Abstract:
Sri Lanka is experiencing a foreign exchange shortage, which has reduced its
ability to purchase food and fuel and led to a complete default on its
international debt. This economic vulnerability has created a political
instability in the country. Accordingly, this situation has been directly
impacted to the Colombo Stock Exchange since investors will remain under
a fear of losing their wealth. Thus, this study aims to examine the
relationship between exchange rate and stock prices through interest rate
and inflation being they are the most critical economic indicators for the
current economic crisis. Monthly data were collected for the period from
June 2014 to May 2022 and dollar rate was used as the exchange rate, three
months treasury bill rate was used as the interest rate and inflation rate
announced by the Central Bank of Sri Lanka based on the National Consumer
Price Index, was used as inflation rate. Structural equation modelling was
used to analyze the data. The results indicated that the exchange rate had
significant negative relationship with stock prices. Sobel test indicated that
the interest rate significantly mediated the relationship between exchange
rate and stock prices while inflation rate was not. Authorities should take
actions to create political stability immediately while restructuring its debts
to reduce dollar out flows. If they are able to control, however, the exchange
rate fluctuations while reducing imports and increasing exports, it will be a
proper solution to have good economic condition of the country. Then, they
can secure the financial market of the country, increasing the confidence of
the investors of the market.
