Investor sentiments and exchange rate volatility

In this paper, we have investigated the role of investor sentiments on the exchange rate volatility in our emerging market. In the past there were many studies that tried to capture the impact of investor sentiments on the stock market returns but the exchange rates are also one of the important economic indicators and is frequently used as the stock market returns and interest rates etc, so we have tried to see the impact of investor sentiments on the exchange rate volatility. The data has been collected from International Monetary Fund website, Karachi Stock Exchange for stock returns and for the purpose to collect various sentimental proxies to measure sentimental index. Also we have not collected exchange rate data in relation to a single base currency rather we have selected a basket of currency i.e., SDR composing mainly of currencies like US dollar, Japanese Yen, Swiss Franc, Pound and Mexican Lira. For empirical testing we have used the sentiment equation mainly composing of six sentimental proxies that are dividend premium, number of initial public issues in a single year, closed end mutual fund discount, first day return on initial public offering, share turnover in Karachi Stock Exchange and equity share in total equity and long term debt issuance. We have run regression on the exchange rate volatility and independent variable was investor sentiment that we have used described above. Before that we also had applied Augmented Dickey Fuller test to check the stationarity and we have applied first differencing to make the time series stationary as in the first level place the series was unit root. Final results confirmed that the investor sentiments did explain the volatility in the exchange rates although the impact is low suggesting that there may be many other factors that explains the variation in the exchange rates. Introduction The foreign exchange market is among one of the most active financial markets having sheer volume of trading all over the world. As a result many of the past researchers have paid due attention on the foreign exchange market to examine the questions regarding speculative efficiency. The volatility in the stock exchanges is attributed to the two major yet somewhat contradictory reasons. According to some researchers the major swings in the exchange rates is attributable to the changes in fundamentals where as others argue that sentiments or anomalies of the investors also play major role in these swings in the exchange rates (Froot and Thaler 1990). https://ir.iba. edu.pk/businessreview/vol8/iss1/9 DOI: 10.54784/1990-6587.1220 Published by iRepository, March 2021 Business Review – Volume 8 Number 1 January – June 2013 124 The uncovered interest parity i.e. the difference between expected currency depreciation and interest differential implies that the interest differential is an estimate of the future exchange rate change. The impact of investor sentiments on the stock market and exchange rate volatility has been given importance with the advent of behavioral finance as much of the variance in stock markets and exchange rates is explained by these investor sentiments. In this paper we will try to find whether these sentiments of the investors affect the exchange rate volatility or not. We will use the investor sentiment index that uses six sentimental proxies on which the data has been collected mainly from the Karachi Stock Exchange. Exchange rate volatility will be calculated and regressed with the sentimental equation discussed above as the independent variable. This study will help us to find out the extent to which these sentiments influence the changes in the exchange rates. Problem Statement With the increase in international trading, the volatility in the exchange rates has increased to a large extent due to the fundamental as well as behavioral aspect thus raising the importance of sentiments that causes volatilities in the exchange rates. Research Questions o To what extent volatility in exchange rate is explained by the investor sentiments o To highlight the most explanatory sentimental proxies that play crucial role in exchange rate volatility. Literature Review With the development of real time information system and reduction in the transaction costs, daily foreign exchange turnover and the volatility in the foreign exchange rates has increased sharply. The increasing level of this foreign exchange turnover shows the large number of small transaction indicating the speculative behavior (Westerhoff 2001). Economics has a very different perspective especially from the social sciences in a sense that most of the behavior of the agents can be assumed as they make rational decisions and well defined preferences that are very much consistent with the preferences prevailing in the market whereas on the contrary, much of the empirical studies suggest that it is difficult to rationalize (Froot and Thaler 1990). The debate that either exchange rates are correctly priced or not is very much important as it effects the prices of all the foreign assets, goods and factors of production and also if the argument of Nurske is considered valid that the speculation in the foreign exchange market drives the prices from the fundamental values then the argument for intervention might be considered quite strong in the foreign exchange market (Froot and Thaler 1990). According to Yu (2011), investor sentiments have significant powers in explaining the returns on the foreign exchange. Talking about the irrational approach, an associated term is noise trader approach which says that that not all investors are rational so thus on the whole limiting the arbitrage possibilities, therefore https://ir.iba. edu.pk/businessreview/vol8/iss1/9 DOI: 10.54784/1990-6587.1220 Published by iRepository, March 2021 Business Review – Volume 8 Number 1 January – June 2013 125 suggesting that the shifts in the resulting sentiments cause high exchange rate volatility (Westerhoff 2001). Besides taking the role of investor sentiments, many of the past researches have taken into account factors like macro economic variables, heterogeneous expectations and central bank interventions to model exchange rate dynamics but much little research has been conducted in measuring the impact of market sentiment indicator on the exchange rate volatility (Brauchler 2005). Many of the researches have also focused on the central bank’s interventions on the volatility of the exchange rates and as a result of which, many studies have tried to find out the channels through which such intervention might be possible as much of the literature admits that central bank often intervene covertly in the foreign exchange market (Hung 1995). In the case where the dynamics are dominated by the strategies that are trend followed, leaning against the wind which in case would be the central bank will reduce the volatility of the exchange rates, otherwise when the fundamentalists do not know by themselves the fundamental values of the exchange rates, the leaning against the wind approach will increase the exchange rate volatility (Westerhoff 2001). There have also been opposing views regarding the sterilized intervention on the exchange rate volatility as according to some policy makers such intervention helps to lower volatility whereas on the contrary some analysts suggests that such interventions only create uncertainty and thus volatility (hung 1995). Country specific risks are sometimes thought to play an important role in shaping the behavior of the country’s macro economic variables particularly the exchange rates (Huang and Suchada 2003). In normal setting if the intervention strategies are used to reduce the volatility, then in certain circumstances the shrewdness of such strategies may determine the effectiveness of such strategies and in such a setting where noise trading is efficient in foreign exchange market, the authorities may use the strategies that enhances the volatility to manage the exchange rate level (hung 1995). According to Baker and Wurgler (2006), investor sentiments do represent significant power in predicting the foreign exchange rates and also returns on the foreign exchanges. Noise traders have a major role in the disruption in regularity of the rational investors as their non fundamental knowledge makes it more risky for the arbitrager, thus having noise impact on the stock market returns and vice versa. These noise traders have no sophisticated or specialized knowledge and their emotions play a major role in their investment decisions in stock markets (Glaser et al 2009). Many studies in the behavioral finance area tried to bring to surface proxies for investor’s sentiments that were thought to play a significant role in investor’s decision making regarding the stock returns but in making a comparative analysis of the techniques able to predict stock returns and behaviors, majority of them did not succeed (Lahmiri 2011). Both the associated variables i.e., the true expected growth rate and the sentiments (misperceived growth rate) have sufficient explanatory powers in predicting the changes in the exchange rates. High true expected growth rates predicts lower spot rate in the future whereas high sentiments predicts higher future spot rates Regression analysis in which both the investor sentiments and forward premium are included to explain the variation in the foreign exchange returns showed greater fitness of model https://ir.iba. edu.pk/businessreview/vol8/iss1/9 DOI: 10.54784/1990-6587.1220 Published by iRepository, March 2021 Business Review – Volume 8 Number 1 January – June 2013 126 than does the model in which only forward premium was included as the explanatory variable suggesting that investor sentiments contain information that is not explained by the forward premium (Yu 2011). According to Friedman (1953), as speculators buy low and sell high, This activity ensures that the exchange rates reflect the