Impact of Risk Free Rate (T-Bill) on Stock Returns

A Research Project
On
Impact of Risk Free Rate (T-Bill) on Stock Returns
KSE 100 index (Karachi Stock Exchange of Pakistan)

Submitted to:
Madam Bushra Nasreen
Degree Title:
MBA Finance (Evening)
Course Title:
Research Project
Course Code:
MGT-799
Submission Date:
July 27, 2010
Submitted By:
Asif Younas (08-Arid-1559)
Waseem Rana (08-Arid-1605)
Mehmood Akhtar (08-Arid-1582)

Pir Mehr Ali Shah

University of Arid Agriculture, Rawalpindi
University Institute of Management Sciences

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Plagiarism Certificate:

It has been certified that the research report submitted by:

Mehmood Akhtar (08-arid-1582)

Waseem Rana (08-arid-1605)
Asif Younas (08-arid-1559)

Was/wasn’t within the specified limits of plagiarism and was/wasn’t in accordance to

Standards specified by the institute.

Certified by

----------------------
Madam Bushra Nasreen
(Supervisor)

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Evaluation Form:

Mehmood Akhtar (08-arid-1582)

Waseem Rana (08-arid-1605)
Asif Younas (08-arid-1559)

Research report submitted for Final Evaluation in Partial Fulfillment of the

requirements for the Degree of

Masters of Business Administration (MBA)

It is certified that, the Research report and the work contained in it conforms to all the
standards set by the Institute for the evaluation of any such work.

1. ------------------------
Madam Bushra Nasreen
(Supervisor)

2. -------------------------
Mr. Abdul Rehman

3. ------------------------

University Institute of Management Sciences

PMAS-University of Arid Agriculture Rawalpindi
2010

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Dedication:

My Loving Parents:
Who always prayed for my success & their love and affection have always been a
source of inspiration for me to difficulties, this taught me a lot about life.

My Respected Teachers:
Who always provide us knowledge, skills and guidance that become a successful way
in our life.

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Table of contents:

1. Abstract
2. Introduction
3. Literature Review
4. Methodology
 Hypothesis Test
 Simple Regression Model
 Correlation
 Coefficient of Determinant
5. Results
6. Discussion
7. Conclusion
8. References

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Abstract:

In this research project, we examine or analyzed the impact of risk free rate (T-Bill)
on stock market return (KSE 100 index) on the bases of last ten years (2000-2009)
historical time series data. For this purpose, we used Simple Regression Model as
well as Correlation Matrix. In this case, KSE 100 index is taken as dependent variable
and T-Bill rate is taken as an independent variable. Our findings or results are; risk
free rate has significant impact on stock market return but it is only 5.7 percent. T-Bill
rate and KSE 100 index have opposite direction because its regression coefficient is
negative. When T-Bill rate increase then KSE 100 index will decrease and vise versa
because, we analyzed it has inverse relationship. Also weak correlation exists between
Risk free rate and Stock Return.

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Introduction:

In this research paper, we examine the quantitative effect of risk free rates on stock
market return data because some investors have positive point of view while some
investors have negative point of view about it. T-Bill rate is an important element to
control the money supply and interest rate in the economy which is issued by the
Central Bank of the country.
Central bank of the country regulates the banking sector as well as organized the
money market. Stock market plays an important role in facilitating productive
investments and promoting economic growth. So, the Pakistani Gov’t felt in
September 1948 to established Karachi Stock Exchange Market later on which is
converted into guarantee limited company in 1949 and that time its paid up capital
Rs.108. Later on, two stock markets were established in Pakistan one at Lahore (LSE)
and other at Islamabad (ISE) in 1970 and 1989 respectively.
In this case, we consider the KSE 100 index because its index made on top 100
companies and it is a large index as compare with other Pakistani stock exchanges.
Stock exchange also provide necessary refreshment to institutions working for
promoting good quality of thrift, in carrying out their aims and the main objectives are
to attract savings and to utilize them profitability for the development of industrial.
With these actions of the capital markets base of industrial finance has greatly
widened the investment opportunities and a large number of small investors are
encouraged to put their savings in equity market investment.
In other words, investors while making the investment decisions investors consider
expected return, expected risk and the expected volatility upon the available
information. Thus, the stock markets activities are generally governed by information.
While the systematically spread information determines the long-term trend and
fundamental strength of the stock market, information that comes as good or bad news
becomes a cause shocks to the stock markets and results in volatility.
Rate of return on the security is free from default risk is called risk free rate (T-Bill
rate). Theoretically the rate of return where the beta is zero is the risk free rate. The
CAPM (Capital Asset Pricing Model) predicts the relation in the risk of assets and its
expected returns. This relation is in two ways. First, it provides a benchmark for

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

evaluating various investments. Second, it helps us to predict about the return of

assets which has not been traded in the stock market.
Risk free rate is essential part of every return computed on financial assets. The SML
(Security Market Line) shows the relationship between the expected return and
standard deviation of a single stock while CML (Capital Market Line) reflects the
relation in risk free rate & straight line emanating from risk free rate (Rf) to tangential
to the efficient Merkowitz frontier.
Investors combine their un-correlated securities that help them to reduce the risk of a
portfolio. They wanted to know about the reasonable level of risk reduction about
their portfolio. Research shows that what will happen to portfolio risk if randomly
selected stocks are combined to equally weighted portfolio. Portfolio risk is the
standard deviation of that stock. As the number of uncorrelated stocks held in the
portfolio is increases, the total risk of the portfolio reduces.
The total risk is the combination of systematic risk and unsystematic risk. The first
Systematic risk is the risk that affect the overall market and that cannot be avoided
such as changes in the economies, world political situation, world economic situation
& world energy situation and this kind of risk cannot be minimized through
diversification. Second is unsystematic risk and it is unique to particular company. It
is a type of risk that can be minimize through proper diversification. Investors always
want to some compensation for taking systematic risk.

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Literature Review:

Leroi Raputsoane (2009) has conducted a research on Relationship between Risk

and Stock Return. In his research, the author examines risk return relationship evident
from South African Stock market return on the base of 8 years historical data. He
analyzed the risk return relationship by using GARCH in mean model. According to
his findings, 95% stock prices index show a positive relationship between risk and
return but only 5% stock prices show negative relationship due to methodological
approach as well as data frequency. Finally, the result of this research paper is about
positive relationship. So, the behave South Africa stock market is according to
standard CAPM (Capital Assets Pricing Model). CAPM show the direct relationship
between risk and market return (high risk and high return, low risk and low return).

John Beirne (2009) has conducted a research on Effect of Interest & Exchange Rate
on Stock market Return. In this paper, the author examine the sensitivity between the
interest rate, stock market return and exchange rate risk in banking and insurance
sectors on the basis of 20 years historical data among the 16 countries by using
GARCH-M model, causality in mean, causality in variance and t-statistics. His
findings are, according to his published research paper, stock market return has a
positive effect on all financial sectors return but interest rate and exchange rate risk
has a mixed effect on financial sectors in short term as well as in long term in return.
In this article, the researcher before 1979 find negative relationship and after this
author finds positive relationship between exchange rate risk and market return but
not find clear pattern across 16 countries. According to researcher, exchange rate has
a positive effect in all Euro economies but negative effect in the rest of world. Interest
rate and exchange rate has not equally clear effect on stock market return in all 16
countries.

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Atilla Cifter & Alper Ozun (2007) have conducted a research on Estimating
Effects of Interest Rate on Stock Market Index. In his article, the authors examine the
interest rate effects on Turkish stock market index on the 3 years daily bases historical
data by using Granger-causality test. This test is used for the determination of cause
and effects. According to their research, they found that long term interest rates have
impact on Istanbul Stock 100 index. Effects of changes in interest rates are increases
on stock exchange prices with increase of time scale. Interest rate negatively effects
on stock market index as compared with investors predictions. So, investor should
make decision according to the volatility in interest rates.

Konsetantines Drakos have conducted a research on Interest Rate Risk and

Common Stock Returns. They in their article used two econometric methodologies to
find out interest rate sensitivity of Greek Banks common stock returns. First, within a
single equation framework where allowing for time volatility of banks excess returns
the null of zero interest rate sensitivity was rejected in 7 banks out of 9 banks. This
opinion suggests that the bank stock return shows significant sensitivity to interest
rates movements. Second, the interdependent nature of banks excess return, a
Seemingly Unrelated Regression Model (SURE Model, by Zellner in 1962) was used
where cross equations dependencies were allowed. Having the advantage of
simultaneously estimation of interest rate sensitivities, a joint test for there
insignificance was rejected, this rejection was the implication of banks as a group
shows significant sensitivity to interest rate innovation. The Interest rate sensitivity is
uniform across banks was also rejected hat suggest the interest rate effects is banks
specific. As a result of these rejections of uniformity hypothesis an empirical
investigation as to which are possible determinants of the cross-sectional variations,
of interest rate sensitivity coefficient was pursued.

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Nosheen & faiza (2008) have conducted a research on Interest Rate Volatility and
Stock Return Volatility. In their research, they analysed the changes in interest rate
volatility on stock exchange return on 4 years historical data by using the GARCH
model with interest rate changes as well as ARCH model with out interest rate
changes. According to their research, they found that interest rate has negatively
affected the stock market return. When interest rate increases then investors preferred
to investment in banks saving account rather than invest in stock exchange.

Marc-Gregor Czaja, Hendrik Scholz & Marco Wilkens (2007) have

conducted a research on Interest Rate Risk Rewards in Stock Returns of Financial
Corporation in German market. In their research, the authors analysed the interest rate
risk on stock return on historical data by using the Nelson and Siegel (1987) approach
to model in the term structure. In this article, they focused on influence of interest rate
risk on stock return variability and whether the interest rate risk is priced in equity
markets in order to find out the magnitude of interest rate risk rewards and there
contribution to total stock returns. They were found that the financial institutions have
a higher exposure to interest rate risk as compared to non-financial corporations.
Standard financial theory suggests based on the some assumptions that the same risk
earns the same return in different segments of the capital market but our results
suggest that a large part of the stock returns of particularly financial institutions might
consist of rewards for bearing interest rate risk.

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Gulin Vardar, Gokce Aksoy and Emre Can (2008) have conducted a research
on Effect of Interest and Exchange Rate on Volatility and Return of financial Sector
Prices Index. In their research, the authors analyzed the interest rate volatility in
return on daily bases sector data over 2001 to 2008 period by using GARCH model.
Basically, this paper is about investigation of effect of interest and exchange changes
own sectors and composite returns and volatility in Istanbul Stock Exchange. The
results shows except the services factors evidence shown that index returns decreases
in response to changes in interest rates. Interest rate and exchange rates are highly
significantly affected by the informational arrivals as well as the conditional volatility
is significantly related to the interest rates in all indices but not for services and
industrial sectors.

Alon Brav & Reven Lehany (2002) have conducted a research on Expected
Return and Asset Pricing Model. In their research, the researchers have used CAPM
(Capital Asset Pricing Model) in Wall Street analyst and Value line analyst. They
come up with the following results; Beta and expected return are positively related
when expected return is used rather then realized return. The firm market value of
equity is negatively related to its expected return. The third point is that the book-to-
market value is not a risk factor. This means that there is no evidence that investors
expect high book-to-market stock to generate higher returns then low book-to-market
stock. The intercept in cross sectional regressions is positive. The last important point
in this article is the market expectations are unobservable yet there are several reasons
to believe the expectation they employ here represent at least a significant portion of
markets expectation.

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Guglielmo caporale & Nicola Spagnolo (2008) have conducted a research on

Interest Rate, Exchange Rate and Stock Return Risk. In their article, they investigated
on interest rate and stock market return risk on banking services, financial services
and insurance services sectors on the bases of historical long and short term in
different countries market data by using GARCH-in-mean model. According to their
results, interest rate and exchange rate risk not gives the clear pattern on all sectors
but in majority cases interest rate has negatively effect on stock return in banking,
financial and insurance sectors.

Gerald A. Pogue, Franco Modigliani and Bruno H. (2002) have conducted the
research to test CAPM on European Stock Markets. In this research they had used
trainer, Sharpe and lintner models to justify the CAPM, they had try to explain the
variables like systematic risk, economic stability, political conditions, time intervals
etc. the results of their research shows a positive relationship between return and risk
in the European stock markets while Germany shows an adverse impact they also
explained the causes of this variability some are:- lack of difference between the
portfolio beta results and lack of beta coefficients. They also explained in their
research that if the pricing of risk is rational, institutional factors or thin markets
might create market inefficiencies which were not shown the tests conducted while
studying.

Safdar Hussain Tahir (2009) has conducted a research on Impact of Risk free rate
on Stock market return. In this paper, the author examines relationship between T-bill
rate and KSE 100 index by using Simple Regression as well as correlation model.
According to his results, risk free rate has no impact on stock market return. No
correlation exists between T-bill rates and KSE100 indexes. So, stock market function
has more variables other than risk free rate.

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Methodology:

We use the Simple Regression Model and Correlation Matrix to find out the relation
in risk free rates (T-Bill) & stock market returns. For this purpose, we have collected
the last ten years (2000-2009) historical monthly time series data of T-Bill rates and
KSE 100 index.
Here, we take the T-Bill rates as an independent variable and stock market return as a
dependent variable.

 Formulation of Hypothesis:
Hypothesis formulation is given below:
Ho: T-Bill rate has no effect on KSE 100 index
Hi: T-Bill rate has effect on KSE 100 index

 Simple Regression Model

Simple Regression Model use in the given following form:
Yi = β1 + β2Xi + εi

Here,
Xi = Risk Free Rate’s Value
β1 = Y intercept
β2 = Slope Coefficient
Yi = Stock Market Return’s Value

εi = Error Term

It is estimated by;
y = Sample Value of Stock Market Returns
x = Sample Value of Risk Free Rates
β2 = Estimated Regression Equation’s Slope
β1 = Y – β2 X
X = Mean of the Risk Free Rates
Y = Mean of the Stock Market Returns
n = Number of Samples

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

 Correlation Matrix (r):

Correlation matrix or coefficient of correlation is a statistical method to use for
determined of linear relationship among two variables. Its positive result indicates the
direct relationship between the variables or both variable moves in the same direction.
Its negative result shows the inverse relationship among the variables or both variable
moves in opposite direction. It’s zero result shows the no correlation tendency
between the two variables, either it may be a positive or negative.

 Coefficient of Determinant (r2):

It is a degree of association between independent and dependent variables or it tells
us, how well independent variable explains the dependent variable. It shows the
goodness of fit. It is a square of the correlation coefficient. It shows the variability in
dependent variable due to change in independent variable.

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Results:

Dependent Variable: Y
Method: Least Squares
Date: 07/23/10 Time: 11:13
Sample(adjusted): 1 120
Included observations: 120 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
C 0.062862 0.020109 3.126091 0.0022
X -0.075233 0.028172 -2.670508 0.0086
R-squared 0.056993 Mean dependent var 0.013889
Adjusted R-squared 0.049001 S.D. dependent var 0.092680
S.E. of regression 0.090380 Akaike info criterion -1.953053
Sum squared resid 0.963896 Schwarz criterion -1.906595
Log likelihood 119.1832 F-statistic 7.131613
Durbin-Watson stat 1.901197 Prob(F-statistic) 0.008642

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Discussion:

The above result is obtained from Eviews software by using last ten years monthly
data. According to above result, we reject the null hypothesis because the risk free
rate has significant impact on Stock Exchange Returns, but it is only 5.7 Percent. The
remaining 94.3 percent effect on Stock Return is due to some other unknown factors.
The regression coefficient is -0.075 shows inverse or negative relation in T-bill rates
and Stock Exchange Return. When T-bill rate increases then KSE 100 index shall go
down and vice versa. The correlation coefficient is -0.239 shows weak or low
relationship.

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 Impact of Risk Free Rate (T-Bill) on Stock Returns

Conclusion:

In this research project, we analyzed the impact of risk free rate on KSE 100 index by
using the simple linear regression model as well as correlation matrix on the basis of
monthly time series data. We conclude that T-Bill rate has significant effect on KSE
100 index but it has only 5.7% effect on KSE 100 index. Results show negative
relationship between our variables. That means people are more relaxed in investing
in T-bills when its interest rate is high rather then investing in Stock Exchange.

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 Choi, J., Elyasiani, E. and Kopecky, K. (1992) “The Sensitivity of Bank Stock
Returns to Market, Interest and Exchange Rate Risks”, Journal of Banking and
Finance, 16, 983- 1004

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