Dynamics of the impact of currency fluctuations on stock markets in India: Assessing the pricing of exchange rate risks

Abstract

This paper studies the dynamics of the impact of currency fluctuation on Indian stock market by assessing the pricing of exchange rate risk during the period 2005–2016, specifically before and after financial crises. Estimating a two-factor arbitrage pricing model, using a random coefficient model, the paper presents evidence that stock returns react significantly to foreign exchange rate fluctuations in the post-crisis period. Particularly, during the last four years of our sample, 2012–2016, the exchange rate risk factor is becoming a prominent determinant of stock returns, indicating that Indian investors are increasingly expecting a risk premium on their investment for their added exposure to exchange rate risk. This is also further corroborated by the study by highlighting the fact that higher the foreign exchange exposure of industry, measured by trade balance (net inflows), higher is their sensitivity to exchange rate risk (βS). A plausible reason for such premium could be the inadequate hedging by Indian firms to mitigate the exchange rate risk. Keywords: Exchange rate risk, Arbitrage pricing theory, Stock returns, Risk premium, Hedging, Financial crisis, JEL classification: G01, G11, G12, G32