Stock Market Development and Economic Growth - Research Paper Example

tInstitution Name Date Supervisor Introduction The stock exchange market is usually the center of different transactions involving buyers and sellers of securities who meet together at a specified price. In Argentina, and other developed and emerging countries, the stock market plays an important role of mobilizing capital. This in turn leads to the growth of various industries and businesses in the country because of the liberalized and globalized policies that have been adopted by the Argentine government. Macroeconomic variables among other factors have an effect on the stock market, and investors will always consider them when valuing stocks. Among the most important macroeconomic variables in this case are interest rate, inflation and exchange rate. These variables have been discovered to have profound effect on the stock market performance. An inverse relationship exists between interest rate, stock prices and exchange rage. The interest rate in this case is the cost associated with borrowing from financial institutions. The same interest rate is usually used as the discount rate when discounting the financial assets’ cash flows. Stock prices are bound to go down with an increase in interest rates. This is caused by the rise of the required rate of return for stocks and thus a fall in stock prices. Investors will normally look out for fluctuations on interest rates as it can give either good or bad information and this is normally caused by the actions of monetary bodies (Lobo, 2000). The other factors taken into account by investors are the stock market and exchange rate. When selling stocks, investors usually convert their earnings in to their preferred currencies and thus they are bound to be affected by the current local exchange rate. The relationship between stock prices and exchange rates is therefore a negative one. an increase in the exchange rate causes a decrease in the stock price while on the other hand a decrease in exchange rate will cause an increase in stock prices. Inflation also has a great impact on the economy and the stock market in the end. Increase in inflation will negatively affect how the stock market performs. Continuous inflation growth is an indicator to investors that country is facing tough economic times and thus investing in the region may be risky. They will therefore feel insecure about investing in the country’s stock market. The Central Bank of Argentina should therefore come up with tight monetary policies that will control the inflation and thus regain the investors’ confidence. Such policies will control the money in circulation and thus banks will increase their interest rates which in turn make firms to suffer when trying to get some finance from the banks. When the inflation rate starts to decrease, investors will also start to gain confidence in the stock market and thus will be attracted to invest in the country. Following the above discussion, it is now clear that the stock market is in some way affected by macroeconomic factors. In this study I am going to conduct a test to determine the existing relationship in the Argentine stock market. 2. LITERATURE REVIEW The impact of inflation and volatility of stock returns was studied by (Rano & Bayero, 2010). In this study, the Genraized Heteroskedasticity Model was used to try and investigate the relationship that exists between the markets of Ghana and Nigeria. From the findings of the normality of data in descriptive statistics showed that Nigerian and Ghanaian stock returns were positive but a little bit more volatile. The stock returns from the model of Nigeria were significant but in that of Ghana they weren’t. The main cause of volatility in both of these markets was the rate of inflation. When inflation decreased, it was subsequently followed by an increase in the market volatility, though not in the Ghana market. (Devereux, Lane, & Xu, 2006) made an analysis on the alternative monetary policies. They found that in emerging markets, financial crisis had an important role to play in improving their monetary policies. In their model of studies, they used nominal rigidities, the fluctuation of imported good’s exchange rates and investment lending constraints. One of their assumptions was that there is a small delay that occurs when pricing imported goods and the exchange rate fluctuates. The nominal interest rate is reduced when the exchange rate fluctuates a little because of the high rates of borrowing. Their finding was that inflation’s stable properties can be determined through the prices of imported goods. (Gay and Robert, 2008) investigated the effect of macroeconomic factors on the stock market returns from four emerging markets, China, Brazil, India and Russia. They built a multifactor model which had oil prices and exchange rate. They gathered monthly data for a period of seven years beginning March 1999 to July 2006 and used the ARIMA model from which they concluded that there is no significant relationship between macroeconomic variables and the returns of emerging markets. The (Hsing.Y, 2012) paper examined various macroeconomic factors that are likely to have an effect on the Argentine stock market index. The macroeconomic variables that they took into account include monetary policy, fiscal policy, GDP, exchange rate, inflation rate and the U.S. stock market index representing the world stock market. The GARCH model was used so as to try and get the correct estimate of the parameters within the variance equation and also to capture the movements of the stock market. From the findings of the study, it was discovered that the Argentine stock market index has a positive relationship with the peso/USD exchange rate, real GDP, U.S. stock market index and the ratio of GDP to M2 money supply. However, it is also negatively influenced by inflation, the percentage of government spending on the GDP and the money market rate. The relationship between stock prices and macroeconomic variables has also been investigated by (Khan and Zaman, 2012). This was on the stock prices of Pakistan’s Karachi Stock Exchange (KSE). The study takes into account data from a 10 year span, 1998-2009. The macroeconomic variables considered include exports, GDP, consumer price index, oil prices, foreign direct investments, money supply M2 and exchange rate. The Augmented Dickey Fuller test is conducted to check stationary of data where at zero lag all of these variables are stationary. They then analyze the data using Multiple regression and the Fixed Effects Model from which they find that the exchange rate and GDP affect the stock prices positively while on the other hand the consumer price index affects the stock prices negatively. They also find an insignificant relationship between stock prices and the money supply M2, export, oil prices and foreign direct investment. Another study was that of (Lobo, 2000) where the relationship of interest rate and stock prices was examined. Lobo did his examination after the Federal fund rate was announced and from his study he found that before the increased Federal fund rate was announced, it was observed that the price adjustments asymmetry gets narrow. In addition, the stock market seemed to respond faster to overpricing news than it did to under-pricing news. In his conclusion, Lobo stated that the stock prices are significantly affected by the announcement of the target rate as it conveyed some new information to investors in the stock market. (Khrawish, Siam & Jaradat, 2010) studied the interest rate and exchange rate of the Amman Stock Exchange. In order to examine the relationship of these variables to the economy of the country, market data was collected for a period of 18 years, 1990-2008 and analyzed using the OLS regression method. From the findings, it was observed that there was a significant positive relationship and thus they rejected the first hypothesis (A) that the market capitalization rate and the interest rates both had negative relationships. Hypothesis B was also rejected because they found a positive relationship between market capitalization rate and market development rate. This led to their conclusion that the government had an important role to play when it comes to intervening in the financial market. The stock market of Italy was analyzed by (Aydemir & Demirhan, 2009) in order to find the effect that macroeconomic variables had on it. They collected market data from 2001-2008 and made an analysis. Dickey Fuller test method was used to study this data and the findings from the casualty test showed that the there was bidirectional casualty between the stock exchange prices and the exchange rate. This indicated that a positive relationship existed between technology indices and the exchange rate. (Rasheed, 2002) also did a study of the Asian market and particularly the markets if India, Pakistan, Sri Lanka and Bangladesh in order to determine the effect that the exchange rate had on the stock returns. The fluctuations of the exchange rate in the long run and short run were considered for all of these countries. Rasheed used the monthly data of the market for a period of six years. In his results, he found no significant relationship between the exchange rate and stock returns for all of the countries that he was studying. He concluded that there was no need of taking the results from one market to predict what would happen to the stock returns of another market because of the exchange rate. He therefore recommended that more research should be done in this area through the use of daily or weekly data so as to find more reliable information on the relationship between the exchange rates and stock returns. ­ (Zahid, 2010) made a study on the macroeconomic variables and their impact on the stock market index. From his findings, the effect of inflation and interest rate are negative on the stock market. He also found some positive, but not very strong, relations with the Pakistan stock market. The linear relationship between interest rate and share price was examined by (Uddin and Alam, 2007) together with the change in interest rate and share price. They also went further to try and exprolore the relationship between interest rate and changes in share prices and interest rate changes and share price changes in Bangladesh. Their findings show that there is a negative relationship with the share prices and which is significant just as the changes in interest rate have a negative impact on the changes in share price. (Mohammad, 2011) made use of the Multivariate Regression Model to compute on Standard OLS formula as well as the Granger casualty test to determine the effect of some macroeconomic and microeconomic variables the Bangladesh stock returns using monthly data from a period of beginning July 2002 to December 2009. Mohammad finds a negative relationship inflation, foreign remittance and stock returns. On the other hand, he finds that the stock market is positively influenced by a growing market capitalization and the market earnings. He doesn’t however find any unidirectional Granger Casualty between the independent variables and the stock returns thereby revealing that the market is informally inefficient. Another study was that of (Geetha, Mohidin, Chandran and Chong, 2011) where the impact of some macroeconomic variables i.e. expected and unexpected inflation rate, interest rate, exchange rate, GDP and the stock market of US, Malaysia and China are looked at. In order to find the actual number of co-integrating vectors, they use the co-integration test and from which they find the short run and long run relationship as being determined by the Vector Error Correction Model. It is indicated in their results there exists a long run co-integration relationship between these studied stock markets and the variables in them. However, they did not find any short run relationship existing between expected and unexpected inflation, interest rate, GDP, exchange rate and the stock markets for U.S. and Malaysia using the VEC. China’s VEC result however indicated that a short run relationship existed between its stock market and expected inflation rates. The relationship between the long-run and short-run dynamics between the stock returns and macroeconomic variables for Germany and United Kingdom were studied by (Mahedi, 2012). The co-integrating relationship is determined using the Johansen Co-integration test. He then examined each case individually when investigating the long-run and short-run relationship using the error-correction models. For the case of United Kingdom, the results show that the short run casualty run from the stock returns to money supply, T-bill, exchange rate, industrial production and from exchange rate to the stock returns. In addition, the long run casualty runs from the inflation to the stock returns. On the other hand, both the long-run and short-run relationships run to the inflation from the stock returns, to the stock returns from the money supply and to the stock returns from industrial production. In the case of Germany, the short-run casualty runs to the inflation from the stock returns, from industrial production and money supply to stock returns. On the other hand, the long-run relationship is running from the inflation to the stock returns and from the stock returns to the industrial production. It is in only one case where he finds an existing long-run and short-run relationship, i.e. from stock returns to the industrial production. His findings show that there are long term casual relationship and short-run interactions for the macroeconomic fundamentals and both the UK and Germany stock markets. RESEARCH METHODOLOGY Objectives of the study The objective behind this study is to carry out an investigation on the impact of interest rate, inflation and exchange rate on the stock returns of Argentina. Methodology In this study, I am going to investigate the effect of exchange rate, interest rate and inflation on Argentina’s stock exchange. This study uses the multiple regression analysis in testing the hypothesis. The stock returns in this case are the depended variable while the interest rate, inflation and exchange rate are the independent variables. The interest rate is the Argentina interbank rate for a period of up to 15 days. The inflation rate on the other hand is the JP Morgan trade weighted index for Argentina while for the exchange rate, peso to $ rate has been chosen. The analysis is on the monthly data that has been collected for a period of 10 years, 2005-2015. Theoretical framework The Buenos Aires Stock Exchange (BCBA) is responsible for conducting Argentina’s stock exchange which is locate at the CBD of Buenos Aires. BCBA succeeded the Banco Mecantil in 1854. The MERVAL is the most significant index of the BCBA stock market. It’s other utilized indicators are the M.A.R, Bolsa General and Burcap. The Wholesale Indol and Indol are its currency indicators. This share market is affected by many macroeconomic variables. Among the most important variables are inflation, exchange rate and interest rate. The theoretical framework lightly demonstrates the relationship in the light of the preceding prose, i.e. the study has identified well inflation rate, interest rate and exchange rate as the independent variables and the stock market as being the dependent variable. Purpose of the study The purpose of this study is to determine the existing relationship between the stock market and inflation, interest rate and exchange rate. In this study I have two hypotheses that I will use to show the relationship. Hypothesis The following are the hypotheses that I have come up with and they can be made by looking at the introduction and literature review. Hypothesis (H0)- stock returns are not affected by interest rate, exchange rate and inflation Hypothesis (H1)- stock returns are affected by interest rate, exchange and inflation Why inflation, exchange rate and interest rate have been chosen for this study When investing, investors normally look at these variables before making the decision of whether to invest or not. If the interest rate fluctuates, then it means that the value of their investment changes. If polices are created by the government to control the money in circulation during inflation then their businesses are also bound to be affected. The exchange rate is also of much importance because investors usually convert the earnings from their investments back in to their local currencies. If the exchange rate is high, then they shy away from investing in the country and will search for areas where the source is secure. I have therefore used these macroeconomic variables as independent variables in my test for their impact and the stock market as a dependent variable. Methodology and data In my study, I am going to use the multiple regression model to test my hypotheses. The equation for the multiple regression model is represented as: S= α + β₁IR + β₂ER +β₃INF + ϵᵼ Where S= Interest rate ER= Exchange rate INF= Inflation ϵᵼ= Error term The value of the stock return will be computed as S= Interest rate is what it costs one to borrow from a financial institution. It can be represented as real interest rate, nominal interest rate or even market interest rate. The nominal interest rate has not been adjusted for inflation while on the other hand real interest rate usually has inflation in consideration. In order to analyze the impact of exchange rate on stock returns in this study, peso to U.S. dollar exchange rate has been selected. This is because most trade transactions in the country are based on dollars as its value is more stable. Its exchange rate is also high in Argentina and when exports are made more peso is received. There are various ways to measure inflation, and some of these are the service price index, consumer price index and the wholesale price index. Consumer price index (CPI) compares prices between goods and services in regards to the base year prices. In Argentina, CPI is the main indicator used in measuring inflation. EMPIRICAL FINDINGS Table1 Regression statistics SUMMARY OUTPUT Regression Statistics Multiple R 0.357864 R Square 0.128066 Adjusted R Square 0.10532 Standard Error 9.312106 Observations 119 The multiple regression value of 35.56% shows that there is a medium correlation between the stock market performance and the three macroeconomic variables. The variability observed in the performance of the stock market is therefore not being caused by the macroeconomic indicators that have been selected for the study. They only cause variability to an extent of 12.80%. Only 10.53% changes in the Marvel stock price can be as a result of the impact of the macroeconomic variables as per the Adjusted R square value, while the other factors explain the other 89.47%. This is an indication that the stock market is very dependent on the other factor which have not been studied here while it doesn’t depend much on the studied macroeconomic variables for the performance of the economy i.e. exchange rate, inflation and interest rate. Investors planning to invest in Argentina should therefore largely consider the other macroeconomic factors. Table 2 ANOVA   df SS MS F Significance F Regression 3 1464.688 488.2293 5.630254 0.00123 Residual 115 9972.262 86.71532 Total 118 11436.95       According to the results of the Anova test, the F value is 5.630254 and with a significance of 0.00123 which is 0.001 when rounded off. Since the results show a probability (or level of significant) of 0.001 which is less than 0.05, then there is proof that interest rate, exchange rate and inflation affect the Merval stock price simultaneously and thus proving that our Hypothesis 2 is correct and we fail to accept Hypothesis 1 at 5% level of significance. Table3. Coefficients of model   Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.308713 2.550286 0.12105 0.903862 -4.74291 5.360338 -4.74291 5.360338 X Variable 1 0.237751 0.255525 0.930441 0.354092 -0.2684 0.743898 -0.2684 0.743898 X Variable 2 -2.11377 0.517618 -4.08364 8.23E-05 -3.13907 -1.08846 -3.13907 -1.08846 X Variable 3 -0.75034 0.564317 -1.32965 0.186266 -1.86815 0.36746 -1.86815 0.36746 Table 3 shows the intercept as well as the coefficients of our regression model. The coefficient of inflation is -2.114, and thus it is negatively related to the stock returns. This result is also significant at 5% because p= 8.23E-050.05. The regression results also show that the exchange rate causes a negative impact on the stock returns, an intercept of -0.75044. This result is also insignificant at 5% since p=0.19>0.05. Foreign investors will always convert their stocks into their home currency first in order to determine the value of the returns. When the exchange rates are high, it means they will get low returns and this will definitely disappoint them. Regression Model used in determining the impact of macroeconomic variables in Merval stock returns Y= a + b1X1 +b2 X2 + b3X3 Where in this case Y= Merval Stock Returns a= the intercept Y and which is constant b1, b2, and b3 = Beta coefficients of X1, X2 and X3 X1= interest rate X2= Inflation X3= Exchange rate Therefore, Merval Stock returns = 0.308713 + 0.237751X1 - 2.11377X2 - 0.75034X3 Conclusion This study looks at the relationship between the Argentinean stock market, represented by the MERVAL of the Buenos Aires Stock Exchange. According to the regression results, there are indications that increase in inflation and exchange rate cause a decrease in the stock prices. On the other hand, an increase in interest rates causes an increase in stock returns. In addition to the above statistical results, there is an indication that there are other factors that greatly influence the stock returns. This therefore calls for more research on these factors. This paper serves to provide evidence on how the performance of the Buenos Aires Stock is affected by macroeconomic factors. This model can therefore be used in the future by investors, the government agencies or companies. Recommendations I would suggest to investors in the Argentine market to closely analyze the patterns of other macroeconomic factors influencing stock returns if they want to maximize profits. They can also partly rely on the forecasted interest rates when making their investment decisions because an increase in interest rates causes an increase in stock returns. In addition, there is need for deep research on the other economic variables that greatly affect stock returns of the Merval. 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