INTRODUCTION TO ECONOMETRICS
The purpose of this report is to identify whether a relationship exists between macroeconomic variables and stock exchange returns in the Pakistani capital market. The techniques of multiple linear regression will be applied to understand if there is indeed a link between the two. The time series data being analyzed is on a monthly basis and spans from January 2003 to January 2009. The indicators taken as the independent variables are manufacturing production index, consumer price index, discount rate, broad money, foreign exchange, gold in million troy ounces, and the nominal effective exchange rate. KSE-100 index is going to function as a proxy for stock exchange returns in Pakistan. Capital markets have always helped economies to mobilize and channel capital to where it is needed most. In fact, capital markets have the capability to increase the efficiency of an economy and the effectiveness of Central Bank policy. However Pakistan happens to be one of the emerging economies and therefore its capital markets are still in the stage of development. Hence to establish a link between macroeconomic indicators and stock exchange returns is even more important in the Pakistani context.
In both economic theory and practice, it is a known fact that saving leads to investment. And investment can impact the economy to such an explicit extent that its role cannot be over emphasized. The investors in the Pakistani market have a wide array of instruments and financial assets they can invest in ranging from bank accounts to shares of a publically traded company. However it is not a simple matter to invest in Pakistan, or for that matter anywhere else in the world. A lot of time and effort is required to determine the fair value of a financial asset, not to mention, expertise and experience are pre requisites as well. It is necessary though, to point out right now, that there are other assets besides financial assets that are at the disposal of domestic and foreign investors anywhere. In fact, it would be appropriate to categorize assets into two broad group’s i.e. physical assets such as property and real estate. The other class of assets would be financial assets that include stocks, bonds, bank deposits and the like. We would concern ourselves with financial assets and more specifically stocks and how to have an idea in what direction the share prices of the stocks listed on the Karachi Stock Exchange are headed. It is a known fact in the developed economies that changes in the macro economic variables can have very profound effects on the performance of a stock exchange. In the US only it has happened so many times. Just recently, starting from August 2007, the stock market crash in the US led to the failure of so many financial institutions. The reasons behind these failures were primarily due to heavy exposure to securities of packaged subprime loans and credit default swaps issued to insure these loans and their issuers. This rapidly evolved into a global financial crisis resulting in a number of bank failures in Europe and sharp reductions in the value of equities (stocks) and commodities worldwide. Therefore it is clear, developed or developing, macro economic variables can act as indicators as to how a stock market will perform in the future, however it is necessary the variables under consideration have a leading timing type attribute, in order to predict the future movements of the stock market index.
History of the Karachi Stock Exchange
Karachi Stock Exchange (KSE) has had the honor of being best performing stock market of the world for the year 2002 by Business Week. It was founded in 1947 and since then has come a long way, with many Pakistani and foreign listed companies. To date, there are 651 companies listed on the KSE, which has even had 663 companies listed in 2006, making it the largest and the most liquid...
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