Does Predicted Macro Economic Volatility Influence Stock Market Volatility Evidence From The Bangladesh Capital Market
Does Predicted Macro Economic Volatility Influence Stock Market Volatility Evidence From The Bangladesh Capital Market
Does Predicted Macro Economic Volatility Influence Stock Market Volatility Evidence From The Bangladesh Capital Market
Authors:
M. Selim Akhter
Associate Professor
Department of Finance and Banking
University of Rajshahi, Bangladesh
Currently PhD Student
University of Western Sydney, Australia
Abstract
According to the famous Capital Asset Pricing Model, mMarket return , proxied by return
fromfrom a broad-based market index should be related to the risk associated with
macroeconomic health of thean economy as the later affects an individual firm’s cash flows
and the systematic risk component. Therefore, the overall performance of Macroeconomic
condition of a firm in terms of its contribution to the market portfolio return, in turn, can be
evaluated based on some macro variables like GDP growth, inflation, etc. In this paper, the
main aim is to findexamine how the macroeconomic risk associated with industrial
production, inflation, and exchange rate is relatedreflected to the stock market return in the
context of Bangladesh. capital market. Monthly data for the 1990.01-2004.12 period are
considered for the study. Since many macroeconomic variables and stock returns are believed
technique is used to find predicted volatility series for the variables considered in the study.
Finally, VAR (Vector Autoregression) is employed to investigate the relation between the
variables. Results show that there is significant unidirectional causality going from industrial
production volatility to market return volatility and from market return volatility to inflation
volatility, . the later being inconsistent with theConsidering all the findings, it can be
concluded that there is relation between stock market volatility and macroeconomic volatility,
but it is not that strong as suggested by standard finance theory warrants further study
1. Introduction
As far as a risk averse investor is concerned, uncertainty is the most important factor in
pricing any financial asset. According to most asset pricing theories, uncertainty or risk is
determined by the covariance between asset return and the market portfolio. Although it has
been recognized for quite some time that the uncertainty of speculative prices, as measured
by the variances and covariances, is changing through time, it was not until recently that
financial economists have started explicitly modeling time variation in second- or higher-
order moments. Sufficient evidences are still to come from emerging markets like the Dhaka
Chowdhury and Rahman (2004) have studied the relationship between the predicted volatility
of DSE returns and that of selected macroeconomic variables of Bangladesh economy. They
have followed the methodology of Schwert (1989; 1990) to calculate the predicted volatility
of the variables used in the study. They have calculated volatility from errors after using an
autoregressive and seasonality adjusted forecasting model. The volatility series derived from
such process has some limitations, which have been corrected in Generalized Conditional
example, empirical research has found evidence of large changes in stock prices are followed
by small changes of either signs. Therefore GARCH models, which take into account the
volatility-clustering phenomenon of security prices, is more suitable in modeling volatility of
financial assets and macroeconomics variables like exchange rates, industrial production,
In the context of present value model of asset pricing, stock price depends on future cash
flows as well as on discount rates. Since future macroeconomic condition obviously has
impact on the future cash flow of a firm, it surely adds to the volatility of stock return when
there is uncertainty about the future health of the economy. In this study we try to find out the
relation between the volatility of stock returns and that of some selected macroeconomic
variables. Considering the nature of financial assets and macroeconomic variables, we use
GARCH (1,1) models to estimate the predicted volatility of the asset returns and other
variables (industrial production, exchange rate and inflation) used in the study. Since there is
a strong link between macroeconomic health of the economy and the stock market return, any
shock to macro economy must impact the stock market return. This is obvious since any
shock to macroeconomic variables is a major source of systematic risk and there is no way
that even a well-diversified portfolio like market portfolio constructed from stock market
index can shift it to anywhere else. After calculating the predicted volatility series, we are set
to use some econometric tools. Since there can be delayed response from any shock to any of
the variables, we perform the Granger causality test. Finally all the variables are considered
in Vector Autoregression (VAR) to see more precisely how any shock to one of the variables
This paper is organized as follows. Next section discusses the notable findings of the
research on the risk-return relationship in the context of the DSE and developed markets.
Section 3 gives the details of how the data are collected and then processed to obtain the
volatility series and what methodologies are used in the study. Section 4 analyzes the
empirical results found from the econometric models. Section 5 concludes the paper with
synthesis of results, policy implications, and possible remedial measures to develop the
market.
Many researchers have studied the volatility of stock market in the context of developed
markets. Officer (1973) shows that aggregate stock volatility increased during the Great
Depression, as did the volatility of money growth and industrial production. He also shows
that stock volatility was at similar levels before and after the depression. Black (1976) and
Christie (1982) find that the stock market volatility can partially be explained by financial
leverage. French et al. (1987) and Schwert (1989) measure market volatility as the variance
of monthly returns of market index. French et al. fail to find a direct positive relation between
expected return and volatility. Schwert also fails to explain much of the change in market
volatility over time using macroeconomic variables. In addition, he finds that the market
volatility changes over time. Schwert (1990) analyzes the behavior of stock return volatility
around stock market crashes. He finds that stock market volatility jumps dramatically during
has so far been done to find how the investors show their attitudes toward risk in Bangladesh
capital market. Chowdhury (1994) investigates the time series behavior of returns in the DSE
using EGARCH-M (exponential GARCH in-the-mean) model. The return series is found to
be conditional heteroskedastic and both the first and second moments of the returns are time-
dependent. The conditional variances of the return series depend upon past volatility shocks
and conditional variances are, therefore, predictable using past information. The significance
of the asymmetry coefficient shows that positive return shocks in the market lead to higher
Hassan et al. (2000) use GARCH models to empirically examine the issue of market
efficiency and time varying risk-return relationship for Bangladesh. The returns display
significant serial correlation, implying stock market inefficiency. The results also show a
significant relationship between conditional volatility and the stock returns, but the risk-
return relationship is negative and significant, a result, which is completely inconsistent with
portfolio theory. Hassan and Maroney (2004) examine the efficiency of the DSE by giving
due consideration to some stylized facts of the market like non-linearity, thin trading, and
structural change. They find non-linearity after correcting for thin-trading in some of the
years under study. However, due to parameter instability, the ability to make profitable
trading strategy is very limited. Chowdhury and Rahman (2004) investigate how predicted
Vector Autoregression (VAR) is used to find the relationship. Findings show that
macroeconomic volatility strongly causes stock market volatility, but not the other way
around. Moreover, any shock to macroeconomic volatility takes long time to be absorbed into
the stock prices. Imam and Amin (2004) find that the volatility of the stock return of
Bangladesh capital market follows a GARCH (1,1) process and there is persistence in
volatility and the conditional volatility after the crash of 1996 is mean reverting. This finding
suggests that current information has no effect on the long run forecasts, rather volatility
shocks (random errors) to the volatility estimated at earlier period influence more in
estimating volatility.
Findings of Chowdhury and Iqbal (2005) show that DSE returns have high volatility
persistence and tend to go away from mean infinitely. However, when data of few months
before and after the crash of 1996 are omitted, volatility persistence has reduced and has the
tendency to go back to mean volatility after its departure from mean. Investors do not
differentiate between positive and negative shock to volatility. The most important but not so
surprising finding is that the market does not give risk premium to additional risk takers since
risk-return relationship is found to be insignificant. They have also found that variance is
predictable from information about past variance. Instead of using traditional measure of
volatility derived from index returns, Chowdhury et al. (2005) use firm-level returns data to
measure the cross-sectional market volatility. They find that there is weak relationship
between risk and return and shock to return and volatility stays in the system for a long
Monthly composite DSE index, industrial production index, foreign exchange rate and
consumer price index for the period January 1990 through December 2004 have been
considered for the study. Stock market index data are collected from the Dhaka Stock
Exchange Monthly Reviews. Industrial production index and exchange rate data are collected
from the IFS (International Financial Statistics). Consumer price index data are collected
from the Economic Trend published by Bangladesh Bank, the central bank of Bangladesh.
Market return, inflation, and rate of change in the industrial production and exchange
rate are calculated as the log differences of the respective variable between time ‘t’ and ‘t-1’
multiplied by hundred. In order to find the volatility series of these variables, we apply
Where yt is the conditional mean of the variable, σt2 is the conditional variance of the variable
and ut is the error term. σt2 gives us the predicted volatility of all the variables used in the
study. We first apply Granger causality test to find the existence and direction of relation. If
the total economy is integrated, then predicted volatility of any of them should affect others.
In such a situation VAR is thought to be an effective tool to capture the relation between all
the variables in a dynamic setting since all the variables are considered simultaneously.
Therefore we use Granger causality test and the VAR for the analysis. A VAR can be
∑
g
Χt = Αo + Α 1 Χ t −i + ε t ,
i =1
⎡σ 1 t −1,t ⎤
⎢ ⎥
Χt = ⎢ ⎥ ( 2)
⎢σ ⎥
⎣ 4 t −1,t ⎦
Where σt-1, t is the volatility of each of the variables from t-1 to t, and g is the order of the
VAR. Since the frequency of data is monthly, we arbitrarily employed a VAR of order 12.
Table1 presents the summary statistics of variances (volatility) of all the variables used in the
study. Mean variance of market return and industrial production is very high compared to
inflation and exchange rate. Market return variance has high mean and very high standard
deviation, a phenomenon, which is completely different from other variables. The results give
important information about the Bangladesh capital market that it is much more volatile than
Mar. Ret Vol. Ind. Prod. Vol. Inf. Rate Vol. For. Ex. Vol.
Table 2 gives pair-wise Granger causality test results. Since there are 4 variables, we
have 12 different causal relationships. Results show significant unidirectional causality going
from industrial production volatility to market return volatility and from market return
Ind. Prod. does not Granger Cause Mar. Ret. 166 1.9358* 0.0348
Mar. Ret. does not Granger Cause Ind. Prod. 0.8827 0.5659
For. Ex. does not Granger Cause Mar. Ret. 166 0.0815 0.9999
Mar. Ret. does not Granger Cause For. Ex. 0.2373 0.9960
Inf. Rate does not Granger Cause Mar. Ret. 166 1.4638 0.1446
Mar. Ret. does not Granger Cause Inf. Rate 10.1825* 0.0000
For. Ex. does not Granger Cause Ind. Prod. 166 0.2802 0.9915
Ind. Prod. does not Granger Cause For. Ex. 0.2088 0.9978
Inf. Rate does not Granger Cause Ind. Prod. 166 0.3908 0.9650
Ind. Prod. does not Granger Cause Inf. Rate 1.1221 0.3469
Inf. Rate does not Granger Cause For. Ex. 166 0.4052 0.9596
For. Ex. does not Granger Cause Inf. Rate 0.1158 0.9998
*
indicates significance at 5% level.
The earlier relation is logical although financial economists believe that stock market
volatility should precede industrial production volatility since there are many qualified
analysts who follow the stock market even on daily basis. However, in the absence of
sufficiently large number of institutional investors and qualified security analysts in the
market, the market may be inefficiently analyzed thereby reflecting incorrect prediction
inflation volatility, the second significant finding. This finding is highly justifiable in a
developed market where skilled investors dominate. In a frontier market like Bangladesh the
opposite causality should have happened mainly due to the dominance of non-institutional
investors, information asymmetry among investors and scope for manipulation. Theoretically
there should be positive relation between inflation uncertainty and stock return volatility,
which should ultimately increase expected returns and decrease stock prices. The limitation
of Granger causality test is that it does not provide the sign of relationship, which is very
well.
Impulse response graphs are shown in Figure 1. All the volatility series are basically
sensitive to their own shock.1 Variance series are usually thought to be persistent and this
phenomenon is quite evident in the impulse response graphs. One important feature impulse
response is that shock to any of the variables stay in the system for a very long period of time
and does not tend to die away even after 12 months. We have already found market volatility
granger-causes inflation volatility. In this connection, first graph confirms that any shock to
the error-term of the market volatility causes positive shock to the inflation uncertainty
(volatility). Top-right graph shows that any shock to industrial production volatility does not
affect market volatility in a systematic manner. Therefore, the sign of relation between
1
This finding is also supported by variance decomposition test, which is not reported in the paper.
MR= Market Return Volatility; FX=Exchange Rate Volatility; INR=Industrial Production Volatility;
INF=Inflation Rate Volatility.
Figure 1. Impulse Response Function
5. Conclusion
This paper investigates how predicted macroeconomic volatility is related to the predicted
systematic risk, it should increase the volatility of stock market and risk-adjusted expected
rate of return. GARCH(1,1) model is used to find the predicted volatility of all variables used
in the study. VAR is then used to capture the relation between the variables in a dynamic
framework.
Results show that the relation between stock market and macroeconomic variables is
not strong. It is found that industrial production volatility Granger-causes stock market
volatility and stock market volatility Granger-causes inflation uncertainty (volatility). The
later result contradicts the theoretical prediction in an efficient and complete capital market.
However, in the absence sufficiently large number of investors and analysts in Bangladesh
capital market, it might have reflected the investors reaction in reverse direction. The dearth
of qualified analysts and institutional investors is a well-known fact in the emerging markets
like the one in Bangladesh. Anyway, this finding needs to re-examined to be sure of the cause
Non-existence of the relationship between stock market and exchange rate fluctuation
can be explained by the fixed exchange rate regime followed throughout the period except for
the last couple of years when the country moved toward flexible exchange rate regime.
Impulse response function shows that market return is basically influenced by its own shock.
Moreover, any shock to market return volatility does not affect other factors that much. More
generally, all the volatility series are mainly sensitive to their own shock and almost
insensitive to shocks to other variables. Finally, volatility shocks to every variable seem to be
very persistent and take very long period of time to die away.
Findings of the study appear to be slightly different from that of Chowdhury and
Rahman (2004) where they have found that predicted volatility of macroeconomic variables
is related with that of stock return in Bangladesh capital market with causality running from
macroeconomic volatility toward stock market volatility. However, they have used different
volatility series and macroeconomic variable with different time frame. Since a better model
is used to calculate the predicted volatility series in this study, its findings are more
confirming the results in similar countries may provide deeper understanding of the
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