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The effects of macroeconomic factors on stock returns: Istanbul Stock Market

Husam Rjoub, Turgut Tursoy and Nil Gunsel
Department of Banking and Finance, Near East University, Nicosia, North Cyprus
Purpose The purpose of this paper is to investigate the performance of the arbitrage pricing theory (APT) in the Istanbul Stock Exchange (ISE) on a monthly basis, for the period January 2001 to September 2005. Design/methodology/approach This study examines six pre-specied macroeconomic variables which are: the term structure of interest rate, unanticipated ination, risk premium, exchange rate and money supply. All these are the same as those used by Chen, Roll and Roll for the US market. In this study, the authors develop one more variable namely unemployment rate, which has a relation with the stock return. Findings Using the OLS technique, the authors observed that there are some differences among the market portfolios. Before starting to comment on the result of OLS, the serial correlation problem was discussed by using Durbin-Watson statistics. In this study, the critical values were ranged from between 1.33 and 1.81 (T 57, K 6). Our test results conrmed that in ten out of the 13 there were no serial correlations. Our results show that there are big differences among market portfolios against macroeconomic variables through the variation of R 2. In the remaining portfolios; there was no evidence to suggest. Research limitations/implications In this paper, the authors face a problem that was no corporate bond in Turkeys market. Originality/value This analysis appears to be the rst empirical test of APT using the CAPM formula for nding the risk premium point for ISE. Keywords Arbitrage, Pricing, Macroeconomics, Stock exchanges, Turkey Paper type Research paper


Studies in Economics and Finance Vol. 26 No. 1, 2009 pp. 36-45 q Emerald Group Publishing Limited 1086-7376 DOI 10.1108/10867370910946315

Introduction The arbitrage pricing theory (APT) was propounded by Ross (1976) as a means of relating changes in returns on investments to unanticipated changes in a range of key value drivers for these investments (Kettell, 2001). Therefore, under the APT framework, all investment have expected returns and affected by macroeconomic forces/factors (the range of these factors are not specied in the initial theory). APT starts with the assumption that security returns are related to an unknown number of unknown factors (Alexander et al., 2001). However, Roll and Ross (1980) stated four major factors; these are the unanticipated change in the ination, risk premiums, the terms structure of interest rates and industrial production. Chen, Roll and Roll (1986) (CR&R) examined the validity of the APT in the US securities market. CR&R (1986) analysis used the US macroeconomic variables as proxies for the underlying risk factors that determine the stock returns. They found several of these macroeconomic variables to be signicant in explaining expected stock

return, particularly, industrial production, changes in risk premium, and twist in the yield curve. In this paper, the CR&R (1986) results are tested to see whether the factors priced in the US market are applicable in Turkey stock market, with adding new variable unemployment rate, because we expected a relation with the stock returns. The aim of this study is to analyze the empirical applicability of the APT for pricing stocks at the Istanbul Stock Exchange (ISE), and to identify the set of macroeconomic variables which correspond more closely with the stock market factors. In this study, we test six macroeconomic variables to price the stocks of ISE which are: the term structure of interest rate, unanticipated ination, risk premium, exchange rate, money supply (M1), and unemployment rate. With these variables specied, we collected information of historical values of the variables and the portfolio returns from the period of January 2001 to period of September 2005. Using these data, we calculated the sensitivity of the portfolios return to the variables (factors). Source of data In the (ISE) web site a total of 259 companys stocks were listed in the (ISE) between January 2001 and September 2005. However, some of these companies had missing data, which left a total of 193 stocks which were subsequently classied in the thirteen portfolios. Table I shows the number of companies under each of the 13 market classication. Table II illustrates the macroeconomic factors that were employed in the analysis. The factors are the term structure of interest rate, unanticipated ination, risk premium, real exchange rate, money supply (M1), and unemployment rate. Literature review CR&R (1986) have tested a set of economic variables to explain the US stock market returns. They examined the inuence of macroeconomic variables on stock returns by
Symbol All MANWPF MANPPP MANNMP MANFBT MANTWP MANCPR MANBMI MANFMP MANOMI ELEGAW TRACOM BANSFC INSCOM Total Industry All stocks Industry sector Manufacturing of wood production including furniture Manufacturing of paper and paper products, printing Manufacturing of non metallic mineral products Manufacturing of food beverage and tobacco Manufacturing of textile, wear and paper industry Manufacturing of chemical, petroleum, rubber and plastic Manufactory of basic metal industry Manufacturing of fabrical metal products Other manufacturing Industry Electric, gas and water Transportation and communication Financial institutions Bank and special nance corporations Insurance companies Number of rms 259 2 13 27 22 34 25 14 25 3 4 5 12 7 193

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Table I. Portfolios classication

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Variables F1 F2 F3 F4 F5 F6


Factors Term structure of nterest rate Unanticipated nation Risk premium Real exchange rate Money supply M1 Unemployment

Measurement TRt LTGBt 2 TBt U 1t I t 2 EI t =t 2 1 Rp Lbt 2 LTGBt

Table II. Macroeconomic factor

Notes: LTGB long term government bond (over three months); TB short term Treasury bill rate (up to three months), LB low-grade bond, I ination

testing seven macroeconomic variables: namely, term structure of interest rate, industrial production, risk premium, ination, market return, and consumption and oil prices between 1953 and November 1984. They found several of these economic variables to be signicant in explaining expected stock return during the test period for which the factors were formed. They note that industrial production, changes in risk premium, twist in the yield curve, and measure of unanticipated ination (of changes in expected ination during periods when these variables are highly volatile) are signicant in explaining the expected returns. Also, they found that consumption, oil price and the market index are not priced by the nancial market. They conclude that the stock returns are exposed to systematic economic news of that the news can be measured as innovations in state variables whose identication can be accomplished through simple and intuitive nal theory. There are relatively few empirical investigations are of which is undertaken by Dhrymes et al. (1984) were they examined the technique used by Roll and Ross (1980). They found that the number of factors extracted increases with the number of securities in the group for which the APT factor analytic procedure is applied. As a second major limitation, they identied the difculty of determining the actual number of factors characterizing the return generating process. For Poon and Taylor (1991), the economic variables which are used in this study include monthly and annual growth rate of industrial production, unanticipated ination, risk premium, term structure of return on value weighted market index. To incorporate potential lead/lay relationships, the procedure carried out for each of the market indicates the macroeconomic factors in this study. They shown that the tested macroeconomic variables do not affect the share price in the UK stock market in a manner similar to that described in CR&R (1986). Cheng (1995) analyzed the monthly return of 61 securities in the UK stock market. He concluded that the explanatory power of APT in pricing UK stock market is not high. Martinez and Rubio (1989) tested the Spanish market return and they found that there were no signicant pricing relationship between stock returns and the macroeconomic variables. Moreover, they found that the multifactor APT with macroeconomic variables fails to explain the size effect in Spanish stock returns. In general, Poon and Taylor (1991) and Martinez and Rubio (1989) found that the model used for testing the APT cannot be used for making prediction either in the Spanish market or in the UK stock market. This means that the macroeconomic factors

affecting stock market return in Spain and UK differ from those reported by CR&R (1986). These ndings indicate that there are other factors affecting stock returns. Methodology The APT model In this study, six macroeconomic variables are examined. The model below is designed to test the effect of those macroeconomic variables on the stock return. The factors tested are the term structure of interest rate, unanticipated ination, risk premium, real exchange rate, money supply (M1), and the unemployment rate. The variables formulated into a linear model as suggested by CR&R (1986) as follow: Ri bi0 bi1 F 1 bi2 F 2 bi3 F 3 bi4 F 4 bi5 F 5 bi6 F 6 ei 1

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where, Ri, actual return on the portfolio I; bi, is the reaction coefcient measuring the change in portfolio return for change in risk factors, Fi, is the macroeconomic factor. In this study, the factors tested are: F1, the term structure of interest rate; F2, the unanticipated ination; F3, the risk premium; F4, the real exchange rate; F5, the money supply; F6, the unemployment rate; ei, a residual error for portfolio I. The simplest of theories of pricing a nancial asset is through discounting future cash ow. The variables that affect future cash ows or risk adjusted discount rate of a company must be considered. The aim of explaining the variables is to measure the macroeconomic forces that inuence the stock returns. Term structure of interest rates The value of any stock is directly affected by the discount rate. In most of the asset pricing theory models, interest rate risk factor is commonly accepted and used. However, using an interest rate may cause problems since the interest rate is highly correlated with other macro-variables. Owing to the correlation problem between interest rates and other macroeconomic variables, the term structure of interest rate is used instead of the interest rate. The term structure of interest rate is determined by the difference between long-term government bond and short-term government bond. The yield spread represents the intertemporal change in the shape of interest rate term structure as follows: TRt LTGBt 2 TBt 2

where, TRt, term structure of interest rates for period t; LTGBt, long-term Turkey Government Bond for period t return (over three months); TBt, short-term Turkey Treasury bill rate (up to three months for period t). Unanticipated ination Ination affects sales revenue and borrowing of a rm through changes in nominal cash ows or the discount rate. Anticipated ination is already priced in the discount rate and sales price. Only the unanticipated ination will affect the market value of a stock. Unanticipated ination can be found as follows:   I t 3 UIt I t 2 E t21

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where, UI (t), unanticipated ination for period t; I (t), realized monthly rst difference in the logarithm of the consumer price index for period t; EI t=t 2 1, the series of expected ination. The risk premium Determining the discount rate risk premium that is required by investors is important. The changes in risk premium affect the value of an asset through changes in the discount rate. The change which results from risk premium represent (measures) the changes in the degree of aggregate risk for the economy. Stock return will be inuenced by changes in risk premium. The risk premium is determined through calculating the yield difference between low-grade bond and long-term government bond. In Turkeys market there is no corporate bond during the tested period, therefore we apply the CAPM equation to nd the risk premium through deducting risk free assets (Treasury bill rate) from market return (the whole stock market return). However, the original formula to nd the risk premium as used by CR&R (1986) is: RPt LBt 2 LTGBt 4


where, RP (t), risk premium for period t; LB (t), low-grade corporate bond for period t; LTGB (t), long-term government bond (more than three months) for period t. The real exchange rate Since there has been a considerable increase in economic globalization, most of the businesses are directly or indirectly affected by international activities. Globalization and liberalization have increased in the last 30 years as a result of the increase; the exchange rates play an important rule in capital mobility. Consequently, sales of cash ow may change in the value. It is considerable as an important risk factor from some investors point of view. Money supply The importance of money supply on stock returns have been found by Fama (1981) and Jensen et al. (1996). The nominal increases in money supply may lead to great uncertainty in ination and may have an adverse consequence on the stock market. Increased nominal money supply leads to portfolio rebalancing towards other real assets. Stock returns respond to unanticipated changes in nominal money supply. Increase in money supply leads to a drop in real interest rates. So companies face low-discount rate for their future cash ow and also respond to increasing income by adjusting their investments so as to generate more sales and prots, resulting in higher future cash ows and higher stock prices. According to the previous explanation of the strong and effective relationship between money supply and stock return (reects the stock price). In this study, we used M1 as a represent of the money supply because it is the longest lasting most timely reported money supply series. Unemployment rate In this study, unemployment rate is represented by the actual amount of persons unemployed in the economy.

Test results Correlation among explanatory variables and portfolios Correlation matrix of the pre-specied economic variables and general portfolios computed over the 57 period are presented, respectively, in Tables III and IV. The macroeconomic variables indicates that the correlation is quite low (from 2 0.938 to 0.389) among those variables. However, the data in Table IV including the whole portfolios shows high relation of correlation indicating a trend in the same direction. The fact that the dependent variables are being used separately will reduce the occurrence of the problem of multicollinearity. This generally occurs where there is a high-correlation ranking (from 0.2 to 0.8) among the explanatory variables. Regression results Before analyzing the coefcients, we look at the diagnostics of regression. In this case, Durbin Watson shows the serial correlation of residuals. In our study, our critical values ranges between 1.33-1.81 (T 57, K 6). Our test results conrmed that ten out of 13 portfolios there is no serial correlation. Only four portfolios lie between the critical value, and these are the manufacturing of basic metal industry, other manufacturing industry, electric gas and water and manufacturing of fabrical metal products. According to the test results there is a high probability that these portfolios have no serial correlation. Regression results show that there are big differences among market portfolios against macroeconomic variables. This can be shown clearly by observing R 2 which varies from 0.0663 to 0.309. In overall test results, unanticipated ination is statistically signicant in explaining our dependant variable in seven portfolios, and risk premium in three portfolios, term structure in one portfolio and money supply in two portfolios (Table V). But, the real exchange rate and the unemployment rate are statistically insignicant in all portfolios. The term structure of interest rate has a positive effect on the returns of nine portfolios. The unanticipated ination has a positive effect on the returns of our 13 constructed portfolios. This means that the markets estimate of the ination rate is very close to the actual rate when announced. The risk premium has a positive effect on the return of eight portfolios. Exchange rate is an important factor in determining international competitiveness. According to the exchange rate movements, the market may gain or lose its competitive position. Even though it seems to be very important factor, this does not necessarily mean there will be an effect on the market. The exchange rate has positive effect on of the two portfolios and has negative effect on of the six portfolios. Money supply (M1) has positive effect in seven of the portfolios and
LTERST LTERST LUNINF LRIKPR LEXCGR LMONSP LUNEMP 1 0.015665 0.369732 0.074696 20.21949 20.03091 LUNINF 1 0.152226 2 0.05187 2 0.15526 2 0.07647 LRIKPR LEXCGR LMONSP LUNEMP

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1 2 0.11695 2 0.93892 2 0.32419

1 0.280141 0.389751

1 0.354959

Table III. Correlation matrix of economic variables


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LBANSFC LELEGAW LMANBMI LMANCPR LMANFBT LMANFMP LMANNMP LMANOMI LMANPPP LMANTWP LMANWPF LTRACOM LINSCOM 1 0.4 0.6 0.5 0.7 0.5 0.5 0.6 0.6 0.5 0.6 0.4 1 0.5 0.5 0.7 0.6 0.3 0.6 0.5 0.5 0.8 0.5 1 0.6 0.7 0.6 0.6 0.6 0.6 0.3 0.7 0.6 1 0.7 0.7 0.4 0.6 0.7 0.5 0.7 0.1 1 0.8 0.6 0.7 0.7 0.5 0.8 0.6 1 0.4 0.7 0.6 0.5 0.8 0.6 1 0.5 0.6 0.3 0.7 0.2 1 0.7 0.4 0.8 0.4

Table IV. Correlation matrix of each portfolios

1 0.5 0.8 0.5 1 0.5 0.4 1 0.5 1


1 0.4 0.6 0.5 0.7 0.7 0.6 0.2 0.5 0.5 0.3 0.6 0.6

Portfolios 2 0.9968 2 0.6087 1.0982 0.6558 2 0.1052 0.8779 0.8414 1.3158 0.1613 0.4690 1.8063 * * 0.8151 2.1910 * * 2 1.0133 2 0.4663 2 0.7236 2 0.3039 1.1238 0.5094 0.3030 2.3051 0.2552 1.7032 0.0056 0.1007 0.0453 0.0466 0.0076 0.0349 0.0280 0.2526 * * 2 0.0412 0.0700 1.4560 0.6395 * * 0.4739 20.7527 * * 21.2786 0.1970 0.1666 20.2487 1.9829 * 0.5154 1.3129 0.3314 * * * 0.3186 * * * 0.1256 0.1844 0.2574 * * 0.2927 * * 0.2659 * * 0.0447 0.0319 0.1439 0.3781 * * * 0.1148 0.202 * 0.7517 0.189 0.309 0.102 0.205 0.199 0.133 0.166 0.066 0.199 0.138 0.249 0.108 0.093




Variables RISKPR EXCGR MONSP UNEMP R2 F stat 3.03 7.91 0.95 2.63 2.54 2.72 2.59 0.73 2.54 2.83 2.77 3.26 0.85

D-W 1.96 1.68 1.78 2.11 1.95 1.68 1.90 1.73 1.86 1.94 1.91 1.85 1.89


2.2495 * * 15.9076 * * 26.8386 28.2214 23.6028 6.7619 242.3716 * 211.2461 232.4717 2.0222 * * * 224.2171 20.5762 29.5490

Notes: *, * *, * * * indicates the independent variables (macro economic variables) are signicant at 10, 5 and 1 per cent levels, respectively. All variables Rit bi0 bi1 Terst bi2 Unifin bi3 Riskpr bi4 Excgr bi5 Monsp bi6 Unenp 1t

are logarithmic. The regression equation used to compute the APT for each portfolio as follows:

The effects of macroeconomic factors

Table V. APT regression results


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the rest portfolios are negatively affected by the money supply. This means that money supply has different effects on the return of the market. Unemployment rate has positive effect on eight portfolio returns as the test results show. Conclusion This study has tried to observe the relationship between the pre-specied macroeconomic variables and stock market returns in the ISE for the period of January 2001 till September 2005, on monthly basis. In summary, the results indicate that there is a signicant pricing relationship between the stock return and the tested macroeconomic variables; namely, unanticipated ination, term structure of interest rate, risk premium and money supply have a signicant effect in explaining the stock market returns in various portfolios. But these results showed a weak explanatory power based on the ndings. This means that there are other macroeconomic factors affecting stock market returns in ISE other than the tested ones.
References Alexander, G.J., Sharpe, W.F. and Bailey, J.V. (2001), Fundamentals of Investments, 3rd ed., Prentice-Hall, Englewood Cliffs, NJ. Chen, N., Roll, R. and Ross, S. (1986), Economic forces and the stock market, Journal of Business, Vol. 59 No. 3, pp. 383-403. Cheng, A.C.S. (1995), The UK stock market and economic factors: a new approach, Journal of Business Finance & Accounting, Vol. 22 No. 1, pp. 129-42. Dhrymes, P.J., Friend, I. and Gultekin, N.B. (1984), A critical reexamination of the empirical evidence on the APT, Journal of Finance, Vol. 39 No. 2, pp. 323-46. Fama, E.F. (1981), Stock returns, read activity, ination, and money, American Economic Review, Vol. 71, pp. 545-64. Jensen, G.R., Mercer, J. and Johnson, R. (1996), Business conditions, monetary policy, and expected security returns, Journal of Financial Economics, Vol. 40, pp. 213-37. Kettell, B. (2001), Financial Economics: Making Sense of Market Information, FT/Prentice-Hall, London. Martinez, M. and Rubio, G. (1989), Arbitrage pricing with macroeconomic variables: an empirical investigation using Spanish data, working paper, European Finance Association, Universidad Del Pais Vasco, Bilbao. Poon, S. and Taylor, S.J. (1991), Macroeconomic factors and the UK stock market, Journal of Business Finance & Accounting, Vol. 18 No. 5, pp. 619-39. Roll, R. and Ross, S.A. (1980), An empirical investigation of the arbitrage pricing theory, Journal of Finance, Vol. 35 No. 5, pp. 1073-103. Ross, S.A. (1976), The arbitrage pricing theory of capital assets pricing, Journal of Economic Theory, Vol. 13, pp. 341-60. Further reading Chen, N. (1981), Some empirical test of APT, Journal of Finance, Vol. 38, pp. 1393-414. Cho, D.C., Elton, E. and Gruber, M. (1984), On the robustness of the ROLL and ROSS APT, Journal of Financial and Quantitative Analysis, Vol. 19 No. 1, pp. 1-10.


Dhrymes, P.J., Friend, I., Gultekin, N.B. and Gultekin, M.N. (1985), An empirical examination of the implications of APT, Journal of Banking & Finance, Vol. 9, pp. 73-99. Gultekin, M.N. and Gultekin, N.B. (1987), Stock return anomalies and the test of APT, Journal of Finance, Vol. 42 No. 5, pp. 1213-24. Hamao, Y. (1988), An empirical examination of the arbitrage pricing theory, Japan and World Economy, No. 1, pp. 45-61. Kim, M.K. and Wu, C. (1987), Macroeconomic factors and stock returns, Journal of Financial Research, Vol. 10 No. 2, pp. 87-98. Perold, F.A. (2004), The capital asset pricing model, Journal of Economic Perspective, Vol. 18 No. 3, pp. 3-24. Priestley, R. (1996), The arbitrage pricing theory, macroeconomic and nancial factors, and expectations generating processes, Journal of Banking & Finance, Vol. 20, pp. 869-90. Roll, R. (1977), A critique of the asset pricing theorys tests, on past and potential testability of the theory, Journal of Financial Economics, Vol. 4, pp. 129-76. Roll, R. and Ross, S.A. (1984), The arbitrage pricing theory approach to strategic portfolio planning, Financial Analysis Journal, Vol. 40, p. 24. Roll, R. and Ross, S.A. (1994), On the cross sectional relation between expected returns and betas, Journal of Finance, Vol. 49 No. 1, pp. 101-22.

The effects of macroeconomic factors 45

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