This study is an attempt to examine the interlinkages between equity prices of Bombay Stock Exchange Sensex (BSE Sensex) and select macroeconomic variables in India in a time series framework. In the first stage of the empirical investigation, the study tries to investigate both the long-run and short-run relationship of equity price (BSE Sensex) with macroeconomic variables, viz., Index of Industrial Production (IIP), Wholesale Price Index (WPI), interest rates (3-month T-bill rate), money supply (M3), Foreign Institutional Investments (FIIs) as well as Morgan Stanley Capital International (MSCI) world index in a cointegration and vector error-correction framework. In the next stage of the empirical investigation, the study explores the dynamic interrelationship of equity prices (BSE Sensex) with different macroeconomic indicators in a cointegrated Vector Autoregressive (VAR) framework by analyzing the impulse response functions and variance decomposition results.

Among various financial asset prices, equity prices are the most closely monitored asset prices and have drawn relatively more attention among economists and policy makers globally. Equities constitute the most dominant form of asset in the economic agents’ financial portfolio. Equity prices are highly sensitive to market dynamics, macroeconomic conditions and future prospects of the economy. Equity prices are often viewed by central banks as one of the macroeconomic variables which can potentially influence the inflation path by impacting inflation expectations through the wealth effect and by altering the cost of funds.

The economic theory, especially the efficient market hypothesis, suggests that equity prices must contain all the relevant information, including publicly available information and central bank’s policy actions (Fama, 1990). Equity prices should also reflect expectations about future corporate performance which ultimately depends on the level of macroeconomic activities (Singh et al., 2011). Equity prices could be used as leading indicators of the economic activities if they reflect the underlying fundamentals of the economy. Hence, investigating dynamic interactions among equity prices and macroeconomic variables is useful for macroeconomic policy makers.

Ample empirical evidence on the linkages between macroeconomic fundamentals and equity returns exists in the financial literature, particularly relating to the developed economies. However, in recent years, there has been an increasing concern that movements in equity market since the mid-1990s could not be explained by the economic fundamentals. This concern surfaced not only for the US but also for European and Asian markets when their stock markets witnessed unprecedented highs in the mid-1990s but were sharply reversed in the 2000s as a result of excessive speculation (Laopodis, 2011).

Applied Finance Journal, Macroeconomic Fundamentals, Determinants of Equity Prices, An Empirical Analysis for India, Macroeconomic Variables and Equity, Studies for Developed Economies, Studies for Emerging Market Economies, Macroeconomic Variables and Equity Prices in India, Reforms in the Equity Market.