1

Causal Relationship among Economic Variables and

Equity Market Returns

THE SYNOPSIS, PARTIAL FULFILLMENT FOR THE REQUIREMENT OF

THE DEGREE OF MBA (COL)

Submitted by

Roll No

Registration No

ALLAMA IQBAL OPEN UNIVERSITY (AIOU)

Islamabad
Year 2012
1

CONTENTS
CHAPTER 1
INTRODUCTION

1.1

SIGNIFICANCE OF STUDY

1.2

OBJECTIVES OF STUDY

1.3

PROBLEM STATEMENT

CHAPTER 2
LITERATURE REVIEW

2.1

THEORETICAL FRAMEWORK

11

2.2

RESEARCH HYPOTHESES

12

CHAPTER 3
RESEARCH METHODOLOGY
3.1

RESEARCH TOOLS / INSTRUMENTS

13

3.2

SOURCE OF DATA

14

3.3

POPULATION AND SAMPLES

14

BIBLIOGRAPHY

18

CHAPTER 1
Introduction
The causal relationship between monetary variables and equity returns has been one of
the most debated topics in finance during the last few decades. Equity prices are the most closely
observed asset prices in an economy and are considered the most sensitive to economic
conditions; high volatility or abnormal movements in equity prices from fundamental values can
have adverse implications for the economy. Thus, it becomes imperative to understand the
relationship and dynamics of monetary variables and equity market returns.
An efficient capital market is one in which security prices adjust rapidly to the arrival of
new information therefore the current prices of securities reflect all information about the
security. In simple words its mean that no investor should be able to employ readily available
information in order to predict stock price movements quickly enough so as to make a profit
through trading shares.
Policy makers, for example, should feel free to conduct national macroeconomic policies
without the fear of influencing capital information and the stock trade process. Moreover,
economic theory suggests that stock prices should reflect expectations about future corporate
performance, so corporate profits generally reflects the level of economic activities. Therefore
the casual relations and dynamic interactions among macroeconomic variables and stock prices
are important in the formulation of the national economic policy.
As for the effect of macroeconomic variables such as money supply and interest rate on
stock prices, the efficient market hypothesis suggests that competition among the profit-

maximizing investors in an efficient market will ensure that all the relevant information currently
known about changes in macroeconomic variables are fully reflected in current stock prices, so
that investors will not be able to earn abnormal profit through prediction of the future stock
market movements (Chong and Koh 2003).
1.1

Significance of Study:
The influence of monetary variables on equity returns has attracted considerable attention

in both developed and developing countries. Many studies have been conducted to find the longterm equilibrium relationship between stock returns and monetary variables for the USA, Japan,
and other industrially developed countries. This study focuses on Pakistan as a rapidly growing
market in South Asia. The Pakistani equity market has shown tremendous growth in the last few
years: The KSE-100 index rose from 1,773 index points in January 2000 to 15,125 in March
2008. This phenomenal growth has also attracted foreign investors and portfolio investment has
increased four-fold. In the current economic scenario, it is necessary to explore the relationship
between monetary variables and equity returns so that the current dynamics of monetary policy
can be examined.
Financial liberalization and globalization provide further impetus for exploration of the
subject, especially in the context of emerging markets such as Pakistan. This interrelationship has
an economic rationale as discounted cash flow techniques for asset pricing assume that stock
prices reflect expectations about futures cash flows. These expectations about cash flows are
based on the expected performance of the corporate sector; the performance of the corporate
sector is influenced by changing patterns in monetary variables. Therefore, any innovation in
monetary variables will affect corporate profits and will ultimately reflect asset prices. If an asset

pricing mechanism is efficient and reflects precisely the fundamentals of the corporate sector,
then equity prices can serve as a leading indicator of future dimensions of economic activity. The
efficient market hypothesis also provides that prices instantly adjust to the arrival of new
information and the current prices of securities reflect all the information available about the
security.. This response is neither equal nor homogeneous across all economic changes, and it
becomes imperative to investigate the interactions among monetary factors and equity prices
since it will provide the foundations for the formulation of monetary policy in the country.
1.2

OBJECTIVES:
The objectives of the study are listed below:

To investigate whether any long run relationship exists among Equity returns, and
economic variables.

To investigate whether any short run relationship exists among Equity returns, and
economic variables.

1.3

PROBLEM STATEMENT:
Whether economic variables significantly affect the Equity Prices in Pakistan?

CHAPTER 2
Literature:
The efficient market hypothesis provides that asset prices respond to the arrival of new
information. This response is stronger in the case of certain economic events whereas in other

cases it may be weaker. Empirical studies try to identify factors that have a significant influence
on equity prices: monetary factors are no exception.
A number of studies have been conducted to investigate the potential response of equity
prices to a change in monetary variables. Jaffe and Mandelker (1976) Fama and Schwert (1977),
Nelson (1976) Chan, Chen and Hsieh (1985), Chen, Roll and Ross (1986), Burnmeister and Wall
(1986), Burmeister and MacElroy (1988), Chang and Pinegar (1990), Defina (1991)
Kryzanowski and Zhang (1992), Chen and Jordan (1993), Sauer (1994), and Rahman, Coggin
and Lee (1998) explore the relationship between inflation and equity prices. Kryzanowski and
Zhang (1992), Sauer (1994), and Mukherjee and Naka (1995) explore the relationship between
the foreign exchange rate and equity market returns. Burmeister and MacElroy (1988) study the
relationship between short-term interest rates and equity market returns. Studies that explore the
relationship between money supply and equity market returns include Friedman and Schwartz
(1963), Hamburger and Kochin (1972) and Kraft and Kraft (1977) Beenstock and Chan (1988),
Nozar and Taylor (1988), Sauer (1994), and Mukherjee and Naka (1995).
Bahmani and Sohrabian (1992) examined the relationship between the exchange rate and
equity market returns for the period 1963-1988 by employing cointegration analysis and Granger
causality analysis. The study provides evidence of bidirectional causality in the short run. Yu
(1997) finds a bidirectional relationship between exchange rates and the equity market in Japan
and unidirectional causality flowing from changes in exchange rates to changes in stock prices in
Hong Kong. However no causality has been observed in the daily time series of the Singapore
market during 1983-1994.
Muhammad and Rasheed (2003) explored the relationship between exchange rates and

equity prices in Pakistan, India, Sri Lanka, and Bangladesh for the period 19942000. The results
indicate that no relationship exists between equity markets and foreign exchange rates in the long
or short run in India and Pakistan. However, bidirectional causality is observed between
exchange rates and equity markets in Bangladesh and Sri Lanka. Stavrek (2005) examines the
presence of causal relationships between equity prices and effective exchange rates in Austria,
France, Germany, the UK, Czech Republic, Hungary, Poland, Slovakia, and United States for the
period 1970-2003. Results provide evidence of unidirectional causality in the long run as well as
short run. Results also indicate that this causal relationship is stronger in developed markets, i.e.,
Austria, France, Germany, the UK, and US. Moreover, the relationship is found stronger for the
period 19932003 than 197092.
Academics as well as professional observers have explored the relationship between
stock prices and various monetary variables that are subjective to monetary policy. One such
variable is money supply; initial studies conducted in the 1960s and 1970s generally indicated a
strong leading relationship between money supply changes and equity prices. However,
subsequent studies have raised questions about the nature of this relationship. They have
confirmed the presence of a relationship between money supply and stock prices but the timing
of the relationship remains debatable. Rozzef (1974) examines stock market efficiency with
respect to money supply by employing regression analysis and trading rule analysis and finds
that equity market returns do not lag behind money supply. The study confirms EMH and
provides that current equity returns incorporate all information about historical as well as
anticipated future changes in money supply. Beenstock and Chan (1988) examine the
relationship between equity markets and a set of macroeconomic variables and provide evidence
of a positive relationship between equity returns and money supply and inflation.

Mukherjee and Naka (1995) explored the long-term relation between equity prices in the
Japanese stock market and six macroeconomic variables, i.e., money supply, industrial
production, exchange rate, inflation, long term government bond rates, and the call money rate
by employing monthly data for the period 1/71 to 12/90. They employ a vector error correction
model (VECM) to investigate the relationship among these variables and provide evidence of a
positive relationship between equity prices and money supply, exchange rate, and industrial
production.. The study reveals a significant negative relationship between equity prices and
inflation, and also shows that industrial production significantly influences equity prices in the
Chinese economy while the direction of this relationship is negative.
Nishat and Rozina (2001) analyzed causal relationships between the Karachi Stock
Exchange Index and inflation, industrial production, narrow money, and the money market rate
by employing a vector error correction model for the period 1/1973 to12/2004. Results indicate
the presence of two cointegrating equations among macroeconomic variables. Industrial
production and inflation are identified as the largest determinants of equity prices in the Karachi
Stock Exchange. Industrial production has a positive relationship with equity prices whereas
inflation is negatively associated with stock prices. Granger causality is found flowing from
macroeconomic variables to stock price, as is industrial production.
Maysami and Koh (2000) examined long-term dynamic interactions between the Strait
Times Index (STI) and macroeconomic variables for the period 1988 to 1995 by employing a
vector error correction model (VECM). The variables are seasonally adjusted money supply,
industrial production index, foreign exchange rate, retail price index (inflation), domestic
exports, and interest rates. Results indicate a cointegrating vector among returns on the Strait
Times Index (STI) and money supply growth, inflation; term structure of interest rates, and

changes in exchange rates. This study investigates the long-term dynamic relationship among
S&P 500, Nikkei 225 and STI by using cointegration analysis and finds that the equity markets
of the US, Japan and Singapore are co-integrated.
Hussain and Mahmood (2001) investigated the long-run causal relationship between
equity prices and macroeconomic variables for the period 7/1959 to 6/1999 by employing a
vector error correction framework. Annual data for gross domestic product, consumption and
investment is analyzed and it is concluded that a long-run relationship exists between equity
prices and macroeconomic variables. Results also reveal the presence of unidirectional causality
flowing from macro variables to stock prices. However, the equity market is not found to
influence aggregate demand so its movement cannot be termed as a leading indicator of
economic activity.
Akmal (2007) investigated the relationship between equity market prices and inflation in
Pakistan for the period 1971-2006 by employing the autoregressive distributed lag (ARDL)
approach to observe cointegration among variables and provides evidence that equity returns are
hedged against inflation in the long run.
Chen(1986). It's based on Arbitrage Pricing Theory. Seven macroeconomic variables for
defining the prior sixty months' returns for all U.S. securities were used in this model. Investor
confidence considered to be one factor, when measured by the spread in yield between high quality
(AAA rated) and intermediate corporate bonds (Baa rated). Yield spread narrows with high
confidence, where as considering the uncertainty; investors accept the risk of lower credit quality
bonds yielding greater premium returns.

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2.1

Theoretical Frame work

Dependant Variable

Independent Variables
Oil Prices

Interest Rate

Inflation
Equity Market
Return
10

11

Gold Prices

Foreign Exchange
rate

Industrial
Production

11

2.2

Hypothesis:

To generate the results from the research topic such hypotheses are formulated. All the research
process will conduct on these hypotheses to find the ultimate results regarding the topic.
HA0: There is a positive relationship between Oil Prices and Equity Market Return
HA1: There is a negative relationship between Oil Prices and Equity Market Return
HB0: There is positive relationship between Interest Rate and Equity Market Return
HB1: There is negative relationship between Interest Rate and Equity Market Return
HC0: There is positive relationship between Inflation and Equity Market Return
HC1: There is negative relationship between Inflation and Equity Market Return
HD0: There is positive relationship between Gold Prices and Equity Market Return
HD1: There is negative relationship between Gold Prices and Equity Market Return
HE0: There is positive relationship between Foreign Exchange Rate and Equity Market Return
HE1: There is negative relationship between Foreign Exchange Rate and Equity Market
Return
HF0: There is positive relationship between Industrial Production and Equity Market Return
HF1: There is negative relationship between Industrial Production and Equity Market Return

CHAPTER 3
RESEARCH METHODOLOGY
3.1

RESEARCH TOOLS / INSTRUMENTS

We investigate the long-term dynamic interaction between the Pakistani equity market

and monetary variables by employing monthly data for the period 2001 to 2010. The monetary
variables we use include gold prices, oil prices, inflation, interest rate, industrial production and
foreign exchange rate. The preference for monthly data is in line with earlier work done by Chan
and Faff (1998) to explore the long-run relationship between macroeconomic variables and
capital markets.
There are several techniques for testing the long-term dynamic interaction between prices
in equity markets and macroeconomic variables. In this study, we emphasize testing the
relationship between monetary variables and the Pakistani equity market, via:

Descriptive statistics

Correlation matrix

Co-integration tests

Granger causality test

Impulse response analysis

Variance decomposition analysis

3.2 Source of Data

This study based on data which is taken from the web site of KSE and other financial
institutions for the last 10 years. The data for individual monetary variable is taken from the
yahoo finance as well as other research publications.
3.3 Population and Sample
To show the relationship between monetary variables and stock market return KSE-100
composite index is used for the stock market return rather than individual sector. So data of KSE100 composite index from 2001 to 2010 is taken, with the individual and proxy data of different
monetary variables.
3.3.1

Efficient Market

An efficient market is one in which securities prices reflect all available information. This means
that every security traded in the market is correctly valued given the available information. In an
efficient market, there are usually a large number of active traders functioning in the
marketplace. A given trader may actively buy securities and sell other securities at the same time,
based on the strength of the current unit price and projections on how the securities will perform
in both the short term and the long term. Because the information regarding the securities in
question is so well defined and so easily accessible, the trades take place with full confidence in
how much return will be realized from each transaction.
3.3.2

Equity Market Return

Equity market returns have been calculated by using following equation

Rt = In (Pt / Pt-1)

Where Rt is return for month t; and Pt and Pt-1 are closing values of KSE-100 Index for month
t and t-1 respectively.
3.3.3

Oil Prices

Crude oil prices measure the spot price of various barrels of oil, most commonly either the West
Texas Intermediate or the Brent Blend. The OPEC basket price and the NMEX Futures price are
also sometimes quoted.
West Texas Intermediate (WTI) crude oil is of very high quality, because it is light-weight and
has low sulphur content. For these reasons, it is often referred to as light, sweet crude oil.
These properties make it excellent for making gasoline, which is why it is the major benchmark
of crude oil in the Americas. WTI is generally priced at about a $5-6 per barrel premium to the
OPEC Basket Price and about $1-2 per-barrel premium to Brent.
3.3.4

Interest Rate

A rate, which is charged or paid for the use of money. An interest rate is often expressed as an
annual percentage of the principal. It is calculated by dividing the amount of interest by the
amount of principal
The benchmark interest rate in Pakistan was last reported at 12 percent. In Pakistan, the State
Bank of Pakistan takes interest rates decisions. The official interest rate is the discount rate. From
1992 until 2010, Pakistan's average interest rate was 12.78 percent reaching an historical high of
20.00 percent in October of 1996 and a record low of 7.50 percent in November of 2002. This
page includes: Pakistan Interest Rate chart, historical data and news.

3.3.5

Inflation

The consumer price index (CPI) is used as a proxy for inflation. The CPI is a broad-based
measure for calculating the average change in prices of goods and services during a specific
period.
Inflation Rate = In (CPIt / CPI t-1)
3.3.6

Gold Prices

Gold prices are the converted dollar prices in Pak rupees on monthly basis. Gold prices are taken
carrot-24, 10 grams or one once. Percentage change is calculated to check the relationship and
normally gold prices has positive relationship
3.3.7

Foreign Exchange Rate

In finance, an exchange rate between two currencies is the rate at which one currency will be
exchanged for another. It is also regarded as the value of one countrys currency in terms of
another currency. Monetary exchange rates are set on the basis of the economic performance and
balance of trade between two countries, whose exchange rate is to be calculated. Balance of
trade between 2 countries can be a positive or negative sum, depending upon the total value of
exports and imports.
The change in the foreign exchange rate is measured by employing the end-of-month US $/Rs
exchange rate and the change in value is worked out through log differencing, i.e.,
Change in Foreign Exchange Rate = In (FERt / FERt-1)
Where FER is the Foreign Exchange Rate US $/Rs

3.3.8

Industrial Production
The indicator measures the amount of output from the manufacturing, mining, electric

and gas industries. The reference year for the index is 2002 and a level of 100. Production data is
often received directly from the Bureau of Labor Statistics and trade associations, both on
physical output and inputs used in the production process. Each individual index is calculated
using the Fischer index formula. Investors can use the IPI of various industries to examine the
growth in the respective industry. If the IPI is growing month-over-month for a particular
industry, this is a sign that the companies in the industry are performing well.

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