Print Email Download Reference This Send to Kindle Reddit This
submit to reddit

Impact Of Macroeconomic Indicators On Capital Market Finance Essay

Abstract

This paper will study the relationship existing between interest rate, exchange rate, inflation and stock return in Pakistani Economy. The data over the period of 1998-2009 is collected for this research study. Stock returns and prices are represented by KSE-100 index. It will examine the causal relationship between macroeconomic indicators and stock returns in Pakistan. Macroeconomic indicators are inflation, exchange rate and interest rate.

Key Words: Macroeconomic indicators, KSE

Introduction

The primary function of capita market is to facilitate flow of funds from having surplus liquidity of deficit units. The greater the efficiency of such funds, the higher the rate of the economic growth. An efficient capital market enhances the liquidity of capital asset and minimizes the transaction costs and improves rate of return. Both sizes of issues (depth) and diversity of issues (breadth) in capital markets lead to lower transaction costs and thus results in increased investment in financial assets.

In today’s economy the role of stock exchange is very important. its function is to act as mediator between savers and borrowers. it mobilizes savings from large number of small investors and channelizes these funds into fruitful investments. It allocates funds among corporations and sectors. The leading stock markets of the world observed negative growth range 50.7% (Pakistan) to 2.9% (China) during the fiscal year 2008-09 (economic survey of Pakistan).

This research paper will discuss about the macroeconomic indicators and their impact on capital market i.e. stock exchange. The macro economic indicators effect stock returns in Pakistan. Interest rate and foreign exchange rates are key macroeconomic variables. Interest rate is the borrowing money price or the cost money. There are different kind of interest rates like short term and long term interest rates, the change in which causes problems to investors. Now, foreign exchange rate is the rate at which one currency can be transferred into another currency. Country imports and exports suffer because of abrupt changes in exchange rate. These two variables affect the profitability and returns of business that’s why we see large fluctuations in stock market, if any change occurs in any of these two variables.

About KSE

The three stock exchanges operating in Pakistan are KSE 100-index, LSE-25 index and ISE-10 index. KSE was established in 1949 and is Pakistan’s largest stock exchange. Since independence Pakistan found huge socio and political problems. In 1991 economic reforms were taken to resolve the problems. The most important was to liberalize the stock market for foreign investors and allowing foreign direct and indirect investment for the first time in Pakistan. These reforms produced positive impact on stock market index.

KSE has share of 70% of total stock transaction on Oct 1, 2004, 663 companies were listed in KSE. The market capitalizations were $23.23 billion. As a result Pak foreign investments and industrial export grow rapidly. Presently our stock market traded in

International market. SECP (Security Exchange Commission Pakistan) allows joint venture with foreign and local brokerage houses which gives new fund interest in Pakistan stock market.

KSE is a leading stock exchange for which it was stated the “Best Performing Stock Market of the World for the year 2002”.it has been ranked for 3 year of being the best performing market of the world in “Business Week” ,an international magazine. Around 654 companies were registered at KSE with market capitalization of US $33.81 billion on Sept 5, 2009. The stock market Pakistan remained volatile for the last few years and the reason of this volatility was political uncertainty and instability such as judiciary crisis, terrorists’ attacks, and assassination of Benazir Bhutto.

Research Questions

Does stock exchange reflects the economy of Pakistan?

Can macroeconomic indicators be used to predict stock returns in Pakistan?

Research Objective

The main focus of my research is on relation between macroeconomic variables and stock prices and returns. And also the impact of such variables on stock prices and returns.

Literature review

N’dri.Konan Leon (2008) estimates the impact of interest rate on stock returns in Korea. For this purpose he took the weekly data on Korean Stock Price Index 200 (KOSPI) for the period of six years (1992-1998) as dependent variable and weekly Negotiable Certificates of Deposits (Korea NCD 91-Day yield) for the same time as independent variable and run the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) and reported that the Conditional market return have a negative and significant relation with the interest rate. John Beirne et al (2009) examined the market, Interest rate and Exchange rate risk effect on the financial Stock returns. To examine this fact they selected three sectors (Banking, Financial Services and Insurance) of 16 different countries including some European countries. They used fourvariate GARCH-M Model. Their variables were short-term debt (90 Day treasury Bills Rate) and 10-years Government bond yield for all the countries. Overall results showed that interest rate and exchange rate effects common in banking sector and financial services but in insurance sector interest rate and exchange rate have limited effect.

Charles et al (2008) estimated the effect of exchange rate on the stock market in Ghana. By taking Treasury bill rates, money supply, foreign exchange rate, inflation and trade deficit as independent variables, using Exponential Generalized Autoregressive Conditional Heteroskedascity (EGARCH) reported that there is a positive relationship between stock market and consumer price index. They also found that whenever the inflation rate is high the volatility of stock returns also high. Overall their result shows that the relationship between macro variables and stock returns are significant.

Md.Mahmudul Alam and Md.Gazi Salah Uddin (2009) estimated the relationship between interest rate and stock returns from developed and developing countries. To examine this they collect the monthly Stock Exchange Index and interest rate from January 1998 to March 2003 of fifteen countries and run the panel regression. They concluded that there is negative relationship between interest rate and stock returns.

Manish Kumar (2008) examined the relationship between Stock prices and Exchange Rate. He collected the daily closing prices of S&P CNX Nifty and INR/ USD exchange rate for the period of 1999-2009. He performed unit root and Co-integration test for long run relationship and linear and non-linear granger causality test for dynamic relation between these variables and argued that there is no long-run relationship between stock index and interest rates but there is bidirectional linear and nonlinear granger causality between stock returns and exchange rates.

Barry V. Cozier and Abdual H Rahman (1988) investigated the stock returns, Inflation and real activity in Canada. Firstly by using rational expectations forecasting procedure, they decompose Canadian inflation series into expected and unexpected components. They argued that there is negative relationship between stock returns and inflation.

Fabio Canova, CEPR and Gianni De Nicolo (1997) analyze the Stock return, term structure, inflation and Real activity for US, Japan, Germany and UK and concluded that nominal stock returns are negatively correlated to inflation only in the US and insignificant for other countries.

Fama (1981) reported that stock market return negatively correlated with the expected inflation and interest rates. Nikiforos T laopodis (2010) investigate the monetary policy and stock market dynamics across monetary regimes. For this study, he collected the Fed’s federal funds and S&P 500 index stock prices for the time span of 1970 to 2005, divided it into three monetary regimes of Burns, Volcker and Greenspan and run vector autoregressive (VAR) model and resulted that throughout each monetary regime effect of monetary policy on stock returns is significant.Olivier J. Blanchard (1981) examined Output, the Stock Market, and Interest Rates concluded that initial inflation may lead to lower real interest rates initially, and to a larger initial change in the stock market.

Francesca Carrieri and Basma Majerbi (2006) examined the pricing of exchange risk in emerging stock markets. They cover eight countries (Argentina, Brazil, Chile, Mexico, Greece, India, Korea, Thailand and Zimbabwe) and collect the returns on monthly basis. They express all returns in 30-day Eurodollars interest rate as proxy for risk free rate and concluded that common exchange risk factor is marginally significant for large size

Portfolios. Sebastian Edwards and Raul Susmel (2003) investigate interest volatility in emerging markets. They collect the 30-days domestic interest rates of five countries (Argentina, Brazil, Chile, Hong Kong and Mexico) and GARCH Model and concluded the hypothesis of independence cannot reject.

Kaul (1990) examined the relationship between expected inflation and the stock market and resulted there is negatively correlated with real activity. According to Fisher’s Hypothesis, the market rate of interest included the expected real rate of interest and expected inflation (Fisher, 1930). As nominal rate of interest and rate of inflation moved one-to-one, then, real rate of interest was not affected by a permanent change in inflation rate in the long-run. Thus, it was concluded that stock returns and rate of inflation moved in the same direction. Hence, real assets such as shares perhaps provide hedge against inflation.

Chatrath et al. (1997) investigated relationship between stock returns and inflationary trends in India. The author’s study provided an evidence of a negative relationship between market returns and inflationary trends in India. Ratanapakorn and Sharma (2007) reported a positive relationship between stock prices and inflation. Humpe and Macmillan (2009), illustrated negative impact of inflation on stock prices. Fama (1981) examined the relationship between real output and stock prices and showed that there was strong relationship between stock prices and gross national product. Humpe and Macmillan (2009) explored positive long-run relationship between stock prices and the industrial production in US.

Several economists documented the impact of foreign exchange rate on stock prices during the last two decades. Aggarwal (1981), Soenen and Hennigar (1988), Bahmani-Oskooee and Sohrabian (1992), Abdalla and Murinde (1997), Bhattacharya and Mukherjee (2003), Smyth and Nandha (2003), Farooq and Keung (2004), Aquino (2004), Aquino (2005), Homma et al. (2005), and Hartmann and Pierdzioch (2007) tried to explore relationship between exchange rate and stock prices. The theory demonstrates that changes in the exchange rate have an important bearing on a firm’s overall profits through firm’s foreign operation which results fluctuations in stock prices. The intensity and direction of changes in share prices depends upon the nature of the firm. Mixed results were found among industrial countries by Aggarwal (1981) and Soenen and Hennigar (1988).

Aggarwal (1981) established positive relationship between the exchange rate

and US stock prices. Soenen and Hennigar (1988) found negative correlation

between the two variables. Ratanapakorn and Sharma (2007) explored positive relationship between stock prices and money supply in US. While, Humpe and

Macmillan (2009) found negative impact of money supply on NKY225 in

Japan. Some studies reported positive impact of interest rate on stock returns

While; some studies explored negative relationship between these two

variables, e.g. Ratanapakorn and Sharma (2007) reported positive

Relationship between S&P 500 and Treasury bill rate in US and Humpe and

Macmillan, (2009) found negative impact of Treasury bill rate on SP55 in US.

Fazal Hussain and Tariq Masood (2001) used variables investment, GDP and consumption employing granger causality test to define the relationship among the selected variables and stock prices, finding shows at two lags of all variables are highly significantly effect on stock prices. Robert D. gay (2008) evaluated the association among stock prices and macro economics variables in cases of China, India, Brazil and Russia which are emerging economies of the world using Oil price, exchange rate, and moving average lags values as explanatory variables employing MA (Moving Average)

method with OLS (Ordinary least square) and found insignificant results which postulate inefficiency in market.

Finally they concluded that in emerging economies the domestic factors influence more than external factors i.e. exchange rate and oil prices. Dr. Aftab (2000) examines the association between monetary and fiscal policy of Pakistan to equities market and the result of his analysis is significant. The result shows that fiscal and monetary policy could change market capitalization by liquidity and equity which can significantly affect the

Market capitalization and stock prices in case of Pakistan from the period 1993 to 1998. Liaquat Ali and Nadeem Ahmed (2008) used data from 1971 to 2006 and try to find out the relationship of economic growth with stock market prices and study shows that there are dynamics association between stock prices and economic growth employing DF-GLS test first time in case of Pakistan.

M. Shahbaz (2006) investigated the association between stock prices and rate of inflation using ARDL approach for dynamics analysis. Result of this study depicts that stock hedges are not in favor of inflation in long run as well as in short run and found that black economy effects long run and short run prices of the stock. The study used variables CPI, (inflation) and share of black economy the sample size of the study is 1971-2006. Safail Sharma (2007) used interest rate, exchange rate and reserve, industrial production index,

Monetary growth and inflation as independent variables with AR and MA to nullify the effects of non stationary in the variables. The result shows that lags values are highly connected with current share prices which recommend the speculation in market. Exchange rate and reserve, industrial production index and monetary growth are significantly associated. The study took data set from 1986 to 2004.

Desislava Dimintrova (2005) used multivariate model and try to find out link among stock prices, exchange rate and economics policy (fiscal and monetary policy). The study defines the interest parity condition affects on stock prices. The result shows that ambiguous affects of deprecation on Stock prices.

Hypothesis

The hypothesis for this research study is that macro economic indicators affect the capital market either positively or negatively. The macro economic indicators are inflation, exchange rate and interest rate.

The macroeconomic indicators like inflation, exchange rate and interest rate have significant impact on economy. The increased interest rate increases the cost of business which in turn lowers the stock returns while decreased interest rate increases the stock returns thus change in interest rate has negative impact. Same is the case with exchange rate but in opposite direction. When foreign exchange rate increases the stock returns also increase and vice versa. Thus the change in exchange rate has positive impact.

Likewise inflation has negative relation with stock prices. As Pakistan is suffering from galloping inflation so the increase in stock prices occurs and returns declines slightly. High inflation was recorded in the month of May, 2008 resulted in the unexpected increase in interest rates by SBP which eventually resulted in sharp fall in Karachi Stock Exchange.

TABLE:

Stock Return

Change in Interest Rate

Change in Exchange Rate

Mean

20%

(3%)

(10%)

Standard Deviation

60%

40%

30%

This table indicates that stock market returns over the period of 1998-2009 is 20%.the change in interest rate over the same period is -3% and change in exchange rate is -10%.the standard deviation for stock return, change in interest rate and change in exchange rate are 60%, 40%and 30% respectively.

Stock prices and interest rate: increase in interest rate cause to increase opportunity cost of holding money which can cause to change portfolio diversification between stock and interest bearing securities as a result stock prices fall. Another reason for falling stock prices is that when interest rate increases it can cause to raise cost of production which deteriorate companies profit and dividend results reduce the prices of shares and inturn returns reduces as well.

Stock market and money supply: increase in money supply cause to increase in inflation

therefore people maintained their real cash balances consequently they sell shares and other assets which cause to decline the share prices but on the other hand increase in monetary growth reduces the interest rate which cause to reduce cost of capital and increase earning of corporation.

Stock market and exchange rate: As stock market is liberalized it can cause to reduce the risk premium and increase competitions in stock market ultimately stock prices have been increased. As foreign exchange currency inflows resulting increases in supply which can cause to appreciate local currency consequently prices of share increase and that improve foreign exchange reserves which cause to appreciate exchange rate while other factors remain constant.

Research methodology

The study used secondary data collected from internet and research studies of 2008-2010.

Population

Population includes all stock exchanges of Pakistan that is Karachi stock exchange, Lahore stock exchange and Islamabad stock exchange.

Sample

Karachi stock exchange is the sample for this research study with the data of 2008-2010.

Conclusion

From this paper following conclusion is drawn

Negative relation between interest rate and stock returns.

Positive relation between exchange rate and stock returns.

And negative relation between inflation and stock prices and returns.

Print Email Download Reference This Send to Kindle Reddit This

Share This Essay

To share this essay on Reddit, Facebook, Twitter, or Google+ just click on the buttons below:

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay.


More from UK Essays