Effect of Macroeconomic Variables on Stock Market Volatility in Kenya

Abstract

Stock market volatility is widely regarded as one of the factors that erode investor confidence in African markets. This happens when a sharp fluctuation in share prices is not explained by changes in fundamental economic factors. Theories in finance have for long viewed macroeconomic variables as predictors of stock market volatility, while studies in behavioral finance have associated stock market volatility with investor behavior, particularly the herding behavior. This study sought to examine the relationship between macro-economic variables and stock market volatility in Kenya. Specifically, the study examined the direct relationship between each of the four selected macro-economic variables namely; interest rates, inflation rate, foreign exchange rate, gross domestic product, and stock market volatility. The study further explored the moderating effect of investor herding behaviour on the direct relationship between selected macro-economic variables and stock market volatility. The study adopted a descriptive research design and targeted all companies listed on the Nairobi Securities Exchange from January 2001 to December 2014. The study used secondary data on interest rate, exchange rate, inflation rate and GDP, covering a period of 14 years. The data was obtained from the Kenya National Bureau of Statistics and the Central Bank of Kenya. Data on share prices and market indices was acquired from the Nairobi Securities Exchange. Stock market volatility was measured by computing the standard deviation of the Nairobi Securities Exchange daily and monthly returns over the 14 year study period. The study used a market-wide herd index which was calculated using the Cross Sectional Standard Deviation (CSSD) method. Data was analyzed using E-views version 8. The study employed both correlation and regression analysis. Results from correlation analysis found that there was a significant relationship between all selected macro-economic variables and stock market volatility. However, when the long run and short run causal relationship was tested using vector error correction model (VECM) and xvii granger causality test, the study found that interest rate and inflation granger cause stock market volatility both in the short run and long run in Kenya, while GDP and exchange rate did not have a direct causal relationship with stock market volatility. The study also established that investor herding behaviour had no direct causal relationship with stock market volatility, however, investor herding behaviour was found to significantly moderate the relationship between exchange rate and stock market volatility on the Nairobi Securities Exchange. The study findings were limited to selected macro-economic variables and methods used in measuring and analysing the relationship. Further studies are recommended to investigate other macro-economic variables in order to understand their effect on stock market volatility in Kenya. The study recommends a strict monetary policy and control of factors contributing to change in inflation and interest rates which the study finds to be the key variables contributing to stock market volatility.