Modeling and Analyzing Macro-Economic Variables as Risk Factors: Evidence from Pakistani Stock Exchange

Abstract

This study attempts to investigate seven macroeconomic risk factors’ effect on fifty stock returns of Pakistani stock market for the time period of July 1998 to June 2014 respectively. The sensitivity coefficients of macro-economic risk variables are identified as market return, money supply, industrial production, and call money rate, term structure of interest rate, exchange rate and inflation. This study jointly estimates economic risk factors and also risk premium associated with these risk factors by employing extended arbitrage pricing theory (APT) model by applying non-linear seemingly unrelated regression. The innovation of each economic variable is used as risk factor and the study estimates the sensitivities of risk factors and the premium for risk using extended APT model. The results indicate that the money supply risk positively affects stock returns and the industrial production, inflationary shock, exchange rate, call rate and the term structure shocks negatively affect the stock returns respectively. Among all the macro-economic risks, the risk premium for the stock returns is significant for facing market risk, inflation risk and interest rate risk. The results of the study imply that since risk premium is the reward for taking risk while holding stock market assets, if the predictable risk increases, it reduces uncertainty of the stocks. Therefore investors, authorities and policy makers are needed to take into account the economic risk factors while considering the sensitivity of stock returns in making decisions.