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“Macroeconomic Factors and Mauritian Stock Market: Impact Analysis through Co integration Approach”
Name: Programme: Student ID:
BAZERQUE Sebastien Finance with law (Level 2) 0810195
interest rates. Granger Causality. Key words: Stock market returns. otherwise investors will not be likely to switch from stock market to money market or other places where the opportunity cost for them will be higher. the reason being that the stock exchange of Mauritius if fairly new compared to other countries. money supply and economic growth. The study will investigate whether current economic activities in Mauritius can explain stock market return in the long run by using a co integration test and in short run dynamic adjustment from a vector error correction model. well-documented in the literature. Cointegration. by now. The cointegration test and the vector error correction model will illustrate whether or not stock price indices are cointegrated with a set of macroeconomic variables such as inflation. Vector Error Correction Model. Macroeconomic variables. The study will also test for the causality of economic variables and stock returns. 9 . Implication of the study and suggestion for the improvement of the study will also be provided. productivity index. The outcome of the study can probably be that there will be no cointegration between growth of stock market returns and fundamental macroeconomic factors. It is generally argued by authors that stock market should react with fluctuations in macroeconomic variables. consumer price index.Abstract The relationship between macroeconomic variables and stock market returns is.
For example. Kwon and Shin (1999) applied EngleGranger cointegration and the Granger-causality tests from the Vector Error Correction Model (VECM) and found that the Korean stock market is cointegrated with a set of macroeconomic variables. For example. long term government bond rate and the short term call money rate. using the Granger-causality test on macroeconomic variables and the Korean stock index. the authors found that the Korean stock index is not a leading indicator for economic variables. the Arbitrage Pricing Theory (APT). the interaction of share returns and macroeconomic variables has been subject of interest among academics and practitioners. developed by Ross (1976). Several studies have attempted to capture the effect of economic forces on stock returns in different countries. exchange rates and inflation. Chen et al. This implies that macroeconomic variables can influence investors’ investment decision and motivates many researchers to investigate the relationships between share returns and macroeconomic variables. (1986) used some macroeconomic variables to explain stock returns in the US stock markets. The results of the long-term coefficients of the macroeconomic variables are consistent with the hypothesized equilibrium relationships. It is often argued that stock returns are generally determined by macroeconomic variables such as interest rates. Mukherjee and Naka (1995) employed the Johansen cointegration test in the Vector Error Correction Model (VECM) and found that the Japanese stock market is cointegrated with six macroeconomic variables namely.INTRODUCTION Over the few decades. inflation rate. The development of cointegration analysis provided another approach to examine the relationships between the macroeconomic variables and stock returns. exchange rate. However. Evidence from financial press indicates that investors generally believe that monetary policy and macroeconomic events have a large influence on the volatility of the stock price. industrial production. Their findings showed that industrial production and changes in risk premium were positively related to stock prices whereas expected and unanticipated information about inflation were negatively related to stock prices. using. money supply. 9 .
091 million in the first half of the year. Net sales by foreign investors in the second half of 2008. which mostly occurred in the last quarter of 2008. stood at Rs308 million as against inflows of Rs1.112. Inflation Despite the recent monetary loosening. Foreign investors disinvested significantly from the local stock market. the BoM calculates measures of core inflation which are used as complementary indicators of the trend component of inflation.1 • • Objectives The aim of the study is to investigate the relationship between the market returns of the stock market of Mauritius with macroeconomic variables. Core inflation volatility has also significantly declined. Attempts to determine whether there exists any long run relationship and a short run dynamics between the stock market of Mauritius and real economic activity in Mauritius.90 on 24 November 2008. share prices of blue chip companies dipped following aggressive selling by both local and foreign investors.17 and 245.1. The decline was mainly driven by sales of banking and hotels stocks. confirming that relative price adjustment (from administered prices) has an impact on inflation. • Tests whether major macro-economic variables in Mauritius can explain stock returns by using a co-integration test and vector error correction model. The SEMDEX and the SEM-7 fell by 35 per cent and 41 per cent. reaching lows of 1. respectively. inflationary pressures have eased since the reversal of last year’s global food and commodity price shock and the slowdown of the domestic economy and portfolio inflows. With the focus on the economic weakness of major export markets and the potential impact on export oriented enterprises amid the revised domestic economic outlook. Since 2006. 9 . the local stock market lost considerable ground in the second half of 2008. Stock Market With mounting economic gloom and heightened risk aversion in international markets.
monetary policy was eased in November and again in early December. With the exception of a short period in the mid 2000s. Exchange rate Mauritius’ exchange rate regime has been reclassified from a managed float to a free float in the Fund’s AREAR classification. within the floating regime. Overall. the BoM accumulated reserves through mid-2008 then allowed them to decline as capital inflows eased late last summer. and the floating exchange has depreciated in nominal effective terms by about 4 percent since January 2009.Growth Looser monetary stance is not always associated with stronger growth. The BoM has since refrained from interventions. In addition.S. growth developments in Mauritius depend heavily on the global economy (particularly the EU which is Mauritius’ main market for exports and tourism). Perhaps this is due to the fact that lower interest rates are associated with monetary expansions of 2000-06 and 2007-08 and have contributed to the private sector credit growth in 2003-2004 and 2007-08. in step with international developments. Foreign exchange intervention by the BoM is in principle limited to smoothing operations. while remaining relatively stable against the U. This trend continued when. Despite periods of lower policy rates and high growth there does not appear to be a strong relationship between short-term interest rates and real output. monetary policy easing tends to be followed by a depreciation of the rupee. Recently. dollar. 9 . This allows the Mauritian monetary and exchange rate regime to combine the flexibility of a floating exchange rate with some of the discipline of a less flexible regime. while at the same time private sector credit growth was high under high interest rate environments of 2004-2006.
The Johansen Cointegration Method. (Methodology will include unit root test. It is to be noted that in this section. Moreover.3 will elaborate on the expected outcomes and what kind of statistical analysis will be performed. 9 . Engel and Granger two step approach of cointegration. the vector error correction model. the granger causality test and the impulse response).2 Outline The layout of the study is as follows: section two deals with the review of literature and section three presents methodology with model specification. the data and the methods used to obtain them will also be specified in section three. Section four will consist of a Gantt chart which will provide details about the tasks and respective dates that is intended to be followed for the dissertation. all the variables and proxies used in the study will be explained. 1. Section 3.movements of the nominal effective exchange rate (NEER) have followed the short-term interest rate (perhaps with a lag). which is testing for stationarity of all the variables.
the current price of an equity share equals the present value of all future cash flows of the share. the exchange rate which also involves the movement of currency affects stock prices in a way similar to inflation variable. import becomes more expensive than export leading to increased production cost of import companies. Next. Probably the relationship between stock prices and macroeconomic variables is well illustrated by the Dividend Discounted Model (DDM) proposed by Miller and Modigliani than other theoretical stock valuation model.1 Theoretical Review Economic theory suggests that stock prices should reflect anticipations about future corporate performance and the corporate profits generally reflect the level of economic activity. According to the DDM. Hamao (1988) showed that the Japanese stock returns were significantly affected by inflation. Owing to the fact that all cost cannot be passed on to the 9 . Thus the determinants of share prices are the required rate of return and the expected cash flows suggesting that economic factors which influence those two affect the share price. In the event the local currency depreciates. then stock prices should be employed as crucial indicators of future economic activities.0 Literature Review 1.1. According to the model. inflation and money supply. By using the multi-factor Arbitrage Pricing Theory. If this was the case. the required rate of return and share price are inversely related. He found a strong positive correlation common stock returns and real variables. Fama (1981) carried out investigations of the relationship between stock prices and real economic activity.
Initially he tested the bivariate relationship between stock prices and money supply changes. Engel-Granger and Johansen.e. Obtained results illustrate that stock return is co-integrated with a set of macroeconomic variables by providing a direct long-run equilibrium relation.2 Empirical Review Studies on whether current economic activities in Turkey have explanatory power over stock returns have been conducted by Karamustafa O and Kucukkale Y (2003). exchange rate of US Dollar.Juselius cointegration tests and Granger Causality test were used in the study to explain the longrun relations among variables questioned. Using cointegration techniques. consequently the stock price should decrease. the macroeconomic variables are not the leading indicators for the stock returns. stock market participants incorporate the information contained in money supply changes into stock prices. Theoretically.R. trade balance. However. will fall.consumer due to competitiveness of the market. 2. the money supply has a negative impact on stock prices because. the inflation rate is also expected to increase. They considered monthly data of stock price indexes of Istanbul Stock Exchange and a set of macroeconomic variables. and the industrial production index. it is well known that bivariate models fail to address the obvious possibility 9 . because any causal relation from macroeconomic variables to the stock returns cannot be determined in sample period. including money supply. In other words Dhaka stock market is informationally inefficient. (1995) explains the lack of efficiency in the emerging stock markets by investigating the issue of informational efficiency in the Dhaka Stock Exchange in Bangladesh. an increase in the money supply would also stimulate the economy and corporate earnings would increase. as money growth rate increases. He argued that in an efficient market the prices of the securities fully reflect all available information i. corporate earnings. which are determinants of stock prices according to the DDM. Chowdhury A. stock return is the leading indicator for the macroeconomic performance for the Turkish case. Results from bivariate models suggest independence between the stock price and monetary aggregates. However. This would result in an increase in future cash flows and stock prices. However. In contrast.
Their findings indicated that the price of any common stock is determined by three variables: the level and growth rate of dividends. they concluded that the average level of stock prices is positively related to the money supply.that the relationship may be driven by another variable acting on both stock price and money supply. No such test was conducted for multivariate model. and the risk premium. The risk-free rate of interest being a function of money supply. the risk-free rate of interest. Hence multivariate models were estimated which shows the presence of a unidirectional causality from the money (both narrow and broad) to stock price. One important limitation of this study is that the cointegrating test was conducted only for bivariate model. Homa and Jaffe (1971) estimated the relationship between the supply of money and an index of common stock prices. 9 . But the findings are insensitive to the functional form of the variables employed. seeking a forecasting tool in the implementation of investment strategies. Thus the stock prices do not immediately reflect changes in monetary policy and the market in inefficient.
Narrowly defined money supply in Mauritius Inflation Rate (INF) Exchange Rate (EX) Gross Domestic Product (GDP) Money Supply (M1) 3. It is the closing index prices of the last trading day in each month. The data will be obtained from the Central Statistic Office. Variable Share Price Index Definition Official published index of the marketweighted value of closing price for 40 shares listed on the Stock Exchange of Mauritius Quarterly End of month price of domestic currency rate in terms of trade weighted index Real production based gross domestic product at constant level. 9 . Monthly data series for the period of July 1997 to June 2005 (96 monthly observations) will be considered. For stock price the data used are the monthly general share price index of the Stock Exchange of Mauritius.2.2 Data Sources The data used for the analysis in this study include selected macroeconomic variables and stock price index. the selection of the variables used for the analysis in this study will be justified. The macroeconomic variables used are monthly data for the same time period as the stock market data (July 1997 to June 2005).0 Data and Methodology 3.1 Data Selection Justification and Hypothesis In this section.
1983. intuitive. cointegration.1 Unit root test Many studies have shown that most macroeconomic time series are not stationary. This creates a problem since in the conditions of non-stationary data the normal properties of Durbin-Watson (DW) and t statistics and measure such as R2 break down. 9 .3.3 Research Methods For the purpose of the study. invalid and spurious results. Augmented DickeyFuller (ADF) test procedure will be employed for implementing stationarity tests. vector error correction (VECEM) will be carried out. Sargan and Bhargava. 1988 among the others) and each has been widely used in the applied economics literature. Granger causality will also be conducted to test for causality. Dickey and Fuller. Phillips and Perron. interest rates. The VECM analyses provide some support for the argument that the lagged values of macroeconomic variables have a significant influence on the stock market. In the study. we postulate the relationship between stock prices and selected macroeconomic variables as described above as follows: 3. and empirical discussion. economic growth and money supply. These tests will examine both long run and short run relationships between stock market index and the economic variables used. A series of tests such as unit roots. There have been a variety of proposed methods for implementing stationarity tests (for example. Running regression with such data produces questionable. the relationship between stock market returns and some selected macroeconomic variables will be examined. stationarity test must be performed for each of the variables. rather non-stationary with a deterministic trend. From the above theoretical. The share price index will be used as a proxy to represent stock market return and macroeconomic variables namely inflation. 1979. To eliminate this problem.1.
Y t =A1Yt-1+A2Yt-2+…………………………….2 Johansen Cointegration Method The Johansen method applies the maximum likelihood procedure to determine the presence of cointegrating vectors in non-stationary time series as a vector autoregressive (VAR). We can rewrite the VAR as: 9 . Xt is a d vector of deterministic variables.. and εt is a vector of innovations.+ A pY t-p + BX t+ U t where Yt is a k-vector of non-stationary I(1) variables. Consider a VAR of order p.1.3.
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