Interest rate and stock market are the two most important elements of a country in terms of economic growth and activity. The interest rate and its influence on equity market reflects an important mechanism for the formulation of monetary policy, managing risk, valuation of various securities and development financial policies by government for stock markets (Alam & Uddin, 2009). According to Mohammad et al. (2009) capital markets are key constituents of modern, market-based economic system due to their role of a channel that mobilizes the flow of long-term financial resources from the savers of capital to the borrowers of capital. Concerning various parameters, including interest rate and money supply, and their influence on the economic activity, an efficient market hypothesis (EMH) presents a point of view that efficient markets must ensure a fair competition among all profit oriented investors in such a way that all presently available pertinent information about changes in macroeconomic variables are adequately reflected by current stock prices so that no one can be able to earn abnormal return in terms of predicting future stock price movement (Chong & Koh 2003, cited in Mohammad et al., 2009). Good investors always look for investing in efficient markets. An inefficient market is the one in which very few people are able to generate extra ordinary profits resulting in a loss of confidence in general public towards the market (Alam & Uddin, 2009).
A significant amount of work has been documented in empirical studies on a number of financial and macroeconomic variables that can have a huge impact on the performance of stock market (Lane 2002, Campbell & Yogo 2003, Goyal 2004). Gross domestic product (GDP), price level, rate of industrial production, interest rate, exchange rate, current account balance, unemployment rate, fiscal balance, etc are frequently cited macroeconomic variables. After reviewing multiple articles and various research journals, we have found enough literature to make our study credible and useful area to explore and analyze. Karachi Inter Bank offered Rate (KIBOR) is a consensus rate at which commercial and other scheduled banks do lending among one another (Ahmad, 2009). It's a benchmark rate for most of the lending transactions in addition to banks lending to customers. In an article entitled 'Launch of Kibor Futures', Ali (2006) makes a point that many debt securities and commercial contacts are directly linked to this reference rate, for instance, a holder of a T-Bill is exposed to interest rate changes despite being not directly exposed to KIBOR.
Interest rate, when it changes, affects due to many reasons. Interest rate reflects the time value of money as it affects other variables in the money and capital market. In capital markets, investors base their decisions on this parameter because of stock valuation and the fact that its fluctuation or volatility directly impacts shifts between short-term money market and long-term capital market (Cifter & Ozun, 2007). The increase in interest rate attracts investors and even general public towards savings as the borrowing will become more expansive or in other words investor will pay the opportunity cost for not saving money in bank and earning a return over it. The negative relationship between interest rate and stock returns can be justified by several reasons; lower rates ultimately reflect higher or rising stock prices and vice versa (Frankle, no date). Particular circumstances prevailing in the market, the benefits of holding equity instrument as an asset, and the costs associated with the transactions, are the three crucial reasons that are associated with the impact that interest rate has on the stock market. Banerjee and Adhikary (2007) states that stock market and interest rate are negatively correlated and that higher interest rate resulting from contractionary monetary policy usually negatively influenced stock market returns.
As far as the business world is concerned, low interest rate is beneficial for business because it makes easier and less cheap to have funds borrowed, facilitate businesses or individuals to make investment in more projects (Keogh, 2008). From the point of view of individual household, low interest rate pushes private consumption upward because the debt financing become easier for the consumers. The positive affect that interest rate has on investment opportunities on business and on the consumption be individual households, reflects the expectations of revenue increment for most businesses. An inflationary environment in the economy raises expected earnings which in turn results in increasing the company valuations and stock prices (Frankle, no date). In addition, Chaudhry (2004) makes a point that low interest rate makes margin financing more affordable, increasing the number of buyers and pushing stock prices upward. The money supply and interest rate has important implications for the business world and the overall economy. The growth of money supply resulting from expansionary monetary policy greatly affects interest rate which in turn influences stock prices (Wong, 2005).
An increase in interest rate has an opposite impact naturally in terms of making investment less lucrative, thereby reducing the expectations of corporate earnings and hence pushing the stock prices downward. Keogh (2008) argues that profit oriented people shift their capital from equity markets to bank deposits, government bonds, and other fixed income securities as the relative reward of investing in stocks falls, pushing down the shares prices and subsequently the stock market. Higher interest rate may possibly lead to slower economic growth that may result in the lower or declining profit margins and lower dividend payment for holders, making shares less lucrative (Alan, 2008). Besides this fact, higher interest rate does not always cause share prices to fall as there are a number of other factors that can influence the price of shares.
Interest rate is one of the most fundamental risks that no one can escape from it whether it is a company or an individual. In a article entitled 'Launch of Kibor Futures', Ali (2006) states that it is not essential that a business is always be impacted by various risks like fluctuations in currency, uncertainty regarding price volatility, and changes in equity markets, it depends on what sort of business a company is involved in but regardless of nature of business, interest rate changes always have vital implications. The above cited phenomena is valid not only for borrowing businesses but for the cash-rich, debt- free corporations as well where invested funds are influenced by fluctuations in interest rate. The individuals too may not be escaped from the effects of interest rate as their savings, investments, borrowing, and value of future cash flows are impacted by variations in interest rate. Stoakes (2006) says that prices of shares fluctuate as a result of difference in expectations of people regarding the company at various points of time and due to those differences, they are willing to buy and sell shares at different prices. If a company is seeing cutting on its growth spending or is making less profit either through high debt expenses or less revenue from consumers, the estimated amount of future cash flows will drop, resulting in the decline in share price (Hussain, 2010). If enough companies experience the same trend, the entire stock market will fall.
There are two distinct types of interest rates on which considerable amount of empirical finance studies have been conducted for several years. The first is well documented empirical relation between level of short-term interest rates and market volatility, and the second one is the positive relation between short-term interest rates and market risk premium (Leon, 2008). Campbell (1987), Breen et al. (1989), Shanken (1990) found out a positive relation between fluctuation in stock market and one-month T-bill yield. Ferson (1989), Fama and Schwert (1997) reported an opposite relation between T-bill yield and future stock returns.
The rational for the relation between interest rate and equity prices is that they have a negative correlation (Banerjee & Adhkari, 2008). Monetary policy having a higher rate of interest usually influence equity prices in an opposite direction or negatively and that is why high rate results in the reduction of value of stocks as stipulated by dividend discount model, making fixed income securities more lucrative in terms of profitability as opposed to holding equity instruments, reducing the willingness of investors to borrow and keep their capital in terms of stocks, and raises the cost of doing business as well that consequently resulted in lower profit margins. On the other hand, monetary policy having lower interest rate helps stock markets to boost.
To a very considerable extent, stock prices are determined by the expected profit or earnings of the business. The internal and external aggregate demands affect the price of stocks in a business that reflects the expected future earnings. The fundamental values of the firm including dividend growth rate, net profit margins, and sales have on them a considerable impact from changes in interest rate (Hussain, 2010). According to Titman and Warga (1989), stock returns might determine the interest rate by making a point that prices of stocks in equity market reflect expectations regarding the financial variables. With respect to the relation between stock market and interest rate, Cifter and Ozun (2007) says that a negative relationship is present between market P/E (price earning ratio) and yield of the government bonds in advanced markets where the efficiency is relatively high and that relation reveals the impact of interest rate changes on the stock markets in the long-run. On the other hand, regarding the emerging markets Gencay and Selcuk (2004) cited in Cifter and Ozun (2007) argues that the impact of interest rate on capital markets might not be clearly defined in the long-run due to their informational inefficiencies or due to their non-coherency; they must be analyzed in the short-run. In the light of above cited theory a cause and effect relation can be develop in the way that rise in interest rate leads to lower spending due to less borrowing practices which in turn negatively impact earnings of businesses and consequently ends up with the significant drop in prices of stocks.
In an article entitled 'Asset Return, Discount Rate, and Market Efficiency' Smirlock and Yawitz (1985) reports that interest rate changes impacts equity market in two ways: 1) by affecting the capitalization rate at which firms calculate the present value of their future expected cash benefits, and 2) by influencing cash flows expectations. In short, the rise in interest rate causes prices to fall and the drop in interest rate causes prices to move upward. Furthermore, if the interest rate has its impact on both capitalization rate and future expectations regarding cash flows, this impact would definitely influence stock market as a whole.
As far as the researches on the interest rate and stock markets are concerned, a number of empirical studies have been conducted after 1970s. Fama (1981, 1990) and Chen, Roll and Ross (1986) with US data, testify the empirical relationship between various macroeconomic variables, including interest rate, and stock prices. Fama (1981) finds that real economic parameters such as capital expenditures, industrial production, real GNP, money supply, and interest rate have positive correlation with returns associated with stock market. On the contrary, Evans (1998) cited in Cifter and Ozun (2007) argues that interest rate and inflation are integrated parameters of the economy having a higher risk; therefore they must offer higher returns to investors that require them to have movements in the same direction that is positive correlation. Chen, Roll, and Ross (1986) state that changes in aggregate production, inflation, and short-term interest rate are economic variables that derive movements in stock prices. Hardouvelis (1987) points out a negative relationship between changes of interest rate and stock prices in terms of money supply as rationalizing factor. Elton and Gruber (1988) cited in Banerjee and Adhkari (2007) derives out positive relation between stock prices and short-term interest rates after applying arbitrage pricing theory (APT) on Japanese stock returns and several other macroeconomic factors including short-term interest rate. The impact of capitalization or discount or policy rate on the fluctuation of stock prices and on the trading volume or turnover has been analyzed by Chen et al. (1999). This study reveals that there has been a considerable contribution of interest rate changes in higher volatility of stock retunes and turnover (trading volume). Changes in the federal funds rate affects equity market (Thorbecke & Alami 1994, cited in Banerjee & Adhkari, 2007). The study gives the evidence of inverse proportionality between stock returns and federal funds rates changes which mean that stock returns witness a significant effect from state monetary policy. A study conducted to examine the co-impact of exchange and interest rates for the first time indicates that prices of shares of almost all profit oriented businesses have been determined largely by these two variables (Choi, Elyasiani, & Kopecky 1992, cited in Cifter & Ozun, 2007).
Unal and Kane (1987) make a point that results of studies that have conducted so far to determine the relationship between interest rate and stock returns depends considerably on the method of investigation and pertinent data frequency. Ehrhardt (1991) cited in Cifter and Ozun (2007) using beta coefficient, explores a very remarkable impact of interest rate on stock returns. Another study has been conducted to examine the impact that interest rate has on stock market returns using regression analysis. In this research Zhou (1996) cited in Uddin and Alam (2009) finds out an important impact of interest rate on stock market in the long-run but falsifies the proposition of one-on-one movement between interest rate and expected returns. Further more, the study provides the evidence that a significant variation in price-dividend ratios has been witnessed due to fluctuations in long-term interest rates and that a high volatility of bonds yields accounts for a high degree of variation in stock market returns.
Regarding the observed behavior of emerging markets of developing countries, Harvey (1993) cited in Uddin and Alam (2009) says that returns associated with stocks of emerging markets can be predicted very easily and there exist a weak correlation between them and returns associated with developed markets. His study suggests that emerging markets need to have more efficiency and that investors can minimize their risks by integrating stocks of emerging and developed markets in their respective portfolios. Lee (1997) initiates a study to predict the differential between market returns and risk free short-term interest rate on the S&P 500 index. The empirical evidence reveals an unstable relationship between the two factors that varies considerable from negative to no relation at all or to an insignificant positive one.
The type of inter-connection that exists between interest rates and stock returns in the markets of developed countries has been the centre of focus in many studies conducted so far. Only few studies have been conducted on the conditions and circumstances in markets of developing countries in terms of interest rate and stock prices and so as a very limited amount of literature has been documented with reference to Pakistani stock markets. One study by Alam and Uddin (2009) examines the market efficiency of fifteen countries including both developed and developing countries. The countries include Australia, Bangladesh, Canada, Chile, Columbia, Germany, Italy, Jamaica, Japan, Malaysia, Mexico, Philippines, South Africa, Spain, and Venezuela. In order to investigate the reasons behind inefficient market, Alam and Uddin (2009) determine the relationship between interest rate and prices of shares as well as between share prices movements and interest rates using time series and panel regressions. The study comes up with the findings that provide an empirical evidence of strong negative relationship between interest rate and stock prices for almost all included countries but for six of the fifteen countries, the study reveals a significant negative relationship of interest rate movements with changes of share price. Working on the Bogotá stock market, Arango (2002) discover an inverse and nonlinear relationship between interest rate and share prices using the inter bank loan rate. A considerable dependence of this stock market on interest rate has been witnesses by this research study. Hsing (2004) cited in Alam and Uddin (2009) reports an inverse or opposite relationship between stock prices and interest rates after analyzing various economic parameters including real interest rate, exchange rate, output, and the stock exchange index using VAR (vector auto regression) model. In South Africa and Zimbabwe stock markets, it has been found that interest rates impact stock prices negatively through three different means: by means of substitution effect (fixed income instruments become more lucrative), by means of rise in capitalization rate (reduced present value of expected cash-flows), and by means of discouraging investment opportunities (Jefferis & Okeahalm 2000, cited in Alam & Uddin, 2009). In another study entitled 'The Impacts of Interest Rate on Stock Market: Empirical Evidence from Dhaka Stock Exchange', Alam and Uddin (2007) analyze the type of relational movement interest rate and stock prices, between changes in interest rate and stock prices, between changes in stock prices and interest rate, and between changes in both. Wong et al. (2005) works to investigate the long and short run equilibrium relationship between major stock indices of Singapore and United States and two crucial macroeconomic variables (money supply & interest rate) using Cointegration and Granger Causality. The results provides an evidence of long-run equilibrium relationship of Singapore's stocks prices with interest rate and money supply but it does not reflected by United States.
There is no consensus on the exact relationship between interest rate and stock prices. There are numerous studies that show positive relationship between these two variables while other studies reveal a negative impact of interest rate on stock market. A research by Ratanapakorn and Sharma (2007) proves a positive relationship between S&P 500 and t-bill rate in United States. A negative relation between t-bill rate and S&P 500 has been reported by Humpe and Mcmillan (2009) cited in Sohail and Hussain (2009). Leon (2008) conducted a study with a purpose of investigating the relationship and volatility between interest rate and stock returns by analyzing the predictive power of interest rate volatility on stock returns in Korea. The researcher finds a strong positive power of interest rate on returns while weak negative power for volatility.
An investigation conducted to analyze the relationship between growth with respect to economic activity and the stock markets development in Pakistan reports such a relationship that holds for the long period of time between stock market development and economic growth in case of developing countries like Pakistan (Shahbaz et al., 2008). Dr. Aftab (2000) cited in Mohammad et al. (2009) tries to explore the linkage between fiscal and monetary polices of Pakistan and comes up with the significant conclusions. The change in fiscal and monetary polices have important implications for market capitalization in terms of equity and liquidity has been the major finding of this study. Similarly, another study finds a dynamic relationship between economic growth and stock market prices (Ali & Ahmed 2008, cited in Mohammad et al., 2009)
