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INTRODUCTION
Over the course of the past year the Pakistani economy has
taken such drastic turns that it has baffled even seasoned
economists and researchers, one such change has been the
unprecedented success of the Karachi Stock Exchange,
represented mostly by the KSE-100 index. Just to take an
example, in April 2003 the KSE-100 index stood a hundred
points shy of the 3000 mark, a coveted position at that
time, and now little over an year later it stands well
past the 5000 point level. Such a radical change has
naturally forced a lot of people to uncover the
fundamental reasons behind the change. This research paper
is an effort by the researcher to find out which are the
fundamental determinants of the KSE index and what is the
extent of their influence on it.
Background Of KSE
1
exchange (4%). The KSE-100 index, which is a weighted
price index of the top 100 companies listed on the stock
market, is usually taken as a benchmark index in Pakistan.
2
Research Questions
3
Theoretical Framework
Where,
4
or term deposits (interest bearing and PLS) offered by All
Scheduled Banks in Pakistan in percent per annum.
Inflation
Interest rates
Industrial production
5
or 95% etc, confidence intervals for each regression
coefficient
6
value is subtracted from the predicted value, and the
difference is divided by the standard deviation of the
predicted values. Often the independent variables are
measures in different units. The standardized coefficients
or betas are an attempt to make the regression
coefficients more comparable.
7
Correlation Coefficients: Correlation coefficients range
in value from –1 (a perfect negative relationship) and +1
(a perfect positive relationship). A value of 0 indicates
no linear relationship.
8
CHAPTER 2
LITERATURE REVIEW
9
1994), (Darrat & Dickens, 1999), while Known, (Shin &
Bacon, 1997) studied these relationships in Korea.
10
More recently, numerous studies have focused on
specialized issues. (Rozeff, 1974) has studied the
relationship between interest rates and stock prices, and
(Barro, 1977) has analyzed the potential relationships
between monetary factors and real industrial output.
(Fama, 1981) investigates the relationships among stock
returns, real economic activity, inflation and money.
(Plosser, 1989) reviews an extensive literature on real
industrial activity and emphasizes the significant role of
technological shocks on the production function and the
economy’s real output. (Mankiw, 1989) criticizes Plosser’s
research and cites the significant role of tight monetary
policies. (Kydland & Prescott, 1990) developed an in-depth
methodological procedure to measure fluctuations for
various variables. They conclude that credit
considerations could play an important role in current and
future industrial activity.
11
other economic series typically associated with the U.S.
industrial activity: real GNP, output per worker-hour, and
gross domestic private investment. In addition, he studied
the behavior of industrial production in Canada, Italy,
West Germany, the United Kingdom, and France. Furthermore,
during the past decade a significant number of papers have
investigated the excessive volatility in stock markets and
questioned the validity of the efficient financial market
hypothesis. (Schiller, 1989) summarizes these studies and
argues that volatilities in stock market indices are
excessive relative to the volatilities in real or monetary
variables.
12
Japanese market and found strong relations, except for the
case of Japanese monthly production.
13
remove important information contained in the permanent
component of economic activity concerning the evolution of
short-run movements. In comparison to the above, long-run
relationship between stock market and the economic
variables has received little attention of researchers
except in (Mukherjee, Naka, 1995), (Chung & Ng, 1998),
(Maysami & Koh, 2000) and (Nasseh & Strauss, 2000). By
using the concept of correlation, the empirical long run
relationships between stock market indices and measures of
economic activity and financial variables can be
investigated. Correlation between stock prices and
economic activity can be seen to be consistent with both
internal & theoretical consumption and production-based
models. These models suggest that stock prices are related
to expected future production through effect on the
discounted value of changes in cash flows and dividends,
(Cochrane, 1991).
14
and 2002) recommend the use of Artificial Neural Network
(ANN) for investigating the correlation relationship as
well as forecasting in capital markets, which has
tremendous promise in terms of methodology.
15
In a recent study under NSE Research Initiative (Kamath,
2002, paper no. 10) uses Artificial Neural Network (ANN)
to examine the relationship of macro-economic factors to
stock market activity. More recent studies like
(Bhattacharya & Mukherjee, 2002), (Rao & Rajeswari, 2000),
(Pethe & Karnik, 2000) use advanced methods in
econometrics to study the same relationship.
16
the market is in a state of economic difficulty. People
are laid off work, which could cause production to
decrease. When people are laid off, they tend to buy only
the essential items. Thus production is cut even further.
This eats into corporate profits, which in turn makes
dividends diminish. When dividends decrease, the expected
return of stocks decrease, causing stocks to depreciate in
value. (Fama, 1981), (Geske et al., 1983), (James et al.
1985), and (Stulz, 1986) all attempt to explain the
negative association between stock returns and inflation.
17
Chapter 3
METHOD
Data
18
4. Finally data for the Karachi Stock Exchange’s 100
index is taken. The reasons for taking the KSE-100
index and not an aggregate index representing all
the stock and companies listed in the KSE is that
the KSE-100 index is sufficiently representative of
the Pakistani Stock Market, since it accounts for
majority of the total trading volume.
Sources Of Data
Procedure
19
be entered into the famous statistical package SPSS. Once
the data has been entered the required tests will be
conducted and the results will be used to analyze the
relationship between the KSE-100 index and the key
economic variables taken as estimators of the index.
20
CHAPTER 4
Model Summary
Table 4.1
Std. Error
R Adjusted of the
Model R Square R Square Estimate
1 .867 .751 .745 361.86019
21
R, the multiple correlation coefficient, is the
correlation between the observed and predicted values of
the dependent variable. The values of R for models
produced by the regression procedure range from 0 to 1.
22
variables selected in the model, i.e. 74.5% of the
variation in the Karachi Stock Exchange index is due to
that Inflation level in the economy, the level of short-
term interest rates and the level of industrial production
in the country.
ANOVA
Table 4.2
Sum of Mean
Model Squares df Square F Sig.
1 Regression 4586524 15288414.
3 116.76 .000
4.166 722
Residual 1518936
116 130942.80
4.688
Total 6105460
119
8.853
23
square (MSR) divided by the residual mean square (MSE).
The regression degrees of freedom is the numerator df and
the residual degrees of freedom is the denominator df for
the F statistic. The total number of degrees of freedom is
the number of cases minus 1. If the significance value of
the F statistic is small (smaller than say 0.05) then the
independent variables do a good job explaining the
variation in the dependent variable.
24
The regression coefficients will now be explained and
analyzed.
Coefficients
Table 4.3
Unstandardized Standardized
Model Coefficients Coefficients T Sig.
Std.
B Error Beta
1 KSE 4352.300 284.287 15.310 .000
INF 3.198 .736 .266 4.343 .000
IPI -1.180 .643 -.097 -1.835 .069
STI -450.183 26.938 -1.049 -16.712 .000
25
regression association between the KSE index and the index
of industrial production index. As expected the Pakistani
benchmark stock exchange does not reflect and is not
affected by actual economic activity but is affected much
more by variation in the monetary variables such as the
interest rates and the level of inflation restricting or
relaxing the level of money available for investment into
the stock exchange. These results will be discussed in
greater detail once the data correlation results are
discussed and as, subsequently, the research questions are
answered one by one.
26
RESULTS OF CORRELATION ANALYSIS
Correlations
Table 4.4
27
correlation coefficient is a measure of linear association
between two variables. The values of the correlation
coefficient range from -1 to 1. The sign of the
correlation coefficient indicates the direction of the
relationship (positive or negative).
28
There is a no significant relationship between KSE and
IPI, i.e. the KSE index is not significantly affected by
any sort of change in the level of industrial production
in the Pakistani economy, this result has important
implications which shall be looked into more deeply later
on.
29
Research questions answered
INDUSTRIAL
KSE INDEX
PRODUCTION
30
stock exchanges in the country i.e. the Lahore (LSE) and
Islamabad (ISE) stock exchanges, and also for policy
writers. Since the index of industrial production is taken
as a proxy for real economic activity in Pakistan, saying
that it has no significant relationship with Pakistan’s
premier benchmark stock market index means that the
Karachi Stock exchange is not significantly affected by
level of economic activity in Pakistan. A country’s stock
exchange is theoretically supposed to reflect the level of
economic activity prevalent, why KSE is not seems like an
economic anomaly. Further light on possible causes for
such behavior will be shed in the subsequent section.
INTEREST
KSE INDEX
RATES
31
As interest rates offered on deposits decrease people find
it more worthwhile to invest their money into other
avenues such as the stock exchanges and real estate etc. A
similar but opposite behavior is witnessed in the case of
an increase in interest rates. When interest rates
increase people find it more profitable to keep their
money in the bank than to invest it in avenues such as the
stock exchange. In this case in addition to gaining more
return by keeping their money in the bank the investor
also avoids facing the considerable amount of risk
inherent in all stock market investments.
32
3. Does inflation affect industrial production index?
INDUSTRIAL
INFLATION
PRODUCTION
33
function however depends on a multitude of other factors
such as the elasticity of demand of the product and
whether or not the product is a necessity of life and so
on.
34
4. Does inflation affect interest rates?
INFLATION INTEREST
RATES
35
policy manipulation by the State Bank of Pakistan. This
relationship is depicted in figure 4.3 on page 50.
5. Does inflation affect KSE index?
36
6. Do interest rates affect industrial production?
INTEREST INDUSTRIAL
RATES PRODUCTION
37
CHAPTER 5
CONCLUSION
38
researchers towards interest rates for predicting and
understanding the behavior of stock exchanges. They have
come up with the most convincing evidence, as of yet, that
interest rates most significantly affect stock market
activity.
39
conducted however report a significant relationship
between industrial production and stock market activity.
40
The relationship between inflation and industrial
production appears to be negative. Once again this result
is in unison with previous research findings by (Plosser,
1989) which suggest that there is a significant negative
relationship between industrial production and inflation.
41
RECOMMENDATIONS
42
institutional investors and foreign owners etc,
whereas the meager amount of floating shares reflect
the share ownership by the general public. This
unhealthy ratio encourages stock market manipulations
by a selected group of individuals and does not let
the index reflect a true picture of the economy. This
tendency must be looked into and policy decisions be
made to change the ratio.
The recent moves made by the Securities and Exchange
Commission of Pakistan (SECP) regarding
demutualization of the KSE are a welcome change and
should be expedited as soon as possible.
The KSE should be converted from a guarantee into a
regular company with share capital and its shares
should be made to float the market just like any
other company. This change along with making the KSE
board accountable to the investor public would also
encourage broader share ownership and prevent
accumulation of majority of shares in the hands of a
select few.
Another way of ensuring that the KSE index reflect
the true performance of the Pakistani economy is to
adopt a share index which is a ‘composite’ of all the
shares listed in the stock exchange rather than an
index of just a few selected shares which are most
widely traded. This move will discourage manipulation
of the index and result in a more realistic appraisal
of the stock market in relation to other markets in
the region and beyond.
43
REFERENCES
44
Hendry, D.F. 1999. Does Money Determine UK Inflation
over the Long Run?, Nuffield College, Oxford, UK.
45
Mallaris, A.G. and Urrutia, J.L., 1991, An empirical
investigation among real, monetary, and financial
variable, Economic Letters, 37, 151-158.
46
Paper Presented in the 4th Annual Conference on Money and
Finance, Mumbai.
47
Correlations, Standardized Multiple Regression Coefficients, Standard errors in
Parenthesis, t values in Brackets, F-statistics and p-values in Italic
Table 4.5
48
Figure 4.1
KSE-100 Index
5000
4500
4000
3500
3000 KSE-100
2500
2000 Mean
1500
1000
500
0
1994JAN
1997JAN
2000JAN
2003JAN
JUL
JUL
JUL
OCT
OCT
OCT
OCT
APL
APL
APL
Figure 4.2
9
8
7
6
5 STI
4 Mean
3
2
1
0
1994JAN
1996JAN
1998JAN
2000JAN
2002JAN
SEP
SEP
MAY
SEP
MAY
SEP
MAY
SEP
MAY
MAY
49
0
50
100
150
200
250
300
350
400
450
500
0
50
100
150
200
250
300
350
1994JAN 1994JAN
SEP SEP
MAY MAY
1996JAN 1996JAN
SEP SEP
MAY MAY
1998JAN 1998JAN
SEP SEP
MAY MAY
2000JAN 2000JAN
Inflation
SEP SEP
MAY MAY
2002JAN 2002JAN
Figure 4.4
Figure 4.3
IPI
CPI
mean
mean
50
APPENDIX: DATA/OBSERVATIONS
51
NOV 203.03 241.5 7.63 1772.24
DEC 203.26 336.7 7.59 1753.82
1998JAN 203.15 336.6 7.49 1609.16
FEB 203.88 323.1 7.39 1681.83
MAR 207.49 334.1 7.29 1553.06
APL 208.42 263.1 7.19 1562.22
MAY 208.73 220.7 7.09 1040.19
JUN 209.71 219.6 7.02 879.61
JUL 211.52 216.3 7.17 920.48
AUG 213.37 219.3 7.32 970.78
SEP 213.61 223 7.47 1111.46
OCT 214.66 219.6 7.62 841.7
NOV 215.68 243.3 7.77 1050.97
DEC 216.19 346.4 7.93 945.24
1999JAN 215.8 331.8 7.82 900.58
FEB 216.61 340 7.71 926.21
MAR 217.36 362.2 7.6 1056.75
APL 217.94 278 7.49 1107.02
MAY 217.78 233 7.38 1222
JUN 217.43 236.3 7.28 1054.67
JUL 218.77 237.4 7.22 1251.79
AUG 220.11 238.5 7.16 1206.51
SEP 221.45 239.6 7.1 1199.29
OCT 222.8 240.7 7.04 1189.32
NOV 222.99 287.4 6.98 1247.4
DEC 222.75 367.9 6.95 1408.91
2000JAN 223.2 325.6 6.89 1772.84
FEB 223.16 315.4 6.83 1930.61
MAR 225.12 272.2 6.77 1999.69
APL 226.39 230.1 6.71 1901.07
MAY 226.15 259.9 6.65 1536.65
JUN 228.52 246.2 6.62 1520.73
JUL 229.81 237.2 6.68 1554.9
AUG 229.68 250.18 6.74 1518.27
SEP 231.92 263.16 6.8 1564.78
OCT 233.24 276.14 6.86 1489.32
NOV 235.05 289.1 6.92 1276.05
DEC 234 314.7 6.96 1507.59
2001JAN 233.62 344.3 6.98 1461.6
FEB 233.43 382.5 7 1423.18
MAR 234.54 361.7 7.02 1324.41
APL 235.33 265.9 7.04 1367.05
MAY 234.27 284.9 7.06 1377.61
JUN 234.29 277 7.06 1366.43
JUL 235.51 253.9 6.81 1228.89
AUG 237.54 263.3 6.56 1258.43
SEP 238.57 265.83 6.31 1133.43
OCT 239.22 268.36 6.06 1406.05
NOV 103.43 273.4 5.81 1358.16
DEC 102.95 344.9 5.56 1273.06
52
2002JAN 103.06 415.1 5.45 1620.18
FEB 103.39 349 5.34 1765.95
MAR 104.74 380.2 5.23 1868.11
APL 105.1 332.4 5.12 1898.95
MAY 104.4 294.3 5.01 1663.34
JUN 104.9 276.5 4.92 1770.11
JUL 106.04 267.6 4.78 1787.59
AUG 106.37 274.6 4.64 1974.58
SEP 106.57 251.8 4.5 2018.75
OCT 106.57 273.8 4.36 2278.54
NOV 106.65 316.6 4.22 2285.87
DEC 106.39 394.9 4.07 2701.41
2003JAN 106.56 417.4 3.7 2545.07
FEB 107.06 394.3 3.33 2399.14
MAR 107.09 454.3 2.96 2715.71
APL 107.45 368.5 2.59 2902.41
MAY 107.14 289.9 2.22 3099.04
JUN 106.92 296.5 1.84 3402.47
JUL 107.53 287.6 1.7 3933.37
AUG 108.24 301.9 1.56 4461.47
SEP 108.89 303.6 1.42 4027.34
OCT 110.49 317.4 1.28 3781.03
NOV 111.15 289.4 1.14 4068.29
DEC 112.2 476 0.99 4471.6
53