Stock Market plays a vital role in mobilizing the savings from a large pool of savers and channelizing these funds into fruitful investments. The investors who invest in stock exchange have the only consideration and that is to maximize wealth. The increasing international diversification, cross-market return correlations, adoption of floating exchange rates by many countries, have increased the opportunities of investment decisions and portfolio diversification decisions (Aydemir and Demirhan, 2009).
The return on stocks is based on a number of factors, the exact number is not yet known. Many studies tried to explain the relationship of macroeconomic factors like GDP, exchange rate, interest rates, money supply, foreign investment and inflation etc with the stock prices (Shew, 2008; Aydemir and Demirhan, 2009; Eleftheriou and Apergis, 2002; Li and Wu, 2008).
There are two explanations for the relationship of exchange rates and stock prices. The flow-oriented model approach as described in Dornbusch and Fischer (1980) research show that currency movements directly affect international competitiveness. In turn, currency has an effect on the balance of trade within the country. As a result, it affects the future cash flows or the stock prices of firms.
The counter argument suggests that taking a portfolio-balance approach (Dornbusch, 1976), where portfolio holders should diversify to eliminate firm specific risk, requires effective investments allocation including currencies. As with other financial instruments, currencies therefore are under the rules of supply and demand for assets. In order for investors to purchase new assets they must sell off other less attractive asset in their portfolio. In other words buying and selling of domestic or foreign investments if less attractive. As countries assets become more valuable, interest rates begin to increase creating an appreciation of domestic currency.
Friedman (1988) stated that monetary growth bumpiness increases the amount of supposed ambiguity. Where investor’s expectations are based on price level of financial assets, Boyle (1990) proposed that changes in uncertainty of money supply will affect prices of financial instruments. Boyle (1990) suggests that changes in monetary uncertainty modify the stock prices risk premium to replicate the added expected prices that investors demand for assuming the risk of keeping stocks. In this way, monetary uncertainty is supposed to depict a negative association with stock prices. Ghazali and Yakob (1997) looks at meeting two objectives firstly, to test for the subsistence of a correlation between the uncertainties linked with the unevenness of growth in money supply and the equity market prices.
Inflation is one the most important macroeconomic indicators to analyze the economic conditions of the economy. Few studies address the linkage among the stock market and inflation, Famma (1990); suggests that macroeconomic variables have projecting power for the stock exchange performance, although they do not consent to the anticipating authority of stock performance for the economy.