Analysis Of The Long Run And Short-run Dynamic Relationship Between The Stock Prices And Exchange Rate In Kenya

Abstract

Stock markets in the world individually and collectively play a critical role in their countries’ economies. They provide an avenue for raising funds, for trading in securities including futures, options and other derivatives which provide opportunities for investors to generate returns. This study examines whether there is a long run and short-run dynamic relationship between the stock prices and exchange rate in Kenya. The study also explores the direction of causation if a long/short-run association is found. The objective is to establish the causal linkages between leading prices in the foreign exchange market and the Nairobi Securities Exchange (NSE). In particular the study uses monthly observations of the NSE 20 share index and the nominal Kenya shillings per US dollar exchange rates as observed by the Central Bank of Kenya from January 1996 to December 2010. Specifically the study uses the monthly prices of the 20 Share index to compute stock returns and the Kenya shilling/ Dollar ratios on a monthly average basis to compute exchange rates which will be used to investigate the causal relationship using granger causality test. The study employs cointegration and standard Granger causality tests based on the vector auto correlative model to examine the long-run and short-run association between stock prices and exchange rates. The unit root Augmented Dickey Fuller test is used to test the stationarity condition for all the time series in the level and first difference. The Johansen cointegration test is used to investigate whether foreign exchange rates and stock prices are cointegrated. Finally a Granger causality test will be performed to find the direction of the relationship between exchange rates and stock prices within the estimated model. The results show that exchange rates Granger-causes stock prices in Kenya and in only that one way are the two related that is a uni-directional causality relationship.