Reviewing multiple articles and research journals based on our topic we found enough data to make our research project credible and useful area to explore and analyze. KIBOR (Karachi Inter-Bank Offered Rate), a benchmark, represents the consensus rate at which banks are willing to lend funds to each other. This benchmark rate is an important reference point as most lending transactions are linked to this rate. In an article entitled 'Kibor- A tool for disciplining corporate lending', Chaudhry (2004) makes the point that in addition to banks lending to customers, many debt instruments and commercial contracts also use KIBOR as a benchmark rate and all parties to these transactions are directly exposed to changes in the KIBOR rate, even if someone is not directly exposed to KIBOR, e.g. holder of a T-Bill, he is still exposed to changes in interest rates.
Interest rate, when it changes affects the stock market due to many reasons. The interest rate increase signal the investors' even general public towards saving as the borrowing rate increases and it will become expensive to borrow money or in other words investor will pay the opportunity cost for not saving his money in a bank and earning profit over it. There are several reasons why the inverse relationship between interest rates and stock prices holds; lower rates typically mean higher stock prices and vice versa. The three main reasons are associated with the impact these rates have on the market are macroeconomic conditions, attractiveness of equity as an asset class and the cost of transacting.
The Decision makers in capital markets are influenced by the interest rates because of both valuation of the stock prices and the fact that its volatility directly influence shifts in capital between short-term money market and long-term capital market.
The economic data and the industrial output suggest a slowdown in the growth rate of the economy. The increase in the interest rates will also impact the KIBOR rates to increase that will adversely impact further credit demand by the industrial sector.
In Pakistan, the situation is some what different as the equity markets still await visibility on the political front. The Pakistani stock market did not take an impact of either side movement of the international equity markets. The declining volumes in different trends from last multiple years also indicated lack of institutional interest in the short-term.
Cifter and Ozun (2007) states that as one of the main parameters in the economy, interest rates reflect the time value of money and affect other parameters in money and capital markets. Investment decision makers in capital markets are influenced by the interest rates because of both valuation of the stock prices and the fact that its volatility directly influence shifts in capital between short-term money market and long-term capital market.
Low interest rates are good for business, they make it cheaper to borrow funds, invest in new projects and expand supply. Low interest rates also increase consumption as debt financing becomes more palatable for the consumer. Because of the positive impact that low interest rates have on business investment and private consumption a reduction in interest rates typically increases revenue expectations for most businesses. Assuming a relatively benign inflationary environment, this increases expected earnings, pushing up company valuations and stock prices.
Naturally an increase in rates has the opposite effect by making investment and consumption less attractive, therefore reducing corporate earnings expectations and pushing stock prices downwards. As the relative reward for investing in stocks falls, investors move money out of the stock market and into bank deposits and government bonds, pushing down the price of shares. The Higher interest rates possibly lead to slower economic growth and this may lead to lower share prices. This Lower growth will lead to lower profits and lower dividends making shares less attractive. The higher interest rates make bonds and securities relatively more attractive than dividends from share prices. Also, higher interest rates will not always cause lower share prices as there are many factors which affect share prices in addition to interest rates. Share prices depend conversely a reduction in benchmark rates. Low interest rates make margin trading more affordable; increase the number of buyers in the market and pushes up stock prices.
Interest rate risk is the one fundamental risk that no one can escape from. Be it a company or an individual. Depending on the nature of business, a company may or may not be exposed to currency fluctuations, commodity price volatility or equity market risk but it will always be affected by interest rate movements (Stoakes, 2007; Christropher, 2008). This is true not only for businesses that have borrowings but also for cash-rich, debt-free companies where invested funds are affected by changes in interest rates. Same goes for individuals as their savings, investments, borrowings and the value of future cash flows are impacted by variations in interest rates. This price fluctuates as a result of the different expectations that people have about the company at different times. Because of those differences, they are willing to buy or sell shares at different prices. If a company is seen as cutting back on its growth spending or is making less profit either through higher debt expenses or less revenue from consumers then the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company's stock. If enough companies experience a decline in their stock prices, the whole market, or the indexes decline.
A large component of a stock's price is tied to the expected earnings of the corporation. The stock price of a firm reflects the expected future cash-flows being affected by the future internal and external aggregate demands. Changes in the interest rates affect the fundamental values of the firms, such as their dividend growth rates, net interest margins and sales. Cifter and Ozun (2007) make a point that in advanced markets whose efficiencies are relatively high, there exist a negative relationship between market P/E and yield of the treasury bills indicating that in the long run the stock markets are affected by the change in interest rates. On the other hand, in the emerging markets in which their informational efficiencies are under question, the effects of interest rates on capital markets might not be clearly defined in the long-run, or should be analyzed in the short-run due to their no coherent dynamics leading asymmetric and high degree of volatility and intensive effects of random shocks. The effects come from the fact that changes in the interest rates have earnings effects on firms. A basic algorithm can be set up by the following way. Increase of interest rates leads available cash to borrow to be less which, in turn, decreases the spending. When the spending is getting less, earnings of the companies go down and their stock prices drop. In a reverse way, Titman and Warga (1989) state the stock returns might determine the interest rates by arguing that the market reflects the expectations of the financial variables on the prices.
Interest rate changes can impact equity prices through two conduits: by affecting the rate at which the firm's expected future cash flows will be capitalized, and by altering expectations about future cash flows. In particular, it is argued that an increase in interest rates causes stock prices to decline and a decline in interest rates causes stock prices to rise. Further, it is argued that if both capitalization rates and expectations about future cash flows are impacted by interest rates, these effects would influence equity prices.
The rationales for the relationship between the interest rate and stock market return are that stock prices and interest rates are negatively correlated (Banerjee and Adhkari, 2008). Higher interest rate ensuing from contraction monetary policy usually negatively affects stock market return. This is because higher interest rate reduces the value of equity as stipulated by the dividend discount model, makes fixed income securities more attractive as an alternative to holding stocks, may reduce the propensity of investors to borrow and invest in stocks, and raises the cost of doing business and hence affects profit margin. On the contrary, lower interest rates resulting from expansionary monetary policy boosts stock market.
Regarding the relationship between stock prices and interest rate, a number of empirical studies have been undertaken after 1970s. Fama (1981), Roll and Ross (1986) and Chen (1991) cited in Cifter and Ozun (2007), tested the relationships between macroeconomic variables and stock prices with US economic data. Fama (1981) documents a strong positive correlation between common stock returns and real economic variables like capital expenditures, industrial production, real GNP, money supply, lagged inflation and interest rates. Roll and Ross (1986) and Chen (1991) find that the changes in aggregate production, inflation, the short-term interest rates, the maturity risk-premium and default risk-premium are the economic factors that explain the changes in stock prices. Smirlock and Yawitz (1985) cited in Cifter and Ozun (2007), state that interest rate changes can impact equity prices through two conduits: by affecting the rate at which the firm's expected future cash flows will be capitalized, and by altering expectations about future cash flows. In particular, they argue that an increase in interest rates causes stock prices to decline and a decline in interest rates causes stock prices to rise. Further, they argue that if both capitalization rates and expectations about future cash flows are impacted by interest rates, these effects would influence equity prices.
Based on fundamental value approach focus on the future growth prospects of a firm and market, participants take buy/sell decisions based on that research. As expected, an increase in the interest rates impacts the valuation of the stocks because it raises the expectations of the investors demanding more profits commensurate with the increased returns on bonds. What is more, an increase in the time value of money leads investors to shift their investments from capital markets to fixed term income securities market. The transition between the markets continues in reverse form when reduction in interest rates make participants to shift their investments to capital markets whose P/E ratio becomes enough low and the shares provide higher rates of capital appreciation than fixed-term income securities or money market instruments. In advanced markets whose efficiencies are relatively high, there exist a negative relationship between market P/E and yield of the treasury bills indicating that in the long run the stock markets are affected by the change in interest rates. On the other hand, in the emerging markets in which their informational efficiencies are under question, the effects of interest rates on capital markets might not be clearly defined in the long-run, or should be analyzed in the short-run due to their non coherent dynamics leading asymmetric and high degree of volatility and intensive effects of random shocks. Especially in emerging markets stock returns tend to have fat-tailed distributions.
Talking about the observed behavior of the market of developing countries stock returns of emerging countries are highly predictable and have low correlation with stock returns of developed countries. Emerging markets are less efficient than developed markets and higher return and low risk can be obtained by incorporating emerging market stocks in investors' portfolios. Uddin and Alam (2007) examines the linear relationship between share price and interest rate, share price and changes of interest rate, changes of share price and interest rate, and changes of share price and changes of interest rate on Dhaka Stock Exchange (DSE). For all of the cases, included and excluded outlier, it was found that Interest Rate has significant negative relationship with Share Price and Changes of Interest Rate has significant negative relationship with Changes of Share Price.
One study examined the market efficiency of fifteen countries and also looked at the effect of interest rate on share price and changes of interest rate on changes of share price. Individual country result is mixed for both developed and developing countries. Interestingly, for Malaysia it is found that Interest Rate has no relation with Share price but Changes of Interest Rate has negative relationship with Changes of Share Price. In case of Japan, it is found that Interest Rate has positive relationship with Share price but change of Interest Rate has negative relationship with change of Share Price. Four countries like Bangladesh, Colombia, Italy, and S. Africa show negative relationship for both Interest Rates with Share price and Changes of Interest Rate with Changes of Share Price. The interest rate and exchange rate changes matter for Bangladesh stock market in the long run. At the same time, they seem to have no significant influences on the stock market in the short run, given the history of interest rate and exchange rate regimes in Bangladesh. In Pakistan the Increase in borrowing rate from banks do effect the investor's decision to invest in the equity market or in savings account at bank but the effect doesn't change very quickly even though the interest rate has an influencing relationship with the stock market. So, if the interest rate is considerably controlled in these countries, as it will be the great benefit for their Stock Exchange through 'demand pull' this way of 'more investors' in share market, and 'supply push' way of more 'extensional investment' of companies.
Interest rates have a strong predictive power for stock returns (Change), and a weak predictive power for volatility (quickness of Change). It is well known that the interest rate is the price of capital allocation over time. A high interest rate attracts more savings, whereas a reduction in the interest rate encourages higher capital flows to the stock market by those expecting a higher rate of return. Investors should therefore pay attention to the monetary policy as a mean for adjusting their investments. Ideally refraining from frequent interest rate and exchange rate manipulations either to stabilize or to prop up the stock market in the short-run, although they might work in this respect in the long run.
There are many types of industries in the stock market for which interest rates may affect the industry greatly (financial stocks) or very little (mining stocks). Companies without strong balance sheets are more greatly affected by a rise in rates since they rely heavily on borrowing. In addition, the individual dividend policy of a particular company greatly affects rates. Also there are sectors in the stock market that are benefited when inter-bank rates rise such as credit investment firms, Banks or leasing houses. They will earn more profit by charging greater interest as per inter-bank rate effects. So the entire stock market based on different sectors will behave differently as per interest rate's importance and usability. One thing to be clarified is that Interest rates are not the only determinant of stock prices and there are many considerations that go into stock prices and the general trend of the market - an increased interest rate is only one of them. A number of macroeconomic and financial variables that influence stock market have been documented in the recent empirical literature without a consensus on their appropriateness as regression (Lanne, 2002; Campbell and Yogo, 2003; Jansen and Moreira, 2004; Donaldson and Maddaloni, 2002; Goyal, 2004; Ang and Maddaloni, 2005). Frequently cited macroeconomic variables are GDP, price level, industrial production rate, interest rate, exchange rate, current account balance, unemployment rate, fiscal balance, etc. Therefore, one can never say with confidence that an interest rate hike by the Fed will have an overall negative effect on stock prices. The results of the researches about the effects of interest rates on stock returns vary based on investigation and frequency of the data. Using the Beta coefficient and interest rates together increases the explanatory power of the model.
