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Macro economics variable and their mutual relation ship

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Mwenda To cite this article: International Journal of Business and Economics Research. The aim of this paper was to analyze the causal relationship between macroeconomic variables and stock prices in the VAR Vector Autoregressive modeling framework using secondary time series annual data from 1980 to 2012.

  1. A stock return is the dependent variable and it is influenced by the above mentioned independent variables. The priori expectations of the five macroeconomic variables are hypothesized as; there exist a positive relationship between real GDP, broad money supply M3 and stock prices whilst there exist a negative relationship between Treasury bill rate TBR , inflation rate INF , foreign exchange rate EXR and stock prices.
  2. Definition of Terms Stock market.
  3. Instrumentation Othman Ismail 2010 defines instrumentation as the use of various survey instruments or questionnaire.
  4. Liquid equity markets make investment less risky and more attractive because they allow savers to acquire an asset or equity and to sell it quickly and cheaply if they need access to their savings or want to alter their portfolios. Model Specification The study employed a vector autoregressive VAR model to estimate and provide empirical evidence on the nature of causal relationship between the NSE 20-share index and changes in macroeconomic variables.

Sim's causality test based on Granger definition of causality was used to test the causality relationship while OLS Ordinary Least Squares is used to test for any significant relationship.

According to Granger causality test results, it is evident that movement in the macroeconomic variables had no significant effect on stock prices except for inflation rate; exchange rate and change in stock prices also seem to be an insignificant factor explaining part of the movement in the macroeconomic variables except for market interest rates.

Also, the regression test result shows that all the macroeconomic variables are jointly significant in explaining the variations in stock prices. Hence, the findings imply that the causality between macroeconomic variables and stock prices runs unilaterally or entirely in one direction from inflation rate and exchange rate to stock prices and from stock prices to market interest rates.

Thus, there is evidence to show that inflation rate and exchange rate are the cause of movement on stock prices and stock prices are the cause of movement of interest rates in Kenya.

  • Instrumentation Othman Ismail 2010 defines instrumentation as the use of various survey instruments or questionnaire;
  • Contrary to this study, Muthike and Sakwa 2011 did a study on can indicators be used as predictors of the stock exchange index trends" and found that treasury bills, money supply, and real exchange rates were positive, while the signs of inflation rates and GDP were negative;
  • Share prices signal the rate of return investors demand on securities of a particular risk class;
  • Site of the Study The location of study was Kenya;
  • Theoretical Literature Review After 1986, the relationship between macroeconomic variables and stock prices was extensively investigated;
  • Muhammad and Rasheed 2002 examined the exchange rates and stock price relationships for Pakistan, India, Bangladesh and Sri Lanka using monthly data from 1994 to 2000.

Background Information Stock market is a market that deals with the exchange of securities issued by publicly quoted companies and the government. The market is a crucial institution in an economy which greatly determines and indicates the performance of an economy. The nature and the state of a stock market is of great concern to the government, investors and generally all the stake holders.

In an emerging economy, it is generally agreed that stock market under general equilibrium must play a very important role in collecting and allocating funds in an efficient manner. They are required to meet at least two basic requirements of supporting industrialization through savings mobilization, investment fund collections and maturity transformation and ensuring the environment of safe and efficient discharge the aforesaid functions. In most of emerging markets economic reform programs including liberalization, privatization and restructuring have not yet been completed or in the process of completion.

In this case the knowledge of the prevailing relationship macro economics variable and their mutual relation ship stock prices and macroeconomic variables like consumption, investment, industrial production, GDP and the like, is predominantly important in the view of the fact that a stable relationship among these variables are likely to reform the important postulate in a variety of economic models.

Stock markets and capital markets act as a link between capital deficits and capital suppliers. Share prices signal the rate of return investors demand on securities of a particular risk class. If the market is inefficient the risk return relationship will be unreliable, Fama 1970Jensen 1968 and Malkiel 1999.

Stock markets may affect economic activity through the creation of liquidity. Stock markets also contribute to economic development by enhancing the liquidity of capital investments. On the other hand, the economic activity, capital investments disinvestments and monetary policy development may have long term effect on movement in stock prices which leads to increased decreased returns and risk premium demand on securities.

Thus, this shows there is evidence that they may exist a bi-directional causality and long-run relationship between movement of stock prices and movement of macroeconomic variables in the real sector of the economy.

Based on the assumption of strong and persistent relationship between macro-economic variables and stock market prices and returns, several considerations have led to revisit the monetary development in Kenya in the recent two decades. Also, major economic and financial reforms under the auspices of the IMF and WB as part of financial sector liberalization removed interest rates and exchange controls. Following the liberalization of the economy, financial disintermediation, rather than deepening occurred.

However, in the context of an already poorly performing economy, lack of discipline in macroeconomic management and a weak banking system, the move to liberalize financial markets produced disappointing results.

The major initial public offers by various firms as equity financing in the mid-2000s lead to large shifts in liquidity, dip in stock prices while the 2008 post-election disturbances impact lead supply networks for food in most parts of the country leading to high inflation rates which had long-term impact on the economy and financial markets.

The escalating oil prices, global economic crisis leading to weak consumer spending and the volatile foreign exchange rate resulting in the weakening of the shilling all combined to reduce the spending power of securities, other investments and drive away foreign investors.

  • According to Granger causality test results, it is evident that movement in the macroeconomic variables had no significant effect on stock prices except for inflation rate; exchange rate and change in stock prices also seem to be an insignificant factor explaining part of the movement in the macroeconomic variables except for market interest rates;
  • Abdalla and Murinde 1997 found out that the results for India, Korea and Pakistan suggest that exchange rates Granger cause stock prices, which is consistent with earlier study by Aggarwal 1981;
  • Most of the findings as of that time were limited to stock markets microstructure neglecting other risk factors.

Statement of the Problem In the view of economic developments, it has become imperative to study the movements of stock returns as well as the numerous macroeconomic aggregates and indicators. This is because the stock market is the most sensitive segment of any developing economy.

This results in stock price volatility which in turn exerts influence on the macroeconomic aggregates. The crucial question here is how instantaneously this information are transmitted to the investors and market analysts at large and reflected in the stock prices.

This brings up the issue of stock market efficiency. The interactions taking place over time, analysis of which necessitates a suitable time series analysis.

The purpose of this research is to investigate the interaction between the stock price and a set of macroeconomic variables in the context of Kenyan economy from the period of 1980 - 2012.

The analysis of the interrelationship runs in terms of Efficient Market Hypothesis.

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The Efficient Market Hypothesis semi-strong formstates that in a semi strong efficient market, everyone has perfect knowledge of all publicly available information and these are fully macro economics variable and their mutual relation ship in stock prices otherwise, the market participants are able to develop profitable trading rules and the stock market will not channel financial resources to the most productive sectors.

Evaluating the relationship between macroeconomic variables and stock return is of crucial concern for an economy. Policy makers would wish to establish which variables to control and how to control them in order to create an enabling environment for thriving investments.

There is therefore a need for an in-depth and an extensive evaluation of the relationship between stock returns and the macroeconomic variables. When markets are volatile the nature of informational flow from one market to the other across the globe is unprecedented, and the potential investors are wary to take risk as at this time, then there is a need to assess the long run relationship and causal linkage of these markets with some crucial macroeconomic variables as to ascertain their true status and provide the prospective investors with a consistent regulatory frame work.

Objectives The general objective of this study was to analyze the relationship between selected macroeconomic variables and stock returns at the Nairobi Securities Exchange Limited. There is no significant relationship between Real GDP and stock returns. There is no significant relationship between Inflation rates and stock returns. There is no significant relationship between Interest rates and stock return.

Scope of Study The study covered the period from the year 1980 to 2012 with annual data provide by the Kenya National Bureau of Statistics. Significance of the Study The significance of the study is as follows: Academic expected gain is to add to the existing literature on the relationship between stock market returns and macroeconomic variables.

Policy makers, financial researchers and wary potential investors will be well informed on the status of the stock markets thereby monitoring the markets on a consistent regulatory frame work.

Limitations of the Study This study is only limited to secondary data which may in one or the other way lead to information which is not updated, hence inaccuracy may occur in analysis of data. Assumption Macroeconomic variables have similar impact on stock market returns depending on the trading mechanisms and regulatory environments. NSE- 20 share index is used as a proxy for stock market performance to conduct the Granger causality test and verify the direction of causality. Definition of Terms Stock market: A market that deals with the exchange of securities issued by publicly quoted companies and the government.

Organized and regulated financial market where securities bondsnotesshares are bought and sold at prices governed by the forces demand and supply. It succinctly refers to how stocks fare under their respective markets given the risks and returns of the macro economics variable and their mutual relation ship.

The money value of all goods and services produced within the country but excluding net income from abroad. Situation in which the mean variance and autocorrelation are constant over time in time series, that is, the statistical properties do not change with time. Introduction In this chapter a detailed literature review on causal relationship between stock returns and macroeconomic variables is given. The chapter is divided into two parts, theoretical Literature Review and Empirical Literature.

This chapter presents theoretical and empirical literature that aims at developing an understanding of the causal linkage between stock prices and selected macroeconomic variables in Kenya. Theoretical Literature Review After 1986, the relationship between macroeconomic variables and stock prices was extensively investigated. A brief overview of the studies using macroeconomic factors models is presented in this section.

The findings of the literature suggest that a significant linkage exist between macroeconomic variables and stock prices in developed economies but such relationship does not exist in developing economies. The linkage between Stock Market and the so called Macroeconomic variables has over the years, gained reasonable academic attention from students, researchers, stock brokers, to mention but a few.

  1. The presence of moderating variables modifies the relationships between independent and dependent variable. This is because the stock market is the most sensitive segment of any developing economy.
  2. Mandelbrot 1963 and Fama 1965 report evidence of large changes of market stock price to be often followed by other large changes which explains cluster effect of the stock.
  3. More recent examples of studies involving a number of macroeconomic variables include Chen 1991 , and Flanery and Protopapadakis 2002.

The earliest work of researchers in this area has been on different activities of the stock markets with response to either a single or two macroeconomic variables. Most of the findings as of that time were limited to stock markets microstructure neglecting other risk factors.

For instance, Fisher 1930 hypothesizes equity stocks to represent claims against real asset of a business and infers that stock may serve as hedge against inflation. Mandelbrot 1963 and Fama 1965 report evidence of large changes of market stock price to be often followed by other large changes which explains cluster effect of the stock.

Other pioneering research in this area include the work of Sharpe 1964Lintner 1965Modigliani and Cohn 1979Nelson 1976Fama and Schwert 1977Fama1981 and Chen et al. Fama 1970 states that an ideal market is one in which prices provide accurate signals for resource allocation.

He goes further to postulate that an efficient market is one in which prices always fully reflect available information. Fama 1970 also classifies three types of efficient markets, the weak form, semi strong and strong form.

The weak form market reflects all pastpublicly available informationwhile the semi strong form not only reflects available informationbut also price change instantly to reflect new public information.

The strong form market fully reflects all information, adjusts instantly to new information and even reflects hidden or "insider" information.

Monetary policy development has been the central debate in economics and finance as the influence of stock market development.

Various studies and monetary condition in Kenya also have shown that there is a long-run significant effect and causality of monetary policy developments on stock returns.

Many profitable investments require a long-term commitment of capital, but investors are often reluctant to relinquish control of their savings for long periods. Liquid equity markets make investment less risky and more attractive because they allow savers to acquire an asset or equity and to sell it quickly and cheaply if they need access to their savings or want to alter their portfolios.

At the same time, companies enjoy permanent access to capital raised through equity issues.

Under arbitrage pricing asset APT Chen, Roll and Ross 1986 identified the following macroeconomic factors such as surprises in inflation, GNP, yield curve and investor confidence as significant in explaining security returns.

In addition their impact on asset prices manifests in their unexpected movements which should represent undiversifiable influences these are, clearly, more likely to be macroeconomic rather than firm specific in naturetimely and accurate information on these variables is required and the relationship should be theoretically justifiable on economic grounds.

This theory can be supported by efficient market hypothesis EMH championed by Fama 1970 in particular with semi-strong form efficiency which states that stock prices must contain all relevant information including publicly available information has important implications for policy makers and the stock broking industry alike.

As for the effect, macroeconomic variables such as money supply and interest rates on stock prices, the efficient market hypothesis suggests that competition among the profit maximizing investors in an efficient market will ensure that all 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 profits through prediction of future stock market movements. Empirical Literature Review A number of studies have used different techniques to estimate the relationship between macroeconomic variables and stock market prices.

In Kenyan studies, Ochieng and Oriwo 2012 on study of effect of macroeconomic factors lending interest rate, inflation rate and 91-day T-bill rate on stock prices from 2008 to 2012 found that that 91—day T-bill rate has a negative relationship with the NASI while inflation has a weak positive relationship with the NASI. Contrary to this study, Muthike and Sakwa 2011 did a study on can indicators be used as predictors of the stock exchange index trends" and found that treasury bills, money supply, and real exchange rates were positive, while the signs of inflation rates and GDP were negative.

The 91-day T-bill rate and the inflation rate were the only clear leading macroeconomic indicators on the NSE-20 Index. The study concluded that the Kenyan stock market formed significant relationships with all macroeconomic indicators identified, except the gross domestic product. Olweny and Kimani 2011 found that macro economics variable and their mutual relation ship causality between economic growth and stock market runs unilaterally or entirely in one direction from the NSE 20-share index to the GDP.

From the results, it was inferred that the movement of stock prices in the Nairobi Securities Exchange reflect the macroeconomic condition of the country and can therefore be used to predict the future path of economic growth whilst Kisaka and Mwasaru 2012their empirical results indicate that exchange rates Granger-causes macro economics variable and their mutual relation ship prices in Kenya.

In other economies, Vuyyuri 2005 investigated the cointegrating relationship and the causality between the financial and the real sectors of the Indian economy using monthly observations from 1992 to 2002, the financial variables used were interest rates, inflation rate, exchange rate, stock returns and real sector was proxied by industrial productivity employing Johansen 1988 multivariate cointegration test supported the long-run equilibrium relationship between financial sector and the Granger causality test showed unidirectional causality between the financial sector and real sector of the economy.

Maghyerch 2002 investigated the long-run relationship between the Jordanian stock prices and selected macroeconomic variables again using Johansen 1988 cointegration analysis and monthly time series data for the period from 1987 to 2000. The study showed that macroeconomic variables were reflected in stock prices in the Jordanian capital market. Orman 2003 focused on examining the impact of real interest rates as key factor on the performance of Egyptian stock market both in terms of market activity and liquidity.

The cointegration analysis through Error correction mechanism ECM indicated significant long-run and short-run relationship between the variables implying that real interest rates had an impact upon stock market performance. More recent examples of studies involving a number of macroeconomic variables include Chen 1991and Flanery and Protopapadakis 2002.

Some studies also find that the predictive ability of certain macroeconomic variables with respect to stock returns is quite uneven over time. On the other hand, there is no dearth of studies, which fail to support the ability of macro variables to predict stock returns.