Institute of Business Management

Seminar in Economic Polices

Thesis paper on

CHANGES IN INTEREST RATE DIRECTLY

AFFECT CAPITAL MARKET ACTIVITY

Submitted to: Sir Ashraf Janjuha

Submitted By: Rajesh Kumar Maheshwari (10669)
Dated: August 23, 2014

Changes in Interest rate directly affect

capital market activity
Abstract
The study has been conducted with intent to analyze that how change in interest rate impacts
the capital market activities. Therefore I have conducted regression analysis between KSE 100
index and 3- months, 6- months and 12- months T bills return. We have taken monthly data of
KSE 100 index and return on T- bills from Fiscal year 2005 to Fiscal year 2014. Data has been
collected from best available sources that are state bank website, KSE website and statistics
book issued by the central bank To analyze the data I have used coefficient of correlation and
regression method to test my hypothesis. The study revealed that there is negative correlation
between KSE 100 index and rate on T bills.

Introduction:
When we look at the macro-economic perspective of any country then stock market is the key
indicators which show the glance of the economy and investment environment in that
particular country. When big companies need funds they use capital market as the first priority
to raise the fund. The listed companies offer shares to general public primarily through initial
public offering and then stock market is the secondary market for buying and selling of shares.
There are three stock exchanges in Pakistan which are Karachi Stock exchange, Lahore Stock
Exchange and Islamabad Stock Exchange. KSE 100 indexes is the major index of Pakistan. Just
like other capital markets our stock markets are much efficient markets and reacts positively
and negatively on the political and economic situation of the our country.
Investment and savings are two important triggers for the economic growth of a country. Most
of economists believe that investments and savings of individuals are used for long term
funding of the companies.

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In market capital both local and foreigner investors participate and invest their funds. For many
reasons capital market within a country is key player for the economic development and funds
mobilization within the country.
Capital market within a country is one way of mobilizing wealth by engaging many investors
into the stock market. One who wants to be beneficiary of profit of from a company then
he/she buys its shares through stock market and became shareholders and makes profit on the
investment in term of capital gain or dividend income whenever a company announces the
dividend.
When we talk about the stock market the first thing which comes in the mind is high volatility.
The major factor behind stock exchange volatility is the political and social condition in the
region. For example the country is going under political instability and country is having war like
situation then there will be a negative image of that country in foreign investors and these
investors will be reluctant to invest into that country. This will lead to down fall in the capital
market activities.
Then the second most important factor which impact stock exchange is economic condition.
When we consider the economic conditions it includes economy of that particular country,
economy of that region and economic situation of developed countries. When the global
economic is facing recession then it firstly hit the capital market activity. The share prices of
stock will go down and hence stock market will collapse which was being observed in great
recession in 2008. On the opposite side when the economy is in growing phase it will create
interest into the capital market as it is being observed in Pakistani capital market right now.
Interest rate is the key indicator of economy which multiplies its impact on other economic
indicators.
An increase in interest means you will get higher return on deposit into bank and putting
money into saving certificates which is risk free, and investors will be less likely to invest in high
risk capital market. Another impact of increase in interest rate in such a way that higher
interest rate will cause company for higher financial cost which will decrease the profitability.
As expectation for profitability decreases then the share prices of that stock also goes down. In

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the opposite scenario demand and prices of leveraged companys share will go up if there is a
fall in interest rate. And increase in share prices means higher index.
When we look at interest rate from State Bank perspective, it is important tool used by the
central bank to manage the inflation in the country. State Bank of Pakistan believes that
inflation within the country is demand pull inflation and to lower down the inflation it increases
the discount rate to attractive people for saving and investment and less likely to go for
consumes it. The second side of increase in interest rate is negative impact on capital market.
Therefore we can say that in an economy it is much difficult to determine the ideal discount
rate which should be favorable in all aspects. To maintain stabilization within the country the
authorities in state banks monetary department keeps eye on economic indicators and make
corrective decision for feasible interest rate in the country.
If we look at history of capital market in Pakistan it can be observed that our market has seen
many ups and down in past one decade. The stock market was highly impacted due to
politically instability, economic down fall and other reasons. During March 2005 first time stock
market gone under huge downfall and then in 2006 it was collapsed. Third and most awful
collapse was observed period during May 2008 to January 2009 when Karachi Stock exchange
was down by some 10,000 points and management placed a floor to avoid any other loss of
investors.
In the light of above discussion it was required to investigate that changes in key economic
variable i.e. rate of interest directly have a direct effect on the capital market activities.

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Objective of study
To analyze the impact of change in interest rate on capital market (KSE 100 index)
performance

Hypothesis
KSE-100 Index and Interest rate
Ho: If the Interest rate increases in the economy then capital market prices will
decrease.
H1: If the Interest rate increases in the economy then capital market prices will
not be affected

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Literature Review
The effects of macro-economic variables like interest rates, money supply, exchange rates
,inflation on capital market returns is wide mentioned topic in monetary and financial economy
literature. Briefly the foremost relevant and current studies during this context are highlighted
as follows
Mashayekh et al. (2011) in their analysis studied the link of macro-economic variables like rate,
rate of interest of annual investment deposits in state banks, rate of interest of bonds and also
the rate of gold worth with Tehran Stock Exchange (TSE). The study was conducted
victimization monthly knowledge from the period of Apr 1998 to March 2008. For completing
necessary checks and analyzes they used power unit Model and JOHANSEN co- integration test.
The results of the study showed that there was long run positive and purposeful relationship
between rate and TSE indicators i.e. stock returns and volume of transaction. Researchers
additional investigated that increase in bank interest rates were inflicting decrease available
exchange activity. They argued that increase in bond rate of interest has no negative result on
TSE as a result of bonds isnt competitive investment chance for stocks. With the assistance of
VECM, researchers investigated the link b/w gold market and securities market and located the
short run relationship b/w them and known that briefly run gold market will be used as a
substitute for securities market likewise as gold returns area unit play a vital role in process the
securities market trend however in long haul.
The relationship between the Capital market performance and also the rate of interest is
derived back to Friedmans cash demand perform (Osuagwu, 2009). Friedman (1956) in theory
illustrated that AN agents call of portfolio allocation like equity investments has an impression
on savings-consumption call and it's determined by the interest rates changes. On the opposite
hand, researchers conjointly build a sway to check rational expectation models of long run
quality costs that state that the distinction between the rationally expected returns of 1 set of
assets and also the another set of assets known as risk premium is capable a continuing over
a while interval (Fama and Schwert, 1977; mythologist, 1987). Fama and chwert (1977)
thought-about securities market returns and Treasury bill rate because the 2 set of assets and

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showed that the expectation model for stock returns and rate of interest is powerfully rejected
victimization US post war knowledge. mythologist (1987) conjointly rejected the rational
expectation theory and showed that term structure of interest rates predicts stock returns. His
results reveals that risk premium on stocks appear to maneuver closely along with long run
twenty year treasury bonds whereas relationship between risk premium on stocks and short
term Treasury bill is somewhat freelance.
Arbitrage valuation Theory (APT), introduced by Ross (1976), crystal rectifier to link stocks
returns to economic variables. Chen et al. (1986) explored the influence of many economic
variables like industrial production, inflation, and unfold of long and short term interest rates
on US stock returns victimization APT. Their findings indicate a number of the economic
variables area unit completely related to expected stocks returns whereas some variables area
unit negatively associated with the expected stock returns. Arango et al. (2002) through
empirical observation explored the link of the share costs on the South American
country|national capital} securities market and also the rate of interest measured because the
bank loan rate of interest in Colombia. Their results reveal AN inverse and non linear
relationship between share costs and also the interest rates. Cointergration analysis, vector
motor vehicle regressive (VAR) model and vector error correction (VECM) model analysis area
unit extensively wont to through empirical observation trace out impacts of economic science
variables on securities market performance recently. as an example, Maysami and Koh (2000)
examined the long run relationships between the Singapore indicator and designated economic
science variables by estimating a VECM. Their results reveal that Singapore securities market is
considerably sensitive to the long and short term interest rates and exchange rates. Mukherjee
and Naka (1995) extensively utilized the cointegration check and VECM analysis and so as to
work out the relationships between the japanese securities market and designated economic
science variables. Per their results, Japanese securities market is cointegrated with rate,
finances, rate, industrial production, long run bond rate and also the short term decision cash
rate.

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Asaolu and Ogunmuyiwa (2011) investigated the impact of economic science variables on the
average Share worth (ASP) of Nigerian securities market. For this purpose they collected the
yearly knowledge from the amount of 1986 to 2007 on External Debt, rate, financial Deficit,
rate, Foreign Capital flow, Investment, Industrial Output, rate and ASP of Nigerian securities
market and used analysis techniques like ADF check, creator relation check, Co-integration and
Error Correction methodology (ECM) and discovered that a weak relationship exist between
ASP and economic science variables of Nigeria and located that ASP wasn't a number one
indicator of economic science indicator of Nigerian economy however a protracted run
relationship exist between ASP and economic science variables for the period under study.

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Research Methodology
Data collection
For any research paper data is much important. For this research paper I have used both
secondary and primary data for in depth analysis. For secondary data I have collected many
research papers which were conducted on this same topic and learned how to conduct the
research. I read out research papers which were published within Pakistan or in other emerging
country or developed country.
And for the primary data I have visited State bank website and Karachi stock exchange website
to get the data for five years. Data has been collected by collecting rate on Treasury bills of 3
months, 6 months and 12 month during the period from July 2004 to June 2014 and also capital
market statistics during the same period.
Data has been collected on monthly basis for the period fiscal year 2004-2005 to fiscal year
2013-2014 on 3, 6 and 12 Months Treasury bill rates from State bank of Pakistan website and
KSE-100 Index from Handbook of Statistics of Pakistan 2014 and Karachi Stock Exchange
website.

Data Analysis Methodology

Data has been analyzed by correlation and regression method. I used computer based software
to analyze the data, this result was generated using SPSS (computer software for statistics) and
to carry out necessary objectives test that are used are correlation and regression analysis.

What is Correlation?
When two variables are frequently connected or associated in some way or such sort of
relationships between two or other additional variables will be studied by means that of
correlation. Correlation measures the association between two variables, in which with the
changes in values of one independent variable, the values of dependent variable changes.
Correlation could also be positive or negative in both sides. During this study we have used co-

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efficient of correlation to seek out the correlation between rate of interest movement and KSE100 Index by formula.

Co-efficient of Correlation
The co-efficient of correlation is a measure of the degree of interdependence between two
variables. The co-efficient of correlation is denoted by r. it is a pure number and varies between
-1 and +1 with the central value of zero. When r = 0, it means that there is no correlation
between two variables
(

)(

Where,
dx = the deviation of individual X values from their mean
dy = the deviations of individual Y values from their mean
n = the number of pairs of values
x = the standard deviation of x values
y = the standard deviation of y values

Regression
In this study I have also used Regression analysis to find out the impact / effect of one variable
to another variable. The regression was originated by Frances Galton in 1885. The regression is
defined as the dependence of one variable upon another variable.
Thus regression may be an applied math tool with the assistance of that area unit in a very
position to estimate the unknown values of one variable from famous values of different
variable.

Regression Co-efficient

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Regression co-efficient is the rate of change in the expected values of the dependent variable
for a given observe variable. There are two regression coefficients: regression coefficient of X
on Y and regression coefficient of Y on X. Regression coefficient are denoted by b xy and byx.
Regression Coefficient of X on Y
Regression coefficient of X on Y gives the values by which X variable changes for a unit in the
value of Y variable. The co-efficient regression of X on Y is given as:

Regression Equation
Regression equations are algebraic expressions of the regression lines. There are two regression
equations, because there are two regression lines.
Regression equation of X on Y
Given below equation is used to find the effect of variation of X on Y variable
(X-X-)=r.

(Y-Y-)

Regression equation of Y on X
And with the help of this equation we find the effect of change of Y on X variable
(Y-Y-)=r.

(X-X-)

Regression equations are used for two functions. Firstly off they supply the worth for regression
lines and second they supply a numerical methodology of sorting out the foremost appropriate
worth of X for a given worth of Y and most fitted worth of Y for a given value of X.

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Result:
Correlation Results
Each time correlation is performed separately of KSE-100 Index with Treasury Bills 3 Months
Rate, Treasury Bill 6 Months Rate and Treasury Bill 12 Months Rate.
Correlation of KSE- Index with 3, 6 & 12 Months T-Bills
T Bill- 3 Months
Pearson Correlation
-0.3
Sig. (1 tailed
0
N
110
T Bill- 6 Month

Pearson Correlation
Sig. (1 tailed
N

-0.21
0.05
110

T Bill- 12 Month

Pearson Correlation
Sig. (1 tailed
N

-0.29
0.01
110

Computer based SPSS has generated result of correlations between KSE-100 index prices and all
three types of T-bills of 3, 6 and 12 months. The result is shown in above table.
As per the results of the correlation test it was observed that T. Bill 03 Month and T. Bill 12
Month has shown a high negative correlation of 0.3 and 0.29 respectively with benchmark
Index while T. Bill 06 Month has shown negative correlation of 0.21 with KSE 100 Index.

Regression Results
Regression analysis has been performed each time separately between KSE-100 Index with
Treasury bills of all the three tenure including 3 months, 6 months and 12 months.KSE-100
Index was considered as a dependent variable while all other variables were used as
independent variables.

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Table A. Regression analysis of KSE-100 Index with T Bill- 03 Months

Model R
R square Adjusted R square Std. error of the Estimate
1 0.285794 0.081678
0.068381
0.088213
* Predictors: (constant), TB Three
Dependent Variable: KSE

Table A: Here we have calculated R as 0.285794 and R square is 0.081678 which translates as
changes in 3 bills T-bills rate is leading to 8.16% movement in KSE-100 index prices movement.

Table B. Regression analysis of KSE-100 Index with T Bill- 6 Months

Model R
R square Adjusted R square Std. error of the Estimate
1 0.201452 0.040583
0.027479
0.090129
* Predictors: (constant), TB Six
Dependent Variable: KSE
Table B: : Here we have calculated R as 0.201452 and R square is 0.040583 which translates as
changes in 6 bills T-bills rate is leading to 4.05% movement in KSE-100 index prices movement..
Table C. Regression analysis of KSE-100 Index with T Bill- 12 Months
Model R
R square Adjusted R square Std. error of the Estimate
1 0.283718 0.080496
0.062292
0.088501
* Predictors: (constant), TB twelve
Dependent Variable: KSE

Table C: In the last table the value of R was clock at Rs 0.283718 where in value of Rs Square is
0.080 which can be explained as interest rate on Treasury bill (12 Months) was causing 8.0% of
prices movement in KSE 100 Index.

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Interest rate and capital market A negative correlation

After analyzing the effect of interest rate on capital market through statistically method now
we are trying to analyze it through fundamentally approach. And from here onward we will
discuss about certain aspects of interest rate and its impact on capital market activities.
Interest Rate in easy words means that the value of borrowing funds. It is the payment we tend
to build to the investor for the ability of mistreatment his cash for our own purpose.
Persistently our payment selections are radio-controlled by the interest burden that we might
be bearing.
Even as shoppers, rate of interest is associate integral a part of our payment habit as we tend to
borrow from the bank for getting house, cars, house recent things etc. For the businessmen
rate of interest is additionally important as they borrow cash from bank for investment
activities like capability growth, fitting of plants, acquisitions, modernization etc. therefore
interest rates play a crucial role in a very businesss profit and hence, on stock costs.
How many people would like to invest in the capital market if bank is offering 12% interest rate
on fixed deposit? Then it comes to concept of risk and return. For an individual investing in
capital market is much risky then deposit it into a bank with a fixed rate of 12%. Investors will
only come to capital market if the expected return in capital market is somehow around 20%.
Otherwise the investors will withdraw the money from capital market and invest it into fixed
deposit or in saving certificates.

The impact of higher interest rate:

If the bank is paying you 12% interest rate, then bank will charge its customers anywhere
between 15% to 18% on their loans. These Customers are anyone who borrows cash from
bank includes big company, little and medium enterprises, farmers and individuals). This, in
turn, can end in higher borrowing prices for them and thereby disturbs the profitability. A drop
in profits would end in drop in stock prices. If interest rate continues to raise for a long term
then it will have associate all spherical negative impact on the economy, leading it into

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a recessionary mode. E.g. Farmers who borrow cash at higher interest rates to shop for land,
fertilizers, seeds, tractors etc would realize it tough to boost agricultural productivity to match
up with the rising prices. Since agriculture is that the backbone of our economy, high discount
rate would act as a road block to the complete growth trend.
In the short term the immediate impact of rise in interest rate is on companies with high debt in
their balance sheet .The interest payment made by them rises which reduces their EPS. Thus
there would be negative sentiments for such stock; resulting into depleted stock price.
In the long term high interest rate would have more sector specific impact. The sectors which
are most impacted by high interest rate is the real estate, automobile and all the capital
intensive industries. So, any investment by you in these sectors must be taken with a lot of
caution during the situation of high interest rates.

Sector wise impact due to interest rate movement

As already proven stock market and interest rate are inversely related. As the interest rates go
up, stock market activities tend to come down. The following points are also worth taking note:

Industries like cement, large manufacturing units, automobile and fertilizers which are
highly capital intensive and more leveraged would be highly affected by the policy rate
movement. For instance if policy rate goes up then these companies have to bear higher
interest rate burden and their profitability will hamper. Same like if discount rate goes down
then these industries have to pay less interest rate and its bottom line will improve which
will lead to increase in share price.

Companies which are highly leveraged and keeping high amount of debt in their boos would
likely to affect badly in term of profitability if interest rate goes up. An increase in interest
rate means finance cost on these loans would likely to increase which will hamper the
bottom line in profit and loss statement. As the profitability decrease investors are less
likely to invest in that stock which means its share price will go down.

Other sectors like Pharmaceuticals and technology based are less affected by interest rates
because these are more on import oriented business. These sectors are exchange rate

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sensitive and their cost of production highly impacted due to any movement in exchange
rate. For many reason Pharma sector is considered as the defensive secotor against interest
rate and many investors are much likely to invest in Pharma sector to get the advantage.

If it is high interest rate scenario and companies are having low debt in their books then
these companies dont have to be worry about. Because their profitability would not be
affected due to higher cost of finance charges. In the Pakistani capital market Fast Moving
Consumer Goods (FMCG) sector is considered to a less affected due to interest rate as they
are keeping lower debt in their books.

Only sector which is major beneficiary of a hike in discount rate is banking sector. Business
of a bank totally relies on the interest rate. If there is hike in interest rate it means bank will
be getting higher income on its outstanding advances to big companies. Wherein bank also
invest in government papers including T- bills and Pakistan Investment bonds(PIBs), an
increase in interest rate means they will be getting higher interest income. The end result
would be increase in profitability and will investors may expect higher payout from bank
therefore its stock price will go up.

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Conclusion
Investment in Stock market is an interesting business activity. Practitioners and analysts always
try to predict future direction of stock market to spot and outperform the market. Beside this
they also try to measure the risk associated with their investment. They try to find out the
relationship between change in interest rate and stock market movement which help them to
take an appropriate investment decision. Investigators might forecast how financial market
changes if micro-economic variables like interest rates in form of KIBOR rate and different Tbills rate and inflation fluctuate on any particular direction. On the other hand, policymakers
may seek linearity of these variables to formulate monetary policies in order to sufficiently and
timely adjust capital market.
I have analyzed the impact of interest rate on the capital market (KSE-100) index prices
movement. After conducting through study we found that short term treasury bills of 3months have high negative correlation of 0.3 with KSE- 100 index at significance level of 0.05.
Whereas on the same significance level 6- months and 12- months T-bills showed negative
correlation of 0.21 and 0.29 respectively with capital market prices movement.
Furthermore we have examined the results of regression between T-bills and KSE-100 share
index. In the regression study between interest rate and capital market, Interest rate on each
type of T- bills was kept as an independent variable. The 3- Months T-Bill is found to be causing
7.71% movement in KSE-100 index. Likewise 6-Months T-Bills and 12- Months B-bills are found
to be causing 3.66% and 7.11% of movement in KSE-100 index share prices.

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APPENDIX
Graphs

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