The Relationship between Volatility of Exchange Rate and Volatility of Stock Return in Iran using Multivariate GARCH Model

The instability of foreign exchange market increases the firms’ costs through increasing uncertainty in investment pay off and consequently, raises their stock returns instability. On the other hand, the instability of the stock returns may change the demand and supply of foreign exchange through the wealth of stock holders, the liquidity and interest rate as well as capital inflows and outflows and then, it volatiles the exchange rate. In this framework, the main purpose of the present research is to investigate the relationship between the volatility of stock return and exchange rate uncertainty in Iran. To study the effect of exchange rate volatility on the return, we have used CAPM and ICAPM and to study the effect of asset return volatility on the exchange rate, we have employed the asset portfolio approach. The research hypotheses have been tested by using a multivariate GARCH model and quarterly data during 1991-2011. The empirical findings indicate the positive effect of real exchange rate volatility on the stock return fluctuations. In contrast, empirical results of this research show that the stock return fluctuations do not affect on the exchange rate volatility. In the framework of the findings, we suggest that policy makers should pay attention to monetary and fiscal discipline and inflation control but not to make policies causing fluctuations in the markets.