Author(s): Ahamed Lebbe Mohamed Jameel and Kevin Low Lock Teng
This study aims to examine the effect of exchange rate volatility on the stock market return volatility of the Colombo Stock Exchange, focusing on the structural break in the US Dollar (USD) exchange rates in terms of Sri Lankan Rupee (LKR). The structural break periods (SBPs) were detected based on structural break dates measured by using the Bai-Perron structural break test. The volatility of the USD exchange rate is used as an independent variable, whereas the All Share Price Index (ASPI) returns of the Colombo Stock Exchange (CSE) is used as a dependent variable in this analysis. The study utilised weekly data from 1997 to 2017. Moreover, we employed the Generalised Auto-Regressive Conditional Heteroscedasticity (GARCH) model to estimate the exchange rate volatility of USD and to explore ER volatility effect on the stock market returns volatility. The study found that (i) the volatility shocks are persistent in the USD exchange rate and ASPI in an extended period and different SBPs. (ii) Sri Lankan stock market is affected by the currency market volatility, but the effect is no homogeneous throughout the extended period of the data, instead, it varies in different SBPs. Freely open ER policy actively contributes to currency market volatility on the Sri Lankan stock market volatility than managed floating ER policy. The study recommends that the findings give necessary implications for the investors, portfolio managers, stockbrokers, and multinational corporations to make significant investment decisions and predict market behavior and take practical preventive actions in the case of volatility and the occurrence 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.