The relationship between macroeconomic variables and the
equity prices has attracted the curiosity of academicians and
practitioners since the publication of seminal paper of Chen, et al.
(1986). Many empirical studies those tested the relationship reveal that
asset pricing theories do not properly identify macroeconomic factors
that influence equity prices [Roll and Ross (1980); Fama (1981); Chen,
et al. (1986); Hamao (1986); Faff (1988); Chen (1991); Maysami and Koh
(2000) and Paul and Mallik (2001)]. In most of these studies, variable
selection and empirical analyses is based on economic rationale,
financial theory and investors’ intuition. These studies generally apply
Eagle and Granger (1987) procedure or Johanson and Jusilieus (1990,
1991) approach in Vector Auto Regressor (VAR) Framework. In Pakistan,
Fazal (2006) and Nishat (2001) explored the relationship between
macroeconomic factors and equity prices by using Johanson and Jusilieus
(1990, 1991) procedure. The present study tests the relationship between
macroeconomic variables such as inflation, industrial production, oil
prices, short term interest rate, exchange rates, foreign portfolio
investment, money supply and equity prices by using Auto Regressive
Distributive Lag (ARDL) bounds testing procedure proposed by Pesaran,
Shin, and Smith (1996, 2001). The ARDL approach in an errorcorrection
setting has been widely applied to examine the impact of macroeconomic
factors on economic growth but it is strongly underutilised in the
capital market filament of literature. This methodology has a number of
advantages over the other models. First, determining the order of
integration of macroeconomic factors and equity market returns is not an
important issue here because the Pesaran ARDL approach yields consistent
estimates of the long-run coefficients that are asymptotically normal
irrespective of whether the underlying regressors are I(0) or I(1) and
of the extent of cointegration. Secondly, the ARDL approach allows
exploring correct dynamic structure while many econometric procedures do
not allow to clearly distinguish between long run and short run
relationships.