stock prices & the macro economic variables

8/8/2019 Stock Prices & the Macro Economic Variables

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Stock Prices & The MacroStock Prices & The Macro

Economic Variables In Pakistan Economic Variables In Pakistan

By: Asim Nizami (MBA)

Under Supervision of DR Ayub Meher


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Introduction Introductiony Over the course of the past decade , Pakistans economy has taken such a drastic turns

that it has confused most of the economists and researchers to watch carefully over the

prediction and decisions.

y The above record performance of KSE 100 Index during the period of 2003 to 2007

made a lot of stakeholders to find the fundamental reasons behind the variation.

y The study is an effort to find out which of the fundamental are the good

determinants of KSE 100 indexs Behavior and also in what direction

y To achieve the objective macro economic variables such as

Interest rate

Inflation rate and

GDP growth rate

were considered to find the relation with that of KSE 100 index


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Back Ground Of A Problem Back Ground Of A Problemy The study is an examination of the correlation between the four variables ( stock prices,

Interest rate, inflation rate & output growth rate) in different economic circumstances

y The study inter-linked the two fields (Finance and Economics) in a way that it validates, if

there is any relationship between the financial market indicator with that of economic

variablesy There is a mutual consent among the macroeconomists and finance theorists that stock

market prices are driven by macroeconomic variables so called fundamentals. Moreover,

it is also agreed that the linkage is both way; reciprocal relation exists between the stock

prices and macro economic variables .

y The reason of examining the two fields together is that the financial feat is closely related

to that of the economic development, because the monetary policy work through these

financial intermediaries therefore it is concluded that the competent financial markets can

be a qualification for the economic strength in a nation


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Back Ground Of A Problem Back Ground Of A Problemy It is resolutely believed that when the economy is performing well, that is the

Interest rate & inflation rate are moderately low level & out put growth rate is high,

stock prices should also advance up to show the relation with the growing economy

y There has been a great deal of research regarding the phenomenon in the developed

economies such as the US, UK, Germany, Japan etc, where researchers have comeup with some very enlightening and insightful results.

y The results would help the students, researchers, economists as well as the individual

investor to much extent in explaining the behavior of stock exchanges and prices,

and in turn, have helped them make better predictions about its current and future

performance and decision regarding investments along with the reasons.

y The study covers the time period started from 1991-92 to the end of 2008-09

covering eighteen years because of the availability of KSE 100 index ( Stock Prices)

from 1990-91 onwards.


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Theoretical FrameTheoretical Frame Work Work y Stock prices are driven through many factors called fundamentals, among

them the top most helpful are the macro economic variables; most notably

among them are Interest rates, inflation rate and out put growth rate.

y Interest rate is the most effective driver having direct and indirect effects to

all the parts of economy through supply of money

y It also drives inflation rate and out put growth rate in the economy as well

as allied with the determination of the stock price.

y So if the macro economic variables fluctuates, it is noticeable that the stock market index also improve to show the after effects of change in the interest

rates.


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Objectives of the StudyObjectives of the Studyy The objective of this paper is to evaluate the relations among key

economic variables such as:

1. Inflation rate ( CPI Based)

2. Interest rate ( Call money rate)

3. Out put growth rate ( GDP growth rate)

y With that of stock prices (KSE 100 Index) in context of Pakistans

economy, where stock exchanges are less mature as compared to

other countries with well matured financial markets for instance

US, Japan and the UK (Fama, 1991)


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Problem Problem Statement Statement

y To estimate the relationship between the stock prices ( KSE 100

Index) and macro economic variables ( Interest rate, Inflation &GDP growth rate) of Pakistan

Target Audience: To facilitate the job of the investors, financial

analysts, researchers, economist as well as the up coming student to

strengthen their understanding about the stock price variations and

its link with the macro economic variables.


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Additional Findings Additional Findingsy In trying to investigate the above mention problem many other

question were also unfolded as

1. Do interest rates affect the KSE 100 index?

2. Do GDP Growth rates in the economy effect KSE 100 index?

3. Do inflation rates affect GDP growth rate (production)?

4. Do inflation rates affect interest rates?

5. Do inflation rates affect the KSE 100 index?

6. Do interest rates affect GDP Growth rate in the economy?


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Trend in KSE 100 Index Trend in KSE 100 Index

Figure 1: KSE 100 Index (1990-91 to 2008-09) Source Business recorder


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Percentage Change in KSE 100 Percentage Change in KSE 100

Index Index

Figure 2: Percentage Change in KSE 100 Index (1990-91 to 2008-09) Source Business recorder


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Some Proclamations Assumptions Some Proclamations Assumptions Stock prices are negatively affected by the interest rate because when ever the

government increases the interest rate

y The cost of borrowing money becomes high

y

In turns the households are left with less disposal income because in the changein spending behavior and demand gradually decreases

y The Businesses too depends on the source of capital by banks and as the cost of

capital increases the spending power of the business also decreases which also

decrease the growth pattern of the company and can be observed from the

decrease in the profitability of the companies

y When the interest increases the investment preference decreases and the equity

market decline due to less of investments take place


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Explanation Of variables Explanation Of variables Interest Rate:

y Interest rate is taken as the discount rate offer by the state of

Pakistan to all the commercial banks in Pakistan and is also referred

as policy rate, so that they can further lend it to earn their own

markup to the customers.

y Interest rate is also one of the tools of monetary policy to control the

money supply in the economy through commercial banks.


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Contd Contd

y When ever the interest rate is high money supply in the economy

would be low

y

Decreasing the disposal for household and hence change in thespending pattern

y Where as if the scenario is opposite, the less interest rate would

increase the disposal and hence spending patterns would lead toinflation


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Trend in Interest RateTrend in Interest Rate

Figure 3: Money at Call & Rates (1990-91 to 2008-09) Source: SBP


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Explanation Of variables Explanation Of variables

Inflation:y Inflation is the gradual increase in the level of goods and services prices over a specific

period of time and define in percentage.

y It is also a good indicator of how economy is performing.

y The rate of the inflation is one of the most important macroeconomic indicators and a key

variable for state bank of Pakistan to consider for scrutinizing while setting up its interest

rate

y

Gauging the inflation at a sustainable level is very important for economicgrowth. Inflation have dual effect not only on consumer side to safe income

groups but also make the cost of business manageable for production side.


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Trend in Inflation RateTrend in Inflation Rate

Figure 4: Inflation CPI based (1990-91 to 2008-09) Source SPB


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ContdContdInflation internationally is among the top most priority in the last year 2008-09

because of

y A series of global shocks starting from the beginning of the financial crises

in the international marketsBut

y Inflation in the developed countries is no more an issue but the danger of

recession is still far greater. Pakistan is one of the many economies where

there is still a chance facing the double digit inflation rate and even reached

to almost 21 percent last year (2009).


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Explanation of Variable Explanation of VariableGross Domestic Product:

y measure of economic performance/out put and it is a valuation of

goods and services produced in term of market, it is the market

value of all final goods and services made within the borders of a

country in a year.

y It is valued on the basis of either cost of production, value added

cost at each level of production or the expenditure incurred (Labor)

to produce those goods and services.


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Trend In GDP Trend In GDP

Figure 5: GDP Growth Rate of Pakistan (1990-91 to 2008-09)Source: SBP


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Methodology Methodologyy Dependent Variable

1. KSE 100 Index

y Independent Variables:

1. Interest Rate:

2. Inflation:

3. Gross Domestic Product:


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Methodology Methodology Hypothesis

Each one of the considered macro economic variable is tested with KSE 100 index

in order to find the root cause along with the strength with which each variable

impact the KSE 100 index

Thus the proposed multiple hypotheses are

y H1

= There is a negative correlation between interest rate and KSE 100 index

y H 2= There is a negative correlation between inflation rate and KSE 100 index

y H3

= There is a positive correlation between GDP growth rate and KSE 100

index


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Methodology Methodology Statistical technique:

In investigate the predicting power of the key macro economic variables over the KSE

y The compiled data was run into famous statistical tool SPSS

y A Multiple linear regression analysis was used and to determine the relationships

between all the variables selected

y The multiple coefficients of correlation were studied to check the variance

accounted for by the model

y The coefficients of the independent variables (Betas) were not considered

y The coefficient of correlation of each variable was analyzed using Correlation matrix

produced by Pearsons correlation test

y Scatter plots were also discussed to define the nature of Relationship between the

variables


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Methodology MethodologyData Collection and Sample period:

y Eighteen years sample size was considered as KSE 100 index started from 1990-91

onward and macro economic variable was available in yearly format (N = 72 number

of observations). A s mentioned in theoretical framework, the data used in the study

has four parts:

1. Inflation rate of Pakistan ( Consumer Price Index of Pakistan)

2. GDP growth rate of Pakistan ( Countrys out put growth rate)

3. Interest rates offered by the state bank of Pakistan ( money at call and rates)

4. Stock Prices ( Karachi Stock Exchange 100 index)


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Methodology Methodology Source of Data:

y Y early data from 1990-91 to 2008-09 has been used in this study.

y Data for the GDP Growth rate, Inflation rate (Consumer Price Index), and

Interest Rates (Money at call and rates) were obtained from the library of State

Bank of Pakistan from 50 years Statistical Bulletin, SBPs A nnual Reports and

the economic survey of Pakistan for the relevant years.

y Data for the Karachi Stock Exchange Index were obtained from the library of

Karachi Stock Exchange along with that Y ahoo Financial Services and CBS

Market Watch in addition to the statistical documents to cross check the data

consistency.

y The assumptions to be verified were that there was a positive relationship

between the KSE 100 index with that of GDP growth rate and negative with

Interest and inflation rate


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Results and Discussion Results and Discussion

M odel R R SquareAdjusted R

Square

Std. Error of

the Estimate

1 .747(a) .557 .463 29.84819

Model Summary

It can be seen that the value of R obtained for the data results is .747 which is avery high and near to 1defining a strong relationship between the KSE 100 indexand Interest, Inflation & GDP growth rate.

Larger values of R 2 indicate the model fits the data well and it can be obtained

by squaring the value of R. Since the R 2 value for our data set is .557 which is afairly large value, explaining the goodness of fit for the model. Furthermore itcan be obtained that 55.7 % of the total variation in the KSE 100 index (stock

prices) is explained by the selected variables (Int, Inf & GDP) by the model i.e.55.7% of the variation in the Karachi Stock Exchange index is due to thatmovement in the interest rates , Inflation rate & GDP growth rate in the

economy.


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M odel R R SquareAdjusted R

Square

Std. Error of

the Estimate

1 .747(a) .557 .463 29.84819

Model Summary contd

A djusted R 2 is a modification of R 2 that is adjusted for the number of

explanatory terms in a given model. Unlike R 2, the adjusted R 2 increases

only if the new term improves the model more than would be expected by

chance. In this case the A djusted R 2 is 46.3 % which shows adding more

term to the model increase the explanatory power of the model and would

not be due to chance.


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Results and Discussion Results and Discussion ANNOVA ( test of variance)

A NNOV A is the results of an analysis of variance

M odel Sum of Squares Df M ean Square F Sig.

Regression15708.606 3 5236.202 5.877 .008(a)

Residual12472.804 14 890.915

Total28181.411 17


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Results and Discussion Results and DiscussionCorrelation Matrix


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Results and Discussion Results and Discussion Scatter Plots

Scatter Plot: Negative Linear Relation between KSE 100 Index and Interest Rate


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Scatter Plot: A negative relation between the Inflation and KE 100 Index


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Scatter Plot: A positive relation between GDP growth rate and KSE 100 Index


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Answer of the questions in First Chapter


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Do interest rates affect the KSE 100 Do interest rates affect the KSE 100

index?index?y Strongest relationship of any variable in this studyy The correlation results suggest that there is a 73.6% negative relationship

y It can be viewed as a good determinant in explaining KSE 100 Indexs behavior

y

A s the interest rate is increased it can be observed that most of the investors findit more convenient to put their money in bank rather than to invest in Equity

market

y Vise versa behavior would be observed in case of interest rate decreases

y When the interest rate decreases investors pour more of the investment in equitymarket and as a result equity index enhance due to injection of money into it


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Do GDP growth rate affect the KSE Do GDP growth rate affect the KSE

100 index?100 index?y The KSE 100 index seem to be least effected by the GDP growth rate of Pakistan as the relation define is around 51.4% and is weaker among the

variable taken but positively effecting

y

Karachi Stock exchange is affected by level of economic activity in Pakistan ina way when ever the production in the economy increase is a good sign of

fulfilling the demand created and hence result in the profitability of the firms

that are listed in the KSE 100 index and eventually increases the prices of the

shares with the combine effect of dividend and returns.

y A s the GDP decreases to 2 % per annum also declined the KSE growth in

negative as 42 %.


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Additional Findings Additional Findings


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Does inflation affect GDP growth rate Does inflation affect GDP growth rate

y There is a weak negative correlation between the inflation rates and the GDP growth rate of

Pakistan. The Pearsons correlation result indicates that there is a 13.7% negative relationship.

y The significant level is also very high rejecting the fact that Inflation affect the GDP growth rate

in Pakistan.

y In the case of this study the inflation is CPI based which does not affect the industrial production

directly, more over industries are more dependent on the prices of the factor (Labor, capital etc)

involved.

y One of the reasons behind inflation not affecting the GDP is the connection between interest

rates and inflation, where GDP is a good responded to the change in interest rates. Referring to

the correlation table the correlation between the GDP and the interest rate is negative 58.2

percent with the significant level of 0.011 which is acceptable.

y One of the most important point to be mentioned that an increase in inflation rates eats up the

corporate earnings, which in turn makes dividends decline. When dividends declined, the

expected return of stocks also decreased affecting share prices to depreciate in value and hence

affecting the stock markets indices


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Conclusion and RecommendationsConclusion and Recommendationsy Based on the result concluded from the regression analysis, correlation matrix

and the scatter plots give an insight about which one of the selected variables is

a good predictor of the stock prices and should be taken into concern while

deciding the investment priorities, when Pakistans economy is taken into

considerationy The relationship between the interest rate and stock market is highly negative as

it was reported by the correlation matrix and found to be very consistent with

the study with other authors taken into consideration.

y

The empirical evidence incurred from the study that the interest rate and thestock price are negatively related, confirmed the acceptance of the hypothesis

that there is a negative relationship between stock prices and interest rate.


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Conclusion and RecommendationsConclusion and Recommendationsy The relationship between the inflation and the stock prices is negative and is

very compatible with the study conducted by (Erb et al, 1995) inflation and the

stock return in the united kingdom and united states as well as (Geske and Roll,

1983) that suggest the relationship between expected, unexpected inflation &

changes in both were negatively related with that of the stock prices.

y The relation between the inflation and the stock was also well documented by

(Fama, 1981) by finding the relation between the stock returns, real activity;

interest and inflation also confirms the phenomena and the underlying theory

behind the relationship of inflation and stock prices.

y Thus the acceptance of the developed hypothesis that is the relationship

between the stock prices and the inflation rate is negative.


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Conclusion and RecommendationsConclusion and Recommendations

y The relationship between the stock prices and the GDP growth rate is

positive showing a good consistency with the study (Fama, 1983, 1990

& 1992) that showed the causal relation between the stock prices,

interest rate, Inflation and GDP growth rate. A lso the study by(Schwert, 1990) verified the relationship between stock return and real

activity backing up the acceptance of the hypothesis that there is a

positive relationship between the share prices and GDP growth rate.

y Where the phenomena is also confirm by the study conducted by (Chen

et al, 1986) who study the relation between the stock return, interest

rate, inflation and GDP growth rate.


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Conclusion & RecommendationConclusion & Recommendationy A relationship is prevailing in between macro economic variable and financial

markets, led to the conclusion that the economic development and the financial

development are closely and directly interlinked.

y H ence the efficiencies of deep, liquid and open financial markets are the sign of

the financial development which in turn directly affected by the monetary policy

prevailing in the economy.

y Looking into the trend of the past 18 years of analysis the interest rate has

reached to its maximum record level and is because of the rise in inflation rate.

y The GDP rate is also reached to its minimum level showing the leastdevelopment is taking place.

y A well functioning and efficient supply of money is a vital source of stability in

the financial markets.


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Conclusion & RecommendationConclusion & Recommendationy Declining quality of macro economic factors, the continuous tightening of the monetary

policy and the security concern since the start of the financial year 2008-09 has led to the

poor performance of the KSE 100 Index

y Restriction of price floor on KSE 100 Index in 2007-08 how ever didnt prove fruitful in

fact it also reduces the investor confidence because most of the investor after the removal

of the price floor pull their investment back and the KSE 100 index declined further y To recover the economic downturn and that of the financial market, government

should increase the supply of money there by introducing the loose monetary

policy as providing the interest rate lower to encourage the real activity in the

economy.

y Government should take into consideration for mutual agreement with other

countries to bring in technologies and new projects to increase the GDP and

reduce the inflation by providing the substantial goods and services, this can

only be done through easing the terms and condition and removing the boundary

for FDIs to operate in Pakistan for the development of goods and service.


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Conclusion & RecommendationConclusion & Recommendationy The study is a good approach for explaining few determinant out of many that

explains the behavior of KSE 100 index but it should be recommended to work more

in this regard in order to develop further explanatory models

y H ow ever to gauge the impact of the economic variables on that of financial markets

further studies can be conducted in order to investigate, further that what are the other variables that can be considered to improve the results of the studies both in long run

and short run. Most notably foreign exchange rate, employment rate, money supply

M2, per capita income, balance of payment and trade etc, should also be studies to

define the prediction value more specifically and accurate.

y The study is explaining the period of 18 years starting from the liberalization of the

economy in 91-92 to 08-09 and it can t be confirm that this trend would remain

exactly the same for future because there may be endless variables involve in the

variation of KSE 100 index.


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Thats all Thats all

stock prices & the macro economic variables

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