Dynamic Response of Stock Prices to Changes in Foreign Exchange Rate

In Kenya, there has been volatility in exchange rates that have been deemed to have an adverse effect on the share prices. The study examined the dynamic response of stock prices to changes in foreign exchange rate. The target population consisted of monthly observations of the Nairobi All Share Index and the nominal Kenya shillings per US dollar exchange rates from the year 2008 to 2015. Secondary data was collected from Central Bank and Nairobi Securities Exchange. The research employed a Vector Auto-Regression model. Ordinary Least Square was used to examine long run relationship between stock prices and exchange rate on equation. The Vector Auto-Regression model was estimated and optimal lag length was obtained by use of Akaike Information Criterion. Vector Moving Average of the Vector Auto-Regression model with the subsequent derivation of impulse response functions and the variance decomposition was used to analyze the dynamic impact of changes in the level exchange rates on the stock prices. The study found that a one standard deviation shock in exchange rates initially leads to a negative impact on stock prices for the first six years, followed by a positive effect in the subsequent four years. The study concludes that exchange rate fluctuations have a significant and prolonged impact on stock prices, with effects that can last for several years. The study recommends that investors and policymakers should adopt a long-term perspective when considering the impact of exchange rate fluctuations on stock prices, given the extended period over which these effects materialize. In addition, companies engaged in international trade should implement financial instruments such as forwards and options to hedge against exchange rate risks. Keywords: Dynamic response, stock prices, foreign exchange rate, Kenya