INTRODUCTION

STOCK EXCHANGE MARKET A stock exchange is an institution where the shares of publicly traded companies listed on that particular exchange are bought and sold between members (or brokers) belonging to the exchange. A stock market brings together people who want to buy and sell stocks and shares, and other investments such as government bonds. In the UK, the main stock market is the London Stock Exchange. Other major exchanges are in New York, Japan, Hong Kong, Germany, Paris and China. The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional financial capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange affords the investors gives them the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate. Some companies actively increase liquidity by trading in their own shares. History has shown that the price of shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. An economy where the stock market is on the rise is considered to be an up-and-coming economy. In fact, the stock market is often considered the primary indicator of a country's economic strength and development. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions. Financial stability is the raison d'tre of central banks. Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction.[citation needed]

KSE (Karachi Stock Exchange) is the colloquial term used for Karachi Stock Exchange (Guarantee) Limited. This is the largest and most established stock exchange in Pakistan. The location of KSE is in Karachi, Sindh, Pakistan and on the Stock Exchange Road in the core of the Karachi Business District. Its foundation is dated way back 1947. It does not only deal with Pakistani exchange but also with overseas listing. KARACHI STOCK EXCHANGE (KSE) KSE (Karachi Stock Exchange) has been declared the Best Performing Stock Market of the World for year 2002 with 654 companies listed in their market capitalization. On December 8, 2009, its recorded market capitalization is Rs. 8.561 trillion. It has the US dollar value of $120.5 billion. By July 30, their market capitalization reached a phenomenal Rs. 2.95 trillion or the approximation of US$350 billion. On December 31, 2007, it closed its KSE 100 Index at 14075.83. On its 6th year in the business, KSE (Karachi Stock Exchange) continues its legacy to be one of the Best Performing Markets in the world. This recognition was declared by the International magazine The Business Week. USA Today, another US newspaper also claimed the organization as one of the best performing stock exchange companies in the world. There are remarkable features of the KSE (Karachi Stock Exchange) which makes it as an emerging key institution in Pakistan when it comes to capital formation. It has 654 listed companies, 692 security listed on exchange and 654 ordinary share. It also has 14 preference shares and 24 debt securities or TFC. KSE (Karachi Stock Exchange) has the main goal of becoming the leader in the financial institution industry. It offers fair, efficient and transparent securities market in its region. Thus, you could simply browse the internet and find myriads of comprehensive and vital information regarding the organization and its activity. Some of the details provided include the KSE 100 Index and live Karachi stock exchange index.

KSE-100
Global economic turmoil and worsen economic conditions 16000 14000 12000 10000 8000 6000 4000 2000 0 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -0.5

Exchange Rate It is a rate at which one currency may be converted into another. The exchange rate is used when simply converting one currency to another, or for engaging in speculation or trading in the foreign exchange market. There are a wide variety of factors which influence the exchange rate, such as interest rates, inflation, and the state of politics and the economy in each country. Also called rate of exchange or foreign exchange rate. There are several ways in which the exchange rate can affect the stock market. First, a depreciating currency causes a decline in stock prices because of expectations of inflation. Second, foreign investors will be unwilling to hold assets in currency that depreciates as that would erode the return on their investment. In a case of USD depreciation, investors will refrain from holding assets in the US, including stocks. If foreign investors sell their holdings of US stocks, share prices ought to drop.

Third, the effect of exchange rate depreciation will be different for each company depending on whether it imports or exports more, whether it owns foreign units, and whether it hedges against exchange rate fluctuation.

Last, on a macroeconomic level, a depreciated dollar will boost the export industry and depress the import industry. The impact on domestic output will be positive. Increasing output is seen as an indicator of a booming economy by investors and tends to boost share prices.
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PKR /USD
Declining Foreign reserves; Reserves plunging to USD 8bn PKR/USD 100 90 80 70 60 50 40 30 20 10 0 % 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -0.02

Interest Rate (KIBOR) Kibor is taken as the key indicator to analyze the macro economic situation of any country. KIBOR is basically followed by the changes in inflation rates. Reason being interest rate consist of real interest rates and inflationary changes/rates. When inflation rate raises it also give rise to the kibor rates. Inflation normally increases because of massive borrowing from state bank which is done through monetization and second which is issuing subsidies to the industries. In a nutshell how the local bourse is affected by the kibor rates can be explained as; KIBOR rates directly impacts on the companys earning which resultantly affects the market. KIBOR in relation with exchange rate can be viewed as negatively correlated reason being when interest rate increases the money supply curtails and people starts putting huge money in the banks because of increasing saving rates. Whereas on the flip side when kibor decreases money supply increases and people start investing in forex market which resultantly depreciates PKR. A practical view can also be seen in the graph.

1QCY07 2QCY07 3QCY07 4QCY07 1QCY08 2QCY08 3QCY08 4QCY08 1QCY09 2QCY09 3QCY09 4QCY09 1QCY10 2QCY10 3QCY10 4QCY10 1QCY11 2QCY11 3QCY11 4QCY11 1QCY12 2QCY12 3QCY12

18 16 14 12 10 8 6 4 2 0 1QCY07 2QCY07 3QCY07 4QCY07 1QCY08

2QCY08
3QCY08 4QCY08 1QCY09 2QCY09 3QCY09 4QCY09 1QCY10 2QCY10 3QCY10 4QCY10 1QCY11 2QCY11 3QCY11 4QCY11 1QCY12 2QCY12 3QCY12 12 Mo KIBOR

12mo KIBOR

Literature Review
The stock market is a mirror of an economy. The Karachi stock exchange (KSE) was established in 1947. The KSE100 Index was introduced in November, 1991. The KSE100 Index consists of 100 companies. These companies are selected on the basis of market capitalization and sector representation. These companies encompass nearly 80 percent of the total market capitalization at Karachi Stock Exchange. Varying evidences of relationship between macroeconomic variables and stock returns widely documented in the existing literature. Several studies explored the predictability of many macroeconomic variables such as exchange rate, inflation, foreign direct investment, real output, money supply, foreign reserves, prices of real estate, terms of trade, and value of trade balance on stock prices. Due to variations in results, it was found difficult to determine which specific macroeconomic variable could be consistent indicator of stock returns. In the past, several studies were conducted using different macroeconomic variables. The studies inter alia included Bhattacharya and Mukherjee (2003), Smyth and Nandha (2003), Aquino (2004), Homma et al. (2005), Aquino (2005), Hartmann and Pierdzioch (2007), Dogan and Yalcin (2007), Ratanapakorn and Sharma (2007), Cook (2007), Shabaz et al. (2008), Alagidede (2008), and Humpe and Macmillan (2009). All the studies found contrasting results about macroeconomic indicators. Very few studies such as Farooq and Keung (2004), Nishat and Shaheen (2004) were conducted in Pakistan. It is therefore, seemed important to under take such a study keeping in view of the volatility of KSE. The intent of the paper was to explore long run and short run relationships between macroeconomic variables and stock prices in Karachi Stock Exchange. Stock market plays an important role in the economic development of a country. According to portfolio approach, the changes in stock market lead to changes in exchange rate due to portfolio adjustment made by investors. Here the portfolio adjustment refers to the process of inflow and
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outflow of capital. While according to traditional approach, exchange rate causes the stock prices to move. The transmission channel of traditional approach is that exchange rate changes affect the balance sheet of firms by changing their assets and liabilities, denominated in foreign currency, thus changing the competitiveness of country and its export oriented firms in the foreign markets which is ultimately, reflected in stock market. According to asset approach, the currency price is equal to the discounted future currency prices and there may not be any link between currency market and capital market. In the literature, findings on relationships between capital markets and currency markets lack consensus. Some researchers like (Abdalla et al. 1997) found causation running from exchange rate changes to stock market returns while others found exactly the opposite one running from stock market returns to exchange rates. Positive association running from stock returns to exchange rates can be justified as follows. If stock returns are higher, local investors will sell their foreign assets and will buy the domestic assets. This conversion of foreign assets into domestic ones will increase the demand for local currency in the foreign exchange market by putting upward pressure on its price. Secondly, increase in stock returns increases the wealth of local investors and they also demand more money, which ultimately results in higher interest rates. If interest rate parity theory does not completely offset interest rate differential, then higher interest rate would attract capital from other countries into local stock market just as Germany attracted capital from other European countries in 1993 by increasing the interest rates.

Research Methodology

Karachi Stock Exchange

Interest Rate

Foreign Exchange Rate

Data Collection
The data we have collected is secondary data. For the KSE variable we have selected KSE-100 Index data from 2007 to 2012 November. For interest rate the data we have selected for interest rate is KIBOR rate obtained from source of SBP. This data is also averaged in quarterly form. For our third variable that is exchange rate we have obtained data from open market sources of PKR/USD exchange rates for the same time period and averaged it to quarterly basis. The sources for the data is given at the back.

KSE-100 Index

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12

KSE-100 11124.13 12597.52 13150.07 14091.65 14459.45 13931.97 10155.4 9269.01 5777.621 7243.642 8238.124 11019.84 9801.808 10053.09 9966.055 11623.74 11865.92 12047.79 11727.73 14883.28 12372.27 13921.45 14883.28

KIBOR(12 month, interest rates)

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12

12mo KIBOR 10.65362319 10.27768831 10.20973333 10.18376812 10.36638889 11.83256579 14.02452703 15.39914286 14.91253521 13.66428571 12.55945205 12.68958333 12.47863014 12.44595588 12.83629032 13.62532258 13.98611111 13.96675325 13.63808824 12.14033333 12.01587302 12.1157377 11.23982456

Foreign Exchange Rate (PKR/USD)

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 PKR/USD 60.83727424 60.72034481 60.55872131 60.9875532 62.65731039 66.20070851 74.13361061 79.52893803 79.55652933 80.69956111 82.58945606 10

4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12

83.60677302 84.61053188 84.64079221 85.72512698 85.80090873 85.51376449 84.64079221 86.8469417 87.85557222 90.59859019 92.17100079 94.55486633

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Data Analysis
To keep all the three variables we have taken relative changes of all the variables to observe the trend with respect to change in each variable. This relative change is in terms of percentages is then analyzed in form of graphs below.
RELATIVE COMPARISON OF THE VARIABLES KSE-100 12mo KIBOR PKR/USD 100 100 100 113.24504 96.47129554 99.80779968 118.2121274 95.83343763 99.54213443 126.6764357 95.58971568 100.2470179 129.9827706 97.30388156 102.9916464 125.2410015 111.0661188 108.8160332 91.29164044 131.6409148 121.8555754 83.32348083 144.5437161 130.7240323 51.93774552 139.9761841 130.7693849 65.11649139 128.2595177 132.6482196 74.05635479 117.8890208 135.7546949 99.06254856 119.1104952 137.4268885 88.11305066 117.1303876 139.0767962 90.37190455 116.8236915 139.1265359 89.58954211 120.4875571 140.9088886 104.4912468 127.8937911 141.0334533 106.6683259 131.2803247 140.5614659 108.3032243 131.0986225 139.1265359 105.4260983 128.0136156 142.7528481 133.7927373 113.9549721 144.4107635 111.2201481 112.7867281 148.919542 125.1464393 113.7241058 151.5041592 133.7927373 105.5023663 155.4225884

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12

KSE-100 11124.13 12597.52 13150.07 14091.65 14459.45 13931.97 10155.4 9269.01 5777.621 7243.642 8238.124 11019.84 9801.808 10053.09 9966.055 11623.74 11865.92 12047.79 11727.73 14883.28 12372.27 13921.45 14883.28

12mo KIBOR 10.65362319 10.27768831 10.20973333 10.18376812 10.36638889 11.83256579 14.02452703 15.39914286 14.91253521 13.66428571 12.55945205 12.68958333 12.47863014 12.44595588 12.83629032 13.62532258 13.98611111 13.96675325 13.63808824 12.14033333 12.01587302 12.1157377 11.23982456

PKR/USD 60.837274 60.720345 60.558721 60.987553 62.65731 66.200709 74.133611 79.528938 79.556529 80.699561 82.589456 83.606773 84.610532 84.640792 85.725127 85.800909 85.513764 84.640792 86.846942 87.855572 90.59859 92.171001 94.554866

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Relation between Karachi Stock Exchange and Foreign Exchange

180 160 140 120 100 80 60 40 20 0 KSE-100 PKR/USD

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Relation between Karachi Stock Exchange and Interest Rate KIBOR

160 140 120 100 80 60 40 20 0 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12 3Q12 KSE-100 12mo KIBOR

3Q12

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Relation between Karachi Stock Exchange and Foreign Exchange and Interest Rate KIBOR

RELATIVE COMPARISON OF THE VARIABLES

180 160 140 120 100 80 60 40 20 0

KSE-100 12mo KIBOR PKR/USD

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Conclusion
The Karachi stock exchange (KSE) reflects all the economic changes and industrial changes going on in the country. Whereas on economic front the country faced huge budget deficit, declining reserves coupled with increasing interest rates scenario. These all economic pressures lead Pakistan to approach IMF as to increase the foreign reserves and curtailing the widened fiscal deficits. To stabilize the economic condition it took a year, where Pakistan had enough reserves to start paying to their debt holders. Furthermore, increasing circular debt followed by deteriorated power and energy crisis also kept the local bourse on pressure because of comparatively decreasing earnings. Keeping In view the macroeconomic changes they also have a severe pressure on the local market. Because the macroeconomic changes directly dictates negatively changes on the company earnings which resultantly pressurizes the local market. Taking into consideration the two variables KIBOR and PKR/USD parity comes into macroeconomic framework.. When the reserves were on the declining mode Pakistan had to approach IMF which resulted in increased interest rates as against before and somewhat kept the exchange rate stable. When inflation rate raises it also give rise to the KIBOR rates. Inflation normally increases because of massive borrowing from state bank which is done through monetization and second which is issuing subsidies to the industries. In a nutshell how the local market is affected by the KIBOR rates can be explained as; KIBOR rates directly impacts on the companys earning which resultantly affects the market. KIBOR in relation with exchange rate can be viewed as negatively correlated reason being when interest rate increases the money supply curtails and people starts putting huge money in the banks because of increasing saving rates. Whereas on the flip side when KIBOR decreases money supply increases and people start investing in FOREX market which resultantly depreciates PKR.
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REFERENCE www.indexmandi.com

www.economictrade.com

www.wikipedia.com

http://www.investopedia.com/ask/answers/199.asp#ixzz2DOvthj4G

www.tradingeconomics.com www.kse.com
Gary S. Moore, Sue L. Visscher, (1993),"Stock Returns, Inflation, and the Business Cycle", American Journal of Business, Vol. 8 Iss: 1 pp. 45 50

J.M. Geyser, G.A. Lowies, (2001),"The impact of inflation and stock prices in two SADC countries", Meditari Accountancy Research, Vol. 9 Iss: 1 pp. 109 - 122

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