Analysis of the relationship between stock market returns and exchange rates in Botswana

Abstract

This study aims to investigate the effect of bilateral exchange rate movements on stock market returns in the Botswana Stock Exchange (BSE), as measured by the domestic company index (DCI). The data used in the study is monthly data from 2001:M1-20014:M11. To examine whether this effect exists or not, Johansen cointegration test, Vector Error Correction model (VECM), Granger causality test, Impulse Response Function (IRF) and Variance Decomposition (VD) are employed. The empirical results indicate that there exists a long run equilibrium relationship between the stock market returns and exchange rates in Botswana. These findings corroborate those found by Mishra (2004), Phylaktis and Ravazzo (2005), Sohail and Hussain (2009) who explored the relationship in developed and emerging markets. The findings of the study revealed that the speed of adjustment in the VECM is significant and relatively slow. This implies that long run movements of the variables are determined by two equilibrium relationships. The causality test indicated a unidirectional causality running from exchange rates to the stock market returns. A significant causality relationship was established between the British Pound, US Dollar, Japanese Yen and the Domestic Company Index. The causality results are consistent with the flow-oriented exchange rate models proposed by Dornbush and Fisher (1980). Therefore, the evidence from this study implies that bilateral exchange rates have a significant effect on the performance of stock prices. As such, investors, bankers and portfolio managers and policy makers need to be vigilant with regard to the spill overs from the foreign exchange rate into the stock market.