Speculative Bubbles in Karachi Stock Exchange

Abstract

The fair price of a stock represents discounted claims on the future profitability of a firm. If markets are perfect, prevailing price level should exhibit a stable relationship with these claims. Dividends are a medium to share firm’s profits with shareholders and consequently they form an integral input for most of the valuation models. Such valuation models warrant a long run relation between stock prices and dividends and a divergence of prices from related dividends is a possible indication of a speculative bubble. Karachi Stock Exchange has witnessed a tremendous growth during last decade. This paper analyzes the presence of a speculative component in the extra ordinary upsurge in the leading stock exchange of Pakistan. We implement cointegration tests, between 1997 and 2008, on price and dividends of various market level indices including KSE 100, FTSE Pakistan, DataStream Pakistan and sector indices of DataStream Bank, DataStream Oil and Gas, DataStream Telecom and DataStream Tobacco. Based on the results from unit root and cointegration, we could not reject a no bubble hypothesis for the sample period for the market level index. In sectoral indices, banking sector depicted a speculative component, however, the price level of Oil and Gas sector did not diverge from the related dividends. These results remained robust with evidence of persistent volatility shocks for the sample period.