AN ANALYSIS ON THE RELATIONSHIP BETWEEN SECTOR STOCK RETURNS AND FOREIGN EXCHANGE RATES IN SRI LANKA: EVIDENCE FROM ARDL APPROACH

Abstract

The relationship between stock returns and exchange rates is a widely discussed topic among scholars across the world. However, there is no universal agreement in this regard and many researchers offer mixed evidence on the association of stock returns and exchange rates. This relationship can be twofold which are long run and short run. However, many researchers examined the association of overall market index of a particular country and exchange rates. There is a dearth of research on specific sector returns and exchange rates. But it is a general truth that some sectors are more exposed to exchange rate risk than other sectors. In this paper, we explore both short run and long run relationships between stock returns of 20 sectors in Colombo Stock Exchange, Sri Lanka and five selected exchange rates which are US Dollar (USD), Indian Rupee (INR), Japanese Yen (JPY), British Pound (GBP) and Euro (EUR). The Auto Regressive Distribution lag approach (ARDL) is used for this study. We found that all the sectors have a long run association with selected exchange rates using ARDL bound test. Further we found that there is no significant short run relationship between sector stock returns and exchange rates using the Wald test. We observe several weaknesses in our short run results which are significant error correction terms (ECT) with positive sign, unstable regressions revealed by Cusum test and the presence of serial correlation. ECTs with positive sign is mainly due to structural changes happened in the Sri Lankan economy and society throughout our study period from 2004 to 2019. More important structural changes are end of the armed conflict in 2009 and liberalization of the Balance of payment and foreign exchange management policy by the Sri Lankan Government. Future researchers have the opportunity to use the insights of our study by employing time series tests such as Chow break point test in order to overcome the problem of ECTs with a positive sign. Further our study will be useful to regulators to impose effective foreign exchange management practices and industry experts to understand and manage foreign exchange exposure to their industries in more meaningful manner.