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CHAPTER I
INTRODUCTION

1.1

Background
The issues of long-run relationship and short-run interdependence between

foreign stock markets and exchange rates have become an important topic in the modern
of financial economies. According to Ibrahim (2005), the degree of linkages or
interdependencies among the stock markets provides important implications on potential
benefits of international portfolio diversification and on financial stability of a country.
Many global investors choose to diversify their funds across these markets to reduce
portfolio risk. This trend has been pronounced in the world stock market when a new
currency which was Euro firstly implemented in the Europe zone. The effect of
introducing Euro has been a significant event in globalization of financial markets which
can loose position of US dollar as strong currency in the world. The Euro is expected to
play a significant role in Asian financial development especially emerging countries like
Indonesia, challenging the existing role of the US Dollar. This makes foreign investors
shift capital using Euro currency. The impact of volatile foreign exchange rate can either
increase or decrease national price stock market.
The recent emergence of new capital market, the launching of new currency and
the adoption of more flexible exchange rate regimes have increased the interest of
researcher in studying the interactions between the stock markets and foreign exchange
markets. The gradual abolition of foreign exchange controls in emerging economies has
opened the possibility of international investment and portfolio diversification. The

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choice of currency denomination has added an important dimension to the overall
portfolio decision.
Classical economic theory suggests a relationship between the stock market
performance and the exchange rate behavior. For example, "flow oriented" models of
exchange rate determination, Dornbusch and Fisher (1980), affirm that currency
movements affect international competitiveness and the balance of trade position, and
consequently the real output of the country, which in turn affects current and future cash
flows of companies and their stock prices. Movements in the stock market may also
affect exchange rates. According to Gavin (1989), equities, being part of wealth, may
affect the behavior of exchange rates through the demand for money according to the
monetarist models of exchange rate determination.
Bodart and Reding (1999) used conditional volatility models to show that, under
the different stages of the European Monetary System, an increase of exchange rate
volatility was associated with a decline in the correlation of national bond markets and an
exchange rate peg was associated with a reduction of bond price volatility. However, they
found only weak evidence on the interaction between exchange rate regime and equity
market behavior.
International stock prices are correlated for many reasons. First, the different
stock markets may be influenced by the same macroeconomic variables, such as trade
linkages between countries or booms and recessions in one country spilling over to other
countries. The rise in an interest rate of one country, caused by high inflation, would lead
to immediate fluctuations or interest rate movements in another country. The stock
market returns in these two markets would be affected by this potential rise in the interest

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rate, causing stock prices to fall due to two well-known facts. An increase in interest rate
makes it more attractive for investors to move their money away from stocks to other
financial instruments such as bonds. In addition based on Durre and Giot (2005), the
firms would face higher financial costs on their debt, which leads to a reduced cash flow.
Second, improved communication technology and the internet increased the speed
of dissemination of news across the globe. Another contributing factor to markets
comovement is the higher degree of cooperation among national governments in recent
years and the removal of trade barriers which prevented the flow of goods, services, and
capital.
Djiwandono (1995) said that improving economy world is influenced by
something that is firstly uncertainty and strong interdependence in world economy.
Secondly, tendency separated monetary economy from production and trade economy.
Thirdly, improving world economy is influenced by activity of global financing.
Existence stock market in one country supports improving economy through financing
business activities. This thing can be done by giving opportunity to community
participating in developing national economy. Stock market is one of sources for
financing national development outside sources that generally are famous such as fixed
deposit, savings, banking credit, and foreign funds (Sumantoro, 1990:51). In economy of
country, stock market has two main functions that are economy functions and financial
functions (Husnan, 1994). As economy function, stock market provides facility and place
to meet investors and party who need funds (issuer). With stock market, investors can
invest their funds with expected to get return, whereas issuer hopes to utilize the

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investment funds. While as financial function, stock market gives opportunity and
changes for investors to obtain return.
Levi (1996) stated that role of exchange rates are formed will be influenced by
innovations of factors such as fundamental, technical, and accumulated psychology in
certainty period. All of factors implicate a condition of exchange rates that tendency is
fluctuate and uncertainty of exchange rates will influence sales income, costs and profit
from business (domestic and international) involved in international goods and service
flowing.
With reasons above, this research would try to examine relationship between
foreign exchange rates & stock markets, and Jakarta Stock Exchange before and after the
introduction Euro. Exchange rates that are employed are US dollar, and Japan Yen
whereas the stock returns for these markets are calculated from the following indices: the
Standard and Poors 500 (S&P500) for the US, the Nikkei225 Index for the Japan, and
LQ45 Index for the Indonesia. The reason chosen US and Japan have the largest market
capitalization in the world and advanced economies (World Economic Outlook: 1998).
Reason choosing Euro currency is attractive for international transactions and has
a proven track record of stability also a well-developed financial market to trade the
currency. Euro currency represents twelve countries in Europe that are Austria, Belgium,
Netherlands, Finland, France, Germany, Republic of Ireland, Italy, Luxembourg, Spain,
Greece, and Slovenia. Almost of countries in Europe have big market capitalization such
as France, Germany, Italy, and Spain. While Almost of countries have joined to employ
Euro as single currency have advance economic.

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In this research, dynamic analysis means that linear relationship between a
variable in one certainty spot with other variables is different in group time. Dynamic
interactions are causal relationship that is happened in time series variable (Chen, 2001).
Variables that are employed in this research are changes of stock markets in advance
countries and changes of foreign exchange rates causing innovation of Jakarta Composite
Index.
This research will examine relationship between foreign exchange rates & stock
markets, and Jakarta Stock Exchange during pre and post the introduction of Euro
periods. The focus of research assess the Indonesia markets long-term relations, shortrun dynamic interactions, and interdependence with two foreign exchange rates (namely,
US Dollar, and Japan Yen) and two developed markets (namely, US and Japan) during
pre- and post-introduction of Euro periods. This research employs methods of Johansen
cointegration test, Granger causality in Vector Auto Regression (VAR) framework, and
error correction model.

1.2

Problem Statement
Based on introduction above, this research will address the question about the

relationship between abroad stock markets and foreign exchange markets toward the
Indonesia stock market during pre- and post- the introduction of Euro periods. Then the
problem can be stated as:
1.

What is the long-run relationship between the Indonesia stock market and the US
stock market?

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2.

What is the long-run relationship between the Indonesia stock market and the
Japan stock market?

3.

What is the long-run relationship between the Indonesia stock market and the US
Dollar currency?

4.

What is the long-run relationship between the Indonesia stock market and the
Japan Yen currency?

5.

What is the short-run interdependence between the Indonesia stock market and
the US stock market?

6.

What is the short-run interdependence between the Indonesia stock market and
the Japan stock market?

7.

What is the short-run interdependence between the Indonesia stock market and
the US Dollar currency?

8.

What is the short-run interdependence between the Indonesia stock market and
the Japan Yen currency?

1.3

Research Objectives
Therefore, the objective of this research can be derived from the problem

statement above. The objectives of this research are:

1.

To examine empirically cointegration relationship between the Indonesia stock

market and the US stock market in long-run.

2.

To examine empirically cointegration relationship between the Indonesia stock

market and the Japan stock market in long-run.

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3.

To examine empirically cointegration relationship between the Indonesia stock

market and the US Dollar currency in long-run.

4.

To examine empirically cointegration relationship between the Indonesia stock

market and the Japan Yen currency in long-run.

5.

To examine either bidirectional or unidirectional causality in short-run dynamic

that probably is existed between the Indonesia stock market and the US market.

6.

To examine either bidirectional or unidirectional causality in short-run dynamic

that probably is existed between the Indonesia stock market and the Japan market.

7.

To examine either bidirectional or unidirectional causality in short-run dynamic

that probably is existed between the Indonesia stock market and the US Dollar.

8.

To examine either bidirectional or unidirectional causality in short-run dynamic

that probably is existed between the Indonesia stock market and the Japan Yen.

1.4

Benefit Research
This research is hoped that can give some benefits are:
1.

For investor can give information that is needed to make decision for
investment before buying stock with observing changes of exchange rates and
abroad stock markets.

2.

For author, as media to train implementing knowledge and theory that have
been obtained for studying to implement in reality business.