Ahamed Lebbe Mohamed Jameel and Kevin Low Lock Teng
The growth of integration and international trade and financial liberalization has brought significant attention from academics, economists, investors, managers and policymakers to emerging economies to identify the exchange rates' effect on stock prices. While numerous studies have addressed this issue, they have failed to account for structural breaks; as a result, it is unclear whether the conclusion reached in previous work is valid or biased. The purpose of this paper is to examine the effect of exchange rates on stock market prices, with a particular emphasis on the structural breaks in the stock market prices of the Colombo Stock market. We used the All-Share Price Index (ASPI) of Colombo Stock Exchange (CSE) as the proxy for the stock market prices, while the exchange rate series of five different currencies expressed in Sri Lanka Rupees was the proxy for exchange rates. We identified structural break periods over the ASPI data from1997 to 2017 using the Bai-Perron structural break test and employed the Autoregressive Distribution Lag (ARDL) model to investigate the short and long-run effects foreign exchange rates on stock market prices. The study found that the exchange rates affect Sri Lankan's stock market in the short-run and long-run, but the effect is divergent (not homogeneous) in different structural break periods. The study recommends that the findings give the investors, portfolio managers, stockbrokers, and multinational corporations necessary implications to make significant investment decisions, predict market behaviour, and take practical preventive actions in the case of structural breaks in both markets. Further, these findings help policymakers and regulatory authorities design appropriate and strategically policies concerning the currency market in Sri Lanka.