IMPACT OF INFLATION AND GROSS

PROJECT[Date] DOMESTIC PRODUCT ON STOCK

RETURN

SUBMITTED BY
ABDULLAH AKHTAR 0031

ASAD AKHTAR 0029

ARSLAN SHAUKAT 0012

TALHA 0013

IMRAN YOUSUF 0033

HUSNAIN 0042

FURQAN 0044

SUBMITTED TO

PROF ADNAN

UNIVERSITY OF CENTRAL PUNJAB

 IMPACT OF INFLATION AND GROSS DOMESTIC
PRODUCT ON STOCKS INDEX

Abstract
Increasing attention is being paid to the relationship between macroeconomic
variables and Karachi Stock Exchange (KSE-100) return. Inflation and Gross
Domestic Product (GDP) were taken as independent variables and stocks return was
taken as dependent variable. The yearly data of all independent variables Inflation and
GDP and dependent variable Stock Return was taken from January 2001 to December
2015. Regression technique was used to find out the relation between variables.
Regression results found that insignificant positive relationship GDP and stock
returns. Inflation has insignificant negative relation with Stock Market Return.

Introduction
The stock market plays a significant part in economic development by promoting
capital creation and floating economic growth. Exchanging of securities in this market
encourages savers and clients of capital by fund pooling, risk sharing, and exchanging
wealth. Monetary activities can be made by flow of funds to the most beneficial
venture. Financial specialists take choices to put resources into specific shares of
organizations, keeping in view their share costs. Speculations propose that there is a
relationship between changes in share prices and changes in money related major
factors.
Variances in Stock costs can be seen in securities exchange consistently. Moreover,
during certain times of the year, it is easy to notice that stock prices rise every
morning, and this may take place many times in one day for some stocks. This means
that stock prices are determined by supply and demand forces. There is no foolproof
method that specifies the exact measure of stock prices.
Stock market is a fascinating area to investigate. In a nation like Pakistan we are
interested to know whether stock returns have anything to do with the large scale
indicators of the economy. The stock exchange picked for the examination is Karachi
stock exchange which is now Pakistan Stock Exchange. "The Karachi Stock
Exchange (KSE), is a stock market at present situated at the Stock Exchange Building
(SEB) on Stock Exchange Road, in the heart of Karachi's Business District. It is
Pakistan's biggest and one of the most seasoned stock exchange markets in South Asia
by market capitalization, with numerous Pakistani group and in addition abroad
enterprises postings."
This study empirically examined the impact of some macroeconomic variables
GDP and Inflation on stock price volatility in the Pakistan Stock Exchange (PSE)
using annual time series data over the period of 2001-2015. Secondary data on
the performance of the stock exchange: KSE All Shares was obtained from the
Pakistan stock exchange website whiles that of macroeconomic variables was
obtained from the world development indicators website.
The greater part of research chips away at macroeconomic factors and stock
instability essentially centered on shaped economies. Such examination has not been
done in developing nations like Pakistan. The little work done focused on the effect of
monetary factors (i.e. exchange rate and interest rate on the volatility of stock prices).
Thusly, this exploration work tries to examine the effect of full scale monetary
factors: expansion and GDP (Gross domestic product) stock value instability in
Pakistan.

Objectives of the study

This study is essential as it is addressing on key issue. The main goal of this study was
to find out the long term relationship between stock returns and applicable
macroeconomic factors for the Pakistan Stock Exchange. Number of studies have
been completed to locate long term relationship between stock returns and
macroeconomic factors for the USA, Japan, and other mechanically created nations.
In this research work, we have attempted to locate a certified relationship between
two chose factors i.e. Stock index and macroeconomic factors. The primary objectives
were:
A study to highlight the level of relationship between stock return and Gross
Domestic Product (GDP).
An assessment to highlight the level of relationship between stock index and
inflation.

Problem statement
Securities exchange assumes an essential part for the improvement of the economy.
An economy can't be formed without stock exchange. The nation assets are put
resources into the share trading system through recorded organizations (Comincioli,
1995).Stock market demonstrates the performance of the organizations, for example,
KSE100 file. Some macroeconomic factors influence the share trading system and
some political, social and universal conditions impacts money markets. At the point
when securities exchange adversely misrepresented its execution diminished so the
organizations recorded in stock exchanges its share esteem likewise diminished.

Literature Review
In the case of the impact of industrial production, theory states that corporate cash
flows are correlated to a dimension of aggregate output such as Gross Domestic
Product (GDP) or industrial production and many. Moreover Fama (1981) suggests
that measures of economic activity such as industrial production and inflation have
important roles in the analysis of stock market activity. Geske and Roll (1983)
suggested a positive linkage between industrial production and stock market prices.
Then Asprem (1989) also found that real economic activity such as industrial production,

exports, and money are positively correlated to stock prices. In another study Nasseh and

Strauss (2000) found the existence of a strong, long-run relationship between stock prices

and domestic and international economic activity in six European economies. Moreover,

Campbell, Lettau, Malkiel, and Xu (2001) in their study on the macroeconomic

determinants of stock market changes have concentrated on the industrial production
growth rate as a measure of business-cycle fluctuations. Kim (2003) in his study
found that the S&P 500 stock price has a positive correlation with industrial
production but negative relationship with the real exchange rate, interest rate, and
inflation. In another empirical research Ewing and Thompson (2007) also explored
the cyclical correlation between industrial production, consumer prices,
unemployment, and stock prices using time series filtering methods. All these studies
are showing the importance of this variable to take into consideration. As a result our
prior expectation is that the effect of increase in industrial production on stock market
index in China and India is positive. On the other hand, unexpected inflation may also
directly affect the stock market index negatively through unexpected innovations in
the price level. Inflation uncertainty may also influence the discount rate, thus
decreasing the present value of future corporate cash flows. The study by Malkiel
(1982) showed a negative relationship between inflation rate and stock market prices.
This is due to two reasons. First, a rise in the rate of inflation tends to increase interest
rate, which may then lead to the lower prices of equities. Second, an increase in
inflation rate may squeeze profit margins for special groups of companies such as
public utilities, leading to a decrease in their stock prices. Omran and Pointon (2001)
indicated that there is a negative correlation between inflation and market activity and
liquidity, and also between inflation rate and both stock market return and prices. The
same result has found by Boyd, Levine, & Smith (2001) who indicated that there is a
significant, negative correlation between inflation rate and growth in the banking
sector and equity market activities. Moreover, Apergis and Eleftheriou (2002) study
showed that inflation influences stock prices negatively in an economy with high
inflationary pressures, such as Greece. Their findings showed that in Greece, if
inflation decreases, the stock prices goes up. In another study Du (2006) showed that
the positive correlation between returns in stock market and inflation in the 1930s is
mainly due to strongly pro-cyclical monetary policy. However, the strong negative
relationship of stock returns and inflation over the period 1952-1974 is because of
supply shocks during this period.
Majority of the studies have found that the current stock levels are positively related
to future levels of real economic activity, as measured by Gross Domestic Product
(GDP) (Geske & Roll, 1983; Chen et al., 1986; Sharma, 2002). The levels of Gross
Domestic Product (GDP) will likely influence stock returns through its impact on
corporate profitability. An increase in output may increase expected future cash and,
hence, raise stock prices, while the opposite effect would be valid in a recession.
A high inflation rate raises the cost of living and results to a shift of resources from
investments to consumption. The demand for market instruments falls leading to
reduction in the volume of stock traded. This will force the monetary policy
authorities to respond to the increased rate of inflation with economic tightening
policies, which in turn increases the nominal risk-free rate and hence raises the
discount rate in the valuation model (Adam & Twenoboah, 2008). Nominal contracts
that disallow the immediate adjustment of the firms revenues and costs prevent cash
flow to grow at the same rate as inflation. Economic theory indicates that inflation
decreases the purchasing power of business cash flow. Changes in inflation
expectation therefore affect the purchasing power of businesses, hence it is expected
that inflation will correlate negatively with stock returns. Ayadi (1991) and
Ekpenyong and Obieke (1994) provide conflicting results. While Ayadi (1991),
provide evidence that inflation has a positive explanatory power, Ekpenyong and
Obieke conclude that inflation was not priced in Nigeria. Chen et al., (1986) records a
negative association while Beenstock and Chan (1988) and Hamao (1988) report a
positive relationship with stock returns.

Theoretical Framework

Independent Variable Dependent Variable

 GDP
INFLATION
STOCK RETURN

Hypotheses

H0: Stock return is not greatly influenced by inflation.

H1: Stock return is greatly influenced by inflation.
H0: Stock return is not greatly influenced by GDP.
H1: Stock return is not greatly influenced by GDP.

Methodology
Sources of data
This study empirically examined the impact of some macroeconomic variables
GDP and Inflation on stock price volatility in the Pakistan Stock Exchange (PSE)
using annual time series data over the period of 2001-2015. Secondary data on
the performance of the stock exchange: KSE All Shares was obtained from the
Pakistan stock exchange website whiles that of macroeconomic variables was
obtained from the world development indicators website.

Sample Size
We obtained yearly data regarding inflation, GDP and stock market returns from
2001-2015. Total observations are 15.

Dependent Variable
Stock Return
A security's loss or gain is for a particular timeframe. Capital gain and income are two
principle goals of return for an investment. Return on stock represents a combination
of dividends and increases in the stock price Return cited as percentage. Return
includes capital appreciation, dividend and return on capital.
Taking after Model is utilized for computation of Value market return.

Return = Rt =Pt-(Pt-1)/Pt-1

Where Rt= Return for Given Period't'

Pt= price in current year

Pt-1 = price in base year or previous year

Then we took the log of these returns.

Independent Variables
Inflation
Inflation is defined as a constant rise in the general level of prices for goods and
services. It is measured as an annual percentage increase. As inflation rises, every
dollar you own buys a smaller percentage of a good or service.
Causes of Inflation
There is no one reason that's universally agreed upon, but at least two theories are
generally accepted:
If demand is growing faster than supply, prices will increase. This usually
occurs in growing economies.
When companies' costs go up, they need to increase prices to maintain their
profit margins. Increased costs can include things such as wages, taxes, or
increased costs of imports.
We took the calculated inflation rate in Pakistan from the year 2001-2015 from the
World Development Indicators website.
Gross Domestic Product (GDP)
The gross domestic product (GDP) is a main indicator used to measure the well-being
of a country's economy. It represents the total dollar value of all goods and services
produced over a specific time period. Usually, GDP is expressed as a comparison to
the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is
thought to mean that the economy has grown by 3% over the last year.
We took the calculated GDP rate in Pakistan from the year 2001-2015 from the World
Development Indicators website.

Regression Model
SUMMARY OUTPUT

Regression Statistics Column1

Multiple R 0.44739364
R Square 0.200161069
Adjusted R Square 0.066854581
Standard Error 0.380258349
Observations 15

ANOVA
Column1 df SS MS F Significance F
Regression 2 0.434226012 0.217113 1.50151033 0.261827484
Residual 12 1.73515694 0.144596
Total 14 2.169382952

Column1 Coefficients Standard Error t Stat P-value Lower 95%

Intercept 0.364918834 0.508800955 0.717213 0.486969126 -0.743663214
GDP 0.509478912 0.49565656 1.027887 0.324276984 -0.570463959
INFLATION -0.400091442 0.390181264 -1.0254 0.325401866 -1.250223385

Upper 95% Lower 95.0% Upper 95.0%

1.473500882 -0.743663214 1.473500882
1.589421784 -0.570463959 1.589421784
0.450040502 -1.250223385 0.450040502

Analysis
In above Regression Analysis results, it is shown that there is an insignificant positive
relation between Gross Domestic Product (GDP) and stock return with t-value is
1.027. Majority of the studies have found that the current stock levels are positively
related to future levels of real economic activity, as measured by Gross Domestic
Product (GDP) (Geske & Roll, 1983; Chen et al., 1986; Sharma, 2002). There is an
insignificant negative relation exists between inflation and stock returns. R square is
0.200161069 which means stock return is 20% explained by inflation and gross
domestic product.
Coefficients in the table shown, 1 percent increase in GDP will increase the stock
return by 50.94% and 1 percent increase in inflation will decrease the stock return by
40%.
P value analysis:
There is insignificant relation between GDP and stock return because p value of
GDP>.05 and subsequently the insignificant negative relation exists between inflation
and stock return as p-value of inflation is > than .05.
As Apergis and Eleftheriou (2002) stated that inflation influences stock prices
negatively in an economy with high inflationary pressures, such as Greece. Achsaani
& Strohis (2002) investigation resulted in a negative relation b/w inflation rates and
share prices. . Omran and Pointon (2001) indicated that there is a negative correlation
between inflation rate and stock market return and prices. Geske and Roll (1983)
suggested a positive linkage between industrial production and stock market prices

CONCLUSION
Stock exchange is considered as the backbone of economy. Currently Pakistan has
three active stock exchanges known as KSE, LSE and ISE (Karachi stock exchange,
Lahore stock exchange and Islamabad stock exchange respectively) and now given
the identity of PAKISTAN STOCK EXCHANGE. There are many factors which
affect the function of Stock market within a country; due one reason or another,
research could not cover all of them. Secondary data was taken from the period of
2001-2015 of GDP, Inflation and Stock returns. By looking at the Adjusted R2 value
0.066854581, it was conclude that model is insignificant and the 20%variation in
dependent variable is because of the independent variables. Findings of the study
shows that there is an insignificant relationship exist between GDP and stock returns.
Although GDP has a positive impact on stock return. While there is an insignificant
relationship exist between stock returns and inflation. Study suggest that inflation,
should be control as it has negative relationship with stock returns so controlling the
inflation rate will lead positive change in the stock returns. The reason why our results
are insignificant could be the sample size of our research work as it has only 15
observations in total which is blow the standard.

REFERENCE
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https://www.investing.com/indices/karachi-100-historical-data
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