The Relationship between Exchange Rates and Islamic Indices in Malaysia FTSE Market: A Wavelet Based Approach

The issue of relationship between exchange rate and stock market is still not conclusive even though many studies have been done and the results are mixed. There is no theoretical consensus on the relationship between stock prices and exchange rates. Thus, this paper aims to examine the relationship between exchange rate and Islamic stock return in Malaysia FTSE market and identify the direction of causation between these two variables by using a time scale decomposition analysis based on the theory of wavelets. In particular, we apply the maximum overlap discrete wavelet transform (MODWT), wavelet variance, wavelet correlation and cross-correlations to analyze the association as well as the lead/lag relationship between the two series at different time scales. The findings based on the time-scale decomposition analysis indicate that the relationship between stock returns and exchange rate is not fixed over different time scales and, in particular, the stock returns are leading exchange rate at the shortest scales, i.e. at scales corresponding to periods of 2-4 days. However, in scales with 8-16 days and 64 days and longer, the stock returns and exchange rate mainly lead each other indicating a bidirectional relationship. Such a result accords quite well with the conventional wisdom which suggests that the investors with longer term horizons are likely to be linked with the macroeconomic fundamentals in their investment activity.