NUST Business School

FIN-325 Alternative Investments - Valuation

How macroeconomic conditions in an economy affect investment
valuation/ stock return?

Submitted to;
Sir Owais Qarni

Submitted by;
Asadullah Sher

BS ACF 2K16 A

Date: 25 Sept, 2018.

In macroeconomics, a variety of economy-wide phenomena is thoroughly examined such as inflation, price levels,
rate of growth, national income, gross domestic product (GDP) and changes in unemployment (Staff,
2018). Economists and analysts often look at macroeconomic factors when they are searching for ways to explain
or meet economic policy goals and create economic stability (Ans, 2018). Various economic factors need to be
taken into account when determining the current and expected future value of a business or investment portfolio.
For a business, key economic factors include labor costs, interest rates, government policy, taxes and management
(BusinessDictionary.com, 2018)
Extensions have been proposed to accounting theoretical modelling, with major implications for valuation and
empirical research, by relating to a new and growing research area called Macro-Accounting. This new research
area focuses on addressing real-life world problems using the value added that accounting can bring to various
macro-level topics that are at the forefront of the academic and professional discussions. Examples are inflation,
inequality, the housing market, recessions, GDP, business cycles, the banking system, and national accounting. To
demonstrate how the interaction between firms and the macro economy can be used in accounting valuation,
consider, for instance, the link to firms’ equity cost of capital. Specifically, firms’ equity values relate to the state
of the overall economy through cost of equity capital effects, where the cross-sectional variation in valuation is
driven by varying sensitivities of firms’ fundamental performance to downside macroeconomic states. In this case,
the downside risk of accounting fundamentals (earnings), that is, the expectation for future downward operating
performance, contains distinct information about firm risk and varies with cost of capital in the cross section of
firms. Firms with high expectations to earnings downside patterns can be those that are likely to be more sensitive
to downward macroeconomic states (Konchitchki, 2016).
Most Investment valuation methods involves reflecting risk, return and expectations of growth through the use of a
yield (Isurv.com, 2018). An explanation of how the rate of interest influences the level of investment in the
economy. Typically, higher interest rates reduce investment, because higher rates increase the cost of borrowing
and require investment to have a higher rate of return to be profitable (Economicshelp.org, 2018). If we talk about
bank equity valuations, results indicate that bank stock prices decline substantially following an unanticipated
increase in the level of interest rates or a steepening of the yield curve. A large maturity gap, however, significantly
attenuates the negative reaction of returns to a slope surprise, a result consistent with the role of banks as maturity
transformers. Share prices of banks that rely heavily on core deposits decline more in response to policy-induced
interest rate surprises, a reaction that primarily reflects ensuing deposit disintermediation. Results using income and
balance sheet data highlight the importance of adjustments in quantities—as well as interest margins—for
understanding the reaction of bank equity values to interest rate surprises (English, Van, & Zakrajsek, 2018).
To study the effect of forex rates on investment valuations and stock returns, profound research has been done on
this topic. The empirical question is whether macroeconomic factors of EMFs such as the foreign exchange rate
and oil price significantly explain stock market returns. The Box-Jenkins ARIMA model used to describe the
relationship will use the moving-averages at the one-month MA(1), three-month MA(3), six-month MA(6), and
twelve-month MA(12) for the lagged dependent of stock market price and the two intervening variables of exchange
rate and oil price. The relationship between exchange rates and stock prices was hypothesized to be positively
related, showing that an appreciation (depreciation) of the domestic currency in terms of USD would have an
unfavorable (favorable) impact on the domestic stock market. This relationship was found to exist between the stock
index price and exchange rate for Brazil, Russia, and China. An interesting point in the results of the study was the
relationship observed between respective stock market prices and monthly oil prices. As expected the relationship
would be inverse, with an increase in oil prices having an unfavorable effect on stock market prices (Gay, 2016).
The empirical findings reported in another article show that global financial market uncertainty and domestic
macroeconomic factors play important role in explaining the stock bond correlation in emerging markets. In
addition, time-varying stock-bond correlation patterns vary significantly between the time horizons. Findings also
suggest that the most important factor influencing stock-bond correlation at short horizon is the monetary policy
stance, while the factors with the highest impact on the stock-bond correlation in long run are inflation and stock
market uncertainty. Furthermore, empirical findings demonstrate positive long run relationship between inflation
and stock-bond correlation suggesting that both stock and bond prices in emerging markets tend to move in the
same direction during high inflation periods. Moreover, analysis show that high equity market uncertainty, as
measured by implied volatility, leads to a higher co-movement of stock and bond prices in emerging markets.
Finally, global stock market uncertainty plays more significant role than global bond market uncertainty in
explaining stock-bond correlations in emerging markets (Dimic, Kivjaho, Piljak, & Aij, 2016).
In this context, the aim of another paper was to study the effect of changes in oil price volatility in the stock markets
of the G7 economies (Canada, France, Germany, Italy, Japan, the UK and the US). Most papers referring to oil
price shocks and stock markets focus on how different specifications of an oil price increase or decrease may affect
stock returns. Few researches have been made to test for the effect of the volatility of oil price on stock markets.
However, considering the importance of oil as a major input in production processes, it is necessary to consider
how the volatility in the price of oil affects investment decisions, and reduces the efficiency of resource allocations
that reflects on declining stock returns. In that research, using monthly data since 1970:01 to 2014:12 for G7
economies, they found that the effect of a change in oil price affects the stock markets not only through a price
increase (or decrease) affecting cash flows or expected returns, but also because of how frequent and large oil price
changes heighten volatility. Our approach measure the reaction of G7 stock markets to a shock in oil price volatility
and show that, as expected, an increase in oil price volatility negatively affects the performance of stock markets in
these economies (Diaz, Molero, & de gracia, 2016).
References:
1. Gay, R. D. (2016). Effect of macroeconomic variables on stock market returns for four emerging
economies: Brazil, Russia, India, and China. The International Business & Economics Research Journal
(Online), 15(3), 119.
2. Dimic, N., Kiviaho, J., Piljak, V., & Äijö, J. (2016). Impact of financial market uncertainty and
macroeconomic factors on stock–bond correlation in emerging markets. Research in International
Business and Finance, 36, 41-51.
3. Konchitchki, Y. (2016). Accounting valuation and cost of capital dynamics: Theoretical and empirical
macroeconomic aspects. Discussion of Callen. Abacus, 52(1), 26-34
4. Diaz, E. M., Molero, J. C., & de Gracia, F. P. (2016). Oil price volatility and stock returns in the G7
economies. Energy Economics, 54, 417-430.
5. Staff, I. (2018). Macroeconomics. [online] Investopedia. Available at:
https://www.investopedia.com/terms/m/macroeconomics.asp [Accessed 14 Sep. 2018].
6. Ans, I. (2018). Macroeconomic Factor Definition & Example | InvestingAnswers. [online]
Investinganswers.com. Available at: https://investinganswers.com/financial-
dictionary/economics/macroeconomic-factor-5297 [Accessed 16 Sep. 2018].
7. Isurv.com. (2018). What is investment valuation? | Traditional method of investment valuation for
beginners | isurv. [online] Available at:
https://www.isurv.com/info/390/features/8805/traditional_method_of_investment_valuation_for_beginne
rs [Accessed 16 Sep. 2018].
8. Economicshelp.org. (2018). [online] Available at: https://www.economicshelp.org/blog/425/interest-
rates/investment-and-the-rate-of-interest/ [Accessed 16 Sep. 2018].
9. BusinessDictionary.com. (2018). When was the last time you said this?. [online] Available at:
http://www.businessdictionary.com/definition/economic-factors.html [Accessed 16 Sep. 2018].
10. English, W. B., Van den Heuvel, S. J., & Zakrajšek, E. (2018). Interest rate risk and bank equity
valuations. Journal of Monetary Economics.