Currency devaluation and stock market response: An empirical analysis

•Stock market declines prior to and after currency devaluation.•Stock market declines more if devaluation is larger or if the country is a developing country.•Stock market declines more if reserves are lower or if country credit rating has deteriorated.•Stock market declines more if real exchange rate depreciated in prior years.

We study local stock market reaction to currency devaluation by a country's central bank. Devaluations appear to be anticipated by the local stock markets, and there are significant negative abnormal returns even one year prior to the announcement of the devaluation. A negative trend in stock returns persists for up to one quarter following the first announcement, and then becomes positive thereafter, suggesting a reversal. We explore whether changes in macroeconomic variables prior to currency devaluations are related to abnormal stock returns. We find that stock returns are significantly lower if the devaluation is larger and if the country is a developing nation. Furthermore, stock markets decline more around devaluations if reserves are lower, if the real exchange rate has depreciated over the prior years, if the capital account has declined, if the current account deficit has gone up, or if the country credit rating has deteriorated.