Relation Between Macroeconomic Variables And Stock Prices Finance Essay

Relation Between Macroeconomic Variables And Stock Prices Finance Essay

In this survey we will analyze the relationship between macroeconomic variables and stock monetary values. Three variables viz. money supply, rising prices and exchange rate will be discussed.

2.1.1 Macroeconomic Variables and stock monetary values

A house ‘s economic ; industry and stock analysis should be taken in history during the rating procedure ( Reily and Brown, ( 2006 ) . The top down attack ( the three-step ) attack asserts that both the economic system and industry affects the returns of single stocks on the rating procedure compared to the bottoms-up attack which indicate that it is possible to supply superior returns to happen stock irrespective of the way of the economic system and province of the industry. The difference between these two attacks is how investors regard the importance of economic and industry influences on single stock returns. Assorted surveies have maintained the top-down investing procedure. The economic background and the public presentation of house ‘s industry affect the value of security and its rate of return. Thus some macroeconomic variables would be regarded as a priori of hazard that are common to all companies.

The relationship between stock monetary values and macroeconomic variables is good illustrated by the Dividend Discount Model ( DDM ) proposed by Miller and Modigliani ( 1961 ) than any other theoretical stock rating theoretical account. The stock ‘s value is still merely the present value of its hereafter hard currency flows. Since the lone hard currency flows an equity proprietor of all time gets are dividends, the theoretical account is called the dividend price reduction theoretical account.

Therefore, the current monetary value of portion of common stock is presented as follows:

Where

Po = the current stock monetary value

D = the expected hard currency dividend,

n = the expected twelvemonth in which the payment of dividend is expected

K = the needed rate of return ( price reduction rate )

If an investor sells the stock, the buyer of the stock is merely purchasing the staying dividend watercourse, so the stock ‘s value is still determined by the dividend it pays.

The most widely known DDM theoretical account is the Gordon growing theoretical account ( Gordon, 1962 ) . It

expresses the value of a stock based on a changeless growing rate of dividends.

Gordon Growth Model has simplified the rating of stock as follows:

This equation simplifies to the infinite period dividend price reduction theoretical account.

Projected stock value P=D/k-g

where

D = expected dividend per portion one twelvemonth from now ;

Ks = required rate of return for equity investor ;

G = growing rate in dividends

This theoretical account is appropriate for happening the stock value with the premises that dividend are expected to go on turning at a changeless rate and the growing rate is supposed to be lower than the needed return on equity, ke

In conformity with the theoretical account the current monetary value of an equity portion equals the present value of the hereafter hard currency flows. Hence, the determiners of portion monetary values are the needed rate of return and expected hard currency flows connoting that economic factors that affect the expected hereafter hard currency flow and needed rate of return influence the portion monetary value. ( Humpe and Mcmillan, 2007, Gan 2006 )

Another method of tie ining macroeconomics variables and stock market returns is through arbitrage pricing ( APT ) ( Ross,1976 ) , where multiple hazard factors can analyse plus returns. It may be used as a cumulative stock market strategy, where a alteration in a given macroeconomic variable could reflect a alteration in an implicit in systemic hazard factor impacting future returns. Some of the empirical work on APT theory, uniting the province of the macroeconomic to stock returns, is identified by patterning a short tally relationship between macroeconomic variables and stock monetary value in footings of first difference, gauging tendency stationarity. Subsequently, Chen et Al. ( 1986 ) , have showed that economic forces affect price reduction rates, the ability of i¬?rms to convey about hard currency i¬‚ows, and future dividend payouts, given the premise that a long-run equilibrium existed among macroeconomic variables and stock monetary values. Granger ( 1986 ) says that the efficaciousness of this asssumption can be analyzed utilizing a cointegration analysis. In statistics, the being of cointegration between appropriate factors indicates that a additive combination of nonstationary clip series shows a stationary series. In economic sciences, the presence of such a additive combination creates a long term equilibrium relationship.

Chen et Al. ( 1986 ) analyze the impact of macroeconomics variables on the stock return. The economic theory says that stock monetary values should reflect expectancies about hereafters corporate public presentation which typically reflect the degree of economic activities. Therefore, if stock monetary values right reflect the implicit in basicss, so the stock monetary values should be applied as important indexs of future economic activity. However, if economic activities reflect the motion of stock monetary values, so the consequences should be the opposite, pregnant economic activities should take stock monetary value. Thus the causal relationship and correlativities between economic sciences factors and stock monetary values are of import in explicating the state ‘s macroeconomic policy. Harmonizing to Oberuc ( 2004 ) , the economic factors normally linked with stock monetary values by research workers are industrial production, dividend output, involvement rate, term spread, default spread, exchange rates, rising prices, money supply, GDP and old stock returns, among others.

2.1.2 Money supply and stock monetary values

Monetary policy influences the general economic system through a transmittal mechanism.

In an expansionary pecuniary policy, the authorities creates extra liquidness through unfastened market operation, ensuing in an addition in bond monetary values and take downing involvement rate which leads to take down required rate of return and therefore higher stock monetary value. Furthermore, higher money supply will take to higher stock monetary values due to higher demand. Thus, ensuing in higher rising prices and higher nominal involvement rate ( Fisher equation ) . Higher involvement rate leads to higher needed rate of return and therefore lower stock monetary value.

Friedman and Schwartz ( 1963 ) analyzed the relationship between money supply and stock returns by sing that the growing rate of money supply would impact the economic system and therefore the expected stock returns.

Peter Sellin ( 2001 ) suggest that the money supply will impact stock monetary value merely if a alteration in money supply alteration premise about future pecuniary policy. He suggests that a positive money supply daze will oblige people to foretell fastening pecuniary policy in the hereafter. The subsequent rise in command for bonds will raise the current rate of involvement. As involvement rate addition, the price reduction rates rise every bit good, and the present value of future net incomes diminution. Thereby diminishing stock monetary values.

In add-on, Sellin ( 2001 ) denotes economic activities diminish in conformity to a rise in involvement rates, which farther reduces stock monetary values. On the other manus, the economic experts argue that a positive money supply daze will take to lift in stock monetary values. They explain that a alteration in the money supply supplies information on money demand, which is caused by future end product outlooks. If the money supply rise, it implies that money demand is lifting, which, efficaciously, indicates a rise in economic activity. Higher economic activity means higher hard currency flows, doing stock monetary values to lift.

2.1.3 Inflation and stock monetary values

Inflation rate varies from one period to another, it is of import to see the consequence of rising prices on stock monetary values. In theory stocks should be rising prices impersonal, with merely unforeseen rising prices negatively impacting stock monetary values. Therefore, lower rising prices means higher price/earnings ratios and higher stock monetary values and frailty versa.

Fisher ( 1930 ) speculates that the nominal rate of involvement is made up of two constituents: the expected rate of rising prices ( Iˆte ) and the existent rate of involvement ( rt ) :

This simple equation is based on the fact that economic agents need to be compensated if their buying power has decreased due to an addition in the monetary value degree. What has come to be concluded as fisher consequence creates a 1 for one relationship between expected rising prices and nominal involvement rates and the ex ante existent rate of involvement that remains changeless over the over the long-term.

Using the generalized Fisher hypothesis Gultekin ( 1983 ) survey find a negative arrested development coefficient between rising prices and stock returns for 26 states from 1947 to 1979.Thus this indicates that it could non happen support for this hypothesis.

In literature a negative relationship is explained between rising prices and stock monetary values by Fama and Schwert ( 1977 ) , Chen et Al. ( 1986 ) because a rise in rising prices rate is prone to take to economic tightening policies which inturn raised the nominal hazard free rate and hence the price reduction rate. A figure of hypotheses in the literature explain this negative relationship.

( I ) The proxy hypothesis by Fama 1981, the relationship between returns and rising prices is non true relation, it is merely the placeholder relationship between stock return and growing rate of existent Gross national product with the opposite relationship between stock returns and rising prices. It illustrates that high rising prices rate may cut down money demand which lowers growing in existent activity. However, a lifting rising prices decreases the hereafter expected net income which will impact on the autumn in stock monetary values through the Fisher ( 1930 ) hypothesis asseverating that existent returns are determined by existent factors.

( two ) Modigliani and Cohn ( 1979 ) -inflation relation possibly that investors suffer from money semblance. If investors wrongly use the hyperbolic nominal involvement rate to dismiss future dividends they will minimise the value of equity with a ensuing autumn in monetary values.

( three ) Fieldstein ( 1980 ) He presents that revenue enhancement associated to depreciation and capital addition is affected by rising prices which accordingly affects plus rating. He explained that lifting rising prices lessenings portion monetary values because of the interaction of rising prices with the revenue enhancement system.

2.1.4 Exchange rate and stock monetary values

In literature a figure of hypotheses support the relationship between exchange rate and stock monetary values.

( I ) ‘Goods market attacks ‘ ( Dornbusch and Fischer, 1980 )

This attack says that alterations in exchange rates influence the fight of a house as fluctuations in exchange rate affects the value of the net incomes and cost of its financess as many companies borrow in foreign currencies to fund their operations and hence its stock monetary value. A currency depreciation makes exporting goods attractive and leads to an addition in foreign demand and hence gross for the house and its value would appreciate and hence the stock monetary values.

Furthermore, an appreciating currency reduces net incomes for an exportation house because it leads to a autumn in foreign demand of its merchandises. Nevertheless, the sensitiveness of the value of an importing house to interchange rate alterations is merely the opposite to that of an exporting house. Therefore an appreciating currency has both a negative and a positive consequence on the domestic stock market for an export-dominant and an import-dominated state, severally ( Ma and Kao, 1990 ) .

Furthermore, fluctuations in exchange rates affect a house ‘s dealing exposure. That is, exchange rate motions besides influence the value of a house ‘s future payables ( or receivables ) denominated in foreign currency. Hence on a macro footing, the impact of exchange rate fluctuations on stock market seems to depend on both the importance of a state ‘s international trades in its economic system and the grade of the trade instability.

( two ) Portfolio Balance Approach

This attack lays accent on the function of capital history dealing. ( Tahir and Ghani, 2004 ) . In this attack, lifting ( falling ) of stock monetary values would pull capital influxs from international investors which may do a rise in the demand for a state ‘s currency. An addition ( lessening ) in stock monetary values will take to an grasp ( depreciation ) in exchange rates due to an addition in the demand ( supply ) of local currency.

However, an exogenic addition in domestic stock monetary values will take to a rise in domestic wealth and as a consequence lead to an addition in the demand for money, therefore increasing involvement rates. High involvement rates will do capital influxs ensuing in an grasp of domestic currency ( Krueger, 1983 ) .

2.2 EMPIRICAL REVIEW

2.2.1 Macroeconomics Variables and Stock monetary values

The work introduced by Chen et Al. ( 1986 ) explained that macroeconomic variables were impacting plus returns consistently using the APT theoretical accounts viz. , the spread between long and short-run involvement rate, expected and unexpected rising prices, industrial production and the spread between high- and low- class bonds utilizing 20 every bit leaden portfolios of US securities from1958 to 1984. They take Industrial production to proxy for the current existent hard currency flows, rising prices influences returns as nominal hard currency flow growing rates are non equal to expected rising prices rate, the spread between long and short term involvement rates and the high or low class bond spread affect the pick of price reduction rate. He found that a long term equilibrium relationship exists between stock monetary values and macroeconomic variables and conclude plus monetary values react sensitively to economic intelligence, particularly to unforeseen intelligence.

However, Hamao ( 1988 ) analyze the Nipponese equity market by using the multi-factor APT similar to Chen et Al. ( 1986 ) in US security market. Factors examined include industrial production, rising prices, investor assurance, involvement rate, foreign exchange, and oil monetary values. He found that stock returns are significantly affected by alterations in expected rising prices and unforeseen alterations in hazard premia and in the incline of the term construction of involvement rates and that alterations in monthly production and trade footings appear insignificant in plus pricing whereas unexpected alterations in exchange rate and alterations in oil monetary values are non priced in the stock market.

Using the multivariate analysis, Mahmood et Al ( 2009 ) analyzed the relationship between economic variables and stock monetary value in six Asiatic Pacific states. By utilizing monthly informations on foreign exchange rate, consumer monetary value index, industrial production and stock monetary value he finds that there is a long tally relationship between the variables in Japan, Korea, Hong Kong and Australia. There is no such relationship between stock monetary value and macroeconomic variables in the short tally period for all countires except Thailand and Hong Kong. The consequences show grounds of short tally relationship running from end product to stock monetary value in Thailand and between foreign exchange rate and stock monetary value in Hong Kong. This relationship will assist investors in taking effectual investing determinations and policy-makers in implementing policies to back up more capital influx into the capital markets of the specific states.

Using cointegration analysis, Chowdhury A.R ( 1995 ) examine the issue of informational efficiency in the Dhaka Stock Exchange in Bangladesh. By utilizing monthly informations on narrow and wide money supply and stock monetary value, he finds that the bivariate theoretical accounts indicate independency between stock monetary values and the pecuniary aggregated connoting the market is informationally inefficient. However, it is distinguished that bivariate theoretical accounts were unsuccessful to turn to the obvious possibility that the relationship may be driven by another variable moving both on the stock monetary value and the money supply. Therefore the multivariate theoretical accounts were estimated by utilizing two more variables viz. industrial production index and the nominal exchange rate. This theoretical account demonstrates a unidirectional causality from the money supply to stock monetary value. These consequences appear to be apathetic to the functional signifier of the variables used. Thus stock monetary value make non reflect immediate alterations in pecuniary policy and neglect to expect future growing in money supply therefore the market is inefficient.

Using Johansen ‘s ( 1998 ) VECM, Mukherjee and Naka ( 1995 ) examine the dynamic relationship between six macroeconomic variables and the Nipponese stock market. They considered monthly informations from January 1971 to December 1990 of Nipponese stock market and macroeconomic variables, affecting money supply, exchange rate, industrial production, rising prices, long-run authorities bond rate and name money rate. A VECM theoretical account of seven equations was used. Obtained consequences illustrate that stock returns are cointegrated with a set of macroeconomic variables by supplying long term equilibrium. He found a positive relationship between, money supply, exchange rate existent activity and short term involvement rate and a negative relationship between long term bond and rising prices

Using quarterly informations from 1991 to 2007 Adam and Tweneboah ( 2008 ) analyzed the impact of macroeconomic variables on stock monetary values in Ghana utilizing quarterly informations from 1991 to 2007. They examined both the long-term and short-term dynamic relationships between the stock market index and the economic factors-inward foreign direct investing, exchequer measure rate, consumer monetary value index, mean oil monetary values and exchange rates utilizing a multivariate analysis and developed the undermentioned equation:

Where

I?0 is a changeless, I?1, aˆ¦.I?4 are the sensitiveness of each of the macroeconomic variables to stock monetary value and is a stationary mistake rectification.

Variables

Concept

LDSI

Log of stock index

LCPI

Log of consumer monetary value index

LXR

Log of exchange rate

LTB

Log of exchequer measures

LFDI

Log of foreign direct investing

They found a long tally cointegrating relation between macroeconomic factors and stock monetary values. The VECM analysis illustrates that the lagged values of rising prices and involvement rate have a important impact on the stock market whereas the inward foreign direct investings, oil monetary values, and the exchange rate show weak influence on monetary value alterations.

2.2.2 Money and Stock Market

Ho ( 1983 ) analyzed the relationship of money supply and stock returns for six Asiatic Pacific states. The states studied were Hong Kong, Australia, Philippines, Japan, Thailand and Singapore. By utilizing monthly informations for stock monetary value and two money supply, M1 and M2 and by using cointegration trial and causality trial, he found that there is a unidirectional causality from money supply to stock monetary value in Japan and Philippines but found bidirectional causality in Singapore. However, Hong Kong, Thailand, Australia besides exhibit unidirectional causality nut it holds true merely for M2.

Using quarterly informations for the period 1961 to 1986 Friedman ( 1996 ) , analyzed the function of the existent stock monetary value as a variable in the demand map for money.He found that existent measure of money ( defined as M2 ) demanded comparative to income is positively related to the chapfallen monetary value of equities ( Standard and Poor ‘s complex ) three quarters earlier and negatively related to the coincident existent stock monetary value. The positive relationship seemed to reflect a wealth consequence ; the negative, a permutation consequence. The wealth consequence appears stronger than the permutation consequence. The volume of minutess has an appreciable impact on M1 speed but non on M2 speed.

2.2.3 Inflation and Stock monetary values

Harmonizing to Fama ‘s ( 1981 ) placeholder hypothesis, expected rising prices is negatively correlated with awaited existent activity that there should be a negative relationship. Kaul ( 1990 ) examined the relationship between expected rising prices and the stock market and found positive returns on the stock market. He clearly theoretical accounts the relationship between expected rising prices and stock market returns instead than utilizing the short term involvement rate as a placeholder for expected rising prices ; his determination is consistent with Fama ‘s ( 1981 ) placeholder hypothesis and demonstrates that the relationship between stock returns and expected rising prices in the US is important and negative.

Fama and Schwert ( 1977 ) found that common stock returns were negatively related to the expected constituent of the rising prices rate and seemingly besides to the unexpected constituent from the period 1953-1971. They claimed, “ We can reject the hypothesis that common stocks are a hedge against the expected monthly rising prices rate. ”

Arjoon.R et Al ( 2010 ) analyze the long tally relationship between rising prices and existent stock monetary value in South Africa by using the bivariate vector autoregressive methodological analysis developed by King and Watson ( 1997 ) . The consequences indicate that existent stock monetary values are consistent to lasting alterations in the long tally. The impulse response showed a positive stock monetary value response to a lasting daze in rising prices in the long tally, connoting that any divergences in the short tally stock monetary value will be adjusted towards the long tally. Hence, the long tally estimations of the existent stock monetary value response to a lasting rising prices daze that are zero or positive are theoretically sensible. It is concluded that rising prices does non take down the existent value of stocks in South Africa at least in the long tally.

Maysami 2004, reported a positive relation between rising prices and Singapore stock returns as such it is contrary to the consequences of Fama and Schwert ( 1977 ) , Nelson ( 1976 ) . Adam and Tweneboah for Ghana ( 2008 ) besides reported a positive relationship between rising prices and stock returns. In instance of CPI, the US and Japan shows a negative coefficient for the stock monetary value. ( Humpe Macmillan 2007 ) .These consequences differ from the empirical plant which have obtained a important negative relationship between stock monetary values and rising prices.

2.2.4 Exchange rate and Stock monetary values

The consequences of these surveies are, nevertheless, inconclusive.

TABLE 2.0 EXCHANGE Rate AND STOCK PRICES

Table 2: Exchange Ratess and Stock Monetary values

Writer ‘s Name

Time Frame

Methodology

Aggarwal ( 1981 )

1974-1978

Correlation analysis

United states

Soenen and Hanniger ( 1988 )

1980-1986

Correlation analysis

Abdalla and Murinde ( 1997 )

1985-1994

Granger causality trial

Pakistan

Amare and Mohsin ( 2000 )

1980-1998

A

Philippines

Muhammad and Rasheed ( 2002 )

1994-2000

Cointegration and

India

Granger causality trial, VECM

A

A

Kim ( 2003 )

1974-1998

ECM and Variance Decomposition

U.S.A

Doong et Al. ( 2005 )

Siam

Cointegration and Granger Causality

Aggarwal ( 1981 ) analyzed the impact of exchange rate alterations in US stock monetary values by utilizing monthly informations from 1974 to 1978 for the floating exchange rate period. Using cointegration analysis he found that there is a positive relationship between the US dollar and the alterations in stock monetary values. However, Soenen and Hennigar ( 1980 ) found a negative relationship in the same market but at different clip period.

Furthermore, Solnik ( 1987 ) examine the influence of several economic variables including exchange rates on stock monetary values in nine industrialised states. He found a weak positive relation between existent stock return derived functions and alterations in the existent exchange rates and found that this would back up the thought that anticipated existent growing has a positive influence on the exchange rate. Hence this weak relation might be generated by the fact that stock returns are a hapless placeholder for existent economic growing and a more complete theoretical account should be designated. The consequence indicates that the exchange rate proved to be a non important factor in explicating the development of stock monetary value.

By analyzing the relationship between exchange rate and stock monetary value for eight advanced economic systems from 1985 to 1991 Ajay and Mougoue ( 1996 ) found that there are important short tally and long tally feedback dealingss between these two fiscal markets. An addition in stock monetary value has a negative short tally effects every bit good as a positive long tally consequence on domestic currency value. Besides, currency depreciation has a negative both short tally and long tally consequence on the stock market.

In using both the Engle-Granger AND Johansen ‘s trial Nieh and Lee ( 2001 ) found no important long tally relationship between stock monetary values and exchange rate in G-7 states, and they conclude that each state ‘s difference in economic phase, authorities policy and outlook form may explicate the differing consequences. Furthermore, they found important short term relationships for these states. However, in some states, stock monetary values and exchange rate may function to foretell the future waies of these variables. For case, they found that currency depreciation stimulates Canadian and UK stocks markets with a one-day slowdown, and that increases in stock monetary values cause currency depreciation in Italy and Japan, once more with a one- twenty-four hours slowdown.

Economists have tried to analyze exchange rates-stock monetary value relationship for a long clip. Most surveies find some dealingss and causality, other find no causality between these two variables. Furthermore, way of causality alterations from one economic system to another. The incompatibility in the findings is due to the different clip slowdowns and frequence of informations used. The ground for these differences can be explained by clip period used for informations, econometric theoretical accounts used and economic policies of states.