An Approach to investigate the relationship between share prices and macroeconomic variables

Abstract

With the development of the economy in Sri Lanka and low interest rate for savings influencing people to invest their money in other profitable areas. Therefore stock market is one of the good opportunities that can open the door for local investors as well as foreign investors to invest their money. This study examines the causal long run relationships among stock prices and macroeconomic variables and forecasting stock prices in an emerging stock market, the Colombo Stock Exchange (CSE). Data is used on four macroeconomic variables obtained by web site of Central Bank of Sri Lanka and the All Share Price Index (ASI) of the CSE obtained from Data Library CD published by the Colombo Stock Exchange for the period January 2003 to December, 2010. Johansen’s co-integration test, Granger Causality Test and econometrics techniques with regression analysis were used in the empirical analysis and indicate that there are long-run causal relationships among stock prices and macroeconomic variables where as Money Supply (M1) and Interest rate in Sri Lanka. These results indicate that stock prices can be predicted from certain macroeconomic variables. The above results have implications for investors, both domestic and international.