putra Malaysia At 02:16 09 March 2015 (PT)

Abstract
Purpose The purpose of the present study is to directly examine the relationship between bilateral
exchange rate and stock market index in a bivariate framework during the period of the floating
exchange rate regime in Thailand.
Design/methodology/approach The monthly data used in this study are the stock market index
or stock prices from the Stock Exchange of Thailand, and the nominal bilateral exchange rate in terms
of baht per US dollar from the Bank of Thailand. The period covers July 1997 to June 2010 with 156
observations. This is the period that the country switched from fixed to floating exchange rate regime.
The stock market return is calculated by the percentage change of stock market index (or stock prices)
while the exchange rate return is the percentage change of the nominal bilateral exchange rate. Three
estimation methods are used to capture the interaction between stock and foreign exchange markets:
bounds testing for cointegration, non-causality test, and the two-step approach with a bivariate
GARCH model and Granger causality test.
Findings The results of the present study show that bounds testing for cointegration does not
detect the long-run relationship between stock prices and exchange rate. In addition, the non-causality
test fails the diagnostic test for multivariate normality in the residuals of the estimated VAR model.
However, the two-step approach adequately detects the linkages between the stock and foreign
exchange markets. It is found that there exists positive unidirectional causality running from stock
market return to exchange rate return. The exchange rate risk causes stock return to fall as expected.
Moreover, there are bidirectional causal relations between stock market risk and exchange rate risk,
but in different directions.
Research limitations/implications Since a rising trend in the risk in the foreign exchange
market causes stock return to fall, both domestic and foreign investors should be aware of the risk or
uncertainty in the foreign exchange market because it can cause their portfolio return to fall. For
policymakers, reducing exchange rate risk cannot be done without the associated costs from a rising
risk in the stock market.
Originality/value This study provides an evidence of volatility (or risk) spillovers in stock and
foreign exchange markets. In addition, the risk in foreign exchange market that adversely affects
return in the stock market is an expected phenomenon under the floating exchange rate regime.
Keywords Stock prices, Exchange rates, Bivariate GARCH, Causality, Volatility spillover, Thailand
Paper type Research paper

1. Introduction
Theoretically, the traditional approach or the flow-oriented theory states that a
depreciation of domestic currency can have a crucial impact on stock prices (SP) by
increasing firms competitiveness, while in turn raising their profitability. When firms
The author is grateful to two anonymous referees for their comments and suggestions that are
very helpful in improving the quality of this paper.

Journal of Financial Economic Policy

Vol. 4 No. 4, 2012
pp. 305-319
q Emerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381211279280

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306

are able to pay more dividends to stockholders, SP will increase. Thus, there should be
a positive relationship between exchange rates and SP. In this case, exchange rates lead
SP. On the contrary, the portfolio balance approach indicates that SP lead exchange rates
on the ground that a rising trend in SP induces foreign investors to invest more in
domestic stocks. This will cause more capital inflows, which in turn cause domestic
currency appreciation. In addition, a rise in domestic SP causes wealth to increase, and
thus induces investors to increase their demand for money, which results in a rise in
domestic interest rates. Higher interest rates induce capital inflows, and thus cause an
appreciation in domestic currency. According to this approach, SP lead exchange rates
with a negative relationship. Another approach called monetary approach or asset
market approach indicates no linkage between SP and exchange rates due to different
factors influencing the two variables. The details of the flow-oriented model are in
Dornbusch and Fisher (1980), the portfolio balance approach in Branson and Henderson
(1985). A comprehensive review of the monetary approach is in MacDonald and
Taylor (1992).
Empirical studies suggest that there is no long-run relationship between SP and
exchange rates in most countries, specifically from the results of bivariate cointegration
tests. Furthermore, the direction of causality seems to depend on specific characteristics
of each country being analyzed. Many studies employ multivariate cointegration tests to
investigate the long-run relationship between SP and exchange rates, along with other
macroeconomic variables. For examples, Kown and Shin (1999) find no long-run
relationship between SP and exchange rate in a bivariate framework, but the long-run
relationship between SP and other variables, including exchange rate, is detected. Their
finding shows that SP are not a leading indicator of the exchange rate and other
macroeconomic variables in Korea. Kim (2003) also employs the multivariate
cointegration test to detect the long-run relationship between SP and the dollar
exchange rate in the USA and finds negative relationship between SP and the
exchange rate.
Gradual abolishment of barriers to capital flows and foreign exchange restrictions,
along with the adoption of more flexible exchange rates in emerging markets are the
main causes of the volatility of exchange rates and risk in the portfolio diversification
process in the past decades. Therefore, understanding the relationship between
exchange rates and SP will provide guidance for investors to diversify their portfolios.
The linkages between stock markets and foreign exchange markets are explored by
many researchers who employ modern time series econometrics. The mutual relations
between the two markets are examined by using the techniques of cointegration and
causality between SP and exchange rates. The study by Frank and Young (1972) is
known as the inaugurate attempt to link SP to exchange rates. However, the results show
no relationship between SP and exchange rates measured in terms of the prices of the US
dollar. Aggarwal (1981) uses the US monthly data to investigate the relationship
between the two variables and finds that the relationship is stronger in the short run than
in the long run during the 1974-1978, which is the first stage of the post-Brettonwood
system that more volatile exchange rates are observed. Soenen and Hennigar (1988) use
monthly data of the US dollar effective exchange rate and stock market index during the
1980-1986 period to investigate this relationship and find a strong negative relationship.
Ma and Kao (1990) examine SP reactions to exchange rate changes under the floating
regime and find that stock returns are minimally or not affected by exchange

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rate fluctuations. Bahmani-Oskooee and Sohabian (1992) provide an evidence of

bidirectional causality of effective exchange rate and SP (the S&P 500 index) in the short
run, but not in the long run. Ajayi and Mougoue (1996) indicate the causation running
from SP to exchange rates in eight industrialized economies. Nieh and Lee (2001) find no
long-run relationship between SP and exchange rates in G-7 countries. Stavarek (2005)
uses monthly data to examine the linkages between SP and effective exchange rates in
EU-member countries and the USA. The results show much stronger causations in
countries with developed capital and exchange rates markets than the less-developed
ones. Causations seem to be unidirectional running from SP to exchange rates. For Asian
economies, Abballa and Murinde (1997) find the causation running from exchange rates
to SP in India and the Philippines, but no causations in Pakistan and Korea. Yu (1997)
uses daily data on Hong Kong, Japan, and Singapore stock markets during the 1983-1994
period to examine the causality between exchange rates and SP. The results are mixed,
i.e. bidirectional causality in Japan, unidirectional causation running from exchange
rates to SP in Hong Kong, and no causation in Singapore. Mansor (2000) finds short-run
causation running from SP to exchange rates in Malaysia using an analysis in a
bivariate framework. Granger et al. (2000) examine the SP-exchange rates nexus in East
Asian countries using Asian flu daily data from January 3, 1986 to June 16, 1998. The
so-called Asian flu is the financial turmoil that continued to exert its devastating force
from the third quarter of 1997 to the first quarter of 1998. This was the period that SP
and exchange rates plunged in tandem in Asian economies. Granger et al. (2000) find that
exchange rates lead SP in South Korea with a positive correlation while SP lead
exchange rates in the Philippines with a negative correlation. The strong feedback
relations (or bidirectional causations) are observed in Hong Kong, Malaysia, Singapore,
Thailand, and Taiwan. Phylaktis and Ravazzolo (2005) apply a multivariate framework
to test for the direction of Granger causality in a group of Pacific Basin countries, namely
Hong Kong, Malaysia, Singapore, Thailand, and the Philippines using monthly data
from 1980 to 1988. Their results show that stock and foreign exchange markets are
positively related and that the US stock market acts as a conduit for these linkages.
Pan et al. (2007) examine the dynamic linkage between exchange rates and SP for seven
East Asian economies during January 1988 to October 1998, and find that the linkage
varies across economies with respect to exchange rate regimes, trade size, the degree of
capital control, and the size of equity market. Nabiha and Mounira (2009) examine the
dynamic relation between stock and exchange crisis in Mexico, Malaysia, Thailand,
Brazil, and Argentina. Using daily data of stock indexes and the US dollar exchange rate
during 1994 and 2003, they find unidirectional causation running from SP to exchange
rate in Mexico, Argentina, and Brazil, but the causation running from exchange rate to
SP in Malaysia and Thailand.
The interactions between the two financial markets are also investigated using a
generalized autoregressive conditional heteroskedastic (GARCH) model. Giovannini and
Jorion (1987) find that stock return movements impact the foreign exchange markets by
changing stock return forecast that can cause changes in economic activities. Booth and
Rotenberg (1990) indicate that exchange rate movements can impose the adverse effect on
the level of competitiveness of firms that are exposed to exchange rate risk. Choi and
Prasad (1995) find that exchange rate movements affect the value of the US multinational
firms. Atindehou and Gueyie (2001) estimate the three factor pricing model and find that
Canadian bank stock returns are sensitive to exchange rate risk, specifically the risk from

Thai stock and

foreign exchange
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308

the US dollar rather than that from the Canadian dollar. Kanas (2000) finds that spillover
from stock markets to foreign exchange markets is significant for five out of six
developed countries, but spillover from foreign exchange markets to stock markets is not
significant for all countries. Chen et al. (2004) find a lagged stock market reaction to
exchange rate fluctuation in New Zealand. Furthermore, they find that the 1997 Asian
financial crisis plays an important part in the volatility transmission between the two
financial markets by changing the nature of spillover from bidirectional spillover before
the crisis to unidirectional one after the crisis. Choi and Fang (2009) confirm the results of
Chen et al. (2004). Narayan (2009) investigates the impact of the Indian rupee depreciation
on the Indian stock market returns using daily data and finds that a depreciation of the
Indian rupee raises stock return volatility. However, an appreciation causes higher stock
return and lower return volatility.
The main objective of the present study is to directly examine the relationship between
bilateral exchange rate and stock market index in a bivariate framework using monthly
data from July 1997 to June 2010, which is the period of the floating exchange rate regime
in Thailand. The afore-mentioned theories are tested. The more recent techniques are
used: the bounds testing for cointegration proposed by Pesaran et al. (2001) and
the non-causality tests proposed by Toda and Yamamoto (1995). Both procedures provide
simplistic methods to test the nexus between SP and exchange rates. The results of the
present study show that bounds testing for cointegration does not detect the long-run
relationship between SP and exchange rate in Thailand. In addition, the non-causality test
fails the diagnostic test for multivariate normality in the residuals of the estimated vector
autoregressive (VAR) model. To adequately examine the linkages in the stock and foreign
exchange markets, the results from the two-step approach is also employed. This
approach involves the estimate of a bivariate CCC-GARCH model of Bollerslev (1990)
and the Granger (1969) causality test. The results reveal that there exists positive
unidirectional causality running from stock market return to exchange rate return.
Furthermore, the exchange rate risk causes stock return to fall in the floating exchange
rate regime. There are bidirectional causal relations between stock market risk and
exchange rate risk, but in different directions. The paper is organized as follows: the next
section describes the analytical framework of this study. Section 3 presents empirical
results. The last section gives concluding remarks.
2. Methodology
The relationship between SP and exchange rates can be examined by cointegration and
causality tests. If the variables in the model are integrated of order one, I(1) and
cointegrated, the causation is obtained in the vector error correction model, which is
a VAR model in first differences of the series with the inclusion of cointegrating
residuals, i.e. a restricted VAR model. An alternative test in the absence of
cointegration is the standard Granger causality test (Granger, 1969). In case
the variables are not I(1) series, for example they are mixed between I(0) and I(1), the
bounds testing for cointegration can be applied. If cointegration does not exist, the
causal relationship can be tested using the non-causality test in level of the series.
2.1 Cointegration test
The long-run relationship between SP and nominal bilateral exchange rate is
specified as:

LSP t a bLEX t 1t

where LSP is the log of stock market index (or SP) in the Stock Exchange of Thailand,
and LEX is the log of nominal exchange rate.
Pesaran et al. (2001) proposed a new method for testing cointegration called a
conditional autoregressive distributed lag (ARDL) and error correction mechanism.
This is known as ARDL bounds testing procedure.
The ARDL model for equation (1) is specified as:
DLSP t a0

p
X

bi DLSPt2i

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i1

q
X

gi DLEX t2i et

j0

where p and q are the optimal number of lagged differences of log of SP and log of
exchange rate, respectively. By adding the lagged level variables into equation (2), the
computed F-statistic is obtained as shown in equation (3):
DLSP t a0 a1 LSP t21 a2 LEX t21

p
X
i1

bi DLSP t2i

q
X

gi DLEX t2i et 3

j0

If cointegration exists, replacing the lagged level variables with the one-period lagged
residuals from the estimate of equation (1) will give the coefficient of the error
correction term. Unlike other techniques of cointegration test, re-parameterizing the
model into the equivalent vector error correction model is not required.
2.2 Non-causality test
The bivariate causality test with two equations can be used to test for Granger
causality provided that the first difference series are stationary. However, Engle and
Granger (1987) and Granger (1988) show that a VAR model in first differences with
cointegrated variables can be misspecified and lead to inferences with errors. Toda and
Yamamoto (1995) develop the test for causal relationship among variables as an
alternative to the standard Granger causality test. This procedure is conducted in the
sense of non-causality test. In the case of bivariate VAR model having k lags, the variables
in the model appear in their levels. The advantage of this method is that one does not need
to know a priori whether the variables are cointegrated as long as the order of integration
of series does not exceed the lag length of the specified VAR model. To use this method, the
optimal lag length is determined using Akaike information criterion (AIC) or Schwartz
information criterion (SIC), then a VAR of order k * k dmax is estimated, where dmax
is the maximum anticipated order of integration. According to Rambaldi and Doran (1996),
the Wald tests for linear or non-linear restrictions are valid whether the series is I(0), I(1)
or I(2). Since many researchers may find the biases when using the standard unit root and
cointegration tests, this procedure can prevent such biases. The test of whether the
variables in the model Granger cause each other is a test of the joint restriction where
all coefficients are zero.
Following Toda and Yamamoto (1995) non-causality test, the VAR model is
specified in the following equations:

Thai stock and

foreign exchange
markets
309

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LSP t a0

k
X

ai LSP t2i

i1

kd
max
X

k
X

jk1

i1

aj LSP t2j

bi LEX t2i

kd
max
X

bj LEX tj u1t

jk1

4
and:

310
LEX t a1

k
X
i1

gi LEX t2i

kd
max
X

k
X

jk1

i1

gj LEX t2j

di LSP t2i

kd
max
X

dj LSP tj u2t

jk1

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5
The error terms in the VAR model are assumed to be white noise. Since the extra
lagged variables are included in the model, the causality test is conducted by testing
for zero restrictions of the coefficients of all lag variables.
2.3 Two-step approach
Cointegration and causality or non-causality tests might not adequately capture the
interactions between stock and foreign exchange markets due to the associated risk in
these two markets. It is possible that exchange rate and stock returns are positively
related, and that exchange rate risk might cause stock return to fall. Furthermore, there
might be causal relationship between volatilities of the two markets.
The two-step approach is used to explain these relationships. The first step is to
estimate a system of equations to model the stock return and exchange rate return
processes, along with their conditional variances. These estimates can generate stock
return volatility and exchange rate return volatility series. In the second step, these
series, along with the stock return and exchange rate return series are employed in
multivariate Granger causality test. Because the relationship in means and in variances
is thought to take several periods, the two-step approach provides room for the ability
to establish causality even though this approach has been criticized for the generated
volatility or uncertainty series. Specifically, in the first step, a bivariate generalized
autoregressive heteroskedastic model with constant conditional correlation
(CCC-GARCH) model of Bollerslev (1990) consists of the following five equations:
r 1;t a1;0

p
X

a1;i r 1;t2i

i1

p
X

b1;i r 2;t2i 11;t

h1;t m1 a1;1 121;t21 b1;1 h1;t21

r 2;t a2;0

p
X
i1

i1

a2;i r 2;t2i

p
X

b2;i r 2;t2i 12;t

7
8

i1

h2;t m2 a2;1 122;t21 b2;1 h2;t21

h12;t r12 h1;t 1=2 h2;t 1=2

10

where r1 is the stock return, and r2 is the return on exchange rate. The conditional
variances of stock return and return on exchange rate are given by h1 and h2,

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respectively. The conditional covariance between r1 and r2 is given by h12. The model
assumes that the coefficients for the ARCH terms (a1,1, and a2,1) and the constants,
a1,0 and a2,0, are non-negative. The coefficients associated with the GARCH terms
(b1,1 and b2,1) are assumed to be greater than or equal to zero. The covariance between
the error terms for the stock return and exchange rate return processes is given by h12.
It is assumed that normality of the error terms in equations (6) and (8) is valid.
Additionally, it is assumed that a constant conditional correlation coefficient r12, in
equation (10) can take on values from 2 1 to 1.
The model is estimated simultaneously in a system of equations to yield estimates
of the conditional means, variances and covariance of stock return and exchange
rate return processes. These estimates are used to derive the two volatility series.
The causal relationships between stock return, stock return volatility, return on
exchange rate and exchange rate return volatility can then be obtained from standard
multivariate Granger causality test. It should be noted that the bivariate GARCH
model with five equations can be used to control for the possibility of correlation
between the error terms in the stock return and exchange rate return processes.
This specification is a simple bivariate GARCH model used by Fountas et al. (2006).
3. Empirical results
The monthly data used in this study are the stock market index or SP from the Stock
Exchange of Thailand, and the nominal bilateral exchange rate (EX) from the Bank of
Thailand. The variable EX is in terms of domestic currency (Thai baht) per US dollar.
The period covers July 1997 to June 2010 with 156 observations. This is the period that
the country switched from fixed to floating exchange rate regime. The stock market
return (r1) is calculated by the percentage change of stock market index (or SP) while
the exchange rate return (r2) is the percentage change of the nominal bilateral exchange
rate. Expected depreciation of domestic currency can discourage foreign investors to
invest in domestic stocks because loss from exchange rate will be materialized when
they sell those stocks for capital gain. Expected appreciation of domestic currency will
do the opposite. Therefore, exchange rate movements can generate the negative or
positive exchange rate return for foreign investors. The US dollar exchange rate series
is used because it can be a good representation of the price in the foreign exchange
market. The nominal effective exchange rate, which is the weighted average index
of various bilateral exchange rates might not be relevant to many foreign investors
who do not want to imitate the effective exchange rate for their currency portfolios.
Most investors only hold a single or few major currencies. In fact, the US dollar
exchange rate dominates all other major currencies. The large depreciation of Thai
bath against the US dollar at the beginning of the 1997 financial crisis was the main
concern of importers, investors as well as policymakers.
In the first step of the analysis, the data are transformed into logarithmic series.
These series are tested for unit roots using the Augmented Dickey-Fuller (ADF) and
Phillips and Perron (PP) tests with a constant only and a constant and a linear trend.
The optimal number of lags is chosen by AIC for the ADF tests while the optimal
bandwidth for the PP tests are chosen by Newey-West using Bartlett kernel spectral
estimation method. The results are reported in Table I.
For the log of nominal bilateral exchange rate series (LEX), all tests show that this
series is I(0), except for the PP test that includes a linear trend. The test results for the

Thai stock and

foreign exchange
markets
311

Table I.
Unit root tests

2 0.984
2 10.611
2 1.513
2 11.626

[9] (0.758)
[0] (0.000) * * *
[0] (0.525)
[0] (0.000) * * *
22.078
210.646
23.255
211.611

[9]
[0]
[4]
[0]

(0.553)
(0.000) * * *
(0.078) *
(0.000) * * *

ADF test (constant trend)

22.379
211.237
21.668
211.612

[3] (0.150)
[22] (0.000) * * *
[2] (0.445)
[4] (0.000) * * *

PP test (constant)

2 4.096
2 11.655
2 3.436
2 11.612

[3] (0.008) * * *
[23] (0.000) * * *
[3] (0.050) * *
[0] (0.000) * * *

PP test (constant trend)

Notes: Significant at: *10, * *5 and * * *1 percent levels, respectively; LEX stands for log of exchange rate while LSP stands for log of stock prices; the
number in brackets is the optimal lag length determined by AIC for the ADF tests and the optimal bandwidth determined by the Bartlett kernel for the PP
tests; the number in parentheses is the p-value provided by MacKinnon (1996)

LEX
DLEX
LSP
DLSP

ADF test (constant)

312

Variable

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log of the stock price series (LSP) show that the series is I(0) by the PP test that include
a linear trend while other tests show that it is I(1). Therefore, it is not conclusive that
the series of dependent and independent variables are I(0) or I(1) because of the mixed
results of the unit root tests. However, both series are stationary in first differences.
The second step is to test for cointegration between the SP and exchange rate series.
Based upon the results of unit root tests shown in Table I, the ARDL bounds testing
procedure specified in equation (3) seems to be suitable for the analysis.
The grid search method is used to select p and q in equation (1). Starting from the
most parsimonious ARDL(1,1) and if the model does not show serial correlation at the
5 percent level using Lagrange multiplier (LM) serial correlation test, then the model is
suitable for testing for cointegration. However, if the serial correlation is present, the
number of lagged first differences will increase. The search continues for all
combinations of p and q until a model that is free of serial correlation is detected.
The suitable ARDL( p, q) model with the lag order of p 1 for the dependent variable
(LSP) and the lag order of q 1 for the independent variable (LEX) is called the
ARDL(1,1) model. The ARDL(1,1) model is used to test for cointegrating relationship
between LSP and LEX because it is free of serial correlation with the x 2 (2) 2.609
and its p-value is 0.271. By adding lagged level of the pair of variables, the computed
F-statistic is 1.248. The critical values at the 5 percent level from Table CI(iii) case III in
Pesaran et al. (2001) is 5.73 for the upper bound and 4.94 for the lower bound. Since the
computed F-statistic is below the lower bound critical value, the null hypothesis of
no cointegration can be accepted. In other words, there is no long-run relationship
between SP and exchange rate. This result is consistent with the finding of Kown and
Shin (1999) who find that there is no cointegration between stock market index and
foreign exchange rate in a bivariate framework.
The third step is to apply the non-causality test in a VAR model using level of each
pair of the series. The empirical results of the Toda-Yamamoto causality test between
nominal US dollar exchange rate and stock market index are reported in Table II.
Based upon the results of unit root test in Table I, the anticipated maximum order of
integration (dmax) is one. Using AIC to determine the optimal lag length in the VAR
model, the lag length appears to be two. Therefore, the (k dmax) order VAR is three.
The results in Table II show that the null hypothesis that LEX does not cause LSP is
accepted, but the null hypothesis that LSP does not cause LEX is rejected at the 1 percent
Null hypothesis
LEX does not cause LSP
LSP does not cause LEX
JB
LM
WH

Modified Wald statistic

4.355 ( )
14.118 *(2)
Misspecification tests for the VAR model
Test statistic
15.823
1.555
143.083

Thai stock and

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313

p-value
0.226
0.003
p-value
0.000
0.817
0.000

Notes: significant at: *1 percent; LEX stands for log of exchange rate while LSP stands for log of
stock prices; ( ) indicates the positive sum of the coefficients of lagged variables, which is positive
causation; JB is the Jarque-Bera statistic for testing the null hypothesis that the residuals are
multivariate normal; LM is the Lagrange multiplier test for serial correlation up to third order in the
residuals, and WH is the White heteroskedasticity test of the residuals

Table II.
Results of non-causality
test between
LEX and LSP

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314

level of significance. The results indicate that a change of nominal exchange rate does
not cause SP to change even though the sum of the estimated coefficients of all lagged
independent variables is positive. In the other direction, a rise in SP causes the nominal
exchange rate to fall. Therefore, there seems to be a positive unidirectional causality
between SP and nominal exchange rate.
Further tests are conducted to examine the misspecification of the augmented VAR(3)
model used in the analysis. In Table II, the Lagrangian multiplier (LM) test statistic
indicates the acceptance of the null hypothesis that there is no serial correlation in the
residuals up to the third order of lags. Additionally, the White heteroskedasticity test
shows that the null hypothesis of the presence of ARCH effect can be rejected at the
1 percent level of significance. However, the Jarque-Bera (JB) statistic shows that the
residuals are not multivariate normal. Thus, it cannot be concluded that the specified
VAR(k dmax) model is suitable for conducting the non-causality tests. In other words,
the results in Table II are not reliable.
The summary statistics show that both stock and exchange rate returns are
negatively skewed. Excess kurtosis is observed in the exchange rate return series. The
JB statistics reject the null hypothesis of normal distribution in both return series,
which indicates the suitability of a GARCH specification. The causal relationships
between stock and exchange rate returns and their conditional variances, and
especially the impact of exchange rate risk on stock market return under the floating
regime are tested using a bivariate CCC-GARCH(1,1) model and the standard Granger
causality test. The CCC-bivariate GARCH model gives the results of stock return
volatility as well as exchange rate return volatility while the standard causality test
gives the causal relationships between the variables of interest.
The results of the estimate of the bivariate AR(p)-CCC-GARCH(1,1) model are
reported in Table III. Assuming constant conditional correlation, the model performs
quite well in the dataset. In addition, the threshold GARCH model proposed by Zakoian
(1994) is also estimated, but the asymmetry is not found. The estimated conditional
correlation is 2 0.531 which is significant at the 1 percent level. This implies that the
two return processes are not independent. The estimated ARCH and GARCH
parameters are non-negative. In addition, the sum of the coefficients of the two terms is
0.959 for the r1-equation, and 0.815 with insignificant GARCH term in the r2-equation.
This indicates the stationary conditional variance series. The system is also free of
serial correlation. The multivariate Granger causality test is thus performed on
stationary series, and the results are reported in Table IV.
The results show some crucial findings. First, an increase in stock return seems to
cause exchange rate return to fall, but the result is not significant. Therefore, there is no
evidence of the impact of stock market return on exchange rate. Second, a rise in exchange
rate return significantly causes stock return to rise. Thus, there exists unidirectional
causality in the mean equations. Third, volatility causations between the two markets are
observed. An increase in stock return volatility significantly causes exchange rate return
volatility to rise while an increase in exchange rate return volatility causes stock return
volatility to fall. In causality sense, there is bidirectional causality in conditional
variances, but in different directions. In other words, an increase in the risk in the foreign
exchange market causes the risk in the stock market to decrease. However, an increase in
the risk in the stock market causes the risk in the foreign exchange market to rise.
The interesting finding here is that the rising risk in the foreign exchange market causes

 0.473h2,t2 1
(0.074)

0.031r2,t2 2
(0.352)

0.779 * * *h1,t2 1
(11.346)

0.058r1,t2 2
(0.659)

20.048 * * *r1,t2 1
(2 2.820)

0.137r1,t2 3
(1.430)

0.024r1,t2 2
(1.377)

0.011r1,t2 4
(0.124)

0.009r1,t2 3
(0.567)

20.570 * *r2,t2 1
(2 2.510)

0.031r1,t2 4
(0.352)

0.383r2,t2 2
(1.271)

Notes: Significant at: *10, * *5 and * * *1 percent level, respectively; r1 is the monthly stock return calculated from the rate of change in the stock market
index and r2 is the monthly exchange rate return calculated from the rate of change in the nominal bilateral exchange rate; h1 is the conditional variance of
stock return, h2 is the condition variance of exchange rate return, and h12 is the conditional covariance of stock return and exchange rate return; the lags of
r1 and r2 are chosen in such a way that the system diagnostic test show no autocorrelation in the residuals in the mean equations; Q(k) is the Box-Pierce
statistic for the residuals

Panel A: stock return equation

r1,t 2 2.499 * * *
0.170 *r1,t2 1
(22.517)
(1.803)
(t-statistic in parentheses)
h1,t 2.797
0.180 * * *121,t2 1
(1.222)
(2.595)
(t-statistic in parentheses)
Panel B: exchange rate change equation
r2,t 2 0.316
0.110r2,t2 1
(21.616)
(0.567)
(t-statistic in parentheses)
h2,t 1.438 * * *
0.741 * * *1 22,t2 1
(3.941)
(3.227)
(t-statistic in parentheses)
Panel C: correlation coefficient
h12,t 2 0.531 * * * (h1,t)1/2(h2,t)1/2
(23.816)
(t-statistic in parentheses)
Panel D: system diagnostic test
Q(4) 6.175,
Q(8) 18.3755
(0.986)
(0.974)
( p-value in parentheses)

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Table III.
Estimates of the bivariate
AR(p)-CCC-GARCH(1,1)
model of stock market
and exchange rate
returns for the period July
1997 to June 2010

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Table IV.
Results from multivariate
Granger causality test

Hypothesis
r1 does not cause r2
r2 does not cause r1
h1 does not cause r2
h2 does not cause r1
h1 does not cause h2
h2 does not cause h1

F-statistic

p-value

0.077 (2)
3.481 * * ()
1.255 ()
4.081 * * (2 )
2.238 * ( )
3.784 * * (2 )

0.630
0.001
0.273
0.000
0.029
0.001

Notes: Significant at: *5 and * *1 percent level, respectively; r1 is the monthly stock return calculated
from the rate of change in the stock market index and r2 is the monthly exchange rate return calculated
from the rate of change in the nominal bilateral exchange rate; h1 is the conditional variance of stock
return, h2 is the condition variance of exchange rate return; the optimal lag length determined by AIC
is eight; ( ) denotes positive causation and (2) denotes negative causation

the stock market return to fall, which is the expected phenomenon under the floating
regime. In the events of rising exchange rate uncertainty, foreign investors might
diversify away from the domestic stocks. However, a rise in the stock market risk does not
impose any impact on the exchange rate return. In fact, the Thai stock market is a small
emerging market that should not influence the foreign exchange market. The dilemma for
policymakers is that stabilizing the exchange rate will lead to higher level of uncertainty
in the stock market, which will lower the rates of return of domestic stocks. The Bank of
Thailand occasionally intervenes in the foreign exchange market when the exchange
rate is out of line. This practice is used to maintain the position of trade balance of the
countries. Even though the intervention by the Bank of Thailand can stabilizes the
exchange rate, the rising trend in volatility of stock return and the lower stock return
are unavoidable. One of the main finding from the present study is from the result of a
positive spillover of risk from the stock market to the risk in the foreign exchange market.
This evidence gives room for the Security Exchange Commission to set proper rules and
regulations for investors so as to mitigate fluctuations of SP and thus stock market return.
As a result, the risk in the foreign exchange market will be reduced. However, these
measures might not be successful if there are excessive speculations in the stock market.
4. Concluding remarks
This study employs the recently developed time series analysis techniques to explore the
causal relationship between SP and exchange rates in an emerging market economy,
namely Thailand. The results from bounds testing for cointegration show that there
is no long-run relationship between SP (stock market index) and exchange rate in a
bivariate framework, which is consistent with the results of other empirical studies.
An alternative approach is to examine the causal links between SP and exchange rate.
The non-causality test is used and the results show that there exists unidirectional
causality between SP and exchange rates. However, the results from non-causality test
should not be reliable because the estimated VAR model does not pass the diagnostic
test of multivariate normality in the residuals.
The results from the two-step approach show that unidirectional causality between
stock and exchange rate return is observed. An increase in the exchange rate return
causes stock return to rise. More importantly, a rising trend in the risk in the foreign
exchange market causes stock return to fall. Both domestic and foreign investors

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should be aware of the risk or uncertainty in the foreign exchange market because it
can cause their portfolio return to fall. For policymakers, reducing exchange rate risk
cannot be done without the associated costs from a rising risk in the stock market.
Instead, some measures that can reduce the stock market risk are beneficial to the Thai
economy in that the foreign exchange market risk will be reduced. The reservation for
this suggestion is that the measures might not be successful in the presence of
excessive speculations of investors in the stock market.
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About the author
Komain Jiranyakul is an Associate Professor at National Institute of Development
Administration, Bangkok, Thailand. He teaches macroeconomics and financial economics.
He recently published papers in Journal of The Asia Pacific Economy, Economics Bulletin, Journal
of Asian Economics, and Asian Economic Journal. Komain Jiranyakul can be contacted at:
jkomain@yahoo.com

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