Macroeconomic factors and equity prices: An empirical investigation by using ARDL approach

Abstract

This study examines the relationship between equity prices and macroeconomic variables such as inflation, industrial production, oil prices, short term interest rate, exchange rates, foreign portfolio investment, and money supply for the period 6/98 to 6/2008 by employing bounds testing procedure proposed by Pesaran, et al. (2001). Autoregressive distributed lag (ARDL) approach has been applied as yields consistent estimates of the long-run coefficients that are asymptotically normal irrespective of whether the underlying regressors are I(0) or I(1). Data has been tested for econometric problems like serial correlation, functional form, normality, heteroscdisticity and unit root by using LM test, Ramsey Reset test, skewness and kurtosis test, white test and ADF Test, and Phillip Parren Test respectively but no problem has been observed. Results of the study reveal that industrial production, oil prices and inflation are not statistically significant in determining equity prices in long run while interest rates, exchange rates and money supply have significant long run effect on equity prices. The error correction model (ECM) based upon ARDL approach confirms that changes in industrial production, oil prices and inflation are not statistically significantly in short run while changes in interest rates, exchange rates, and money supply have significant short term effect. However, foreign portfolio investment has significant short term effect but no long term effect. The tests suggest that adjustment process is quite fast and model is structurally stable. This study facilitates the investors in taking effective investment decisions by estimating the future direction of equity prices using expected trends in exchange rates, money supply and interest rate. Similarly, study suggest to the architects of monetary policy to be careful in revision of interest rates as capital market responds negatively to such decisions. The study also suggest that macroeconomic policies should be designed keeping in view the response of the capital market because efficient market hypothesis indicates that capital markets respond to new information.