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CHAPTER 1

INTRODUCTION

Broad Problem Area

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

The KSE is a relatively young (it was established soon


after independence in 1947) and small market. In 2002, it
had 758 stocks listed with a total market capitalization
of about $10 billion or 16% of GDP. The KSE captures 74%
of the overall trading volume in Pakistan. There are two
smaller stock exchanges covering the remaining 26%: The
Lahore stock exchange (22%), and the Islamabad stock

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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.

Rationale Of The Study

There is a consensus among macroeconomists and finance


theorists that stock market prices are driven by
macroeconomic variables, the so- called “fundamentals” in
the economy. Moreover, it is also agreed that the linkage
is two-way; that is, feedback exists between the stock
market and real activity.

There has been a great deal of research into the


phenomenon described above in the developed economies such
as the US, the UK, Germany, Japan etc, where researchers
have come up with some very informative and insightful
results. These results have helped them explain to some
degree the behavior of their stock exchanges and in turn
have helped them make better predictions about its current
and future performance. It is only logical that such
studies be conducted for the Pakistani stock market so
that we too can benefit from the predictive power of
economic variables for our stock exchanges.

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Research Questions

Trying to investigate relations between the variables, the


aim is to make it easier to try to answer the following
hypothesis:-

1. Does industrial production affect the KSE index?


2. Do interest rates affect the KSE index?
3. Does inflation affect industrial production?
4. Does inflation affect interest rates?
5. Does inflation affect the KSE index?
6. Do interest rates affect industrial production?

In analysis of this paper ten years’ monthly data for the


period 1994 until 2004 is taken for all variables.

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Theoretical Framework

To examine the relationship for the hypothesis listed, the


following multivariate model is specified:

U = (KSE, IPI, INF, STI)

Where,

KSE= KSE-100 Index


IPI= Industrial Production Index of Pakistan
INF= Inflation rate of Pakistan
STI= Short Run Interest Rate of Pakistan, in percentage

The Karachi Stock Exchange’s 100 index (KSE), being an


equally weighted price index, is calculated by taking the
average of the prices of a set of 100 biggest companies
listed on the KSE. These companies are sufficiently
representative of the Pakistani Stock Market, because of
the weight of these companies; the KSE-100 index accounts
for majority of the total trading volume.

The Industrial Production Index, (IPI), is included as a


proxy for real economic activity in the Pakistani market.

Inflation (INF) is taken on a monthly basis from the


Consumer Price Index.

The Short Run Interest Rates (STI), corresponds to the


Weighted average rate of return on 3 month or less fixed

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or term deposits (interest bearing and PLS) offered by All
Scheduled Banks in Pakistan in percent per annum.

Objectives Of The Study

The objective of this paper is to investigate the


relations among key economic variables such as:

Inflation
Interest rates
Industrial production

and the stock market index in the small Pakistani economy,


where stock exchanges are less mature as compared to those
in e.g. US, Japan and the UK.

Definition Of The Terms

The following terms have been used extensively in the


report and therefore it is appropriate to adequately
define them for the reader.

Liner Regression: Linear Regression estimates the


coefficients of the linear equation, involving one or more
independent variables that best predict the value of the
dependent variable.

Confidence intervals: depicts the model’s ‘confidence’ in


the result i.e. whether estimations have been made at 90%

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or 95% etc, confidence intervals for each regression
coefficient

R squared change: The change in the R2 statistic that is


produced by adding or deleting an independent variable. If
the R2 change associated with a variable is large, that
means that the variable is a good predictor of the
dependent variable.

Descriptives: Provides the number of valid cases, the


mean, and the standard deviation for each variable in the
analysis.

Part and partial correlations: Convey the zero-order,


part, and partial correlations. Values of a correlation
coefficient range from –1 to 1. The sign of the
coefficient indicates the direction of the relationship,
and its absolute value indicates the strength, with larger
absolute values indicating stronger relationships.

Residuals: Depicts the Durbin-Watson test result for


serial correlation of the residuals and casewise
diagnostics for the cases meeting the selection criterion.

Predicted Values: Values that the regression model


predicts for each case.

Unstandardized: The value the model predicts for the


dependent variable. The unstandardized coefficients are
the coefficients of the estimated regression model

Standardized: A transformation of each predicted value


into its standardized form. That is, the mean predicted

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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.

Adjusted: The predicted value for a case when that case is


excluded from the calculation of the regression
coefficients.

S.E. of mean predictions: Standard errors of the predicted


values. An estimate of the standard deviation of the
average value of the dependent variable.

Prediction Intervals: The upper and lower bounds for both


mean and individual prediction intervals.

Mean: Lower and upper bounds for the prediction interval


of the mean predicted result.

Individual: Lower and upper bounds for the prediction


interval of the dependent variable.

Residuals: The actual value of the dependent variable


minus the value predicted by the regression equation.

Bivariate Correlations: The Bivariate Correlations


procedure computes Pearson's correlation coefficient, with
its significance levels. Correlations measure how
variables are related. Pearson's correlation coefficient
is a measure of linear association.

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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.

Test of Significance: Dependent on either two-tailed or


one-tailed probabilities. If the direction of association
is known in advance, One-tailed is taken. If the direction
of association is not known then Two-tailed test of
significance is taken.

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CHAPTER 2

LITERATURE REVIEW

The relationships among real, monetary and financial


variables have been active topics of economic research for
most of this century. An increasing amount of empirical
evidence noticed by several researchers leads to the
conclusion that a range of financial and macroeconomic
variables can affect stock market activity (e.g. Campbell,
1987, French, Schwert and Stambaugh, 1987, Fama and
French, 1989, Balvers, Cosimano and McDonald, 1990, Been,
Glosten and Jaganathan, 1990, Cochrane, 1991, Campbell and
Hamao, 1992, Ferson and Harvey, 1993, Glosten, Jaganathan
and Runkie, 1993 and Pesaran and Timmerman, 1995, 2000).

The relationship between stock market activity and


fundamental economic variables in the U.S. is well
documented (Fama 1970, 1990 and 1991). In recent years,
numerous studies (Fama 1981, Chen, Roll and Ross 1986,
Chen 1991) modeled the relation between stock market
activity and real economic activities in terms of
production rates, productivity, GNP growth rate,
unemployment, yield spread, interest rates, inflation,
dividend yields, etc. These relationships among stock
market activity, real economic activity and monetary
variables in the U.S. also have been studied by (Geske &
Roll 1983), (Mallaris & Urrutia, 1991), (Darrat & Brocato,

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1994), (Darrat & Dickens, 1999), while Known, (Shin &
Bacon, 1997) studied these relationships in Korea.

(Mallaris et al., 1991) studied the linkage among


industrial production, interest rates and the S&P 500
Index; the results seem to suggest that the
interrelationships among the three variables are not
statistically significant, contrary to what the economic
and financial literature assumes. Since this finding
challenged economic conventional wisdom, it is worth
determining whether the economic role of the stock markets
in relatively less developed countries, such as Pakistan,
is or is not clearly significant. Specifically, it is
interesting to examine how the Pakistani market responds,
in terms of stock market activity, to changes in its
fundamental economic variables. This question, as of yet,
remains unanswered.

(Harbeler, 1937) has summarized a wealth of economic


theories attempting to explain the nature and causes of
stock market activity and particularly fluctuations. The
great depression of 1930’s and the impact of Keynes’
General Theory interrupted the research of the Pre-
Keynesian economists, and during the 1950’s to the late
1960’s the Keynesian doctrine of aggregate demand and
activist fiscal policy distracted attention from the
monetary and financial areas. (Friedman & Schwartz 1963,
1982), among other economists, have redirected the
attention of researchers to the role of interest rates,
while financial economists such as (Sharp, 1964) focused
on financial assets.

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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.

(Malliaris et al., 1991) observed that the performance of


the stock market might be used as a leading indicator for
real economic activities in the United States. For the
United Kingdom, (Thornton, 1993) also found that stock
returns tend to lead real economic activity. In related
work, (Chang & Pinegar, 1989) and (Chen et al., 1986) also
concluded that there is a close relationship between stock
market and the domestic economic activity.

(Neftci, 1984) presented evidence to support his


hypothesis that recessions in economic activity tend to be
steeper and more short-lived that recovery in economic
activity. (Falk, 1986) extended the study of Neftci to

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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.

This evidence increases the challenge to industrial


activity theorists who must now explain not only potential
relations among changes in levels of real, monetary,
economic and financial variables, but also relations among
their volatilities. Actually, this is not a new idea;
(Friedman et al., 1963) had shown that changes in the
volatility of interest rates generated changes in the
volatility of industrial output. In their seminal paper,
(Chen, Roll and Ross, 1986) find that the following macro
variables were significant in explaining expected stock
market activity: industrial production, changes in the
risk premium, twists in the yield curve and, more weakly,
measures of unanticipated inflation and changes in
expected inflation during periods when these variables
were highly volatile.

Studies on non-US markets have mostly been based on the


(Chen et al., 1986) approach. (Hamao, 1988) tested the

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Japanese market and found strong relations, except for the
case of Japanese monthly production.

(Martinez & Rubio, 1989) used Spanish data and found no


significant relationship between stock market activity and
macroeconomic variables. (Poon & Taylor, 1991) are also
unable to explain activity in the UK by factors used by
Chen et al. More recently, (Kaneko & Lee, 1995) have re-
examined the US and the Japanese markets. They found that
both the term and risk premiums, as well as the growth
rate of industrial production, are significantly related
in the US. In Japan, however, international factors have
become increasingly more important. As opposed to the
findings of (Hamao, 1988), changes in oil prices, terms of
trade and exchange rates were significant in Japanese
stock market activity. (Jones & Kaul, 1996) investigated
the response in the stock market of oil prices in the US,
Canada, the UK, and Japan. They concluded that the US and
Canadian stock markets are rational, in the sense that the
response to oil shocks could be completely accounted for
by their impact on current and future cash flows. In the
UK and Japan, however, stock markets have overreacted to
new information about oil prices.

Standard stock valuation models predict that stock prices


are affected by the discounted value of expected cash
flows. (Chen et al., 1986) and (Fama, 1990) have shown
real economic activity, interest rate and stock returns to
be correlated. However, most of these earlier studies
focus upon the short-run relationship between stock market
and financial and macro-economic variables, which may

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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).

More recently, empirical models without any specific


theoretical structure have been applied in a more
pragmatic fashion to the two-way relationship between
stock market indices and real economic variables. The
regression model has been particularly popular in this
area given that it can be used as a framework for formal
examination of inter-relationships within a given data. A
relatively early application of the regression model to
the analysis of the relationship between the stock indices
and the macro economy is by (Lee, 1992) and more recent
ones can be found in (Cheung et al., 1998). Recently
several researchers like (Baestaens et al. 1995); (Kaastra
Ibeling & others 1996), (Katsurelis, 1998), (Kamath, 1999

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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.

Moving towards market in Pakistan’s immediate vicinity,


there have been several studies regarding the relationship
between the stock exchange activity and the key economic
variables. Taking the example of India, (Sharma Kennedy,
1977) and (Sharma, 1983) tested the weak-form efficiency
of the Bombay Stock Exchange (BSE). Both of these studies
with the former covering the 1963-1973 period and the
later encompassing the 1973- 1971 period, conclude that
Indian stocks generally conformed to random-walk behavior
in that successive period changes were independent.
(Poterba & Summers, 1988), however, find evidence of mean
reversion in Indian stock prices, suggesting a deviation
from random-walk behavior. Technical analysis of the stock
market can thus be conducted based on this result.

(Darat & Mukherjee, 1987) apply a regression model along


with Akaike’s final prediction on the Indian data over
1948- 1984 and find that a significant causal relationship
exists between stock market activity and selected macro-
economic variables. (Naka, Mukherjee and Tufte, 1996) have
analyzed relationship among selected macroeconomic
variables and the Indian stock market. By employing a
regression model, they find that domestic inflation and
domestic output are the two most prominent factors
influencing stock market activity.

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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.

(Bhattacharya & Mukherjee, 2002) test the causal


relationships between the BSE Sensex and five
macroeconomic variables. Their major findings are that
there is no linkage between the stock prices and money
supply, national income and interest rate while the index
of industrial production leads the stock price and there
exists a significant correlation between stock market
index and rate of inflation.

(Rao & Rajeswari, 2000) try to explore the role being


played by a good number of macro economic variables in
influencing the stock market when reduced into a
manageable number of economic factors. (Pethe & Karik,
2000) use regression and correlation models to test
relationship between stock market behavior and some macro-
economic variables.

(Fama, 1981) asserts that there is a strong relationship


between stock returns with other macroeconomic variables,
notably, inflation and national output as well as
industrial production. The inflation rate is an important
element in determining stock returns due to the fact that
during the times of high inflation, people recognize that

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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.

Most past empirical literature shows that stock market


activity is negatively correlated with inflation (Fama &
Schwert, 1977; Gultekin, 1983; and recently Barnes et al.,
1999 among others). (Fama, 1981) explains the negative
short-run correlation between stock returns and inflation
by the negative short-run correlation between inflation
and real activity.

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Chapter 3

METHOD

Data

In analysis of this paper ten years’ monthly data for the


period January 1994 until January 2004 is taken for all
variables. (N=120, for each variable).

As already mentioned in the theoretical framework portion,


the data used in the study has four portions:

1. The first portion of the data is the information


regarding the Inflation rate of Pakistan, which is
fairly represented by the Consumer Price Index of
Pakistan or the CPI.
2. The second portion of the data is the information
regarding the industrial production level of
Pakistan, this is represented by the Quantum Index
of Manufacturing. This index is taken as a proxy for
real economic activity in Pakistan.
3. The third portion of the data is the Short-term
interest rates offered on very short term fixed or
term deposits. A weighted average of the rate of
return on 3 month or less fixed or term deposits
offered by all the scheduled banks in Pakistan is
taken.

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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

Monthly data from January 1994 to January 2004 has been


used in this study. Data for the Industrial Production
Index, Consumer Price Index, and Interest Rates were
obtained from the State Bank of Pakistan’s Monthly
Statistical Bulletin, SBP’s Annual Reports and the
economic survey of Pakistan for the relevant years. Data
for the Karachi Stock Exchange Index were obtained from
Yahoo Financial Services and CBS MarketWatch in addition
to the statistical documents mentioned above.

Procedure

To test the predicting power of the key economic variables


over the KSE index a linear regression model is used and
to determine the relationships between all the variables
selected including the independent and all the dependent
variables, a bivariate correlation model is used.

To find out the regression relationship between the


dependent and independent variables the compiled data will

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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.

Furthermore to find out how the four variables taken are


interrelated, Pearson’s correlation test will also be
applied. The correlation test will indicate the level of
interrelatedness of the four variables i.e. KSE-100 index,
Industrial Production index, Short-term interest rates and
the level of inflation in the Pakistani economy over the
course of the time period taken.

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CHAPTER 4

RESULTS AND DISCUSSION

The results that were obtained after running the data


through SPSS are as follows.

The results for linear regression will be discussed first


followed by those for correlation between the four
variables i.e. KSE-100 index, Industrial production index
(IPI), Short-term interest rates of Pakistan and the
inflation level of Pakistan (INF).

RESULTS OF REGRESSION ANALYSIS

Model Summary
Table 4.1

Std. Error
R Adjusted of the
Model R Square R Square Estimate
1 .867 .751 .745 361.86019

Explanation: The above table gives the summary of the


model which has been applied to the data. This table
displays R, R squared, adjusted R squared, and the
standard error.

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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.

Analysis: It is important to point out here that larger


values of R indicate stronger relationships. It can be
seen that the value of R obtained for our data results
is .867 which is a very high value given the fact that the
maximum value which R can obtain is 1.

Moving on to the values for R Square also called the


coefficient of determination, R squared is the proportion
of variation in the dependent variable explained by the
regression model. Once again the values of R squared range
from 0 to 1. Small values indicate that the model does not
fit the data well whereas larger values of R squared
indicate the model fits the data well. Since the R squared
value for our data set is .751 which is a fairly large
value considering the fact that R squared value can at
most be equal to 1 it can be said that the model fits the
data very well.

Adjusted R squared attempts to correct R squared to more


closely reflect the goodness of fit of the model in the
population. It can be seen that even the adjusted R
squared, which presents a somewhat reduced value of R
squared, is giving a value of .745 which is a
significantly high value. The interpretation that can be
obtained from the adjusted R squared value is that 74.5%
of the variation in the KSE index is explained by the

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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.

The following are the results for Analysis of Variance


(ANOVA) Model.

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

Explanation: The above table summarizes the results of an


analysis of variance. The sum of squares, degrees of
freedom, and mean square are displayed for two sources of
variation i.e. regression and residual. The output for
Regression displays information about the variation
accounted for the model, whereas the output for Residual
displays information about the variation that is not
accounted for by the model and the output for Total is the
sum of the information for Regression and Residual. The
mean square is the sum of squares divided by the degrees
of freedom (df). The F statistic is the regression mean

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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.

Analysis: A model with a large regression sum of squares


in comparison to the residual sum of squares indicates
that the model accounts for most of variation in the
dependent variable. It can be clearly seen from the table
that the value for regression sum of square is three times
larger than the value for the residual sum of square.
Since the value of the regression is larger than that of
the residual it can be said that the independent variables
account for most of the variation in the dependent
variable. In other words, the independent variables chosen
i.e. Pakistan’s Inflation level, Short-term interest rates
and level of industrial production account for most of the
variation in the dependent variable i.e. the Karachi Stock
Exchange index.

Furthermore the significance value of the F statistic is


very small (.000) which means that the independent
variables i.e. CPI, IPI and STI do a very good job
explaining the variation in the dependent variable, i.e.
KSE.

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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

Explanation: The unstandardized coefficients are the


coefficients of the estimated regression model. Often the
independent variables are measures in different units. The
standardized coefficients or betas are an attempt to make
the regression coefficients more comparable. The t
statistics can help to determine the relative importance
of each variable in the model. Once again the values are
significant if they are less than .05, any value greater
than .05 is not significant.

Analysis: It was necessary to present this table since the


independent variables were measured in different units,
i.e. CPI and IPI were measured in absolute units whereas
STI was measured in percentage per annum. The results
suggest that there is a significant relationship between
the KSE index and all the independent variables except for
the industrial production index. There is no significant

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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.

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RESULTS OF CORRELATION ANALYSIS

This section discusses the results of the bivariate


correlation test applied to the sample data.

As in the previous section the result table will first be


explained and the results will then be analyzed.

Correlations
Table 4.4

INF IPI STI KSE


INF Pearson
1 -.410 .641 -.367
Correlation
Sig. .000 .000 .000
N 120 120 120 120
IPI Pearson
-.410 1 -.455 .272
Correlation
Sig. .000 .000 .003
N 120 120 120 120
STI Pearson
.641 -.455 1 -.834
Correlation
Sig. .000 .000 .000
N 120 120 120 120
KSE Pearson
-.367 .272 -.834 1
Correlation
Sig. .000 .003 .000
N 120 120 120 120

Explanation: As a measure of correlation, Pearson’s


correlation is employed. The correlations table displays
Pearson correlation coefficients, significance values, and
the number of cases with non-missing values. The Pearson

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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).

The absolute value of the correlation coefficient


indicates the strength, with larger absolute values
indicating stronger relationships. The correlation
coefficients on the main diagonal are always 1.0, because
each variable has a perfect positive linear relationship
with itself. The significance of each correlation
coefficient is also displayed in the correlation table.
The significance level (or p-value) is the probability of
obtaining results as extreme as the one observed. If the
significance level is very small (less than 0.01) then the
correlation is significant and the two variables are
linearly related.

Analysis: Looking first of all at the level of


significance, all the variables except IPI reflect a very
small level of significance, smaller than the threshold .
01 level, signifying a high level of significance. The
only variable which has resulted in an insignificant level
of significance is the index of industrial production’s
correlation with the Karachi Stock Exchange index. This
result further validates the result obtained from the
regression analysis which indicates that the industrial
production index does not do a good job explaining
variation in the KSE index.

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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.

There is a very strong negative relationship between KSE


and STI, i.e. the KSE index is greatly affected in a
negative sense by an increase in the Short-term interest
rates prevailing in Pakistan and is affected positively by
a decrease in the short-term interest rates.

Further detail of the correlative relationships between


the dependent and the independent variables is looked into
in more detail along with support from economic theory in
the next section.

29
Research questions answered

1. Does industrial production affect the KSE index?

INDUSTRIAL
KSE INDEX
PRODUCTION

The KSE index does not seem to significantly affect the


index of industrial production. There does seem to exist a
very weak positive relationship between KSE and IPI i.e.
if one increases the other should increase and if one
decreases the other should decrease, but this relationship
does not seem to be a significant one since the level of
significance is greater than the threshold significance
level of .01 and thus the relationship cannot be called
significant. This result indicates that there is no
significant relationship between the aforementioned
variables at the 5% significant level. There would however
be significance at the 10% level, but as a norm these sort
of time series analysis are always taken ‘at most’ at the
5% significance level therefore it can be concluded that
there is no significant relationship between industrial
production and the KSE index.

This result has important implications for all who are


involved in forecasting stock markets in Pakistan, since
the KSE is thought to significantly affect the other two

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.

2. Do interest rates affect the KSE index?

INTEREST
KSE INDEX
RATES

The short-term interest rates seem to a have a very strong


relationship, in fact the strongest relationship of any
variable in this study, with the Karachi Stock Exchange
index. The correlation results suggest that there is an
83.4% negative relationship between the short-term
interest rates and the KSE index. This is a very strong
relationship indeed and falls exactly in place with
previous research conducted into the investment function
and how the stock exchange is a substitute for other means
of savings in the economy e.g. depositing money into
commercial banks in short-term fixed and term deposits.

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.

This sort of behavior is exactly in accordance with proven


economic theory regarding the inverse relationship between
interest rates and investment. When interest rates
decrease investment increases and when interest rates
increase investment decreases. It is simply a matter of
opportunity cost. The opportunity cost of investing in say
the stock market is the interest that would have been
received if the money had been kept with a bank, and since
the money is not being kept in the bank but is rather
invested in the stock market the opportunity cost of the
stock market investment is the amount of interest forgone.
If the opportunity cost (interest) is large enough then
the person ends up not investing in the stock market but
rather preferring to keep the money lying in the bank.

32
3. Does inflation affect industrial production index?

INDUSTRIAL
INFLATION
PRODUCTION

There is a negative correlation albeit a weak one between


the level of inflation in the Pakistani economy and the
index of industrial production. The Pearson’s correlation
result indicate that there is a 41% negative relationship
between the consumer price index and the index of
industrial production.

This result falls in line with previous economic and


operations research done which suggest that the demand for
a company’s product is the heaviest entity in its
production function. The greater the demand for a
company’s product the greater the level of production the
company will commit itself to in order to satisfy that
demand. It is also a well know fact that demand for a
product is dependent on the level of disposable income
available with the people. Furthering this chain of
relations, the level of disposable income available with
the public is directly related to the prevalent inflation
level in the economy, the more expensive things are,
ceteris paribus, the more money it will take to buy them
thereby reducing the amount of money left to buy other
things. This leads to a direct decrease in the level of
disposable income thereby reducing demand leading to a
decrease in the production function of all industries
across the board. The level of decrease in the 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

There is a strong positive correlation between interest


rates and inflation, following the Pearson’s correlation
result it can be said that there is a 64.1% positive
relationship between inflation and interest rates i.e. if
the level of inflation increases so do the interest rates.

Once again this behavior of the variables can be explained


through monetary economic theory. One of the lead causes
of inflation is said to be “too much money chasing too few
goods”. It is a well known economic fact that when the
level of money supply increases in an economy the general
price level of goods also increases. People simply have
too much money and there are not that many goods to
satisfy the increase in demand that results from increase
in money with the public. This results in an increase in
commodity prices across the board otherwise known as
inflation.

The primary way to control inflation is to simply increase


the interest rates, and this is the practice that has, as
expected, been prevalent in the Pakistani market in the 10
year period from January 1994 to January 2004. The 64.1%
strong positive relationship between inflation and
interest rates can be attributed to prudent monetary

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?

INFLATION KSE INDEX

There is a very weak negative correlation between the


inflation level prevalent in the Pakistani economy and the
KSE index. Pearson’s correlation suggests a 36.7% negative
correlation between the above mentioned two variables.
Being a weak correlation it does not deserve too much
attention nevertheless since there is a slight correlation
it is worth mentioning. One possible explanation of this
very weak correlation is that in case of an inflationary
trend the purchasing power of the public’s disposable
income, ceteris paribus, decreases. Inflation also
decreases the amount of investable funds since a greater
amount of the public’s disposable income goes towards the
transactionary use of money rather than towards the
speculative use of money.

This decrease in the amount of money available for


investment use affects all investable avenues e.g. real
estate etc. Investment in the stock exchanges is simple
another use of investable money and it too therefore is
affected by inflationary trends.

36
6. Do interest rates affect industrial production?

INTEREST INDUSTRIAL
RATES PRODUCTION

Pearson’s correlation results suggest a negative


correlation between short-term interest rates and
industrial production. The results indicate a 45.5%
negative correlation between the above mentioned two
variables. Once again the negative correlation can be
attributed to interest rates eating away at the demand for
the products of a company. An increase in interest rates
leads to people putting their money in banks and other
financial institutions rather than spending it on
purchasing goods and services. This decreases the amount
of money available to be spent on goods and services and
hence demand for goods suffers across the board. Same is
the case with businesses, they get a greater return
keeping their money in bank deposits rather than investing
it in their businesses or expanding their output capacity
etc.

All these factors combine to negatively affect the level


of industrial production in the economy.

37
CHAPTER 5

CONCLUSION AND RECOMMENDATIONS

Judging from the results obtained from the regression and


correlation analysis, the following conclusion and
recommendations can be made:

CONCLUSION

The relationship between the KSE index and the various


variables can be summed up as follows:

A highly negative and significant relationship between the


KSE index and the short-term interest rates has been
observed over the course of the past ten years, this
finding is consistent with the findings of (Rozeff,1974)
in which he too observed a strongly negative correlation
between interest rates and the stock market index.
Additionally studies conducted by (Geske & Roll, 1983)
also look into the relationship between interest rates and
stock market activity and find a significant negative
relationship between the two.

Perhaps the greatest amount of research into the


relationship between interest rates and stock market
activity has been undertaken by (Friedman & Schwartz,
1963, 1982). They redirected the attention of the

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.

The relationship between industrial production and the


Karachi Stock exchange has been discovered to be
insignificant, this finding is in direct contradiction to
most previous research conducted in advanced economies
such as the US and the UK. It is contrary to (Thornton,
1993)’s study into the UK market in which he found that
stock returns tend to lead real economic activity. It is
also contrary to (Chang and Pinegar, 1989) and (Chen et
al., 1986) who also concluded that there is a close
relationship between stock market and domestic economic
activity.

This result seems to indicate that the Karachi stock


exchange is not efficient in the sense that it does not
reflect the country’s true economic activity but is highly
affected by changes in monetary variables, suggesting
speculative intentions at work.

This result is however consistent with the finding of


(Mallaris and Urrutia, 1991) who studied the linkage among
industrial production, interest rates and the United
States’ S&P 500 Index; their results seem to suggest that
the interrelationships among the three variables are not
statistically significant. The bulk of the studies

39
conducted however report a significant relationship
between industrial production and stock market activity.

The relationship between inflation and the Karachi Stock


Exchange is found to be negative. This result conforms to
previous research conducted by (Fama, 1981) who
investigated the relationships among stock returns, real
economic activity, inflation and money. The results also
conform to studies conducted by (Darat and Mukherjee,
1987), (Naka, Mukherjee & Tufte, 1996) and (Bhattacharya
and Mukherjee, 2002). These studies employed various
regression models and concluded that domestic inflation is
one of the most prominent factors influencing stock market
activity. They also note that an increase in inflation
rates 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 further eroding the stock index.

The relationship between inflation and interest rates is


well documented not only through empirical research but
also by virtue of deep rooted economic theory. The result
obtained from this study also validates these theories.
There seems to be a strong positive correlation between
these two variables for the most obvious reason that money
supply has a direct impact on inflation; and the interest
rate is the single most powerful determinant of money
supply. Furthermore the results obtained are in conformity
with previous research conducted by (Chen et al., 1986)
and (Fama, 1990)

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.

The inflation rate is an important element in determining


industrial production due to the fact that during the
times of high inflation, people recognize that the market
is in a state of economic difficulty. People are laid off
work, which causes production to decrease. When people are
laid off, they tend to buy only the essential items. Thus
production is cut even further.

Finally, the relationship between interest rates and


industrial production gives a significant negative
outlook. This result is further reinforced by a previous
research study conducted by (Barro, 1977) which suggest a
negative correlation between the aforementioned variables.

Another convincing study conducted by (Kydland & Prescott,


1990) looks into this very relationship and concludes that
credit considerations, which are directly affected by
interest rates, could play an important role in current
and future industrial activity.

41
RECOMMENDATIONS

Based on the results obtained from the empirical analysis


of key economic variables over the past ten years, the
following recommendations can be suggested:

 To recall, the most striking discovery of this


research has been the insignificant relationship
between the Karachi Stock Exchange and the level of
industrial production in the economy. This result
seems to indicate that the Karachi stock exchange is
not efficient in the sense that it does not reflect
the country’s true economic activity but is highly
affected by changes in monetary variables.
 The above mentioned fact suggests that the KSE is
moved largely by speculative motives rather than
‘real’ production and performance oriented motives,
policy decisions must be made to prevent this
behavior.
 The ratio of blocked to floating shares in Pakistan
must be altered. In Pakistan this ratio is an
alarming 80 to 20, i.e. 80% blocked shares in
relation to 20% floating. In comparison the US has on
average the exact opposite ratio of blocked to
floating shares, i.e. 20:80 or 20% blocked in
relation to 80% floating. This can be one of the
reasons why the KSE index does not reflect real
economic activity. The staggering amount of shares
blocked reflect concentration of ownership of KSE
shares in the hands of a few, including large

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
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47
Correlations, Standardized Multiple Regression Coefficients, Standard errors in
Parenthesis, t values in Brackets, F-statistics and p-values in Italic

Table 4.5

Intercept Interest Industrial Inflation R F


rates Production Square Statistic
KSE-100 1.000 -.834 .272 -.367 .751 116.76
Index - -1.049 -.097 .266
(284.287) (26.938) (.643) (.736)
[15.310] [-16.712] [-1.835] [4.343]
.000 .000 .069 .000 .000

The table shows the results in a summarized form

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

Short term interest rates

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

Index of Industrial Production


SEP SEP
MAY MAY

Figure 4.4
Figure 4.3

IPI
CPI

mean
mean

50
APPENDIX: DATA/OBSERVATIONS

Month INF IPI STI KSE


1994JAN 265.58 295.7 6.67 2178.11
FEB 268.84 274.3 6.67 2291.18
MAR 269.97 276 6.67 2528.16
APL 276.72 249.1 6.67 2448.71
MAY 275.8 203 6.67 2381.72
JUN 278.46 200.1 6.67 2244.04
JUL 282.95 195.9 6.73 2319.77
AUG 285.59 194.2 6.79 2281.36
SEP 289.74 189.8 6.85 2196.65
OCT 294.6 198.5 6.91 2324.67
NOV 298.74 238 6.97 2157.97
DEC 301.29 294.2 7 2143.3
1995JAN 306.17 317.3 6.95 2078.2
FEB 305.77 284.7 6.9 1812.56
MAR 308.46 234.5 6.85 1864.19
APL 308.72 270 6.8 1711.71
MAY 310.08 214 6.75 1532.71
JUN 312.28 221.2 6.69 1513.49
JUL 160.98 200.9 6.79 1605.89
AUG 164.23 204.9 6.83 1801.71
SEP 165.7 205.2 6.9 1754.53
OCT 165.88 226.6 6.97 1663.87
NOV 167.66 267.7 7.04 1547.14
DEC 168.78 313 7.08 1416.9
1996JAN 169.41 298.8 7.11 1464.29
FEB 170.6 275.7 7.14 1631.94
MAR 172.9 289.9 7.17 1727.98
APL 174.3 231.3 7.2 1571
MAY 174.95 223.3 7.23 1715.64
JUN 175.14 226.6 7.28 1749.66
JUL 177.59 213.4 7.3 1653.92
AUG 179.9 207.9 7.32 1502.54
SEP 181.99 205.9 7.34 1353.67
OCT 184.17 221.5 7.36 1397.49
NOV 186.4 238.6 7.38 1500.47
DEC 188.03 307.2 7.39 1474.21
1997JAN 192.11 290.5 7.48 1371.29
FEB 194.2 264.4 7.59 1588.48
MAR 193.33 300.8 7.66 1640.91
APL 197.96 227 7.75 1602.68
MAY 197.57 206.4 7.84 1541.98
JUN 196.95 214.6 7.93 1504.54
JUL 198.17 212.4 7.87 1989.51
AUG 199.46 210.2 7.81 1762.29
SEP 200.72 203.7 7.75 1849.7
OCT 201.53 217.7 7.69 1875.01

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

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