In the recent past, there has been an outpour of inquisitive literature on the causes of exchange rate fluctuations and all these are because researchers, decision-makers, and policy analysts desire a much better understanding of relationships as well as causal factors of important and deterministic statistics values in economics. Almost daily, our knowledge of the nature of the driving factors of the various economies around the world is being updated by the trends in stock markets with some correlation with movements in crude oil prices. All these variables as we understand are subject to the demand and supply of exchange resources between individuals, firms, and countries. It can be thought of, by intuition, that International stock-market interactions exist within countries where crude oil is used as a medium of exchange as well as a standard of deferred value which of course stands to offset exchange rate fluctuations in some cases.
Of the existing body of existing literature that considers the relationship of the three variables of concern, Abdelaziz et al. (2008) considered the linkage between stock prices and exchange rates in four the Middle East emerging markets and revealed that the evidence on stock market prices and exchange rates relies almost independently on the introduction of a global market index. Their research also revealed that for the countries considered, crude oil prices emerge as the dominant factor in the relationship between stock index, crude oil price, and exchange rate. Their establishment of the relationship between stock prices and exchange rates is important for a prediction of the path of the exchange rate which may have implications for multinational corporations and investors alike in their decisions to trade with the country. Similar reasoning can apply to the case of Canada as a net oil exporter. Changes in the price of crude oil are important in explaining the movements of foreign exchange rates in Canada. When crude oil prices increase, there is an increase in government revenue from the sale of oil. Sometimes, this implies that government spending on infrastructure and public goods will rise. A consequence of this is usually in the positive build in the goodwill towards the country, experienced by foreign investors and businessmen alike. An important note from Abdelaziz et al. (2008) is that government policymakers may play a significant role in influencing real exchange rates and stock prices through oil prices.
Dimitrova’s (2005) study focused attention on the US and UK over a roughly fifteen year period with the view of establishing a linkage between stock market prices and exchange rates using a multivariate, open-economy, short-run model that allowed for a simultaneous equilibrium in the goods, capital, foreign exchange and stock markets in two countries. Her finding revealed that currency depreciation may depress the stock market and this implies that an appreciating exchange rate boosts the stock market. Changes in oil prices are affective of the demand on the CAD. Since oil is traded in USD, the CAD/USD exchange rate is affected as a consequence. Currency devaluation at this time may be applicable to cushion the effect of the exchange rate fluctuation and to check inflation as well.
In agreement with Basher et al. (2010), only little is known of the dynamic nature of the oil prices relationship with exchange rates and stock market prices. It is why an inquiry was made for the sake of a more complete understanding of the dynamic relationship between these variables. The result in their paper shows that oil prices can be predicted by a demand and supply model. An importance of this can be seen in establishing, that in addition to global supply and demand conditions for oil, oil prices also respond to emerging market equity markets and global financial capital markets. Another result is that an increased demand for global credit can put pressure on oil prices to rise and consumers in developed economies could end up paying more for oil and its related products. Also, actions taken by the central bank of a country affects the exchange rate of that country. Interest rate, as a monetary policy tool available to central banks affects exchange rate dynamics. Favorable interest rates are attractive to investors. An inflow of investors into Canada will increase demand on Canadian goods and services as well as the TSX Index.
Because our paper seeks to establish the relationship between the three variables, we now move our discussion to Yanagisawa’s (2010) paper that sought to answer the question on whether higher share prices and weaker US dollar could lead to higher crude oil prices. The research results found a positive correlation between crude oil prices and share prices and a negative correlation between crude oil prices and exchange rates which meant that higher share prices as well as a weaker US dollar led to higher crude oil prices. There was also an inspection conducted on the data characteristics of these variables and the result will now make us think of the relationship between the variables as having a relationship with time as Yanagisawa (2010) found bidirectional causality between any two of the variables in 2008. A typical TSX trader is in business to make as much return on investment as possible. Stocks in oil related sectors can be conjectured to make the most profit when prices go up. Higher oil prices, if unchecked may translate to higher commodity prices and this invariably affects exchange rates, most especially against the currency that the oil is traded in.
Yanagisawa (2010) is not left alone in his finding that our variables are related to time. Amano and Norden (1995) of the bank of Canada after a survey of exchange rate models also believed that whenever sample periods are extended, monetary models fail to fit the data as they might have for earlier periods. So, time series research and analysis on the determinants of real exchange rate may help us better understand the components that play a major and significant role in real exchange rate determination. Interestingly, they were able to identify a real factor by examining the ability of real domestic oil prices to account for permanent movements in the real effective exchange rate of some first world countries including the United States. If oil prices can cause permanent movement in the exchange rates of the USD, then the CAD’s conversion will be indirectly affected.
Imarhiagbe (2010) also helped contribute to our literature in his investigation of oil price relationship with stock prices and exchange rates in the long-run by identifying three major oil producing countries as well as three major oil consuming countries based on availability of data. He tested each variable for evidence of unit root and then probed the dynamic link between financial markets, exchange rates and changes in oil prices. The TSX Index, crude oil prices, CAD/USD exchange rate are three of the very important economic indicators in Canada. A check on the dynamic link between these indicators is paramount to our understanding of the effect that may be caused on the other variables by changes in any one of them.
Time series method was used by Wang et al. (2010) in their exploration of the impacts of fluctuations in crude oil price, exchange rates of the US dollar against other currencies among other variables on the stock price indices of the United States, Germany, Japan, Taiwan, and China. They also considered the long and short-term correlations among these variables. Empirical results presented by their findings revealed co-integrations among fluctuations in oil price, exchange rates of the dollar against other currencies and the stock markets in Germany, Japan, Taiwan and China. An indication that can be inferred here is the long-term relationship among these variables.
This paper seeks to establish the correlation that may exist between stock index, crude oil price, and exchange rate. It is almost commonsensical that oil is a major world commodity that drives most economies and we demonstrate the relationship of changes in its price with CAD/USD exchange rate and TSX Index. An understanding of this relationship is of utmost importance because of the role these variables play in the determination of trade in terms of foreign investment and demand for locally produced goods and services both locally and by foreigners seeking to buy Canadian goods and services. The CAD/USD exchange rate consideration is very important because the transaction currency in oil markets is USD and stock value of the CAD will be affected whenever there is an adjustment in the USD due to oil price fluctuations and or exchange rate adjustment. It is why some countries have devalued their currency against the dollar. One of the possible results is that they experience oil rise in price. The flexibility in exchange rate does not necessarily imply abandoning pegging in favor of a floating exchange rate. Mindful countries manage exchange rate with a view of the implications that may be brought about by the changes in the exchange rate on the demand and supply sides of the economy, both in the short, market and long run scenarios. Trade offs are absolutely necessary as most nations strive to achieve stability in the real effective exchange rate over time.
Oil prices will affect earnings of industries and firms where oil is a direct input to its production process. Since oil is heavily depended on for running the economy, oil price fluctuations will definitely affect domestic financial market as well as the perception on these markets by foreign investors. While the effect may not be immediate on stock prices, most of the literature considered established an affective relationship between these variables, most especially in times of a shock and there seems to be a common agreement on the types of policies governments should take in terms of shocks. While some of them proposed fiscal policies, others discussed more on monetary policies. These policies will in turn affect investment, exports and imports which are affective factors to the exchange rate and stock indices of any country.
Next, we proceed to discuss the unit root process, cointegration and error correction models in the following section before describing the data and results in Section 4. Empirical results will be analyzed in Section 5 and Section 6 will conclude the paper.
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