The Effect of Macroeconomic Variables on Stock Prices in Emerging Sri Lankan Stock Market

Abstract

This study investigates the effects of macroeconomic variables on stock prices in emerging Sri Lankan stock market using monthly data for the period from September 1991 to December 2002. The multivariate regression was run using eight macroeconomic variables for each individual stock. The null hypothesis which states that money supply, exchange rate, inflation rate and interest rate variables collectively do not accord any impact on equity prices is rejected at 0.05 level of significance in all stocks. The results indicate that most of the companies report a higher R2 which justifies higher explanatory power of macroeconomic variables in explaining stock prices. Consistent with similar results of the developed as well as emerging market studies, inflation rate and exchange rate react mainly negatively to stock prices in the Colombo Stock Exchange (CSE). The negative effect of Treasury bill rate implies that whenever the interest rate on Treasury securities rise, investors tend to switch out of stocks causing stock prices to fall. However, lagged money supply variables do not appear to have a strong prediction of movements of stock prices while stocks do not provide effective hedge against inflation specially in Manufacturing, Trading and Diversified sectors in the CSE. These findings hold practical implications for policy makers, stock market regulators, investors and stock market analysts.