INTRODUCTION

Background

The stock prices movements are an important indicator of the economy. In the well-organized stock market, the savings are mobilized and the investment projects are activated, which lead to economic activities in a country. Stock markets play very essential role in the economy. To act as mediator between savers and borrowers is the stock market’s key function.

It mobilizes savings from a large pool of small savers and channelizes these funds into fruitful investments. Stock market operations harmonize the preferences of the lenders and borrowers. The Stock market also allows transference of funds among corporations and sectors. It also provides liquidity for domestic expansion and credit growth. In this way stock markets help in improving the economic efficiency through the following means:

• Growth of savings;
• Efficient allocation of investment resources;
• Alluring foreign portfolio investment.

Stock return consists of dividend and increases in price (capital gain). It is important to investors and business organization to know the company’s stock value and investment returns. The decision whether to choose a particular stock is one of the most important implications for the stock price. A lot of models and techniques have been developed and used by investors to help them obtain better returns on their stock investment.

Capital Asset Pricing Model (CAPM) is the most influential and widely used one factor pricing model. The model estimates the expected return of a stock, given the return for a theoretical risk free asset, market return and the stock’s sensitivity to the market risk. In other words, non diversifiable market risk is the only risk factor that is used in the model and it is sufficient to explain the risk-return trade-off with an efficient market portfolio. The model’s success depends on whether or not any persistent excess return can be made without taking additional market risk through β’s.

Capital asset pricing model is most practitioners’ favourite when estimating expected return for an individual stock. CAPM developed by Sharpe (1964) and Linter (1965) was the first theoretical model that explains the non diversifiable market risk’s impact on return. The model estimates the expected return of a stock. Non diversifiable risk is the only risk factor that is used in the model, which is represented by beta in the CAPM model.

However, Ross (1976) has developed the APT model arbitrage pricing theory, which argues that there are other factors that affect stock return rather than stock’s beta that is accounted for in CAPM model.

Ross (1976) argues that these factors which are macroeconomic factors are not incorporated in the CAPM and therefore should be incorporated when pricing or determining the required rate of return for any stock.

In Ross (1976)’s APT, the macroeconomic factors that affect stock price and return were not defined, the model only tells how strong is the effect for non-defined factors.

Yet, Chen, Roll & Ross (1986) hypothesised and tested a set of macroeconomic data series to explain US stock returns. Based on the Arbitrage Pricing Theory (APT) developed by Ross (1976), they investigate the sensitivity of macroeconomic variables to stock returns having employed seven macro series: term structure, industrial production, risk premium, inflation, market return, and consumption and oil prices. It is assumed that the underlying variables are serially uncorrelated and all innovations are unexpected. In their research, Chen, Roll & Ross (1986) found a strong relationship between the macroeconomic variables and the expected stock returns. Having first illustrated that economic forces affect discount rates, the ability of firms to generate cash flows, and future dividend payouts, Chen, Roll & Ross (1986) provided the basis for the belief that a long-term equilibrium existed between stock prices and macroeconomic variables. It was noted that industrial production, changes in risk premium, twist in the yield curve, and measure unanticipated inflation and changes in expected inflation during period when these macroeconomic variables are highly volatile, are significant in explaining expected returns. Evidence by Chen, Roll & Ross (1986) suggests that consumption, oil prices and market index are not priced by the financial market. According to their conclusion, stock returns are exposed to systematic news that is priced by the market.

In light of the above, this paper aims to examine the influence of macroeconomic forces on stock returns in Jordanian stock market, Amman stock exchange (ASE) index, using APT.

According to Fisher’s Hypothesis, the market interest rate incorporates the expected real rate of interest and expected inflation (Fisher, 1930). Real rate of interest was not affected by a permanent change in inflation rate in the long-run because nominal rate of interest and rate of inflation moved one-to-one.

To this extent, it was concluded that stock returns and rate of inflation moved in the same direction. Hence, real assets as well as shares perhaps provide hedge against inflation. Relationship between stock returns and inflationary trends in India was investigated by Chatrath et al. (1997). The study provided an evidence of a negative relationship between market returns and inflationary trends in India. In their study, a positive relationship between stock prices and inflation was reported by Ratanapakorn and Sharma (2007); while, a study by Humpe and Macmillan (2009) illustrated negative impact of inflation on stock prices.

Overview of Jordanian Economy

Jordan is a small country with limited natural resources, but has improved much since its inception as a country. Its current GDP per capita soared by 351% in the Seventies. But this growth proved unsustainable and consequently shrank by 30% in the Eighties. But it rebounded with growth of 36% in the Nineties.

Jordan’s open economy can only rely on limited natural resources. Only 6 percent of the country is arable land and water resources are among the scarcest in the world. However, there are sizeable mining resources, primarily potash and phosphates, of which it is the third largest world exporter.

Jordan was heavily impacted by the war in Iraq, disruption of trade with Iraq (its main export market), having not only important economic consequences for the economy but also having an adverse impact on prospects for development. Moreover, tensions in the region contributed to a significant drop in foreign investor interest in Jordan, in addition to marked deterioration of income from tourism.

The leading sector in Jordan is services, which account for 70 percent of GDP and the role it plays in supporting production is underlined in the King’s new economic guidelines. While the agricultural and construction sectors account for only a small portion of GDP, they employ a significant percentage of the workforce. The main manufacturing industries are textiles, mining (potash and phosphates), fertilisers, pharmaceuticals, oil refining, and cement.

1.2 Problem Statement

It has been argued that there are other variable rather than systematic risk (non-diversifiable risk) is not the only risk factor that investors should be compensated for. However, researchers had been studying this gap for years, finding that using beta or systematic risk (CAPM) as the only factor that influences stock return does not lead to match the actual rate of return on the stocks in the market. Thus, researchers have started to think about macroeconomic variables. However, a new model has been developed for this purpose, which is arbitrage pricing theory (APT); this theory assumes that there are several macroeconomic variables that affect stock price and return. Unfortunately, this model does not identify what exactly are those macroeconomic variables, until (Roll and Ross 1984), who have identified some macroeconomic variables that might affect stock return, such variables as interest rates, inflation, industrial production, and the spread between high and low bonds grades, those variables were significantly priced in the stock market. On the other hand, they found that oil price risk was not separately rewarded in the stock market.

Al-Sharkas (2004) empirically investigated the relationship between macroeconomic variables in Jordan. The empirical evidence shows that there exists a cointegrating relation among the variables. However, most of the researchers have suggested further examination of the macroeconomic variables using different methodologies, time periods, samples. Therefore, as mentioned earlier, Jordanian economy has experienced heavy negative impact after the war in Iraq in the year 2003. Thus, the current study considers this event as a possible impact on the relationship between macroeconomic forces and stock returns in Jordan.

Research Objectives

This study initially aims to examine the effect of some macroeconomic variables that exist in the Jordanian stock market on stock returns in Amman stock exchange (ASE). Therefore, research objectives can be written as follows:

• To examine the relationship between inflation rate and stock returns;
• To investigate the relationship between stock returns and interest rates;
• To examine the impact of money supply on stock returns;
• To examine the relationship between oil price risk and stock return.

Research Questions

In light of the research objectives, this paper questions the following:

Is there any relationship between inflation and stock return?

Is there any relationship between interest rates and stock return?

Is there any relationship between money supply and stock return?

Is there any relationship between oil price risk and stock return?

1.5 Significance of the Study

In the past many studies have examined the determinants of stock returns and prices,