Mahesh Kumar

The relationship between exchange rates and key economic factors is crucial and may vary across countries depending on the economic context. This paper analyzes cointegration relationships among exchange rate, balance of payments, interest rate, inflation, and trade openness using the Johansen Cointegration Test in the context of the Indian economy. The study uses annual time-series data from 2008 to 2024. Stationarity of the variables is first tested using the Augmented Dickey-Fuller test. The Johansen Cointegration Test is then applied to identify long-run equilibrium relationships, while a Vector Error Correction Model captures short-term dynamics and adjustments towards equilibrium. The exchange rate makes modest adjustments across cointegrating relationships, sometimes restoring equilibrium, other times diverging from it. The balance of payments shows large coefficients, primarily amplifying deviations. The interest rate has minimal adjustment, showing little response to disequilibrium. Inflation and trade openness have small, negative coefficients, indicating weak correction toward equilibrium. Overall, the balance of payments amplifies deviations, while other variables show varying degrees of error-correcting behavior. The model explains 67.4% of the variation in exchange rate changes (R-squared = 0.674), with an adjusted R-squared of 0.5, accounting for predictors. The F-statistic (3.87, p = 0.0115) shows the model is statistically significant. Short-run changes in the exchange rate are influenced by past exchange rates, balance of payments, inflation, and trade openness, while interest rates play a minimal role.

Type of the article: Research Article

Abstract
Foreign exchange markets have intrigued not only corporations engaged in export and import, but also individuals and other entities seeking to achieve decent risk-adjusted returns and protect themselves from future currency exchange rate exposure. Hence, researchers are drawn to examine the volatility of returns and identify diversification and hedging opportunities to mitigate country and financial risks of the five largest trading currencies with respect to the Indian currency, the rupee. The study used historical daily exchange rate data for the Indian currency with respect to American dollar, euro, British pound, Japanese yen, and Australian dollar, spanning from January 1, 2008 to December 31, 2025.
American dollar has the highest average daily return among the five currencies, followed closely by euro and pound. Pound exhibits the highest standard deviation, and its volatility suggests greater uncertainty for investors dealing in these transactions. High correlations between dollar-euro and euro-pound indicate that they are influenced by similar economic factors or market sentiments. Frequent structural breaks highlight the possibility for currency exchange rates to shift dramatically due to unforeseen events. This is a crucial insight for risk management, as it signals the need for dynamic hedging strategies that can adapt to sudden changes in market conditions. Investors and policymakers can leverage these findings to optimize currency portfolios and reduce financial risk, especially when seeking diversification benefits and long-term stability amidst global market shifts.