Data and Methodology

This study uses monthly returns on stock index. The month-end closing values of the KSE-100
index were obtained from online database of Yahoo finance for the period from July 1997 to Dec
2010. The market returns are calculated by taking first difference of logs of two consecutive
month-end closing values.
Y= 100*ln (Pt/Pt-1)
The domestic macroeconomic variables used for the study are, Exchange rate and Interest rate.
The data on these macroeconomic variables were obtained from monthly publication of state
bank of Pakistan and International Monetary Fund (IMF). Data on all variables cover the period
July 1997 to Dec 2010.
In our study we have taken time series data for econometrics analysis several preliminary
statistical steps must be taken the step included descriptive statistics, unit root, and co integration
testing. The nature of time series data, it is necessary to test stationary of each individual
variable. Stationary means mean and variance between two time periods depend only on the
distance or lag between the two time periods and not on the actual time at which co variance is
computed to check the stationary ADF (augmented dickey fuler) test. It consists of regressing
level and first difference of the time series against constant.

Unit Root Test

In the Time series data unit roots exist, subject to stochastic trends that’s why examining the
stationary of a time series is important. The Augmented Dickey Fuller (Dickey Fuller 1979) was
employed to check the non-stationary of the series. Time series is non-stationary is the null
hypothesis in ADF test. The rejection of null hypothesis means that the series are stationary. This
hypothesis can be rejected by proving strong evidence against it.

Co integration Test
Cointegration test was used to identify equilibrium or a long-run relationship
among the variables. If there was a long-run relationship between variables,
then divergence from the long-run equilibrium path was bounded and the
variables were co-integrated. Johansen and Juselius (1990) procedure
undertook the most of the problems of Engle and Granger approach such as
(i) In EG approach we have to do with the order of integration, (ii) In case of
more than two variables, there may be more than one cointegrating
relationships, and (iii) It relies on two step approach. The Johansen and
Juselius (1990) approach was based on maximum likelihood estimates and
gives maximum Eigen Value and Trace Value test statistics for detecting
number of cointegrating vectors. This procedure provides framework for
cointegration test in the context of vector autoregressive approach. Johansen
method was explained as follows:

Johansen-Juselius Co integration Test

Having concluded that each of the series is stationary, we proceed to examine whether
There exists a long-run equilibrium between stock prices and the macroeconomic variables
Selected

Error Correction Model

The presence of co integration indicates that at least one of the variables tests react to deviations
from the long-run relationship. Here we investigate whether stock prices corrects for
disequilibrium.