Analysis of Capital Market with Respect to the Rationales of International Finance Theory - Example

Analysis of Capital Market with respect to the rationales of International Finance Theory Table of Contents Introduction 3 2.Rationale of the report 3 3.Impact of macro-economic indicators on capital markets of various nations 4 4.Evaluation of the rationales underlying the issues affecting the capital market 5 5.Conclusion 8 Reference list 9 1. Introduction The international finance theories and policies are developed on the basis of global macroeconomic environment; hence, they are also termed as international macroeconomics. It is one of the important branches of financial economics. The theories analyze various macroeconomic concepts from an international point of view. The capital market, especially the stock market, is an important source of fund generation for various industries in a country, which in turn shapes economy (Ratanapakorn and Sharma, 2007). Various companies raise fund by issuing capital market instruments such as shares, bonds and debentures in the stock market. The stock market benefits both investors and firms by creating an alternative source of income for investors and availing the pool of investment to the firms. The modern day finance theory emphasizes on role of information in determination of value of assets. Many authors have argued that macroeconomic data affects various market instruments including currency values (Naik and Padhi, 2012). The relationship between stock price and macroeconomic variables in developed and developing economies has been a subject of extensive study for various scholars. Many of them have used macroeconomic factors to determine return on stock and risk factors. Many authors have also claimed that macroeconomic factors not only influence capital market factors, but also non-market factors such as, currency value, international price of crude oil and reserves. There are several macro-economic factors such as, inflation, recession, money supply, foreign exchange rate, political scenario and GDP, which affect the market (Naik and Padhi, 2012). 2. Rationale of the report The main purpose of this report is to examine sensitiveness of the capital market to change in macroeconomic variables. The paper has reviewed various methods employed by a number of authors to understand implication of rationale of macroeconomic theories on capital market. The paper has tried to answer the research oriented questions and provide clear understanding of variables of International Finance Theory. In any country, the capital market plays a vital role in terms of providing firms with a pool of investment that has been accumulated from investors. The main objective of this research is to study and establish relationship between capital market changes and macro-economic scenario prevailing at national and international levels. The paper has included various factors associated with International Finance Theory while analyzing data related to the study. The research aims at gathering information on impact of international finance theory on capital market and determining validity. The paper intends to find answer to the following: a. What are the macroeconomic factors that influence capital market (stock market) of a country? b. How do these factors affect performance of the capital market? The subject of this paper can be best explained in an exploratory research framework; hence, the research has considered a number of literatures to understand capital markets of different countries and factors of international finance theory. Qualitative analysis of literature, such as, journal and research papers, has been done to determine effect of macro environmental variables on instruments of capital market. 3. Impact of macro-economic indicators on capital markets of various nations The literatures prepared earlier reveal that the relationship between stock market and macroeconomic variable has been classified in two categories. The first category investigates the influence of macroeconomic variables on value of capital market instruments. The other category focuses on establishing sensitiveness of the market with respect to volatility of the macroeconomic condition. Since this research paper is relevant to the first category, only reviews those are related have been considered. Panetta (2002) surveyed a set of macroeconomic factors in order to understand influence on stock return by converting return on equity as a function of macro-economic factors. The empirical result of this survey found that expected industrial production, sudden inflationary rise and difference in earnings from long-term and short-term government bonds significantly affect the return value. The author also explained that macroeconomic factors have indirect effect on market return. The variable affects discount rates and value of future dividends. Other authors have also worked in this field by examining long and short term relationship between price of US stock index and macroeconomic factors for period of 1975-1999. They employed Johansen’s co-integration technique and vector error correction model and their study revealed that industrial production, foreign exchange rate, short-term interest rates, inflation and money supply generate positive impact; whereas long-term interest rate has a negative impact. They further explained that impact of macroeconomic variables is more prevalent in long run over short run (Ratanapakorn and Sharma, 2007). Several other authors have also conducted their research in different countries and came across nearly similar results. Authors like, Mukerjee and Naka, conducted their study in Japan and recognized that Japanese market was co-integrated with variables like, inflation, call money rate, bond rate, money supply and so on, thereby exhibiting long run equilibrium with the stock market (Naik and Padhi, 2012). In addition, Mookerjee and Yu studies the relationship between Singapore market return and variables like, foreign exchange reserve, foreign exchange rate and broad and narrow supply of money. It indicated that apart from foreign exchange rate, all other variables shared long run relationship with market return (Naik and Padhi, 2012). According to Wongbampo and Sharma (2002), stock return in countries such as, Malaysia, Indonesia, Singapore, Philippines and Thailand, varies to a certain extent with fluctuations in macroeconomic factors such as, Gross National Product, inflation, money supply, foreign exchange rate and interest rate. Their study found that stock prices of all five countries were positively related to output growth, which was negatively affected by overall price level. Moreover, individual country’s stock market was affected differently. For instance, interest rate has a positive influence on Philippines, Singapore and Thailand, but negatively affects that of Malaysia and Indonesia. In Indian context, a number of authors have employed techniques such as, Johansen co-integration approach method, Johansen co-integration approach and error correction mechanism, in order to determine factors that affect the Indian stock market. Yet, results did not exhibit any long-run relationship. Nevertheless, a bi-directional cause effect relationship was established between inflation rate and return on stock (Naik and Padhi, 2012). 4. Evaluation of the rationales underlying the issues affecting the capital market The evaluation of the theoretical framework used for data analysis reveals that most authors have utilized Johansen co-integration approach and Vector Error correction mechanism. Some authors have used Toda and Yamamoto non-Granger causality technique, while a few have employed VAR framework and Artificial Neural Network (ANN) to determine the link between macroeconomic factors and stock values. All these theories and approaches are important parts of financial economics and hence, form part of the international finance theory (Krugman, 2009). Further, many authors have tried to study the impact of macroeconomic variables on the capital market using the econometric models and theory. The authors have used neoclassical growth model using production function approach. In this model, the growth of GDP has been considered as a function of aggregate public investment, foreign direct investment, capital market index and debt overhang. The authors have applied regression analysis of ordinary least square method. The empirical result shows that public investment in the capital market has significant impact on the gross domestic product, while the debt overhang was influenced insignificantly. Interestingly, another significant development has been observed that share index, value of share traded and number of deals in the capital market also affect the economic development (Owolabi and Ajayi, 2013). Among all macroeconomic indicators, most common indicators that have consistently influenced capital market of various countries are foreign exchange rate, money supply, interest rate, inflation, GDP and industrial production. These factors have been briefly explained to have a better understanding of their effect on the capital market. 4.1 Inflation: A general definition of inflation suggests that it is a sudden increase in average price of consumer and industrial goods due to increased demand and/or shortage of supply. It is a common notion that a stock market perform best when the economic condition is strong and inflation rate is low. Stock is considered to be negatively correlated with inflation. Hence, with increase in inflation, shareholders prefer higher risk premium. The impact of inflation on share prices is explained in a cyclic form. Inflation reduces the purchasing power of individuals, as consumption is affected. This results in declining profit and revenue of firms and as the economic slowdown occurs, price of shares fall (Krugman, 2009). 4.2 Money supply: From an economist’s point of view, money is defined as any form of saving and/or investment that can be converted into cash (liquid asset) over the time. Money acts as a medium of exchange as well as a of value addition. Money in the form of currency acts as an exchange medium, which when saved or invested results in value addition in future. When money supply increases in an economy, it results in increase in the stock price. However, when money supply in the economy contracts, it depresses the price of shares. So, in a number of countries, the governments often regulate money supply so that market crash due to excessive fall in stock price can be avoided (Krugman, 2009). 4.3 Foreign exchange rate: The foreign exchange rate is defined as the value of one currency with respect to that of one unit of another currency. Some countries have fixed exchange rate, while others have floating exchange rate. The foreign exchange rate has an indirect impact on the stock price. Hsing (2004) explained that fluctuation in this macroeconomic variable affects output of a country. The author employed open economy Mundell-Fleming framework (International Finance Theory) in order to show that net export is affected by the real exchange rate. Hence, fluctuation in exchange rate results in the same in stock market and export. 4.4 Interest rate: Interest rate and stock market share an indirect relationship, similar to that with foreign exchange rate. Interest rate is basically the cost or charge paid by an individual for using someone else’s money. Interest rate is the cost paid on loans, debentures and bonds. When interest rate increases, it reduces borrowings as well as constricts money supply and vice-versa. So, with rise in interest rate, stock prices fall and the opposite occurs with decline in the former. In addition, when there is a hike in the interest rate, investment in general stock becomes risky and investors’ preferences shift towards government bonds, which are considered safe (Krugman, 2009). 4.5 Industrial output: Industrial output is directly proportional to value of the stock of a particular firm. It is often observed that when product demand declines, it eventually results in reduction of stock value. Furthermore, it has also been witnessed that industrially developed firms are often considered as stars in the stock market (Krugman, 2009). 4.6 Gross Domestic product: The GDP is a country’s measurement of economic health. It is one of the most important macroeconomic indicators. The GDP is defined as the aggregate goods and services produced within the country in a given period of time, usually one year. GDP has a substantial impact on the stock market. The stock market improves with growth in the GDP. However, a slight drop in GDP value may cause severe depression in the stock market (Krugman, 2009). 5. Conclusion The research paper was prepared to determine the relationship between macroeconomic variables of international finance theory and capital market. The main purpose was to uncover ways in which underlying issues of macroeconomics affect stock prices. The research presents a descriptive study of various factors that affect the stock market of a country in context of international macroeconomics. Since the subject is not limited to one location and required vast data, secondary data collection method was employed. The researcher undertook qualitative analysis of vast quantity of literature available from authentic sources. The study indicated that authors have employed various techniques of international finance such as, Johansen co-integration approach, Vector Error correction mechanism, Toda and Yamamoto non-Granger causality technique, VAR framework and Artificial Neural Network (ANN), with respect to different macroeconomic variables and stock markets in separate countries. It was established that different variables have either positive or negative effect on the stock price. Macroeconomic indicators such as, inflation rate and interest rate, have an negative (inverse) effect on stock prices, while money supply, foreign exchange rate and industry production have a positive effect. The researcher has carried out discussion with respect to a number of countries, which adds a globalised effect to it and enhances its credibility. Reference list Hsing, Y., 2004. Impacts of Fiscal Policy, Monetary Policy, and Exchange Rate Policy on Real GDP in Brazil: A VAR Model. Brazilian Electronic Journal of Economics, 6, pp. 1-12. Krugman, P. R., 2009. International economics: Theory and policy. India: Pearson Education. Naik, P. K. and Padhi, P., 2012. The Impact of Macroeconomic Fundamentals on Stock Prices Revisited: Evidence from Indian Data. Eurasian Journal of Business and Economics, 2012, 5(10), pp. 25-44. Panetta, F., 2002. The stability of the relation between the stock market and macroeconomic forces. Economic Notes, 31(3), pp. 417-450. Ratanapakorn, O and Sharma, S. C., 2007. Dynamics analysis between the US Stock Return and the Macroeconomics Variables. Applied Financial Economics, 17 (4), pp. 369-377. Wongbampo, P. and Sharma, S.C., 2002. Stock Market and Macroeconomic Fundamental Dynamic Interactions: ASEAN-5 Countries. Journal of Asian Economics, 13, pp. 27-51. Owolabi, A. and Ajayi, N.O., 2013. Econometrics analysis of impact of capital market on economic growth in Nigeria (1971-2010). Asian Economic and Financial Review, 3(1), pp. 99-110. 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