Stock Prices in the UK Stock Market (Essay Sample)

THE EFFECTS OF MACROECONOMIC VARIABLES ON STOCK PRICES IN THE UKSTOCK MARKETby Dona M
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Chapter I
Introduction
The relationship between macroeconomic variables and stock prices has been extensively studied in developed capital markets and literature on the above variables are widely available. However, multifactor models have been developed as an explanatory factor of the variation in equity prices and these studies have typically focused on developed markets. The relationship between macroeconomic variables and stock prices has been examined in Emerging Stock Markets (ESMs) after 1980s. However, interest in investing in emerging markets has grown considerably over the past decade. Harvey (1995a) shows that returns and risks in ESMs have been found to be higher, relative to other developed markets
Numerous studies have been conducted to determine the determinant of stock price movements. Many studies suggest that strong relationships exist between macroeconomic variables and stock prices in developed such in the United Kingdom economy. Although most of the studies were carried out in emerging market contexts recently, there is a paucity of such studies in London Stock Market with the exception of a few like Samarakoon (1996 b, 1998 c, 1998 d); Samarakoon et al. (2000); Perera, (1994), Nimal, (1997), Premawardena; (1997)}. This study extends these literatures by considering the relationship between stock prices and macroeconomic variables in the UK Stock Market. Macroeconomic variables such as money supply, exchange rate, inflation rate and interest rate on stock prices form the foundation of this study. The findings imply that there exists significant association between most of the macroeconomic variables and stock prices in the UK Stock Exchange.
The theoretical motivations for undertaking the study on the effect of macroeconomic variables on stock prices are discussed as follows. The relations between exchange rate movements and stock prices are based on the rise in the domestic interest rate. This leads to capital inflows and makes the exchange rate appreciate and this suggests that, for export dominant industries, currency appreciation has a negative effect on stock prices in such industries because of reduction in exports while currency appreciation boosts the stock market (positive effect on stock prices) for import dominant industries due to increase in imports. Numerous studies have been conducted in developed capital markets with regard to the relationship between stock prices and interest rates and results of most studies suggest that stock and bond returns are predictable and that one may be used to forecast the other. Whenever the interest rate on Treasury securities rises, investors tend to switch out of stocks, causing stock prices to fall. The effects of inflation on the returns to financial assets have been an important theoretical issue for many years. The basic theoretical concept in this area is commonly attributed to Irving Fisher (1930) who posited that the nominal interest rate fully reflects the available information concerning the possible future values of the rate of inflation. This hypothesis has received wide acceptance among economists and has played an important role in the monetary theory, finance and macroeconomics. All the above considerations motivated to conduct this research study in the UK context.
The above theoretical motivations and empirical evidence reveal relationships between stock prices and macroeconomic variables. This leads to studying the effects of macroeconomic variables on stock prices in the UK context. When considering the above facts, the results of a study of this nature will be of enormous importance to numerous parties. The findings of the study hold practical implications for various parties. Therefore, a study of this nature is timely and essential.
The stock exchange acts as the most important market for capital and a well-developed capital market is essential to promote economic development. The UK government has been offering a number of incentives to boost the stock market. Specially, foreign investors are granted substantial incentives to invest in UK company shares. The government has taken several significant listed in the London Stock Exchange are already involved in the development of infrastructure - the Power Sector, Telecom, Water and Health while other sectors in the LSE cover a significant role in the UK macroeconomic. By taking into consideration the above factors, the results of a study of this nature will be of enormous importance for both local and foreign investors, stock market regulators, multinational corporations, stock market analysts and policy makers. Therefore, this type of study is very essential to promote the stock market steps to boost the UK Stock Market. Further, the capital market plays an important part in the economy and companies
Still, the paucity of literature on the effects of macroeconomic variables on stock prices and little attention of the responsible parties and the insufficient knowledge of this issue in the UK context could not be added to the information set available to the above parties. In order to fill this gap in the literature in UK Stock Market this study will add immensely to the existing literature of UK Stock Market. Therefore, the research problem of this study is to find out whether there is any relationship between macroeconomic variables and stock prices in the London Stock Exchange. The primary objective of the study is to identify the impact of behaviour of macroeconomic variables on stock prices. The remainder of the paper proceeds as follows: Chapter 2 reviews the literature; chapter 3 describes the methodological issues and data used; chapter 4 discusses the results. Chapter 5 analyses the empirical findings of the study while chapter six is the conclusions made from the study. The final chapter is the reflections inferred from this study.
Chapter II
Literature Review
This chapter refers to the former academic work concerning the influence of macroeconomic variables on stock prices with distinctive reference to the UK stock market. Countless researches have been investigated how macroeconomic factors affect the stock prices throughout the world. For instance, many of the researches attempt to broaden the research in developed and emerging stock markets. While investigating this principles, it is initiated the significance of theoretical underpinnings and empirical evidences. The chapter is divided into two sections. Section one, discusses the previous literature regarding the effects of macroeconomic factors on the stock returns in developed and emerging stock markets. This part analyses the effects of several macroeconomic variables such as interest rate, exchange rate, inflation, cash flow, money supply and stock returns in UK’s London Stock Exchange and, where applicable, other stock markets around the world. Section two, critically evaluates this issue in a UK perspective.
Previous literature in developed and emerging stock markets
It is been examined that macroeconomic factors on stock prices cause the volatility of stock markets around the world since 1970s. While identifying the stock returns these variables are considered as a major indicator. The strong correlation between the macroeconomic variables and stock returns are disclosed by various academics in both the past and present day literature. These studies were carried out on both developed and emerging capital markets. It is deliberated that, on the valuation process the economic and industry environment as well as the investigation of individual companies or stocks should be taken in to attention. According to several soundings it is noted that an individual’s success or failure could be affected by his or her family, society or, economic background. As per Reilly and Brown (2006, p. 15) pointed out the economic and industry environment of a firm should be considered during the valuation process, or in other words in the valuation of securities. Consequently, the significance of the economic and industry environment on the valuation process distinguished by the top-down (the three-step) approach contrast to the bottom-up approach.
According to the top-down approach it is certified that the total returns for individual stocks are expressively affected by both the economy and industry, regardless the assets that a firm hold, while the bottom-up approach opposes that statement as it believes that it is possible to find greater returns of stocks regardless of the economy and industry outlook. However, the top-down investment process has been strengthened by the outcomes of various speculative researches examining the effects of economic variables on stock returns. In addition to the individual quality and prospective profitability of a firm, it is also believed that the economical atmosphere and industry performance is influenced by the value of a security and its rate of return. In so doing, certain macroeconomic variables would be considered as an indicator of risk that is common in most organisations.
The hypothetical valuation models illustrate the link between stock prices and macroeconomic variables. Those are such as Dividend Discount Model (DDM), Free Cash Flow Valuation and Residual Income Valuation Model. As reported in these models, the current prices of an equity share is approximately equal to the present value of all future cash flows; therefore if any economic variable affects cash flows and required rate of return, in turn influences the share value as well.
As stated in Moore (1983) the general level of stock prices has been much higher at the top of a boom than at the bottom of a recession in the USA. The st...