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Proceedings of Eurasia Business Research Conference
16 - 18 June 2014, Nippon Hotel, Istanbul, Turkey, ISBN: 978-1-922069-54-2
Co-Integration Analysis of Macroeconomic Variables as
Determinants Equity Risk Premium: Evidence from KSE100
Muhammad Imran* and Muhammad Zakaria^
Stock market of any country plays a vital rule in discovering the economic growth
progress. The industrial growth and its importance cannot be overlooked in economic
growth. Companies need capital for their expansion and new opportunities to create.
Investors have to two best options for investment i.e. investment in money market or
investment in stock market. Investment in stock market not free of risk and investor
always demand for high return due to the risk they are taking. In this research we are
discussing the premium that earn by the investor for the risk the investors are availing
upon their investment. The equity risk premium (ERP) has been calculated by taking
the difference of market return and interest free returns. Monthly data has been used
in this study ranging from July 2001 to Dec 2013. ERP has been used as endogenous
variable while interest rate, inflation, exchange rate and foreign private investment
have been used exogenous variables. Augmented Dicky Fullor and Phillop Perron test
has been used to verify that data is stationary at same level. Schwarz information
criterion has been used to find the suitable lag length for performing co-integration
test. Co-Integration test has confirmed that there is long term relationship between
endogenous and exogenous variable. In order to confirm the causality of relation we
perform Granger Causality test and found that interest rate does granger cause to
equity risk premium followed by exchange rate that causes equity risk premium at
10% significance level. In addition to that exchange rate does granger causes to
interest rate. Variance decomposition and impulse response showed that interest rate
has significant effect followed by exchange rate and Inflation over equity risk premium.
Foreign private investment has no or very little effect on equity risk premium.
Keyword: Equity premium, Inflation, Exchange rate, co-integration, granger causality,
variance decomposition
*PhD Scholar and ^Assistant Professor in the Department of Management Sciences, COMSATS Institute
of Information Technology, Islamabad