This study examines the causal relationship between macroeconomic variables and returns in the banking sector. Interest rate, exchange rate, and money supply are selected as macroeconomic variables because they are highly related with the activities of banks. Data on macroeconomic variables is collected from the publications of the Central Bank of Sri Lanka from January 2006 to December 2015. The Bank, Finance and Insurance (BFI) sector index is taken from the Colombo Stock Exchange website to calculate stock returns. The Augmented Dickey Fuller Test is used to check the stationary value of the time series data set. Results show that share returns are stationary at level and all macroeconomic variables are stationary at first difference. The Granger Causality Test is used to determine causality among variables. The results indicate a one way causality between share returns and exchange rate, a one way causality between money supply and share returns, and no causality between share returns and interest rate. Using causality results, variables are identified as independent and dependent to run regressions to identify the effects of each variable. Regression results show that there is a significant impact of exchange rate on stock returns as well as a significant impact of share returns on money supply. Investors are advised to key in on exchange rate changes when investing money in banking sector companies.
Keywords: banking sector, exchange rate, interest rate, money supply