Impact OF MC, LIR, I, and GCF on RIR

Impact of Market Capitalization, Inflation consumer prices, Gross

capital formation and lending rate of interest on real interest rate
with reference to the United Kingdom

Submitted by Ali Bhutta, Usman Tariq, Waqar Asim and Usman Tariq

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 Impact OF MC, LIR, I, and GCF on RIR

Abstract:
This study is carry on for the purpose to finding the impact of the Market capitalization, inflation
consumer prices, gross capital formation and lending interest rate with reference to the United Kingdom
The key factors that impact the real interest rate are market capitalization, lending interest rate, and gross
capital formation and inflation consumer prices. It is observed in the study that market capitalization and
lending interest rate have more significant impact on real interest rate than gross capital formation and
inflation consumer prices. So the investors that want to invest in any project or want to deposit the money
in bank they can consider the above mentioned factors which are explain the real interest rate in broad
terms for United Kingdom. For the further future analysis we recommend that the number of independent
variables can be increased that are not included by our model of study.

Key terms:
In this article we are going to use some keywords as observations here these are the explanations about
them,

MC is Market Capitalization

LIR is Lending Interest Rate

I is Inflation

GCF is the Gross capital formation

RIR is Real interest rate

Introduction:

This article is written on the impact of the market capitalization, lending interest rate, inflation, consumer
prices and gross capital formation on real interest rate. This tells us that what the relation between these
different variables. To show the relation of these variables we have use time series date and some
regression, VIF and other tests. There is some background of these variables here,

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 Impact OF MC, LIR, I, and GCF on RIR

Exchange-rate risk

Exchange-rate risk, also called currency risk, is the risk that changes in the relative value of certain
currencies will reduce the value of investments denominated in a foreign currency.

The risk that a business' operations or an investment's value will be affected by changes in exchange rates.
For example, if money must be converted into a different currency to make a certain investment, changes
in the value of the currency relative to the American dollar will affect the total loss or gain on the
investment when the money is converted back. This risk usually affects businesses, but it can also affect
individual investors who make international investments. It is also called currency risk.

Market capitalization
Market capitalization or market cap is the market value of a company's issued share capital in other
words, Number of shares multiplied by the current price of those shares on the stock market. Companies
are ranked as large-cap, mid-cap and small-cap depending on their market capitalization (market cap),
though the actual criteria for classification depend on the market concerned.

If a company has 35 million shares outstanding, each with a market value of $100, the company's market
capitalization is $3.5 billion (35,000,000 x $100 per share).

Lending Interest Rate:

The rate lending rate is that you have to pay to a bank or other financial institution when you borrow
money from them. The amount charged, expressed as a percentage of principal, by a lender to a borrower
for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage
rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or
building. Interest is essentially a rental, or leasing charge to the borrower, for the asset's use. In the case of
a large asset, like a vehicle or building, the interest rate is sometimes known as the "lease rate". When the
borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered
high risk, the interest rate that they are charged will be higher.

Inflation Rate:
Inflation is the rate at which the general level of prices for goods and services is rising and, consequently,
the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation,
in order to keep the economy running smoothly.

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 Impact OF MC, LIR, I, and GCF on RIR

Gross capital formation:

Gross capital formation (formerly gross domestic investment) consists of outlays on additions to the fixed
assets of the economy plus net changes in the level of inventories. Fixed assets include land
improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; and the
construction of roads, railways, and the like, including schools, offices, hospitals, private residential
dwellings, and commercial and industrial buildings. Inventories are stocks of goods held by firms to meet
temporary or unexpected fluctuations in production or sales, and "work in progress." According to the
1993 SNA, net acquisitions of valuables are also considered capital formation.

Research questions:
We want to work on these research questions here

Is there is any change in real interest rate due to change in market capitalization?

Is there is any change in real interest rate due to change in consumer inflation?

Is there is any change in real interest rate due to change in lending interest rate?

Is there is any change in real interest rate due to change in gross capital formation?

Is there any change in real interest due to change in market capitalization, consumer inflation, lending
interest rate, gross capital formation if all other circumstances remain constant?

Is there no any change in real interest due to change in market capitalization, consumer inflation, lending
interest rate, gross capital formation if all other circumstances remain constant?

How much change in real interest accrue due to change in market capitalization, consumer inflation,
lending interest rate, gross capital formation if all other circumstances remain constant?

Search objective
We want to consider the impact of these variables (market capitalization, inflation, gross inflation on the
real interest rate the results of this research will add good value to the knowledge of the readers that how
he can understand that what are the basic elements behind the changes of the real interest rate in the
economy. And how much the real interest depend upon these factors that will elaborate that if some wants
to check the interest rate of the loan or investment so he can understand it by this article

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Literature review:
The significance of inflation, market capitalization, gross capital formation, and the economic sentiment
indicator for stock market indices has been examined extensively in the international literature. Numerous
researchers consider any of these factors to be a reliable indicator of future stock market movements real
interest rates. However, the methodological approaches among the empirical studies are not similar, since
different statistical models are applied to capture the significance of each variable in the determination of
stock prices. The major findings regarding the correlation between these variables and the stock market
are presented here.

(Dornbusch 1976)Utilizing bank-level information for 80 nations in the years 198895, this article
demonstrates that distinctions in premium edges and bank benefit mirror an assortment of determinants:
bank attributes, macroeconomic conditions, unequivocal and verifiable bank tax assessment, store
protection regulation, general money related structure, and hidden lawful and institutional markers. A
bigger proportion of bank advantages for total national output and a lower business sector fixation
proportion lead to lower edges and benefits, controlling for contrasts in bank action, influence, and the
macroeconomic environment. Remote banks have higher edges and benefits than local banks in creating
nations, while the inverse holds in mechanical nations. Likewise, there is proof that the corporate taxation
rate is completely passed onto bank clients, while higher store prerequisites are not, particularly in
creating nation this tells us that there are variations in the Real interest due to change in Market
capitalization.

(Barr and Campbell 1997)This paper tells us expected future real interest rates and inflation rates from
observed prices of UK government nominal and index-linked bonds. The estimation method takes
account of imperfections in the indexation of UK index-linked bonds. It assumes that expected log returns
on all bonds are equal, and that expected real interest rates and inflation follow simple time-series
processes whose parameters can be estimated from the cross-section of bond prices. The extracted
inflation expectations forecast actual future inflation more accurately than nominal yields do. The
estimated real interest rate is highly variable at short horizons, but comparatively stable at long horizons.
Changes in real rates and expected inflation are strongly negatively correlated at short horizons, but not at
long horizons.

(Subeniotis, Papadopoulos et al. 2011)In this article we map the relationship between the EU-12 stock
market price indices and four crucial macroeconomic factors, using panel data analysis. The examined
variables are market capitalization, industrial production, the economic sentiment indicator, and inflation,

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 Impact OF MC, LIR, I, and GCF on RIR

while the twelve countries are those which have adopted the euro. The empirical results reveal a strong
effect of the first three factors, while inflation has a negative but not statistically significant coefficient.
Further, the variables that affect the stock markets positively are market capitalization and the economic
sentiment indicator. Finally, an applied statistical model confirms the significant convergence of the EU-
12 stock markets in the long run, indicating a low geographic diversification across European markets.

(Jaffe and Mandelker 1976)A report tells a negative relationship between annual stock returns and
concurrent rates of inflation over short sample periods, but a positive relationship over the much longer
period from 1875 to 1970.

There was one more concept by (Boudoukh and Richardson 1993) who examine stock returns and
inflation using one-year and five-year periods during 18021990 in the US and UK, also find inflation to
have a positive long-run effect.

(Anari and Kolari 2001)examine monthly time series of stock price indices and goods price indices for six
industrialized countries from 1953 to 1998, and estimate the long-run Fisher effect. They explain that
inflation has long lasting effect on the real interest rate of the economy The model applied in their study is
the following:

(Naceur and Ghazouani 2007)l. measure stock market liquidity using the ratio between total values traded
and market capitalization and find that liquidity has a positive impact on the stock market, since larger
amounts of savings are channeled through the stock markets. Their estimation of both fixed and random
effect specifications was carried out using an econometric methodology.

Finally, the studies by Chen (1991), (Estrella and Hardouvelis 1991)are earlier examples which confirm a
positive relationship between the spread of long-term and short-term interest rates, which have a strong
impact on stock markets and the economic sentiment indicator.

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 Impact OF MC, LIR, I, and GCF on RIR

Conceptual framework:
This article is written on the impact of the market capitalization, lending interest rate, inflation, consumer
prices and gross capital formation on real interest rate. This tells us that what the relation between these
different variables. We consider that there will be the change in the real interest due to change in the
market capitalization, lending rate, inflation and gross capital formation so this study will be something
like this

Lending rate inflation

Market Gross capital

capitalization Real formation
interest
rate

Research methodology:
In this article the research is made on the base of the quantitative data. We collect the date of the different
years and different states of the United Kingdom to show the impact of the IVS on the DV.

We have developed following hypotheses for this research here.

Null hyp:
There is no change in RIR due to change in MC, LIR, I and GCF

Alternative hyp:
There is change in RIR due to change in MC, LIR, I and GCF

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 Impact OF MC, LIR, I, and GCF on RIR

Variables:
In this article we are working on these variables.

Dependent variable:
Real interest rate
Exchange-rate risk, also called currency risk, is the risk that changes in the relative value of certain
currencies will reduce the value of investments denominated in a foreign currency.

Independent variables:
Market capitalization
Capital formation
Inflation consumer prices
Lending interest rate

Relation in key variables:

Lending rate inflation

Market Gross capital

capitalization Real formation
interest
rate

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 Impact OF MC, LIR, I, and GCF on RIR

Key findings:
Key findings of our work are here explained in detail.

If there is one unit change in market capitalization there will be .013515 unit positive changes in real
interest rate which is significant at 6.6%.

If there is one unit change in lending interest rate there will be .5328484 unit positive change in real
interest rate which is highly, highly significant at 0.2%.

If there is one unit change in inflation, consumer prices there will be -.1012293 unit negative changes in
real interest rate which is insignificant at 6.26%.

If there is one unit change in Gross Capital Formation there will be .0860065 unit positive changes in real
interest rate which is not significant at 7.22%.

Final results:
Here are the results of our work.

In table 1

Table 1

Interpretation of R2 and adjusted R2:

R2 is basically the value of variation in dependent variable which is Real Interest Rate as explained by all
the independent Variables which are Market Capitalization, Lending Interest rate, Inflation consumer
price, Gross Capital Formation of our model. R2 of our study is 74.07 which is explaining the fact that
there is 74.07% variation in dependent variable that is real interest rate is due to all independent variables
which are Market Capitalization, Lending Interest rate, Inflation consumer price, Gross Capital Formation
of the model. This value is much high and we can conclude that remaining 25.93% variation is due to
some other factors which are not included in the model of the study. It is denoted by E the error term.

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 Impact OF MC, LIR, I, and GCF on RIR

Adjusted R2 is basically the adjusted value of R2 as per the sample size of the study. Better the sample size
means that better the value of adjusted R2 this is smaller than R2. . The value of adjusted R2 is 69.75%
which is less than the value of R2 that is 74.04% which is high than the value of adjusted R2.

If we want to have a decision on the basis of this analysis we will do the decision on the basis of R2.

Regression Model: (Table 2)

Table 2

real interest rate Coef. Std. Err. t P>|t| 95% Conf. Interval
market capitalization 0.0135158 0.0070039 1.93 0.066 -0.0009396 0.0279712
Lending interest rate 0.5328484 0.1517301 3.51 0.002 0.2196928 0.846004
Inflation consumer prices -0.1012293 0.2050466 -0.49 0.626 -0.5244248 0.3219661
Gross capital formation 0.0860065 0.2392116 0.36 0.722 -0.407702 0.5797149
_cons -3.469293 4.061422 -0.85 0.401 -11.85166 4.91307

Interpretations of regressions:
Explanations of Table 2

If there is one unit change in market capitalization there will be .013515 unit positive changes in real
interest rate which is significant at 6.6%.

If there is one unit change in lending interest rate there will be .5328484 unit positive changes in real
interest rate which is highly, highly significant at 0.2%.

If there is one unit change in inflation, consumer prices there will be -.1012293 unit negative changes in
real interest rate which is insignificant at 6.26%.

If there is one unit change in Gross Capital Formation there will be .0860065 unit positive changes in real
interest rate which is not significant at 7.22%.

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 Impact OF MC, LIR, I, and GCF on RIR

Correlation model: (Table 3)

Table 3

real
market lending inflation gross capital
interest
capitalization interest rate consumer prices formation
rate
real interest rate 1

market
0.3741
capitalization 1
0.0456
lending interest 0.813 0.1324 1
0 0.4935
inflation
0.0788 -0.3818 0.3196
consumer prices 1
0.6844 0.041 0.091
gross capital
0.734 0.2923 0.7903 -0.0601
formation 1
0 0.1239 0 0.7567

Interpretations of correlation:
Explanation of table 3

Real interest rate and market capitalization are low and positively correlated at 0.37 and highly significant
at 4.5%. Lending interest rate is highly positively correlated with real interest rate and weakly correlated
with market capitalization at 0.813 and 0.1324 respectively. The correlation between lending interest rate
and real interest rate is highly, highly significant where as the correlation between lending interest rate
and market capitalization is insignificant.

Inflation consumer prices is weakly and positively correlated with real interest rate and low positively
correlated with lending interest rate at 0.0788 and 0.3196 respectively where as it is weakly and
negatively correlated with market capitalization at -0.3818. Correlations of Inflation consumer prices with
market capitalization are lending interest rate are highly significant and significant respectively. Here the
correlation between Inflation consumer prices and real interest rate is insignificant.

The correlation between Gross capital formations with real interest rate is good and positive, with market
capitalization is low and positive, and with lending interest rate highly and positively correlated at 0.7340,
0.2923 and 0.7903 respectively. Significance of correlation among Gross Capital Formation with Real

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 Impact OF MC, LIR, I, and GCF on RIR

interest rate and lending interest rate are highly, highly significant. The correlation of gross capital
formation and market capitalization is insignificant.

VIF TEST: (Table 4)

Table 4

Variable VIF 1/VIF

lending interest rate 4.19 0.23854
gross capital formation 3.78 0.264487
inflation consumer prices 1.8 0.556654
market capitalization 1.29 0.776164
Mean VIF 2.76

Interpretation of VIF:
Explanation of table 4

In order to check the problem of correlation is either, low or reasonable. We have to go for VIF test, If the
mean value of VIF is less that % than we can conclude that the level of correlation problem is
low/reasonable. So we can go for further analysis by considering all the variables in the model.

In our study the mean value of VIF is 2.76 is less than 5 which shows that our study is good fit for further
analysis.

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 Impact OF MC, LIR, I, and GCF on RIR

Conclusion:
Form the above discussion it can be concluded that real interest rate is impacted by many different
variables. The key factors that impact the real interest rate are market capitalization, lending interest rate,
and gross capital formation and inflation consumer prices. It is observed in the study that market
capitalization and lending interest rate have more significant impact on real interest rate than gross capital
formation and inflation consumer prices. So the investors that want to invest in any project or want to
deposit the money in bank they can consider the above mentioned factors which are explain the real
interest rate in broad terms for United Kingdom. For the further future analysis we recommend that the
number of independent variables can be increased that are not included by our model of study.

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 Impact OF MC, LIR, I, and GCF on RIR

Bibliography:
Anari, A. and J. Kolari (2001). "Stock prices and inflation." Journal of Financial Research24(4): 587-602.

Barr, D. G. and J. Y. Campbell (1997). "Inflation, real interest rates, and the bond market: A study of UK
nominal and index-linked government bond prices." Journal of Monetary Economics39(3): 361-383.

Boudoukh, J. and M. Richardson (1993). "Stock returns and inflation: A long-horizon perspective." The
American economic review: 1346-1355.

Dornbusch, R. (1976). "Expectations and exchange rate dynamics." The journal of political economy:
1161-1176.

Estrella, A. and G. A. Hardouvelis (1991). "The term structure as a predictor of real economic activity."
The Journal of Finance46(2): 555-576.

Jaffe, J. F. and G. Mandelker (1976). "The value of the firm under regulation." The Journal of
Finance31(2): 701-713.

Naceur, S. B. and S. Ghazouani (2007). "Stock markets, banks, and economic growth: Empirical evidence
from the MENA region." Research in International Business and Finance21(2): 297-315.

Subeniotis, D. N., et al. (2011). "How Inflation, Market Capitalization, Industrial Production and the
Economic Sentiment Indicator Affect the EU-12 Stock Markets." European Research Studies14(1): 105.

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