Explaining the Simultaneity between Monetary Policy and Excess Stock Returns in Pakistan Stock Exchange

Abstract

This paper investigates the role of monetary policy in predicting excess stock returns in Pakistan. The methodology used in this study is structural VAR in order to consider simultaneity problems through long-run restrictions. The results of IRF (impulse response function) confirm that monetary policy is a phenomenon of short-term to predict returns in the Pakistan Stock Exchange (PSX). The results of VD (variance decomposition) suggest that the most dominant factor to predict FEV (forecast error variance) of stock return(s) is policy rate. The implication of these findings is that various policies of the central bank while using different monetary-based variables can influence the investment-related decisions, as well as the state of the economy on the whole. This study substantially makes a contribution to the monetary literature of the central bank of Pakistan.

         Keywords: stock return predictability, monetary policy, simultaneous equations, structural VAR