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Pir Mehr Ali Shah Arid Agriculture University Rawalpindi.

University Institute of Management Sciences (UIMS).

Research ProjectResearch Project

(MGT – 799)(MGT – 799)

Research On:

Impact of Interest Rate on Karachi Stock ExchangeImpact of Interest Rate on Karachi Stock Exchange

Submitted In Respect Of:

Sir, Ahmed RazaSir, Ahmed Raza

Submitted By:

Aamish Hameed KhanAamish Hameed Khan (07-Arid-406)(07-Arid-406)

Shahid MehmoodShahid Mehmood (07-Arid-445)(07-Arid-445)

Omer Javed Omer Javed (07-Arid-454)(07-Arid-454)

M. ShoaibM. Shoaib (07-Arid-451)(07-Arid-451)

MBA-4MBA-4thth

(Finance) (Finance) Section “A” Section “A”

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TABLE OF CONTENTS

SEARILSEARIL NO.NO.

DESCRIPTIONDESCRIPTION PAGE NO.PAGE NO.

1. Definition 05

2. Introduction 05

3. Literature Review 07

4. Data & Methodology 12

5. Hypothesis 14

6. Findings 14

7. Appendix 1 15

8. Appendix 2 18

9. Appendix 3 22

10. Bibliography 26

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DEDICATION

We dedicate this research project to our

Respected parents and teachers whose

Prayers enable us to perform every task efficiently.

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ACKNOWLEDGEMENT

By the grace of God and the most efforts of our group, we are able to accomplish our

research project well in time. At this moment we must pay special thanks to our

guiders for their cooperation and guidance that made us accomplish our Project. Also

we are grateful to Sir. Ahmed Raza, our supervisor, who showed a keen interest and

cooperated whole-heartedly through out the entire course of activities.

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DEFINITIONS

“Interest is a fee, paid on borrowed capital” and “the percentage of the principal that is paid as a fee (the interest), over a certain period of time, is called the interest rate.”

“Stock exchange is a market in which stocks and shares of listed companies are bought and sold.”

INTRODUCTION

Stock returns and their volatility has been hot issue for research since very

long but still research for the factors affecting stock returns and their volatility is

continued. There are numerous macro-economic factors that affect stock returns and

their volatility. These factors include growth rate of industrial production index,

change in consumer price index, growth rate of narrowly defined money supply,

change in exchange rate, interest rate, growth rate of international crude oil price,

return on the MSCI World Equity Index, real gross domestic product, inflation rate

and inter-bank money market transaction.

In our research we will find the impact of only interest rate on stock returns.

Interest rates defined by monetary policy of economy has been considered as an

important factor to determine the stock return variance however no unanimous

viewpoint about the predictive power of interest rates to determine stock return

variance has yet observed.

Stock market in an economy plays a vital role in assessing its economic

conditions. Improved stock return means higher profitability of firms and thus overall

growth of economy while decreased stock return means lower profitability of firms

and thus overall decline of economy. Stock market basically serves as a channel to

direct the funds from individuals to investors by mobilizing individual owned

resources. With this role of the stock market, volatility in stock prices can

significantly affect the performance of the financial sector as well as the entire

economy.

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Stock return volatility refers to the variation in stock price changes during a

period of time. Normally investors and agents perceive this variation as a measure of

risk. The policy makers use market estimate of volatility as a tool to measure the

vulnerability of the stock market. There exist an asymmetric relationship between

stock return and stock return volatility. With a fall in stock prices, volatility increases

more than when stock prices increases.

Relationship of interest rate and stock return has been widely examined by

researchers. The interest rates indirectly affect the valuation of the stock prices and

also its volatility directly creates a shift between the money market and capital market

instruments. Interest rate volatility influences the valuation of the stocks by affecting

the basic values of the firm, such as net interest margin, sales and etc. An increase in

interest rates negatively affects the value of assets by increasing the required rate of

return. Furthermore, high interest rates induce the investors to keep their money

deposited in saving bank accounts to get high interest rather to put it into risky stock

market. So with the increase in interest rate stock prices decline. As the risk free

returns come down, investors switch their money from bank accounts to stock market

investments. Consequently, demand of stocks increases and the stock markets go up

as a result of interest rate cut.

Although their are number of factors that affect stock prices but many

researchers consider interest rate as one of the most significant determinants of the

stock prices, however still it can not be said with confidence that changes in interest

rate will directly and significantly affect the stock market and so the stock returns in

overall manner.

The purpose of our research is to find the impact of interest rate on Karachi

Stock Exchange (KSE) returns. Although there are many factors that affect Karachi

Stock Exchange returns, we specified our area of research to interest rate only.

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LITERATURE REVIEW

Ugur Ergun, Abu Hassan Shaari Mohd Nor and Mansor Bin Jusoh (2008)

examined the impact of external stocks on the linkages of Istanbul stock exchange

with monetary and macro-economic indicators in Turkey. For this purpose they used

monthly data of Istanbul stock exchange index, industrial production index, broad

money supply, short-term interest rate and USA exchange rates for the period span

from 1996 to 2008. Their research results indicate that: 1). Istanbul stock exchange

has long run linkages with the variables including industrial production index, broad

money supply and interest rate but has no linkage with U.S Dollar. 2). Istanbul stock

exchange has direct bilateral causality relationship with interest rate, broad money

supply and industrial production index. 3). U.S exchange rate has no impact on

Istanbul stock exchange with selected monetary policy and key variables. So to

sustain development in Istanbul stock exchange particularly and in whole economy

generally, policy makers should focus on interest rate as it is key policy variable.

Nousheen Zafar, Syeda Faiza Urooj and Tahir Khan Durrani (2008)

investigated the effects of interest rate volatility on stock returns and volatility using

monthly returns of Karachi stock exchange and 90 days T-Bills rate for the period of

January 2002 to June 2006. Their results indicate that interest rate volatility has a

negative relationship with stock return volatility but it has no significant impact on

stock return volatility and thus do not help much in predicting volatility in Karachi

stock exchange. Although it is generally accepted that when interest rate increases

people tend to deposit their savings in banks accounts rather then investing in stock

exchange market. Also it reduces the profitability of firms and thus stock prices go

down. As interest rate in economy is determined by monetary policy of that country,

policy makers should concentrate on it for adjusting the volume of stock market and

overall investments in economy.

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Gulin Vardar, Gokce Aksoy and Emre Can (2008) conducted the research to

investigate the impact of interest rate and exchange rate on the composite and sector

price indices, which are Financial, Industrial, Services and Technology in the Istanbul

stock exchange. In this article they used daily sector data over the 2001 to 2008

period. The result of the research indicates that both changes in interest rate and

exchange rate effects stock returns in Istanbul stock exchange. The result also indicate

that changes in interest rate have no significant impact on volatility of industrial and

services sector while changes in interest rates have an increasing impact on volatility

of technology sector, financial and composite indices, volatility declines by the

changes in this variable. As 90% of composite index of Istanbul stock exchange was

composed of financial sector stock, the composite index react in the same manner as

financial sector index. Their research results provide useful information to the

investors that they should follow closely the monetary policies in the country to take

decision on their investments.

Daferighe. Emmanuel E and Aje. Samuel O (2007) examined the impact of

Real Gross Domestic Product, Interest rate and Inflation rate on stock prices of

quoted companies in Nigerian Stock Exchange from 1997 to 2006. For analysis

purpose they used regression which showed that the explanatory variables accounted

for 95.6% of the variation in stock prices. The results of their research showed that

reduction in interest rate and inflation rate increases stock prices while reduction in

real gross domestic product decreases stock prices and increases in interest rate and

inflation rate decreases stock prices while increase in real gross domestic product

increase stock prices. They conducted on the basis of their research that government

should implement policies that reduces the inflation rate and increases the real gross

domestic product. The interest rate should be kept moderate to encourage investment

and transaction in stock.

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Serkan Yilmaz Kandir (2005) investigated the impact of macro-economic

variables on stock returns of Istanbul Stock Exchange for the period July 1997 to June

2005. The macro economic variables used in this study are growth rate of industrial

production index, change in consumer price index, growth rate of narrowly defined

money supply, change in exchange rate, interest rate, growth rate of international

crude oil price and return on the MSCI World Equity Index. The data used for this

study was related to all non-financial firms listed on the Istanbul Stock Exchange.

The analysis was based on stock portfolios rather than single stocks. He used a

multiple regression model to test the relationships between the stock portfolio returns

and seven macro-economic factors. Empirical findings revealed that exchange rate,

interest rate and world market returns affected all the portfolio returns, while inflation

rate was significant for only three of the twelve portfolios. On the other hand,

industrial production, money supply and oil prices do not appear to have any

significant affect on stock returns.

Rajni Mala and Mahendra Reddy (2007) of Fiji Islands investigated the

volatility of returns in financial markets of small developing economies. For this

purpose they used a time series data for the period 2001 to 2005 on specific firms and

they founded that seven out of sixteen firms listed on South Pacific Stock Exchange

was volatile. They then investigated the interest rate as major factor causing volatility

of returns which gave positive results.

Shaharudin. Roselee S and Hon Su Fung (2008) investigated the

predictability of the stock return of different sizes of firms listed in Bursa Malaysia

for the period of January 1996 to July 2007. For this purpose they used macro-

economic variables that include Price index, Industrial Production index, Money

Supply(M3), Interbank Money Market Transaction, three months and six months

Treasury Bills Discount Rate and crude oil prices. They choose 120 companies listed

on Kuala Lumpur Stock Exchange. They divided the firms into four different sizes

include small, medium, large and mix caps firms. They then investigated the impact

of macro-economic variables on stocks of chosen companies and concluded that

interest rate is inversely related with the returns of all sizes of firms and an increase in

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interest rate may cause a recession and thus cause a decline in future corporate

earning.

Prashanta K. Banerjee and Brishnu Kumar Adhikary (2007) investigated

the impact of changes in interest rates and exchange rates on the stock market return

in Bangladesh ( Dhaka Stock Exchange ). They used monthly data from January 1983

through December 2006. They gave the conclusion that changes in the interest rate

shows short-term net positive feedback effects on stock market return, which is

counterintuitive. This relationship can be explained by the indirect initiatives taken by

the Central bank of Bangladesh, which had no result. In brief, a reduction in interest

rates failed to create a bullish stock market in Bangladesh. After the debacle in

Bangladeshi stock market in 1996 and in the absence of a developed corporate debt

market in Bangladesh, investors prefer bank deposits as the best instruments in which

to invest their savings.

Ologunde, Elumilade and Asaclu (2006) examined the relationship between

stock market capitalization rate and interest rate in Nigeria. They obtained time series

data from central bank of Nigeria and Nigerian Stock Exchange. They concluded that

there is impact of interest rate on Nigerian Stock Exchange. With the increase in

interest rate, stock return decreases and hence the capitalization rate. With the

decrease in interest rate, stock return increases and hence the capitalization rate.

Shahid Ahmed (2008) investigated the nature of the causal relationship

between stock prices and the key macro-economic variables representing real and

financial sector of the India economy for the period March,1995 to March,2007 using

quarterly data. These variables are the index of industrial production, exports, foreign

direct investment, money supply, exchange rate, NSE Nifty and BSE Sensex in India.

The results of the study reveal differential causal links between aggregate macro-

economic variables and stock indices in the long run. However, the revealed causal

pattern is similar in both markets in the short run. The study indicates that stock

prices in India lead economic activity except movement in interest rate. Interest rate

seems to lead the stock prices.

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Nil Gunsel and Sadik Cukur (2007) investigated the effects of macro-

economic factors on the London Stock Returns. For this purpose they used seven

macroeconomic variables that include the term structure of interest rate, the risk

premium, the exchange rate, the money supply, unanticipated inflation and industry

specific variables that include dividend yield and sectoral unexpected production.

Their results indicated that macroeconomic factors have a significant effect in the UK

stock market; however, each factor may affect different industry in different manner.

That is, a macroeconomic factor may affect one industry positively but may affect the

other industry negatively.

Ching-Chun Wei (2008) investigated the impact of Chinese interest rate on

the industrial production and stock market index. They used the data from

January,1985 to July, 2007. On the basis of their research they concluded that interest

rate has no effect on the Shanghai composite stock index market, while interest rate

has effect on industrial production and Shenzhen composite stock market.

Nicholas Apergis and Sophia Eleftheriou (2000) observed the relationship

between stock prices, inflation and interest rate in Greece over the period 1988-1999.

They gave the results that Athens Stock Exchange follow inflation rather than

nominal interest rate movements. The results also demonstrate that the continuous

reduction of inflation in Greece is expected to contribute to a more substantial

increase in stock prices and thus higher economic growth.

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DATA AND METHODOLOGY

Independent variable Dependent variable

We have taken T-bills rate as risk free rate of interest from website of State

Bank of Pakistan and stock indexes of Karachi Stock Exchange from b-recorder.com

for the period January 2001 to June 2008.

We applied correlation on data. The correlation is one of the most common

and most useful statistics. A correlation is a single number that describes the degree

of relationship between two variables.

It indicates the strength and direction of a linear relationship between two

variables. A number of different coefficients are used for different situations. The best

known is the Pearson product-moment correlation coefficient, which is obtained by

dividing the covariance of the two variables by the product of their standard

deviations. Despite its name, it was first introduced by Francis Galton.

The correlation is 1 in the case of an increasing linear relationship, −1 in the

case of a decreasing linear relationship, and some value in between in all other cases,

indicating the degree of linear dependence between the variables. The closer the

coefficient is to either −1 or 1, the stronger the correlation between the variables.

INTEREST RATE STOCK RETURNS

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Several authors have offered guidelines for the interpretation of a correlation

coefficient. Cohen (1988) has observed, however, that all such criteria are in some

ways arbitrary and should not be observed too strictly. This is because the

interpretation of a correlation coefficient depends on the context and purposes. A

correlation of 0.9 may be very low if one is verifying a physical law using high-

quality instruments, but may be regarded as very high in the social sciences where

there may be a greater contribution from complicating factors.

A symbol “r” is used to stand for the correlation.

Then to find out whether correlation gives right relationship, we will apply t-

test at 10% level of significance and will apply here two-tailed t-test. If value of

correlation lies in acceptance region, we will accept null hypothesis and if value of

correlation does not lie in acceptance region, we will reject null hypothesis and accept

alternate hypothesis.

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HYPOTHESIS

We have formulated the following hypothesis and conducted the research to test

which one is true.

H0: P=0 (There is no correlation between interest rate and KSE returns.)

H1: P≠0 (There is correlation between interest rate and KSE returns.)

FINDINGS

When we applied formula on our data we got correlation of -0.2448 which is

showing that there is a negative relationship between Interest rates and stock returns,

that is, if interest rate increases their will be decrease in KSE returns and vice versa.

To test our hypothesis, we apply t-test at 10% level of significance, which

gave the results that we reject null hypothesis and accept alternate hypothesis, that is,

the correlation exists between interest rate and KSE returns.

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Appendix 1

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TO FIND CORRELATION

DateT Bill

Rates (X) KSE IndexKSE

Returns (Y)Jan-01 10.96 1461.6 1000Feb-01 11.55 1423.18 973.71374Mar-01 11.54 1324.41 930.59908Apr-01 11.56 1367.05 1032.19547May-01 12.53 1377.61 1007.72466Jun-01 12.07 1366.43 991.88450Jul-01 10.92 1228.89 899.34354Aug-01 10.50 1258.43 1024.03795Sep-01 10.35 1133.43 900.66988Oct-01 8.35 1406.05 1240.52654Nov-01 8.04 1358.16 965.94004Dec-01 7.06 1273.06 937.34170Jan-02 6.02 1620.18 1272.66586Feb-02 6.46 1765.95 1089.97148Mar-02 6.47 1868.11 1057.84988Apr-02 6.40 1898.95 1016.50866May-02 6.35 1663.34 875.92617Jun-02 6.34 1770.11 1064.19012Jul-02 6.40 1787.59 1009.87509Aug-02 6.38 1974.58 1104.60452Sep-02 6.34 2018.75 1022.36931Oct-02 5.56 2278.54 1128.68854Nov-02 4.32 2285.87 1003.21697Dec-02 3.51 2701.41 1181.78637Jan-03 3.19 2545.07 942.12652Feb-03 2.09 2399.14 942.66169Mar-03 1.64 2715.71 1131.95145Apr-03 1.73 2902.41 1068.74814May-03 1.66 3099.04 1067.74715Jun-03 1.21 3402.47 1097.91097Jul-03 1.21 3933.37 1156.03370Aug-03 1.61 4461.47 1134.26146Sep-03 1.61 4027.34 902.69351Oct-03 1.66 3781.03 938.84053Nov-03 1.64 4068.29 1075.97401Dec-03 1.64 4471.6 1099.13502Jan-04 1.68 4841.33 1082.68405Feb-04 1.77 4840.37 999.80171Mar-04 1.77 5106.66 1055.01439Apr-04 1.84 5430.43 1063.40152May-04 2.08 5497.79 1012.40417Jun-04 2.08 5279.18 960.23675Jul-04 2.52 5289.92 1002.03441Aug-04 2.62 5346.15 1010.62965Sep-04 3.00 5217.65 975.96401Oct-04 3.19 5332.24 1021.96199

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Nov-04 3.73 5567.79 1044.17468Dec-04 3.73 6218.4 1116.85247Jan-05 4.16 6747.39 1085.06851Feb-05 4.79 8260.06 1224.18594Mar-05 5.35 7770.33 940.71108Apr-05 7.08 7104.65 914.33054May-05 7.82 6857.67 965.23685Jun-05 7.92 7450.12 1086.39232Jul-05 7.97 7178.93 963.59924Aug-05 8.08 7796.86 1086.07550Sep-05 8.14 8225.66 1054.99650Oct-05 8.14 8247.37 1002.63930Nov-05 8.20 9026.59 1094.48103Dec-05 8.25 9556.61 1058.71763Jan-06 8.28 10523.37 1101.16140Feb-06 8.29 11456.12 1088.63605Mar-06 8.29 11485.9 1002.59948Apr-06 8.29 11342.17 987.48640May-06 8.29 9800.69 864.09303Jun-06 8.45 9989.41 1019.25579Jul-06 8.50 10497.66 1050.87888Aug-06 8.80 10063.54 958.64602Sep-06 8.80 10512.52 1044.61452Oct-06 8.80 11327.71 1077.54468Nov-06 8.80 10619.47 937.47721Dec-06 8.80 10040.5 945.48033Jan-07 8.80 11272.33 1122.68612Feb-07 8.80 11180.02 991.81092Mar-07 8.80 11271.59 1008.19050Apr-07 8.90 12369.7 1097.42281May-07 8.90 12961.14 1047.81361Jun-07 8.90 13772.46 1062.59635Jul-07 8.90 13739.53 997.60900Aug-07 9.10 12214.26 888.98674Sep-07 9.10 13353.68 1093.28604Oct-07 9.10 14321.39 1072.46766Nov-07 9.20 13998.52 977.45540Dec-07 9.30 14077.16 1005.61774Jan-08 9.30 14016.94 995.72215Feb-08 9.60 14934.3 1065.44652Mar-08 9.80 15125.89 1012.82886Apr-08 9.89 15122.47 999.77390May-08 10.49 12130.51 802.15137Jun-08 11.49 12289.03 1013.06788

CORRELATION IS: -

- - 0.24480.2448

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Appendix 2

TESTING FOR SIGNIFICANCE OF CORRELATION

α = 10%

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α /2 = 5%

From t-table, the value of t is

t = 0.173

r = -0.2448

Pearson Product-Moment Correlation Coefficient

Table of Critical Values

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df= N-2N = number of pairs of data

Level of significance for two-tailed test

.10 .05 .02 .01

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1 .988 .997 .9995 .9999

2 .900 .950 .980 .990

3 .805 .878 .934 .959

4 .729 .811 .882 .917

5 .669 .754 .833 .874

6 .622 .707 .789 .834

7 .582 .666 .750 .798

8 .549 .632 .716 .765

9 .521 .602 .685 .735

10 .497 .576 .658 .708

11 .476 .553 .634 .684

12 .458 .532 .612 .661

13 .441 .514 .592 .641

14 .426 .497 .574 .628

15 .412 .482 .558 .606

16 .400 .468 .542 .590

17 .389 .456 .528 .575

18 .378 .444 .516 .561

19 .369 .433 .503 .549

20 .360 .423 .492 .537

21 .352 .413 .482 .526

22 .344 .404 .472 .515

23 .337 .396 .462 .505

24 .330 .388 .453 .495

25 .323 .381 .445 .487

26 .317 .374 .437 .479

27 .311 .367 .430 .471

28 .306 .361 .423 .463

29 .301 .355 .416 .456

30 .296 .349 .409 .449

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35 .275 .325 .381 .418

40 .257 .304 .358 .393

45 .243 .288 .338 .372

50 .231 .273 .322 .354

60 .211 .250 .295 .325

70 .195 .232 .274 .302

80 .183 .217 .256 .284

90 .173 .205 .242 .267

100 .164 .195 .230 .254

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Appendix 3

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T-BILLS RATES MOVEMENT

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

1/2/

2001

1/2/

2002

1/2/

2003

1/2/

2004

1/2/

2005

1/2/

2006

1/2/

2007

1/2/

2008

T BILL RATES MOVEMENT

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KSE RETURNS

0

200

400

600

800

1000

1200

1400

1/2/

2001

1/2/

2002

1/2/

2003

1/2/

2004

1/2/

2005

1/2/

2006

1/2/

2007

1/2/

2008

KSE RETURNS

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RATES VS RETURNS

RATES VS RETURNS

0

500

1000

1500

0.00 5.00 10.00 15.00

RATES VSRETURNS

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BIBILIOGRAPHY

Ugur Ergun, Abu Hassan Shaari Mohd Nor and Mansor Bin Jusoh. External shock effect on the internal linkages of Istanbul stock exchange.http://www.eurojournals.com/ejefas_14_11.pdf

Nousheen Zafar, Syeda Faiza Urooj and Tahir Khan Durrani. Interest rate

volatility and stock return and volatility.http://www.eurojournals.com/ejefas_14_13.pdf

Gulin Vardar, Gokce Aksoy and Emre Can. Effects of interest and exchange rate on volatility and return of sector price indices at Istanbul stock exchange.http://www.eurojournals.com/ejefas_11_12.pdf

Daferighe. Emmanuel E and Aje. Samuel O. An impact analysis of Real GDP inflation and interest rates on stock prices of Quoted companies in Nigeria.http://www.eurojournals.com/irjfe_25_05.pdf

Serkan Yilmaz Kandir. Macroeconomic variables, firm characteristics and stock returns: Evidence from Turkey.http://www.eurojournals.com/Pages%20from%20irjfe16serkan.pdf

Rajni Mala and Mahendra Reddy. Measuring stock market volatility in an emerging economy.http://www.eurojournals.com/8rajni.pdf

Shaharudin. Roselee S and Hon Su Fung. A study of size effect and macroeconomic factors in Malaysian stock returns.http://www.eurojournals.com/irjfe_24_09.pdf

Prashanta K. Banerjee and Brishnu Kumar Adhikary. Dynamic effects of changes in interest rates and exchange rates on the stock market return in Bangladesh.

Ologunde, Elumilade and Asaclu. Stock market capitalization and interest rate in Nigeria.http://www.eurojournals.com/IRJFE4%2012%20ologunde.pdf

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Shahid Ahmed. Aggregate economic variables and stock markets in India.http://www.eurojournals.com/irjfe%2014%20shahid.pdf

Nil Gunsel and Sadik Cukur. The effects of macroeconomic factors on the London stock returns.http://www.digitallibrary.com

Ching-Chun Wei. Effect of China interest rate to industrial production and

stock markets index.http://www.eurojournals.com/irjfe_18_01_Ching.pdf

Nicholas Apergis and Sophia Eleftheriou. Interest rates, inflation and stock prices: the case of Athens stock market.http://www.digitallibrary.com