The Effect of Macroeconomic Variables on Stock Prices in Emerging Sri Lankan Stock Market

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TITLE :           The Effect of Macroeconomic Variables on Stock Prices in

Emerging Sri Lankan Stock Market

WRITER :       L.M.C.S. Menike

A.    The background and research purposes

The results indicate that most of the companies report a higher R2 which justifies higher explanatory power of macroeconomic variables in explaining stock prices. Consistent with similar results of the developed as well as emerging market studies, inflation rate and exchange rate react mainly negatively to stock prices in the Colombo Stock Exchange (CSE).

The negative effect of Treasury bill rate implies that whenever the interest rate on Treasury securities rise, investors tend to switch out of stocks causing stock prices to fall. However, lagged money supply variables do not appear to have a strong prediction of movements of stock prices while stocks do not provide effective hedge against inflation specially in Manufacturing, Trading and Diversified sectors in the CSE. These findings hold practical implications for policy makers, stock market regulators, investors and stock market analysts.

B.     Method

This study investigates the effect of macroeconomic variables on stock prices.  number of researchers in various countries have found significant relationships between macroeconomic variables and stock prices. These studies concerned multi-factor models as well as single- factor models which incorporate macroeconomic variables as explanatory factors of the variation in equity returns. The following methodological approach is adopted in this study for establishing the relationship between macroeconomic variables and stock prices in the Emerging Sri Lankan Stock Market.

1.Data

The empirical analysis is carried out by using monthly data. The sample period spans from September 1991 to December 2002 and the study was carried out by using 136 monthly observations.

2. Sampel

Although there are 242 stocks listed on the CSE, most stocks do not trade frequently. In order to ensure a reasonable sample size, those stocks, which were traded at least once a month during the sample period, have been included in the sample.

3. Variabel

Avast amount of studies document that significant relationships exist between macroeconomic variables and stock returns. Further, multi-factor models have been developed as an explanation for the variation in security returns and the extant literature suggests that a wide range of factors explain security returns {Fama, 1981, Chen et al., 1986, 2005, Gjerde et al., 1999, and Bilson et al., 2001, Asprem (1989), Jenson et al. (1996), Abdullah and Hayworth, Bulmash and Trivoli (1989), Hooker (2004), Booth and Booth (1994), Wasserfallen (1989). Such variables include goods price, money supply, real activity, exchange rates, interest rates, political risks, oil prices, the trade sector, budget deficits, trade deficits, domestic consumption, unemployment rate, imports and regional stock market indices and real wage.

4. Development of Hypotheses

This research observes the effects of macroeconomic variables on stock prices in the emerging Sri Lankan Stock Market. In order to achieve the objective of the study, the following hypotheses are developed.

·         Hypothesis 1: Money Supply and Stock Prices

·         Hypothesis 2: Money Supply and Exchange Rate

·         Hypothesis 3: Inflation Rate, Interest Rate, and Exchange Rate.

·         Hypothesis 4: Money Supply, Exchange Rate, Inflation Rate and Interest Rate

·         Hypothesis 5: Money Supply, Exchange Rate, Inflation Rate, Interest Rate, Lagged Money Supply and Lagged Inflation Rate.

5. The model

This study examines the effect of macroeconomic  variables on stock prices in selected companies in the CSE. Numerous researchers have developed multifactor models relating to a number of macroeconomic  variabel.

multifactor models relating to a number of macroeconomic variables

C.     The results of research and discussions

·         Overall Results

This section presents the main results of regression on monthly data for the period from September 1991 to December 2002. The impact of macroeconomic variables on stock prices is estimated using four concurrent macroeconomic variables and four lagged variables taken together by employing a multiple regression model.

·         Empirical findings - sector wise

The empirical evidence is found that current money supply reacts mainly ositively to stock prices except DFCC while the current exchange rate impacts predominantly negatively to stock prices in the Banking Sector, rejecting the null hypothesis at 5% level. The explanatory power of variables in explaining stock prices is more than 50%.

D.    Conclusion

The stock prices mainly appear to have an inverse relation to exchange rate, concurrent inflation rate and Treasury Bill rate in the CSE. Consistent with the theory which indicates a direct relation, money supply is mainly positively related to stock prices. This result supports the findings of Bilson et al. (2001), Lynge (1981) and Roley (1982). Chen et al. (2005), Bulmash and Trivoli (1991) and Barrows and Naka (1994) that find a positive relation between money supply and stock returns. Rozeff (1984), Campbell (1987), Kaul (1987) and Booth and Booth (1997), confirmed the theory that an expansionary monetary policy increases stock returns. The most significant variable-the exchange rate- is mainly negative to stock prices supporting the findings of Solnik (1987) and Soenen & Hernigar (1988) and Bilson et al. (2001).