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ë Over the course of the past decade , Pakistan¶s economy has taken such a drastic turns
that it has confused most of the economists and researchers to watch carefully over the
prediction and decisions.

ë The above record performance of KSE 100 Index during the period of 2003 to 2007
made a lot of stakeholders to find the fundamental reasons behind the variation.

ë  


 


  
 
 




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ë To achieve the objective macro economic variables such as

u Interest rate

u Inflation rate and

u GDP growth rate

were considered to find the relation with that of KSE 100 index
#%&' 
ë The study is an examination of the correlation between the four variables °

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* in different economic circumstances

ë The study inter-linked the two fields (Finance and Economics) in a way that it validates, if
there is any relationship between the financial market indicator with that of economic
variables

ë There is a mutual consent among the macroeconomists and finance theorists that stock
market prices are driven by macroeconomic variables so called ³fundamentals´. Moreover,
it is also agreed that the linkage is both way; reciprocal relation exists between the stock
prices and macro economic variables.

ë The reason of examining the two fields together is that the financial feat is closely related
to that of the economic development, because the monetary policy work through these
financial intermediaries therefore it is concluded that the competent financial markets can
be a qualification for the economic strength in a nation
#%&' 
ë It is resolutely believed that when the economy is performing well, that is the
Interest rate & inflation rate are moderately low level & out put growth rate is high,
stock prices should also advance up to show the relation with the growing economy

ë There has been a great deal of research regarding the phenomenon in the developed
economies such as the US, UK, Germany, Japan etc, where researchers have come
up with some very enlightening and insightful results.

ë The results would help the students, researchers, economists as well as the individual
investor to much extent in explaining the behavior of stock exchanges and prices,
and in turn, have helped them make better predictions about its current and future
performance and decision regarding investments along with the reasons.

ë The study covers the time period started from 1991-92 to the end of 2008-09
covering eighteen years because of the availability of KSE 100 index °
 
*
from 1990-91 onwards.
  
+ ,
 
+ ,
ë Stock prices are driven through many factors called ³fundamentals´, among
them the top most helpful are the macro economic variables; most notably
among them are Interest rates, inflation rate and out put growth rate.

ë Interest rate is the most effective driver having direct and indirect effects to
all the parts of economy through supply of money

ë It also drives inflation rate and out put growth rate in the economy as well
as allied with the determination of the stock price.

ë So if the macro economic variables fluctuates, it is noticeable that the stock

market index also improve to show the after effects of change in the interest
rates.
&- 
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ë The objective of this paper is to evaluate the relations among key
economic variables such as:

1. Inflation rate ( CPI Based)

2. Interest rate ( Call money rate)

3. Out put growth rate ( GDP growth rate)

ë With that of stock prices (KSE 100 Index) in context of Pakistan¶s

economy, where stock exchanges are less mature as compared to
other countries with well matured financial markets for instance
US, Japan and the UK (Fama, 1991)
 

 

ë Y



 

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'  / To facilitate the job of the investors, financial

analysts, researchers, economist as well as the up coming student to
strengthen their understanding about the stock price variations and
it¶s link with the macro economic variables.
'
+

ë In trying to investigate the above mention problem many other

question were also unfolded as

1. Do interest rates affect the KSE 100 index?

2. Do GDP Growth rates in the economy effect KSE 100 index?

3. Do inflation rates affect GDP growth rate (production)?

4. Do inflation rates affect interest rates?

5. Do inflation rates affect the KSE 100 index?

6. Do interest rates affect GDP Growth rate in the economy?

 !(
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ë r stock market index acting as a benchmark for the stock market to evaluate the prices (of
the stock) with and to keep a watch on how Karachi stock exchange is performing over the
period of time.

ë The companies with the highest market capitalization are considered being a part of it from
each of the sector.

ë The index was first formed in 1991 with base index points of 1000.

ë In particular, KSE 100 is designed to provide investors with wisdom of how the Pakistan
equity market is performing.

ë It is also used as a standard of how economy is working because it seems to be reacting

sensitively to the happening of any economic, financial & political event
    !

Figure 1: KSE 100 Index (1990-91 to 2008-09) Source Business recorder

   
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Figure 2: Percentage Change in KSE 100 Index (1990-91 to 2008-09) Source Business recorder
  

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ë The cost of borrowing money becomes high

ë In turns the households are left with less disposal income because in the change
in spending behavior and demand gradually decreases

ë The Businesses too depends on the source of capital by banks and as the cost of
capital increases the spending power of the business also decreases which also
decrease the growth pattern of the company and can be observed from the
decrease in the profitability of the companies

ë When the interest increases the investment preference decreases and the equity
market decline due to less of investments take place
!(
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1
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ë Interest rate is taken as the discount rate offer by the state of

Pakistan to all the commercial banks in Pakistan and is also referred
as policy rate, so that they can further lend it to earn their own
markup to the customers.

ë Interest rate is also one of the tools of monetary policy to control the
money supply in the economy through commercial banks.
0
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ë When ever the interest rate is high money supply in the economy

would be low

ë Decreasing the disposal for household and hence change in the

spending pattern

ë Where as if the scenario is opposite, the less interest rate would

increase the disposal and hence spending patterns would lead to

inflation
  


1

Figure 3: Money at Call & Rates (1990-91 to 2008-09) Source: SBP

 !(
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ë Inflation is the gradual increase in the level of good¶s and service¶s prices over a specific
period of time and define in percentage.

ë It is also a good indicator of how economy is performing.

ë The rate of the inflation is one of the most important macroeconomic indicators and a key
variable for state bank of Pakistan to consider for scrutinizing while setting up its interest
rate

ë Gauging the inflation at a sustainable level is very important for economic

growth. Inflation have dual effect not only on consumer side to safe income
groups but also make the cost of business manageable for production side.
  
1


Figure 4: Inflation CPI based (1990-91 to 2008-09) Source SPB

Cont¶d
Inflation internationally is among the top most priority in the last year 2008-09
because of

ë r series of global shocks starting from the beginning of the financial crises
in the international markets

But

ë Inflation in the developed countries is no more an issue but the danger of

recession is still far greater. Pakistan is one of the many economies where
there is still a chance facing the double digit inflation rate and even reached
to almost 21 percent last year (2009).
!(

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.


/

ë measure of economic performance/out put and it is a valuation of

goods and services produced in term of market, it is the market
value of all final goods and services made within the borders of a
country in a year.

ë It is valued on the basis of either cost of production, value added

cost at each level of production or the expenditure incurred (Labor)
to produce those goods and services.
 %.

Figure 5: GDP Growth Rate of Pakistan (1990-91 to 2008-09)

Source: SBP


ë . (  
 

1. KSE 100 Index

ë  (  

/

1. Interest Rate:

2. Inflation:

3. Gross Domestic Product:



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Each one of the considered macro economic variable is tested with KSE 100 index
in order to find the root cause along with the strength with which each variable
impact the KSE 100 index

Thus the proposed multiple hypotheses are

ë ü¦* There is a negative correlation between interest rate and KSE 100 index

ë ü* There is a negative correlation between inflation rate and KSE 100 index

ë ü* There is a positive correlation between GDP growth rate and KSE 100
index







 3 /

In investigate the predicting power of the key macro economic variables over the KSE

ë The compiled data was run into famous statistical tool SPSS

ë r 
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was used and to determine the relationships
between all the variables selected

ë The 
(   

 
 were studied to check the variance
accounted for by the model

ë The coefficients of the independent variables (Betas) were not considered

ë The coefficient of correlation of each variable was analyzed using Correlation matrix
produced by Pearson¶s correlation test

ë Scatter plots were also discussed to define the nature of Relationship between the
variables
 

4



  
ë Eighteen years sample size was considered as KSE 100 index started from 1990-91
onward and macro economic variable was available in yearly format (N*72 number
of observations). rs mentioned in theoretical framework, the data used in the study
has four parts:

1. Inflation rate of Pakistan °0

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*

2. GDP growth rate of Pakistan °0
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*

3. Interest rates offered by the state bank of Pakistan ° 


*

4. Stock Prices ° 
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ë Aearly data from 1990-91 to 2008-09 has been used in this study.

ë Data for the GDP Growth rate, Inflation rate (Consumer Price Index), and
Interest Rates (Money at call and rates) were obtained from the library of State
Bank of Pakistan from 50 years Statistical Bulletin, SBP¶s rnnual Reports and
the economic survey of Pakistan for the relevant years.

ë Data for the Karachi Stock Exchange Index were obtained from the library of
Karachi Stock Exchange along with that Aahoo Financial Services and CBS
Market Watch in addition to the statistical documents to cross check the data
consistency.

ë The assumptions to be verified were that there was a positive relationship

between the KSE 100 index with that of GDP growth rate and negative with
Interest and inflation rate
 1


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It can be seen that the value of R obtained for the data results is .747 which is a
very high and near to 1defining a strong relationship between the KSE 100 index
and Interest, Inflation & GDP growth rate.

Larger values of R2 indicate the model fits the data well and it can be obtained
by squaring the value of R. Since the R2 value for our data set is .557 which is a
fairly large value, explaining the goodness of fit for the model. Furthermore it
can be obtained that 55.7 % of the total variation in the KSE 100 index (stock
prices) is explained by the selected variables (Int, Inf & GDP) by the model i.e.
55.7% of the variation in the Karachi Stock Exchange index is due to that
movement in the interest rates , Inflation rate & GDP growth rate in the
economy.
 1


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rdjusted R2 is a modification of R2 that is adjusted for the number of

explanatory terms in a given model. Unlike R2, the adjusted R2 increases
only if the new term improves the model more than would be expected by
chance. In this case the rdjusted R2 is 46.3 % which shows adding more
term to the model increase the explanatory power of the model and would
not be due to chance.
 1


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2    4 2
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Regression
15708.606 3 5236.202 5.877 .008(a)

Residual
12472.804 14 890.915

Total
28181.411 17

rNNOVr is the results of an analysis of variance

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ë Strongest relationship of any variable in this study

ë The correlation results suggest that there is a 73.6% negative relationship

ë It can be viewed as a good determinant in explaining KSE 100 Index¶s behavior

ë rs the interest rate is increased it can be observed that most of the investors find
it more convenient to put their money in bank rather than to invest in Equity
market

ë Vise versa behavior would be observed in case of interest rate decreases

ë When the interest rate decreases investors pour more of the investment in equity
market and as a result equity index enhance due to injection of money into it
.%.

 

 
  !6
ë The KSE 100 index seem to be least effected by the GDP growth rate of
Pakistan as the relation define is around 51.4% and is weaker among the
variable taken but positively effecting

ë Karachi Stock exchange is affected by level of economic activity in Pakistan in

a way when ever the production in the economy increase is a good sign of
fulfilling the demand created and hence result in the profitability of the firms
that are listed in the KSE 100 index and eventually increases the prices of the
shares with the combine effect of dividend and returns.

ë rs the GDP decreases to 2 % per annum also declined the KSE growth in
negative as 42 %.
.

 

  
 !6
ë There is a moderate negative correlation of 50.6% between the inflation rate
prevalent in the Pakistani economy and the KSE index

ë 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.

ë Inflation also decreases the amount of investable funds since a greater amount
of the public¶s disposable income goes towards the use of money for transaction
purpose rather than towards the speculative use of money.

ë Investment in the stock exchanges is simple another use of investable money

and it too therefore is affected by inflationary trends.
'
+

 .

 
%.


ë There is a weak negative correlation between the inflation rates and the GDP growth rate of
Pakistan. The Pearson¶s correlation result indicates that there is a 13.7% negative relationship.

ë The significant level is also very high rejecting the fact that Inflation affect the GDP growth rate
in Pakistan.

ë In the case of this study the inflation is CPI based which does not affect the industrial production
directly, more over industries are more dependent on the prices of the factor (Labor, capital etc)
involved.

ë One of the reasons behind inflation not affecting the GDP is the connection between interest
rates and inflation, where GDP is a good responded to the change in interest rates. Referring to
the correlation table the correlation between the GDP and the interest rate is negative 58.2
percent with the significant level of 0.011 which is acceptable.

ë One of the most important point to be mentioned that an increase in inflation rates eats up the
corporate earnings, which in turn makes dividends decline. When dividends declined, the
expected return of stocks also decreased affecting share prices to depreciate in value and hence
affecting the stock markets indices
.


 





6
ë There is a strong positive correlation between interest rates and
inflation, following the Pearson¶s correlation result shows that there is a
66.9% positive relationship between inflation and interest rates i.e. if
the level of inflation increases so as the interest rates.

ë 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 ³too much money chasing too few goods´

ë rlso explains the validity of Fisher effect that rise in inflation will lead
to rise in interest rate, mostly used by the government intervention to
control the inflation through out the economy.
.




 
 
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 6

ë r negative correlation between interest rates and GDP Growth rate is

58.2%

ë Which is a sign that Interest rate is a good determinant of GDP than

Inflation rate.

ë Individual Preference to put the money in banks & less of the

transaction would take place, in turns business would produce less of a
good to cater the less demand in the economy

ë On the other hand the business too rely on bank loan to run their
operations, when the cost of capital increases the expanding rate of the
businesses also decreases showing a decrease in the GDP growth rate.
0
1  


ë Based on the result concluded from the regression analysis, correlation matrix
and the scatter plots give an insight about which one of the selected variables is
a good predictor of the stock prices and should be taken into concern while
deciding the investment priorities, when Pakistan¶s economy is taken into
consideration

ë The relationship between the interest rate and stock market is highly negative as
it was reported by the correlation matrix and found to be very consistent with
the study with other authors taken into consideration.

ë The empirical evidence incurred from the study that the interest rate and the
stock price are negatively related, confirmed the acceptance of the hypothesis
that there is a negative relationship between stock prices and interest rate.
0
1  


ë The relationship between the inflation and the stock prices is negative and is
very compatible with the study conducted by (Erb et al, 1995) inflation and the
stock return in the united kingdom and united states as well as (Geske and Roll,
1983) that suggest the relationship between expected, unexpected inflation &
changes in both were negatively related with that of the stock prices.

ë The relation between the inflation and the stock was also well documented by
(Fama, 1981) by finding the relation between the stock returns, real activity;
interest and inflation also confirms the phenomena and the underlying theory
behind the relationship of inflation and stock prices.

ë Thus the acceptance of the developed hypothesis that is the relationship

between the stock prices and the inflation rate is negative.
0
1  


ë The relationship between the stock prices and the GDP growth rate is
positive showing a good consistency with the study (Fama, 1983, 1990
& 1992) that showed the causal relation between the stock prices,
interest rate, Inflation and GDP growth rate. rlso the study by
(Schwert, 1990) verified the relationship between stock return and real
activity backing up the acceptance of the hypothesis that there is a
positive relationship between the share prices and GDP growth rate.

ë Where the phenomena is also confirm by the study conducted by (Chen

et al, 1986) who study the relation between the stock return, interest
rate, inflation and GDP growth rate.
0
1  

ë r relationship is prevailing in between macro economic variable and financial
markets, led to the conclusion that the economic development and the financial
development are closely and directly interlinked.

ë üence the efficiencies of deep, liquid and open financial markets are the sign of
the financial development which in turn directly affected by the monetary policy
prevailing in the economy.

ë Looking into the trend of the past 18 years of analysis the interest rate has
reached to its maximum record level and is because of the rise in inflation rate.

ë The GDP rate is also reached to its minimum level showing the least
development is taking place.

ë r well functioning and efficient supply of money is a vital source of stability in

the financial markets.
 0
1  

ë Declining quality of macro economic factors, the continuous tightening of the monetary
policy and the security concern since the start of the financial year 2008-09 has led to the
poor performance of the KSE 100 Index
ë Restriction of price floor on KSE 100 Index in 2007-08 how ever didn¶t prove fruitful in
fact it also reduces the investor confidence because most of the investor after the removal
of the price floor pull their investment back and the KSE 100 index declined further

ë To recover the economic downturn and that of the financial market, government
should increase the supply of money there by introducing the loose monetary
policy as providing the interest rate lower to encourage the real activity in the
economy.
ë Government should take into consideration for mutual agreement with other
countries to bring in technologies and new projects to increase the GDP and
reduce the inflation by providing the substantial goods and services, this can
only be done through easing the terms and condition and removing the boundary
for FDI¶s to operate in Pakistan for the development of goods and service.
 0
1  

ë The study is a good approach for explaining few determinant out of many that
explains the behavior of KSE 100 index but it should be recommended to work more
in this regard in order to develop further explanatory models

ë üow ever to gauge the impact of the economic variables on that of financial markets
further studies can be conducted in order to investigate, further that what are the other
variables that can be considered to improve the results of the studies both in long run
and short run. Most notably foreign exchange rate, employment rate, money supply
M2, per capita income, balance of payment and trade etc, should also be studies to
define the prediction value more specifically and accurate.

ë The study is explaining the period of 18 years starting from the liberalization of the
economy in 91-92 to 08-09 and it can µt be confirm that this trend would remain
exactly the same for future because there may be endless variables involve in the
variation of KSE 100 index.
 
"