The Relationship between Macroeconomic Variables, Trading Volume and Stock Returns: Granger Causality Evidence from the Colombo Stock Exchange

The stock market serves as a crucial indicator of a country's economic health, driving growth through investment and efficient capital allocation. This study explores the causal relationship between macroeconomic variables, trading volumes, and stock returns in the Colombo Stock Exchange (CSE). Using Granger causality analysis, the study examines variables such as exchange rate, money supply, and inflation. While extensive research exists in developed markets, studies in frontier markets, particularly Sri Lanka, remain limited. Previous research, largely based on data from 1985-2001, fails to reflect significant economic shifts caused by the financial crisis, the Covid-19 pandemic, and 2019 terror attacks. This raises questions about the relevance of past findings in the current context. The study utilizes quantitative data from reputable sources, including the Central Bank of Sri Lanka and the CSE, and employs EViews statistical software for analysis. Findings reveal a causal relationship between stock returns and exchange rates (reverse causality) as well as trading volumes, while no significant link is found with inflation and money supply. This study contributes by providing updated empirical evidence for a frontier market during a period of economic turbulence, identifying a novel reversal in the exchange rate–stock return relationship, and highlighting the enduring predictive value of market microstructure variables over conventional macroeconomic measures. These insights can help policymakers and investors focus on market liquidity and stock returns as key indicators for economic forecasting, rather than traditional macroeconomic variables.