The stock market alone is a vast concept and to understand the workings of the stock exchanges around the world, one needs to dive in deep. An interesting subject for many, it makes for a good hobby or an occupation as well. Owing to the numerous stock exchanges around the world which make up the global stock market, the foreign currencies of their respective nations are bound to play some part. This is where exchange rate comes into play! When the concept of exchange rate is first introduced in school, it probably scares a couple of students. Well, it is a complicated topic to begin with. It is quite interesting if one grasps the underlying notion but the whole aspect of perceiving it from the point of view of different countries makes it all the more confusing. But fret not! Not only will we be simplifying the idea of exchange rate but we will also be spelling out the correlation between the stock market and the exchange rate.
The stock market plays an important role in a country’s economy. It brings investors and shareholders together and provides them with a platform to trade financial instruments. This way, it helps in escalating growth. Moreover, it offers liquidity and hence improves efficiency.
On the other hand, the exchange rate is the value of one nation’s currency in terms of another nation’s currency. It is an indicator of the economy’s health. For example, if we talk about the Indian Rupee (INR) in terms of United States Dollar (USD), we can write it both ways i.e. 1$=75.14 ₹ or 1₹=0.013$, both are correct. The value of 75.14 is determined by the market forces and we arrive at the value of 0.013 by simply dividing the dollar by rupee (1/75.14=0.013). This rate is usually written as USD/INR= 75.14.
Although this concept can be confusing to get a hold on initially, it is a simple division coupled with the idea of shifting your point of view. A trick to make it easier is to think of yourself as the resident of the country at hand. For instance, if you need to study the INR in terms of USD, you put yourself in the shoes of an Indian and find out the amount of INR required to buy 1 USD. The same can be reversed and applied from the point of view of a resident in the US.
While studying exchange rates, we also come across the terms “Appreciation” or “Depreciation” of a currency. If a currency goes up in value, it is said to appreciate and if it falls, it is said to depreciate. Here again, there are two points of view. For example, if the rate USD/INR= 75.14 increases to USD /INR= 76 then one of the currencies is depreciating and the other is appreciating. But which is which? The logic here is simple – you were able to buy 1 USD with 75.14 INR before, but now you need to pay 76 for the same. Hence, USD has become more expensive and the value of INR has decreased.
This phenomenon happens under the Floating exchange regime. Under a free market mechanism, the exchange rate among countries is determined by the laws of supply and demand. It is allowed to float and is determined by the fluctuation in the foreign exchange market. It automatically adjusts itself and provides a cushion against global crises. But these fluctuations might undermine investors’ confidence in the domestic currency. This can make decision making difficult.
Countries can tie their currencies to another currency or a valuable asset as well. By doing this, they are “pegging” the value of their currency to a stable asset, hence, stabilizing their own currency. Stability can boost investors’ confidence in the home currency and increase the demand for domestic securities. Though this Fixed regime does offer security but under this, the government is required to maintain large amounts of reserves.
Nations can also choose a mid-ground. A Pegged Floating exchange rate system is a hybrid of the two regimes explained above.
With the rising complexity in global relations, the foreign exchange market has evolved too. The systems explained above are just a few of the many types of exchange rate systems which are popular among countries.
The correlation between the Stock Market and Exchange Rate has been widely discussed and debated. At first glance, buying and selling stocks may seem unrelated to the fluctuations in the exchange rates. But in today’s integrated global economy, nothing works in isolation. Exchange rate may affect or get affected by stock markets. Though there are little concrete evidence and no perfect science pertaining to this, financial and economic logic iterates simple facts.
Many theories do help in the determining and forecasting the exchange rate but one of the modern theories elucidates a relationship between domestic and foreign securities - The Portfolio Balance Approach (with regards to exchange rate). It suggests that market value of a firm can be affected by the health of the domestic currency. If the domestic market is performing well, then it would signify increased wealth which would lead to an increase in demand for the domestic currency. Subsequently, domestic assets would be more valuable and people would start selling off foreign assets causing a boom in the domestic market. This would ultimately lead to an appreciation in the domestic currency.
Whereas, if a currency appreciates, imports would become cheaper and hence the percentage of exports that make up the country’s trade would fall. This would lead to fall in domestic output and ultimately the stock price.
Although there isn’t a definite answer to whether there exists a relationship between stock prices and exchange rate, research shows that exchange rates do affect stock markets in some countries through the varied ways illustrated above.
As a trader, one needs to take everything in account.
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