Cointegration Relationship Between Exchange Rate Volatility and Performance of Nairobi Securities Exchange Market, Kenya

Abstract

The stock exchange markets in developing countries are generally characterized as unstable and shallow. The current international integration of financial markets provides a channel for currency depreciation to affect stock prices, thus there is need to identify if there is any relationship between the two markets. Specifically the study seeks to determine the trend and correlation between the exchange rate and the NSE 20 share index; and establish empirically the long run relationship between the exchange rate and the NSE 20 share index. Based on the theoretical framework on “flow-oriented” and “stock-oriented” models of exchange rates, the study will be able to determine the relationship between the two financial markets. Exploratory and correlational research design was used. The target population consisted of all the 55 stocks listed at NSE as at December 2011 from which NSE 20 share index is derived from. Due to the nature of the study of finding the relationship between the Exchange rate and the NSE 20 share index which are all time series. Correlation analysis, Augmented Dickey Fuller Test, and Engle and Granger (EG) Co integration Test were adopted using the use monthly time series from 1996:1 to 2011:12. The results indicated that there is a significant weak negative correlation between the NSE 20 share index and the exchange rate of -0.224. Both the series are integrated of order one. On the other hand, results from the cointegration regression indicate that the residual (error) series are not stationary at levels but it is stationary in the first difference or is generated by an integrated of order one process at both the 1% and 5% significance levels indicating no long run relationship between the two markets that is the Securities market and the foreign exchange market.

Keywords: Cointegration relationship, Exchange rate Volatility, Nairobi Securities exchange