-1-

Pir Mehr Ali Shah

Arid Agriculture University
Rawalpindi.
University Institute of Management Sciences (UIMS).

Research Project
(MGT 799)
Research On:

Impact of Interest Rate on Karachi Stock Exchange

Submitted In Respect Of:

Sir, Ahmed Raza

Submitted By:
Aamish Hameed Khan

(07-Arid-406)

Shahid Mehmood

(07-Arid-445)

Omer Javed

(07-Arid-454)

M. Shoaib

(07-Arid-451)
MBA-4th
(Finance)
Section A

-2-

TABLE OF CONTENTS
SEARIL
NO.

DESCRIPTION

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

-3-

DEDICATION
We dedicate this research project to our
Respected parents and teachers whose
Prayers enable us to perform every task efficiently.

-4-

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.

-5-

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.

-6-

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.

-7-

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.

-8-

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.

-9-

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 macroeconomic 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

- 10 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 macroeconomic 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.

- 11 -

Nil Gunsel and Sadik Cukur (2007) investigated the effects of macroeconomic 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.

- 12 -

DATA AND METHODOLOGY

INTEREST RATE
Independent variable

STOCK
RETURNS
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.

- 13 -

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 highquality 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 ttest 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.

- 14 -

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: P0 (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.

- 15 -

Appendix 1

- 16 -

TO FIND CORRELATION
Date

T Bill
Rates (X)

Jan-01
Feb-01
Mar-01
Apr-01
May-01
Jun-01
Jul-01
Aug-01
Sep-01
Oct-01
Nov-01
Dec-01
Jan-02
Feb-02
Mar-02
Apr-02
May-02
Jun-02
Jul-02
Aug-02
Sep-02
Oct-02
Nov-02
Dec-02
Jan-03
Feb-03
Mar-03
Apr-03
May-03
Jun-03
Jul-03
Aug-03
Sep-03
Oct-03
Nov-03
Dec-03
Jan-04
Feb-04
Mar-04
Apr-04
May-04
Jun-04
Jul-04
Aug-04
Sep-04
Oct-04

10.96
11.55
11.54
11.56
12.53
12.07
10.92
10.50
10.35
8.35
8.04
7.06
6.02
6.46
6.47
6.40
6.35
6.34
6.40
6.38
6.34
5.56
4.32
3.51
3.19
2.09
1.64
1.73
1.66
1.21
1.21
1.61
1.61
1.66
1.64
1.64
1.68
1.77
1.77
1.84
2.08
2.08
2.52
2.62
3.00
3.19

KSE Index
1461.6
1423.18
1324.41
1367.05
1377.61
1366.43
1228.89
1258.43
1133.43
1406.05
1358.16
1273.06
1620.18
1765.95
1868.11
1898.95
1663.34
1770.11
1787.59
1974.58
2018.75
2278.54
2285.87
2701.41
2545.07
2399.14
2715.71
2902.41
3099.04
3402.47
3933.37
4461.47
4027.34
3781.03
4068.29
4471.6
4841.33
4840.37
5106.66
5430.43
5497.79
5279.18
5289.92
5346.15
5217.65
5332.24

KSE
Returns (Y)
1000
973.71374
930.59908
1032.19547
1007.72466
991.88450
899.34354
1024.03795
900.66988
1240.52654
965.94004
937.34170
1272.66586
1089.97148
1057.84988
1016.50866
875.92617
1064.19012
1009.87509
1104.60452
1022.36931
1128.68854
1003.21697
1181.78637
942.12652
942.66169
1131.95145
1068.74814
1067.74715
1097.91097
1156.03370
1134.26146
902.69351
938.84053
1075.97401
1099.13502
1082.68405
999.80171
1055.01439
1063.40152
1012.40417
960.23675
1002.03441
1010.62965
975.96401
1021.96199

- 17 Nov-04
Dec-04
Jan-05
Feb-05
Mar-05
Apr-05
May-05
Jun-05
Jul-05
Aug-05
Sep-05
Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06
Apr-06
May-06
Jun-06
Jul-06
Aug-06
Sep-06
Oct-06
Nov-06
Dec-06
Jan-07
Feb-07
Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08

3.73
3.73
4.16
4.79
5.35
7.08
7.82
7.92
7.97
8.08
8.14
8.14
8.20
8.25
8.28
8.29
8.29
8.29
8.29
8.45
8.50
8.80
8.80
8.80
8.80
8.80
8.80
8.80
8.80
8.90
8.90
8.90
8.90
9.10
9.10
9.10
9.20
9.30
9.30
9.60
9.80
9.89
10.49
11.49

5567.79
6218.4
6747.39
8260.06
7770.33
7104.65
6857.67
7450.12
7178.93
7796.86
8225.66
8247.37
9026.59
9556.61
10523.37
11456.12
11485.9
11342.17
9800.69
9989.41
10497.66
10063.54
10512.52
11327.71
10619.47
10040.5
11272.33
11180.02
11271.59
12369.7
12961.14
13772.46
13739.53
12214.26
13353.68
14321.39
13998.52
14077.16
14016.94
14934.3
15125.89
15122.47
12130.51
12289.03

CORRELATION IS: -

- 0.2448

1044.17468
1116.85247
1085.06851
1224.18594
940.71108
914.33054
965.23685
1086.39232
963.59924
1086.07550
1054.99650
1002.63930
1094.48103
1058.71763
1101.16140
1088.63605
1002.59948
987.48640
864.09303
1019.25579
1050.87888
958.64602
1044.61452
1077.54468
937.47721
945.48033
1122.68612
991.81092
1008.19050
1097.42281
1047.81361
1062.59635
997.60900
888.98674
1093.28604
1072.46766
977.45540
1005.61774
995.72215
1065.44652
1012.82886
999.77390
802.15137
1013.06788

- 18 -

Appendix 2

TESTING FOR SIGNIFICANCE OF CORRELATION

= 10%

- 19 /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
df= N-2

Level of significance for two-tailed test

- 20 N = number of pairs
of data

.10

.05

.02

.01

.988

.997

.9995

.9999

.900

.950

.980

.990

.805

.878

.934

.959

.729

.811

.882

.917

.669

.754

.833

.874

.622

.707

.789

.834

.582

.666

.750

.798

.549

.632

.716

.765

.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

- 21 30

.296

.349

.409

.449

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

- 22 -

Appendix 3

- 23 -

T-BILLS RATES MOVEMENT

- 24 -

KSE RETURNS

- 25 -

RATES VS RETURNS

- 26 -

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

- 27 -

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