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Table of Contents

Table of Contents....................................................................1 CHAPTER 1.............................................................................2 INTRODUCTION.......................................................................2 1.1 Introduction......................................................................2 1.2 Problem Statement...........................................................3 1.3 Objective of the Study.......................................................4 1.4 Significance of the Study...................................................5 1.5 Definition of Terms............................................................6 2. Literature Review...............................................................8 2.1 Introduction.....................................................................8 2.2 Macroeconomic Factors....................................................8 2.3 Crude Oil...........................................................................9 2.4 Gold................................................................................10 2.5 T-bill (short term interest rate)........................................11 2.6 Kuala Lumpur Composite Index (KLCI)..............................11 2.7 Arbitrage Pricing Theory (APT).........................................12 2.8 Efficient Market Hypothesis (EMH)...................................13 CHAPTER 3............................................................................14 RESEARCH METHODOLOGY....................................................14 3.2 Conceptual Framework....................................................15 3.3 Research Design .............................................................16 References...........................................................................19

CHAPTER 1 INTRODUCTION 1.1 Introduction Recent rise in the prices of commodity has become a major concern for the world economy. From January of 2009 to December of 2010, price of WTI crude oil rose by more than 118%. Rising crude oil price can increase the cost of production and thus decrease the aggregate supply. Historical data shows the fluctuation of crude oil have greater adjustment speed to equilibrium than other commodities. Refer to Hammoudeh et al. (2007) that the price of oil and inflation rate has close cause and effect relationship and they tend to follow each other. Gold, seen as a commodity that can maintain purchasing power and hedge against inflation well, historically has negative relationship with stock market slump and positive relationship with rising inflation. With the rising of commodity prices and continuously expansionary monetary policy maintained by central banks, global inflation is expected to rise, thus make gold an attractive investment tools. Fluctuation in exchange rate will affect international trade and economy, thus, affect stock markets. When domestic currency appreciates, domestic importers enjoy lesser cost dealing with same amount of goods thus enjoy greater profit. This will have positive effect on the domestic stock price of the said importers. The commodity analysts employ various types of methodology such as fundamental or technical analysis to forecast the future trend of the crude oil price, while investment bankers start to develop and launch new commodity mutual funds or unit trust products to attract attention of the public. On the other hand, as a precaution and in order to protect

their investment, risk adverse investors are moving their assets into the safer assets like precious metal, e.g.; gold and silver. As such, a number of researches has been shows a positive correlation with the international crude oil price and gold price trend in the market. The linkage of gold between the risings of crude oil price has been investigated and empirical studies show that the two commodities are correlated each others. For example, P. Narayan, S. Narayan and Zheng (2010) observe on the long-run relationship between gold and oil spot and futures markets at various stages of maturity and found that a significant positive correlation between crude oil and gold price. Understanding the relationship of oil price, gold price, exchange rate and stock market prices thus is important in global economy perspective. 1.2 Problem Statement Oil has become a precious commodity since industrialization and influences the various economic activities of the country. The effective hedging tools to hedge against inflation are gold which among others has been caused by rising oil prices. At present, with the present escalating oil prices, the world economy is grappling to contain inflation and to ensure that the economic growth is not derailed. Crude oil and gold has been a subject of studies by academics in various countries because of the inter-relationship of prices of commodities. The good indicator of expected inflation in the market is gold while oil is a barometer for deflation. Thus, when inflation is expected, investors will divert their asset to the gold portfolio to protect their asset value. Investor will reallocate their funds and start to buy safer financial assets such as government bond when the deflation is expected. This

reaction can partially be explained by behavioral finance whereby the investors are irrational and market is an imperfect. The study attempt to investigate and address the significant level of relationship between the commodities and the impact on 10 major sub-sector components indices in FBM Kuala Lumpur Composite Index (KLCI) based on the importance of these two commodities prices. The limitation of researches conducted on the different degree of impact of the crude oil price, gold price, market return, and short-term interest rate against sub-sector components index results on only a small number of studies were mainly using stock index FBM Kuala KLCI as the general proxy for overall performance of stock market. However, the stock index consist a numbers of sub sector components index and it may not be a true reflective of a particular contribution of a sector to the overall stock market index. Therefore, the purpose of study is to investigate the degree of significant level for commodities impact to a particular sub sector composite index based on various sub-sectors. 1.3 Objective of the Study The main objective of the study is to examine the relationship between gold price, crude oil price and sub sector index KLCI in terms of market return, and short-term interest rate. The study will includes the examination of correlation between sub sector indices and four (4) other variables which are London Bullion Market, Crude Oil WTI, T-bill band 4 and sub-sector price index. Besides that, a sub-analysis on the gold oil ratio will also be conducted. Gold oil ratio is a barometer of economic vibrancy. During the times are good; the ratio's indicator remains low and these reflect a relatively robust price and demand for crude oil. While during economy slumps, the ratio is high, as gold is seeked by investors

looking for a safe heaven. In other words, this would infer that when the gold oil ratio is below the benchmark, gold price is either too cheap or crude oil is too expensive and viceversa. 1.4 Significance of the Study The economies of the world are now integrated in terms of capital flows and trade with formation of global network across different region. As such, when financial crisis occur, it will have systematic effect throughout the world. Whereby, with advancement of technology and innovation of financial product, risk adverse investors should be more alert on the important signals or indicators as a guide to monitor and time the market to avoid any unexpected risk. As mentioned in the objectives above, the relationship of crude oil prices, gold price, market return, and short-term interest rate on majors selected sub-sector index has became our purpose of investigation in this paper. The results on this study will add to the body of knowledge and assist policymakers like Bank Negara Malaysia and the Security Commission as well as pratictioners such as corporate managers and investors to participate in the stock market. It also enhance their understanding on the level of impact on the four (4) variables to the selected sub-sector indices. For the purpose on this study, the Arbitrage Pricing Theory (APT) model was adopted in evaluating the major sub-sector components indices relationship with various macroeconomic risk factors. It postulates that every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. The conclusion of the study shall enrich investor understanding on some sub-sector industries relationships to macroeconomic risk factors.

1.5 Definition of Terms KLSE (Kuala Lumpur Composite Index) The Kuala Lumpur Composite Index (KLCI) is a capitalization-weighted stock market index and it was transitioned to the FTSE Bursa Malaysia KLCI to be the market benchmark for the Malaysian market. It is used as a proxy to measures the performance of the Kuala Lumpur Stock Exchange. Its comprises of 30 largest companies which listed on the Main Board by full market capitalisation and meet the eligibility requirements of the FTSE Bursa Malaysia Ground Rules. The move provide domestic and international investors with a more transparent, investable and tradable benchmark to stimulate the creation of derivatioves and other index-linked products. London Bullion Market (LBM) (U$ Troy Ounce) price The London Bullion Market is the world largest wholesale over the counter (OTC) market for gold. Trading is conducted among members of the London Bullion Market Association (LBMA), overseen by the Bank of England. Index shows the performance of gold prices over time per troy ounce. The troy ounce is a weight measure for precious metals, which is still used in the Anglo-American zone. It is named for the French city of Troyes. Crude Oil WTI (West Texas Intermediate) Crude Oil WTI is a grade of crude oil used as a benchmark in oil pricing. WTI also known as Texas light sweet with the meaning of light (low density) and sweet (low sulfur) crude oil.

T-Bill band 4 T-Bill band 4 is type of money market instrument. The Central Bank of Malaysia issued Malaysian Treasury Bills (MTB) and this instrument are tradable on yield basis (discounted rate) based on bands of remaining tenure (e.g., Band 4 = 68 to 91 days to maturity). The standard trading amount is RM5 million, and this money market instrument market in the secondary market. This instrument represents a short-term interest rate in the Malaysia money market. The high or low interest rate will make bonds look more attractive than stock and consequently impact the stock price return. Sub-sector Price Index Major sub-sector prices index are the 10 majors sub-sector price index consist of Consumer, Plantation, Finance, Trading and Services, Industrial, Industrial Products, Construction, Mining, Properties, and Technology. Each index is representing overall performance instituted on sub-part of FBM Kuala Lumpur Composite Index (KLCI).


2.1 Introduction In this chapter, a comprehensive review on four (4) variables, theories of Arbitrage Pricing Theory (APT) model and Efficient Market Hypothesis (EMH) will be provided. The four (4) varies include gold, crude oil, T-bill and Kuala Lumpur Composite Index (KLCI). This chapter aim to provide better understanding of the relationship between variables and sub-sector index. 2.2 Macroeconomic Factors Numerous studies have been conducted to analyze the relationship between stock market index and macroeconomic variables. The studies reveal strong relationships between stock returns and macroeconomic variables. Nishat and Shaheen (2004) investigated the relationship between a set of macroeconomic variables and the index of Karachi stock market. The results showed that industrial production has positive impact while inflation has negative impact on the indexs performance. Choo, Lee and Ung (2011) do research on behavior of Japanese stock market volatility against few macroeconomic variables. The authors carried out the comparison study using GARCH models and Ad Hoc methods. Their finding shows that macroeconomic variables used in this study have no direct relation with Japanese stock market.

Achsani and Strohe (2002) examined the relationship between inflation and the index of Jakarta stock exchange. The study concluded that inflation has a negative relationship with indexs performance. Chen (1991) revealed that market excess returns can be predicted using Treasury bill rate, term structure and lagged production growth rate. Maysami et al. (2004) studied on relationship between macroeconomic variables and stock exchange of Singapore and come out with conclusion that the Singapores stock market and property index have positive relationship with industrial production, price levels, money supply, exchange rate, as well as short and long-term interest rates. 2.3 Crude Oil According to Huang et al (1996), oil future returns have not much impact on S&P Index. Al-Rjoub and Samer Am (2005) investigated the effect of oil price shocks in the U.S. from 1985 2004 on America share market. Their finding show that stock market did react to oil price shock. Regarding the effects of oil prices to an economy, Hamilton (1983) use Granger Causality test and discovered that the rise of oil price lead the output of US economy nearly three to four seasons. Basher and Sadorsky (2006) investigated that crude oil is very important in modern economies and it have significant impact on the countrys economy growth. Cunadoa and Gracia (2005) investigated the time leading relationship of oil prices and inflation in six Asian countries using Granger Causality test. They concluded that US dollar based oil prices lead inflation in Japan, Singapore and Thailand. LeBlanc and Chinn (2004) pointed out that the rise of oil prices have fair impacts on the rise of inflation rates in US, Japan, UK, France and Germany.

Lots of studies are done on finding relationship between oil prices and stock values. Driesprong, Jacobsen and Maat (2004) found that investors in stock markets under react to short term oil price changes. Huang, Masulis and Stoll (1996) applied vector autocorrection models to find the time-series relationship. They found out that crude oil futures lead oil companies stock prices. However, they couldnt find significant relationship for others stock prices. Another related study by Sadorsky (1999) showed a different conclusion. He showed that international crude oil price is an important factor which predicts the stock prices very well. Hamilton (2009) studied the factors that change the international crude oil prices and the statistical behavior of crude oil prices. He found that although scarcity of resource made a small contribution to the increase in oil price at 2007, the present situation would be different and crude oil prices might play an important role. 2.4 Gold Gold has the essential position among the major precious metal class. It can even be considered the leader of the precious metal pack as increases in its prices seem to lead other precious metal to increase price as well. (Sari et al, 2010). Gold can be use as a risk management tools in hedging and diversifying commodity portfolios. Melvin and Sultan (1990) investigate the relationship between gold and crude oil markets using dissimilar approach. The study was based on the implication of the gold prices through the export revenue channel. They found that stock shock will leads to prospect of official gold purchases and this will increase gold price. Ismail et al. (2009) developed a forecasting model for gold prices using Multiple Linear Regression Method by using economic factors such as inflation, currency movement


and others. Based on their finding, they concluded that several economic factors such as Inflation rate (INF), Money Supply (M1), Standard & Poor 500 (SPX), Treasury Bill (TBill) and US Dollar index (USDX) have influence on the gold prices. 2.5 T-bill (short term interest rate) Treasury bills are short-term securities issued by the U.S. Treasury. The treasury sells bills to refinance maturing issues and also to help finance current federal deficits. Tbill rate is a benchmarking for short-term interest rate and it is consider as risk free. Thus, T-bill rate is taken into consideration for financial valuation purpose and widely used to determine the fair value of stock. According to Damodaran (2002), returns on both Treasury bill (t-bills) and Treasury bond (t-bonds) and the risk premium for stocks can be estimated relative to each other. The risk premium is larger when estimated relative to short term government securities like Treasury bills. 2.6 Kuala Lumpur Composite Index (KLCI) The KLCI was chosen to represent the market growth optimal portfolio in this research paper. The index comprises of largest 30 companies listed on the Malaysian Main Market by full market capitalization. Petttengill et al. (1995) studied the relationship between return and beta when the excess return on market index is positive or negative. Based on the studies, the result concluded that there is positive relationship between beta and realized returns. Hodoshima et al. (2000) also come out with similar result whereby test is done on 20 beta sorted portfolios. However, the researchers also point out that negative


relationships during market downturn are steeper in Tokyo Stock Exchanges (TSE), resulted in negative return for holding beta risk in long run. Both research concluded that there is a positive and significant relationship between portfolio return and beta during up market while negative relationship during down market. Moreover, test of individual stock returns also shows similar result. 2.7 Arbitrage Pricing Theory (APT) The arbitrage pricing theory (APT) is an asset pricing model based on the idea that an assets returns can be predicted using the relationship between that same asset and many common risk factors. Created in 1976 by Stephen Ross, this theory predicts a relationship between returns of a single asset and returns of portfolio through a linear combination of many independent macro-economic variables. APT describes the price where a mispriced asset is expected to be. A mispriced security has a price which is different from theoretical price predicted by the model. APT is often viewed as an alternative to the Capital Asset Pricing Model (CAPM) due to flexible assumption requirements of APT. CAPM has been considered as a main tool to study on the risk-return trade-off assets. It has been widely used in academic research as well as business financial studies. CAPM has its restrictions. It assumes that investors are rational and based on some unpractical assumptions. According to Fama and MacBeth (1973), there are several variables e.g. the market value of equity ratio (MVE), earnings to stock price ratio (E/P), and book-to- market equity ratio that have bigger influence than market beta. Ross (1979) also studied on APT which was considered a new model replacing CAPM. She concluded


that market beta is not the only variable to measure market systematic risk. Besides, there are multiple variables that can affect stock returns. Although APT model is widely discussed in academic literature, its practical usage has been limited. The APT differs from the CAPM in that it is less restrictive in its assumptions. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical market portfolio. Thus, investors have to perceive the risk sources so that they can estimate factor sensitivities. In fact, even professionals and academics cant agree on the identity of the risk factors. 2.8 Efficient Market Hypothesis (EMH) The Efficient Market Hypothesis (EMH) was developed by Professor Eugene Fama in the early 1960s. It was widely accepted up until the 1990s, when behavioral finance economists became main stream. Based on his theory the security prices will adjust instant and rapidly when public received new information of the company. Therefore, the current prices of securities already reflected all available information. Investors should not be able to occupy readily information to forecast future stock price and gain excess return from it. Financial theorist developed three major version of the hypothesis: weak, semistrong, and strong. In weak-form efficiency, future share price cannot be predicted by analyzing historical price. The abnormal return cannot be earned in long run. Moreover, technical analysis techniques will not consistently produce abnormal profit, though some forms of fundamental analysis may still make extra returns. The future price movements are solely determined by information in the future. Hence, price must follow a random walk without pattern.


In semi-strong-form efficiency, share prices rapidly adjust to publicly available new information in an unbiased fashion. Semi-strong-form efficiency implied that neither fundamental analysis nor technical analysis techniques can generate excess return. In strong-form efficiency, share prices already reflect all information, both public and private. According to this hypothesis, no one can earn excess returns from the market. If there are legal barriers to private information become public, as with insider trading laws, strong-form efficiency is impossible.



This chapter provides an outline of the research process designed to investigate the relationship between economic variables and Sub-sector price index. 3.1 Dataset For the purpose of this study, the daily data for interdependent and dependable variables e.g. FBM KLSE (Kuala Lumpur Composite Index), T-Bill band 4, Crude oil WTI (West Texas Intermediate) price, London Bullion Market (LBM) (U$ Troy Ounce) price, and Sub-sector Price Index are collected from the DataStream and cover a period of 11 years i.e. from 17 April 2000 to 18 April 2011. There are 2610 daily observations obtained from DataStream. In relation to this, the dependable variable consists of ten (10) majors price index e.g., Consumer Product, Plantation, Finance, Trading and Services, Industrial, Industrial Products, Construction, Mining, Properties, and Technology. 3.2 Conceptual Framework The conceptual framework of this study was derived from literature review where proven macroeconomic variables like FBM Kuala Lumpur Composite Index (KLCI) are use for independent variables. Crude oil WTI (West Texas Intermediate) future contract price, London Bullion Market (LBM) (U$ Troy Ounce) price, and T-bill band 4 had been widely used in evaluating a significant statistical relationship between dependent variables i.e. sub-sector price index. Further to that, crude oil price is also proven to be a macroeconomic variable that has direct impact to the performance of the stock market. In fact, oil price can affect prices directly by impacting future cash flows or indirectly through an impact on the interest rate used to discount future cash flows. On the other hand, Gold is a long run effective hedging tool for hedge against inflation and political uncertainty.


Fluctuation of gold price will send a signal to investors and theyre start to expecting the stock market will going down in future. The relationship of the variables to price index is depicted as shown:

1. Crude Oil WTI 2. London Bullion Market (LBM) (U$Troy Ounces) 3. KLSE (Kuala Lumpur Composite Index) 4. T-Bill Band 4

Sub Sector Price Index Consumer Product, Plantation, Finance Trading and Services, Industrial, Industrial Products, Construction, Mining, Properties, and Technology.

3.3 Research Design The Arbitrage Pricing Theory (APT) is an expansion model of Capital Asset Pricing Model (CAPM) single index factor model. CAPM specifies that risk as a function of only one factor, the securitys beta coefficient. In a reality, according to APT the risk / return relationship is much more complex, with an equity excess return a function of more than one factor. For example, CAPM method is not suitable on this research because there are a various interdependent variables effect the dependent variables. Thus, we should adopt the APT (Arbitrage Pricing Theory) model to define and analyses these factors. However, APT does not determine what particular factor that contributed to the risk and return.


In addition, the statistical technique that simultaneously develop a mathematical relationship between a single depend variable and two or more independent variables. With the four independent variables the prediction of Y is expressed by the following equation: Regression equation is; Multi-factor Regression Model: Rit = + MRtMRt + oil Oilt + GoldGoldt+ T-billT-billt + it Indicators: = Intercept / Alpha Rit : Return on major sub sector MRt : Market returns Oilt : Oil returns Goldt : Gold returns T-billt : T-bill returns (1)

it: Error term of ith indices on time t

Where the Sub sector price index is a dependent variable and it shows the return on the Sub sector price index. Beta is the coefficient term and we have four (4) independent variables; Gold price, Oil price, Market returns, and short-term interest rate respectively. We used Ordinary Least Squares (OLS) method to evaluate the relationships between the Gold price, Oil price, Market returns, and short-term interest rate against the ten (10) sub sector price index. The market return was benchmark to the FBM Kuala Lumpur Composite Index (KLCI) composite share price index. Time series of T-bill band 4 taken considerations as a short-term interest rate and same time this instrument consider as a riskfree interest rate.


The first steps, we required to calculate the gain percentage on each independent and dependent variables using below formula: Daily return formula is calculated using as per below:

Ri,t = (Pi,t - Pi, t-1)/ (Pi, t-1) Where; Ri,t is the price return of ith variable on time t Pi, t is the closing price of day t for variable i. Pi, t-1 is the closing price previous of day t for variable i.


Then daily returns are aggregated to run regression analysis. Then after, used the input and the multi-factor regression model to run the regression analysis on each interdependent and dependent variable to examine whether each of them have any significant relationship. In addition, the sub-part of the analysis section will examine the Gold Oil ratio analysis, the purpose is to determining whether the current Gold Oil ratio is below the benchmark ratio - either too cheap, or crude oil is too expensive, otherwise when ratio is greater than benchmark, oil is either too cheap or gold. The analysis on Gold ratio trend will cover from period 17 April 2000 to 18 April 2011. The mean of gold oil ratio as an indicator for investor to decide whether the gold price is expensive, crude oil prices is cheap or the gold price is cheap, crude oil price is expensive. Using below formula: Gold Ratio = Gold Price0, t / Crude oil Price0, t Where; Gold Price0, t is the closing price of day t for Gold. (3)


Crude oil Price0, t is the closing price of day t for Crude oil. Assumptions and Limitation of the Study There are five important variables involved in this study which include four (4) independent variables and one dependent variable. In obtaining data for each variable, this study had outlined the research framework with several assumptions and limitations to enable data collection to be done. i. T-Bill band 4 considered to be the short-term interest rate (risk-free interest rate). ii. KLSE (Kuala Lumpur Composite Index) represent as a benchmark for the market return. iii. Using Crude oil WTI (West Texas Intermediate) future contract price, is a type of crude oil used as a benchmark in oil pricing and underlying commodity of New York Mercantile Exchanges oil futures contracts. iv. London Bullion Market (LBM) (U$ Troy Ounce) price. This index shows the performance of gold prices over time per troy ounce. The troy ounce is a weight measure for precious metals. v. Consists of 10 majors sub-sector price index e.g. Consumer, Plantation, Finance, Trading and Services, Industrial, Industrial Products, Construction, Mining, Properties, and vi. All research data are limited from period 17/04/2000 18/04/2011

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