Relationship between the Macroeconomic Variables and the Stock Market Prices - Coursework Example

Relationship between the Macroeconomic Variables and the Stock Market Prices Name Institution Date Relationship between the Macroeconomic Variables and the Stock Market Prices Introduction The Nobel Peace Prize winner Paul Samuelson wrote in a Newsweek column that Wall Street Indexes predicted nine out of the last five recessions. This was widely seen as a joke but it later came to be understood as an important aspect of the stock market. The quote mainly indicates that there is a relationship between the macroeconomic variables and the stock market prices. The trends in the stock market prices are as a result of the events in the macroeconomic environment (Bodie, Kane & Marcus, 2008). The stock market plays an essential role in the financial intermediation. This enables the business in both the developing and developed countries to obtain extra funds that may be used to support the growth and development. The amount that can be raised is dependent on the stock market prices. The fall in the stock market prices has negative impacts on the investors. The investors may end up with massive losses when the process in the stock market falls. The external factors that influence the growth and development of the economy are considered as the macroeconomic variables (Brealey, Myers & Allen, 2008). The stock market prices are related to the macroeconomic variables. This has been highlighted in both the developing and developed countries. The global recession which was witnessed in 2008 had a direct impact on the stock prices. The same is also applicable when the global oil prices fell. The paper thus discusses the relationship between the stock Market prices and the macroeconomic variables. Discussion Arbitrage pricing and the capital asset pricing model According to the Arbitrage pricing model, the return on an asset is specified as a number of risk factors which are common in that asset class. The model further indicates that the investors are usually interested in taking advantage of the arbitrage opportunities that are found in the broader market (Brigham & Houston, 2009). This therefore makes the rate of return a function of the return on alternative investment as well as the risk factors. The theory indicates that the risk factors influence the performance of the investment. Assets in different categories have different sensitivity to the risks in the market environment. The theory indicates that the macroeconomic variables have a direct impact on the returns in the stock market. This is mainly based on the ability to influence cash generation by the firms. The macroeconomic variables have direct influence on the discount rates which affects the ability of the firm to generate cash or pay dividends. This therefore ends up affecting the prices in the stock market. The theory indicates that the fundamental valuation model plays a vital role in determining the prices of the stock (Brown & Reilly, 2008). The process is thus discounted based on the expected future dividends. The model thus indicates that any systematic influence that affects the future dividends is likely to affect the stock process. The macroeconomic variables are known to have a direct impact on the future dividends. The theory therefore suggests that the macroeconomic variables have a direct influence on the stock prices. This theory however makes an assumption of homogenous expectations and perfect competition. The capital asset pricing model was developed as a means to investigate the effects of risks on expected results on investments. According to the theory, the expected returns on an asset are measured in accordance with the risks which are related to the class of investment (Elton, Gruber, Brown & Goetzmann, 2006). The risks can also be measured in accordance with the history of the risk that is associated with the investment. The aspect of specific risks is also highlighted in the capital asset pricing model which is also featured in the arbitrage pricing model. The theory further indicates that the investors can be compensated by the market for taking systematic risks. However, this is not applicable when dealing with specific risks. The theory further indicates that there is only one independent variable that influences the stock prices in the market. This independent variable is the risk premium of the market. The risk premium in the market is mainly associated with the macroeconomic variables which have a direct impact on the stock prices. An assumption that market is frictionless is made through the use of the capital asset pricing (Haugen, 2000). The assumptions that are made through the use of the theory are also similar to that of the arbitrage theory. Both theories highlight the relationship between the macroeconomic variables and the stock prices. The analysis of the theory indicates that the macroeconomic variables affect the factors that influence the stock market prices. This therefore indicates that the stock market process have a direct relationship with the macroeconomic factors. Influence of the macroeconomic variables Interest rates The interest rates in the market are an important macroeconomic variable that influences the stock prices in the market. The variation in the interest rates is usually as a result of changes in the short term and long term government bonds. The cash flow from stocks in most cases changes with the interest rates. This is an indication that the stock prices are influenced by the macroeconomic variable such as the interest rate. A negative relationship exists between the stock prices and the interest rates in the market (Jones, 2006). The interest rate is an important determinant of the corporate profits made by an organization. Higher future dividends are preferred by most of the investors. However the investors will only be willing to pay a certain amount for the stock prices if profit is high. This is an indication that the stock market price is directly related to the interest rate. The capital inventories and requirements in most of the organizations are financed through borrowings. Any reduction in the interest rate therefore encourages borrowing by the organizations. This in turn leads to more investments and better stock prices that may contribute to profitability. An increase in the stock prices may also make the stock transactions more costly (Reilly & Norton, 2006). This is considering that most of the companies purchase the stock through the use of borrowed money. In such a situation, the demand for the stock reduces leading to price depreciation. The interest rate is thus an important variable that influence the stock prices. Inflation Inflation is a macroeconomic variable that influences the stock prices. The levels of inflation vary from one country to the other depending on the economic factors. An increase in inflation has a direct negative impact on the economy. As a result of this, the central bank and the ministry of finance may end up developing economic policies aimed at tightening the economy (Shiller, 2006). The presence of such policies usually leads to an increase in nominal risk free rate. This in turn leads to an increase in the discount rate as highlighted using the arbitrage pricing model. An increase in the cash flow in the market may not neutralize the high discount rate during the inflation period. This may further create more economic problems that may see the cash flow initially decreasing. This is therefore an indication that inflation has a negative relationship with the stock prices. The stock prices may end up depreciating in the market as a result of inflation. A high level of inflation discourages the investors from purchase the stock as it may not have positive return as highlighted in the arbitrage pricing theory (Elton, Gruber, Brown & Goetzmann, 2006). It is therefore due to this reason that investors find it difficult to invest in the stock market in some of the developing countries which have a high level of inflation. Inflation also means that the currency looses value and hence leading to negative effects on the stock market. This macroeconomic factor is important to the investors as inflation is a common problem in the market. Exchange rates The exchange rate is an economic variable that changes from time to time. This can be attributed to other market forces that have a direct impact on the economic growth. The exchange rate may appreciate or depreciate from time to time. The dollar is the currency used in the international market and it determines the exchange rate. When there is depreciation in the exchange rate, the demand increases (Bodie, Kane & Marcus, 2008). An increase in the demand for export leads to an increase in the cash flow in the country. However an assumption made by the capital asset pricing model can be utilized in this scenario. On the other hand, an appreciation of the currency leads to more investments being attracted. Attracting investments has the potential of improving on the stock prices in the market (Shiller, 2006). This is therefore an indication that the exchange rates have a positive relation with the stock prices in the market. The exchange rate is however dependant on the levels of the international trade as well as the trade balances. The dominance of the import and export sector of the economy is therefore an influential factor in terms of determining the stock prices in the market. Money supply The supply of money in the market has a negative relationship with the price market stock. An increase in the supply of money in the market means that the stocks can be bought easily. However, the easy access impacts negatively on the actual return as the value of the stock depreciates. On the other hand an increase in the supply of money has negative impact on the overall economy. The increase in money supply is an indication of excess liquidity in the market to buy securities (Brown & Reilly, 2008). This may also lead to an in the security prices. An increase in money also leads to inflation in the market. Inflation has overall negative effects on the stock prices. The supply of money therefore needs to be regulated in order to ensure that it does not contribute to inflation and hence affecting the stock prices (Brown & Reilly, 2008). The discount rates may also be impacted negatively when there is an increase in money supply. The stock prices may be reduced when the discount rate increases. The economic stimulus may however be useful in terms of controlling the supply of money in the market. This may impact positively on the market stock prices. Industrial production The industrial production is a macroeconomic variable that influences the stock market prices. The industrial production is usually high when the economy is experiencing expansion. However when the economy is experiencing a recession, the industrial production is low. A positive relationship therefore exists between the industrial production and stock market prices (Jones, 2006). The accumulation of assets is a factor that contributes to the economic growth. The accumulation of assets leads to the generation of the cash flow. This is contributes positively towards better returns for the investors. However, the type of assets varies as the economic recession in USA was a result of huge investments in real estate which impacted negatively on the stock prices. The growth of industrial production impacts positively on the stock market prices and hence leading to the attraction of more investors (Haugen, 2000). Promoting industrial production therefore leads to positive relationship between the variable and the stock market price. The stock market prices in countries such as Japan recently experienced a fall. This was directly linked to the industrial production which was not growing as a result of recession. Conclusion In conclusion, it is evident that there is a relationship between the macroeconomic variables and the stock market prices. The macroeconomic variables can influence the stock market prices in a positive or negative way. It is evident from the arbitrage pricing and asset pricing model that a relationship exists between the macroeconomic variables and the stock market prices. The interest rates have negative impacts on the stock market price when it goes up. Inflation drives the stock market prices higher but with a low value. The foreign exchange adds value to the currency and this has positive impacts on the stock market prices. It is evident that an increase in money supply impacts negatively on the stock market prices since it contributes to inflation. The industrial production however has positive effects on the stock market prices. References Bodie, Z., Kane, A. & Marcus A. J. (2008). Essentials of Investments, 8th Edition. New Jersey McGraw-Hill. Brealey, R.A., Myers, S.C. and Allen, F. (2008). Principles of Corporate Finance, 9th Edition. New Jersey: McGraw-Hill. Brigham, E.F. & Houston J.F. (2009). Fundamentals of Financial Management, 12th Edition. South-Western. Brown, K.C. & Reilly, F.K. (2008). Investment Analysis and Portfolio Management, 9th Edition. South Western College, International Edition. Elton, E.J., Gruber, M.J., Brown, S.J. & Goetzmann, W.N. (2006). Modern Portfolio Theory and Investment Analysis, 7th Edition. London: John Wiley & Sons. Haugen, R.A. (2000). Modern Investment Theory, 5th Edition. New Jersey: Prentice Hall. Jones, C.P. (2006). Investments: Analysis and Management, 10th Edition. NY: John Wiley & Sons. Reilly, F.K. & Norton, E.A. (2006). Investments, 7th Edition. NY: Thomson South-Western. Shiller, R.J. (2006). Irrational Exuberance, 2nd Edition. Broadway Business. Read More