Macroeconomic Factors and Equity Prices - Pakistan Institute of ...

1. Introduction
The link among macroeconomic variables and the equity market has always attracted the
curiosity of academicians and practitioners as it has an innate appeal. Debate on impact of
macroeconomic factor on equity prices has been at the centre of theoretical and empirical
research since the seminal paper of Chen et al (1986). The relationship between the
macroeconomic variables and the equity prices has been tested in many empirical studies.
Literature reveals that asset pricing theories do not specify the underlying macroeconomic
factors that influence equity prices. Such studies include Roll and Ross(1980), Fama(1981),
Chen et al.1(986), Hamao(1986), Faff(1988), Chen(1991), Maysami and Koh(2000), and Paul
and Mallik(2001). In most of the studies variable selection and empirical analyses is based on
economic rationale, financial theory and investors’ intuition i.e Chen et al.(1986), Mukharjee and
Naka(1995). These studies generally apply Eagle and Granger (1987) procedure or Johanson and
Jusilieus (1990, 1991) approach in VAR Framework. In Pakistan, Fazal(2006) and Nishat(2001)
also apply the same procedure to explore the relationship between macroeconomic factors and
equity prices by using Johanson and Jusilieus (1990,1991) procedure.
The aim of this study is to test the relationship between the inflation, industrial production, oil
prices, short term interest rate, exchange rates, foreign portfolio investment, money supply and
equity prices for the period 6/98 60 6/2008 by employing bounds testing procedure proposed by
Pesaran, Shin and Smith (1996, 2001). This methodology is adopted as it has following
additional benefits. First , determining the order of integration of macroeconomic factors and
equity market returns is not an issue .The Pesaran ARDL approach yields consistent estimates of
the long-run coefficients that are asymptotically normal irrespective of whether the underlying
regressors are I(0) or I(1) and of the extent of cointegration. Secondly, some econometric
procedures used to assess the impact of macroeconomic factors on equity prices is do not allow
one to distinguish clearly between long run and short run relationships. However, the ARDL
approach allows exploring correct dynamic structure.
ARDL approach in an error-correction setting has been widely applied to examine the impact of
macroeconomic factors on economic growth but it is strongly underutilized in the capital market
filament of literature. In Pakistan only Akmal (2007) investigate the relationship between stock
returns and inflation for the Pakistani equity market for the period 1971-2006 by employing
autoregressive distribution lag approach Therefore, this study first time explores the relationship