Relationship between Stock Prices and Exchange Rate: A Bivariate and Multivariate Analysis from Pakistan’s Economy

Abstract

This research aims to find the relationship between stock prices and macroeconomic variables i.e. exchange rate, money supply, reserves, interest rate and inflation using data set of KSE100 from June, 1996 to December, 2010. Two measures of exchange rate are being used i.e. real effective exchange rate and nominal effective exchange rate. With Johansen co-integration test, FMOLS and Granger Causality tests as econometric techniques. No evidence of long-run relationship between stock price and exchange rate in bivariate models have been observed but in case of multivariate structure of model, stable long-run co-integration is being observed between stock prices and macroeconomic variables. Results indicate that exchange rate, money supply and interest rate are positive determinants of stock prices in Pakistan whereas negative impact of reserves and inflation is being found for stock price. In both cases bivariate and multivariate models, evidence of unidirectional causality from exchange rate to stock price has been observed. But the direction of macroeconomic variables gets differ in like unidirectional causal relationship is found between stock prices and inflation that runs from inflation to stock prices, from money supply to real effective exchange rate, consumer price index to real effective exchange rate, real effective exchange rate to Total reserve, Consumer price index to Total reserve, and Total reserves to Bank rate. However interest rate and reserves fails to establish any causal linkage with stock prices. Furthermore, unidirectional causality found that is running

Keywords: Inflation, Money Supply, Asset Pricing, Portfolio Choice, Financial Markets

JEL Classification: E31, E51, G12, G11, G15