The Impact of Macro Economic Variables on Stock Prices: Evidence From Colombo Stock Exchange

Abstract

The impact of macro-economic variables on share prices is one of the major concern in Sri Lanka as there are many variables impact on share price. Although there are number of studies conducted to identify the relationship in between these two, the results are contradictory. This study is undertaken to identify the impact of most significant three macro-economic variables namely, Gross Domestic Product (GDP), Interest Rate (IR) and Exchange Rate (ER) on Sri Lankan stock market index (S & P SL 20 index share price) over the period of July 2012 - June 2017 using monthly time-series data. In terms of analysis, Johansens co-integration model has applied to identify whether there is any long-term causality between the variables. The test revealed that there is no long-term causality between the variables, which emphasizes the researcher to use Vector Autoregressive Model (VAR). VAR model revealed that there is a short run relationship between share price and previous month exchange rate only. The previous months exchange rate has a negative significant impact towards share price. Interest rate and GDP are found to be insignificant in determining share price. Variance decomposition revealed that the shock to the price lag and ER cause huge variation in price within short term period. Impulse Response confirmed that the price lag and exchange rates error term shock were affected significantly to the price in the short run. In the Granger Causality test, there is a unidirectional relationship between the exchange rate and share price. It can be concluded that understanding the impact of IR, GDP and ER on S&P SL 20 index with the recent data can be useful to investors as well as policy makers for being prudent on their financial decisions.

Keywords: S&P SL 20 Index, Macro Economic Variables, VAR, Johansen Co-Integration Test, Granger Causality

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