Research Proposal on

Effects of Macroeconomic Variables on Stock Returns

Evidence from Pakistan

Muhammad Bin Qasim

[email protected]

BS Accounting & Finance

Fall, 2020

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR, PAKISTAN 

Introduction

Stock market plays a very important role in the economic growth and development. Efficient

capital markets can enhance the growth and wealth of the economy. The stock market

performance can be measured by the changes in its index, which is affected by different factors

including macro-economic factors. Chong & Koh (2003) examined the efficient market

hypothesis proposed that all related or necessary information to investors about macroeconomic

variables and profit maximizing decreases the prospect of net income. Finally share prices

replicate the current scenario of variables which help in increasing profits.

Stock market is a subsidiary which allows investors to easily buy and sell stocks. As a result of

an active link between macroeconomic variables and stock prices, policies are made on the basis

of these factors. The availability of information regarding security prices is important to the

investors. This decreases the level of risk of the investor.

The aim of this research is to investigate the link between macroeconomic variables and stock

prices in Pakistan. Different variables affect the stock prices like money supply, exchange rate,

inflation and interest. The most important factors are exchange rate, and inflation. Khan el al

(2012) investigated macroeconomic variables are very crucial as they effect the stock market

performance. When investors value the stocks they deem macroeconomic variables. For the

evaluation of stock market returns they used exchange rate, inflation rate, and interest rate as

indicators of macroeconomic variables as they have greater effect.

Due to the presence of high inflation rate in Pakistan, this has become very important. Inflation

has a negative impact on the economic activities. To get information regarding inflation is vital

for the investor. If inflation gets too high without being in the knowledge of the investors, it will

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR, PAKISTAN 

destroy their plans. Mohamed et al. (2007) analyzed the impact of macroeconomic variables on

stock returns in Malaysia which established a positive connection between stock prices and

inflation.

Similarly exchange rate too has an impact on the stock returns. When exchange rate increases it

has a negative effect on returns, and when the rate decreases it shows a positive effect on the

returns. Lee & Wang (2012) identified that exchange rate and sock returns are positively

correlated in Japan, Thailand and in Taiwan the exchange rate and stock return are negatively

correlated while in Singapore no association was found.

Money supply shows a relationship with stock returns. When the money supply is lower, interest

rates will be higher and investors feel hesitant to invest. There should be a balance in money

supply. If the money supply is higher the inflation will be caused. Sohail & Hussain (2009)

identified that there were positive relationship between money supply, industrial production,

effective exchange rate on stock return and negative relationship between inflation on stock

exchange returns. Al-Mutairi & Al-Omar (2007) used Vector auto regression techniques in their

thesis and concluded that money supply, interest rate, government expenditure and inflation rate

has little effect on Kuwait stock exchange. For the study they used monthly wise data from 1995

to 2005.

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR, PAKISTAN 

Research objectives

1. To search out effects of macroeconomic variables on stock prices.

2. To understand impact of money supply on stock returns.

3. To examine the link between exchange rate and stock returns.

4. To illustrate the significant relation between inflation and stock returns.

Hypotheses

The following hypothesis are being drawn;

1. H1: There is no relation between money supply and stock returns.

H2: There is a relation between money supply and stock returns.

2. H3: There is no link between exchange rate and stock returns.

H4: There is a link between exchange rate and stock returns.

3. H5: There is no association of inflation with stock returns.

H6: There is an association of inflation with stock returns.

Theoretical Framework

Fama (1981) proposed proxy hypothesis which illustrates the negative relationship between

inflation rate and stock prices. The negative stock returns – inflation relationship is explained by

the positive relationship between stock returns and basic determinants of equity values, such as

capital expenditures, average real rate of return capital and productivity of a company (Fama,

1981). In contrast, if you consider stock or security as capital goods, inflation treats the capital

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR, PAKISTAN 

goods in the same aspect as other goods, such as agricultural products and industrial products.

Simply put, rising in inflation rate should result in higher price level of general goods as well as

securities. However, this assumption was argued by Feldstein (1980) that when the future

expected inflation rate is higher, the ratio of stock price to real earning will drop. It is due to the

fact that effective tax rate on a company’s source of income is increased to correspond to higher

inflation rate.

A number of hypotheses support the existence of a causal relation between stock prices and

exchange rates. For instance, ‘goods market approaches’ (Dornbusch and Fischer, 1980) suggest

that changes in exchange rates affect the competitiveness of a firm as fluctuations in exchange

rate affects the value of the earnings and cost of its funds as many companies borrow in foreign

currencies to fund their operations and hence its stock price. A depreciation of the local currency

makes exporting goods attractive and leads to an increase in foreign demand and hence revenue

for the firm and its value would appreciate and hence the stock prices. On the other hand, an

appreciation of the local currency decreases profits for an exporting firm because it leads to a

decrease in foreign demand of its products. However, the sensitivity of the value of an importing

firm to exchange rate changes is just the opposite to that of an exporting firm. In addition,

variations in exchange rates affect a firm's transaction exposure. That is, exchange rate

movements also affect the value of a firm’s future payables (or receivables) denominated in

foreign currency. Therefore, on a macro basis, the impact of exchange rate fluctuations on stock

market seems to depend on both the importance of a country’s international trades in its

economy and the degree of the trade imbalance.

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR, PAKISTAN 

Keynesian economists argue that there is a negative relationship between stock prices and money

supply whereas real activity theorists argue that the relationship between the two variables is

positive (Sellin, 2001).

The Keynesian economists argue that change in the money supply will affect the stock prices

only if the change in the money supply alters expectations about future monetary policy.

According to them, a negative money supply shock will lead people to anticipate tightening

monetary policy in the future. They bid for funds in anticipation of tightening of money supply

in the future, which will drive up the current rate of interest. As the interest rate goes up, the

discount rates go up as well and the present value of future earnings falls. Stock prices

consequently decline. Furthermore, they argue that economic activities decline as a result of

increase in interest rates, which further depresses stock prices (Sellin, 2001). The real activity

economists believe that change in money supply, assuming accommodating monetary policy,

provides information on money demand. In other words, they argue that increase in money

supply means that money demand is increasing in anticipation of increase in economic activity.

Higher economic activity implies higher expected profitability, which causes stock prices to rise.

Hence, the real activity theorists argue that there is a positive relationship between money supply

and stock prices (Sellin, 2001).

Independent Variables Dependent Variable

Money supply

Exchange rate

Inflation rate Stock Returns

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR, PAKISTAN 

Figure 1: Conceptual Framework

Data and Population description
This research is applied to identify the impact of exchange rate, inflation rate and interest rate on

stock market returns. Secondary data will used in this study. The exchange rate and inflation rate

data will be taken from Federal bureau of Statistics of Pakistan website interest rate data from

State Bank of Pakistan and the stock market returns data from the website of Karachi Stock

Exchange of Pakistan. The research study will cover the data from January 2010 to December

2019. The proposed population in this study will be the listed companies on KSE 100 index.

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR, PAKISTAN