International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 50 (2010)

© EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/finance.htm

Do Interest Rate, Exchange Rate effect Stock Returns? A

Pakistani Perspective

Muhammad Ishfaq Ahmad

Junior Lecturer, Lahore Business School, The University of Lahore
E-mail: m.ishfaqahmad@hotmail.com
Tel: 92-333-4622693

Ramiz ur Rehman
Assistant Professor, Lahore Business School, The University of Lahore
E-mail: ramiz_rehman@hotmail.com
Tel: +92-4235321456-60; Fax: +92-4235321760

Awais Raoof
Associate Professor, Lahore Business School, The University of Lahore
E-mail: awais_raoof@hotmail.com
Tel: +92-4235321456-60; Fax: +92-4235321760

Abstract
This study examines the relationship between stock return, interest rate and
exchange rates in Pakistani economy. For this, the data of short term interest rate, exchange
rate (Rs/US $) and stock market returns (KSE-100) over the period of 1998-2009 is
collected. A multiple regression model is applied to test the significance of change in
interest rate and exchange on stock returns. The results show that both the change in
interest rate and change in exchange rate has a significant impact on stock returns over the
sample period.

Keywords: Interest rate, exchange rate and stock returns

Introduction and Literature Review

Interest rates and foreign exchange rates are the key macroeconomic variables of any economy. Interest
rate is the price of borrowing money or it can also be defined as the cost of money. It has a very
significant role in an economy. Any change in interest rate can cause problem for the investors. There
are several types of interest rates available in an economy, including short term and long term interest
rates. Foreign exchange rate on the other hand is the rate at which one currency can be converted into
another currency. Like interest rate, exchange rate is also a very important variable for any economy.
The country’s import and export can suffer if the exchange rate changes abruptly. These two variables
are beyond the control of any corporation, and businessmen always wish a steady change in these
variable. Because a rapid change in these variable can affect the profitability and returns of the
business. That is the very reason; we often see the huge fluctuation in stock market if any change is
observed in these variable.
International Research Journal of Finance and Economics - Issue 50 (2010) 147

As interest rate plays a very important role in returns, many researchers analyze the Impact of
interest rates and foreign exchange rate on stock returns. N’dri.Konan Leon (2008) estimates the
impact of interest rate on stock returns in Korea. For this purpose he took the weekly data on Korean
Stock Price Index 200 (KOSPI) for the period of six years (1992-1998) as dependent variable and
weekly Negotiable Certificates of Deposits (Korea NCD 91-Day yield) for the same time as
independent variable and run the Generalized Autoregressive Conditional Heteroskedasticity(GARCH)
and reported that the Conditional market return have a negative and significant relation with the
interest rate. John Beirne et al (2009) examined the market, Interest rate and Exchange rate risk effect
on the financial Stock returns. To examine this fact they selected three sectors (Banking, Financial
Services and Insurance) of 16 different countries including some European countries. They used four-
variate GARCH-M Model. Their variables were short-term debt (90 Day treasury Bills Rate) and 10-
years Government bond yield for all the countries. Overall results showed that interest rate and
exchange rate effects common in banking sector and financial services but in insurance sector interest
rate and exchange rate have limited effect.
Charles et al (2008) estimated the effect of exchange rate on the stock market in Ghana. By
taking Treasury bill rates, money supply, foreign exchange rate, inflation and trade deficit as
independent variables, using Exponential Generalised Autoregressive Conditional Heteroskedascity
(EGARCH) reported that there is a positive relationship between stock market and consumer price
index. They also found that whenever the inflation rate is high the volatility of stock returns also high.
Overall their result shows that the relationship between macro variables and stock returns are
significant.
Md.Mahmudul Alam and Md.Gazi Salah Uddin (2009) estimated the relationship between
interest rate and stock returns from developed and developing countries. To examined this they collect
the monthly Stock Exchange Index and interest rate from January 1998 to march 2003 of fifteen
countries and run the panel regression. They concluded that there is negative relationship between
interest rate and stock returns.
Manish Kumar (2008) examined the relationship between Stock prices and Exchange Rate. He
collected the daily closing prices of S&P CNX Nifty and INR/ USD exchange rate for the period of
1999-2009. He performed unit root and Co-integration test for long run relationship and linear and
non-linear granger causality test for dynamic relation between these variables and argued that there is
no long-run relationship between stock index and interest rates but there is bidirectional linear and
nonlinear granger causality between stock returns and exchange rates. Barry V. Cozier and Abdual H
Rahman (1988) investigated the stock returns, Inflation and real activity in Canada. Firstly by using
rational expectations forecasting procedure, they decompose Canadian inflation series into expected
and unexpected components. They argued that there is negative relationship between stock returns and
inflation. Fabio Canova, CEPR and Gianni De Nicolo ( 1997) analyze the Stock return , term structure,
inflation and Real activity for US, Japan , Germany and UK and concluded that nominal stock returns
are negatively correlated to inflation only in the US and insignificant for other countries.
Fama (1981) reported that stock market return negatively correlated with the expected inflation
and interest rates. Nikiforos T laopodis (2010) investigate the monetary policy and stock market
dynamics across monetary regimes. For this study, he collected the Fed’s federal funds and S&P 500
index stock prices for the time span of 1970 to 2005, divided it into three monetary regimes of Burns,
Volcker and Greenspan and run vector autoregressive (VAR) model and resulted that throughout each
monetary regime effect of monetary policy on stock returns is significant. Olivier J. Blanchard (1981)
examined Output, the Stock Market, and Interest Rates concluded that initial inflation may lead to
lower real interest rates initially, and to a larger initial change in the stock market. Francesca Carrieri
and Basma Majerbi (2006) examined the pricing of exchange risk in emerging stock markets. They
cover eight countries (Argentina, Brazil, Chile, Mexico, Greece, India, Korea, Thailand and
Zimbabwe) and collect the returns on monthly basis. They express all returns in 30-day Eurodollars
148 International Research Journal of Finance and Economics - Issue 50 (2010)

interest rate as proxy for risk free rate and concluded that common exchange risk factor is marginally
significant for large size port folios.
Sebastian Edwards and Raul Susmel (2003) investigate interest volatility in emerging markets.
They collect the 30-days domestic interest rates of five countries (Argentina, Brazil, Chile, Hong Kong
and Mexico) and GARCH Model and concluded the hypothesis of independence cannot reject. Kaul
(1990) examined the relationship between expected inflation and the stock market and resulted there is
negatively correlated with real activity.
This paper contributes to the existing literature by examining the effect of interest rates and
foreign exchange rate on stock returns in Pakistan perspective. These papers consist of two sections.
Section I explained the Data and methodology and section II the findings and results of the paper.

Methodology And Variable Construction

The stock market returns are the true reflector of the changes in macro economics variable of any
economy. To test this relationship, we collect the data of interest rates, exchange rate and stock market
return from the period of 1998-2009 on yearly basis from the State Bank of Pakistan and Karachi Stock
Exchange respectively. A multiple regression model is applied to test the significance of independent
variables on dependent variable. The model is as follow:

In the above model, the stock market returns are dependent variable while the change in interest
rate and change in exchange rate are independent variables. The sample period which we have selected
for this study is also important because in that decade we have witnessed a phenomenon growth in
stock market as well as very stable interest and exchange rate in Pakistan.

Results And Discussion

The results show that the average stock market return over the period of twelve years is 20%. The
average change in interest rate is -3% during the same period while the average change in exchange
rate is -10%. The standard deviation of stock returns, change in interest rates and change in exchange
rates are 60%, 40% and 30% respectively. (See Table-1)

Table 1: Descriptive Statistics

SR ∆ INT ∆ ER
Mean 0.2 (0.03) (0.1)
Standard
Deviation 0.6 0.4 0.3

The results of multiple regression model show that the R-square is 55% which indicates that the
multiple regression model has very strong power of test with 44% of standard error. The co-efficient of
change in exchange is 2.62 which show a positive relationship with stock return. The p value of change
in exchange rate is 0.01. The test statistics show that the change in exchange rate has a significant
impact on stock market but in positive direction. On the other hand, the change interest rate coefficient
is -1.56 shows its negative relationship with stock returns. The p value of change in interest rate is 0.05
also indicates its significant impact on stock returns. (See Table-2 & 3)
International Research Journal of Finance and Economics - Issue 50 (2010) 149
Table 2: Regression Statistics

Multiple R 0.74
R Square 0.55
Adjusted R Square 0.45
Standard Error 0.44
Observations 12

Table 3: Test Statistics

Co-eff SE t Stat P-value

Intercept 0.26 0.13 2.04 0.07
∆ ER 2.62 0.82 3.18 0.01
∆ INT -1.56 0.68 -2.29 0.05

The ANOVA result shows that the overall multiple regression model is significant with p value
0.03. The results give a clear indication that the change in interest rate and change in exchange rate has
a significant impact on stock returns. (See Table – 4)

Table 4: ANOVA

df SS MS F Significance F
Regression 2 2.09 1.04 5.44 0.03
Residual 9 1.73 0.19
Total 11 3.82

Conclusion
The macro economic variables always have a significant impact on stock market. The change in
interest rate and in exchange rate show its significance on an economy. The increase interest rate
increases the cost of business which ultimately lowers the returns. While a decline in interest rate gives
a positive message to the stock market and stock returns increases eventually. Similar is the case with
the change in exchange rate but in opposite direction.
This paper also analyzes the same results in the Pakistani perspective. The results give a clear
indication that the change in interest rate and exchange rate has a significant impact on stock returns.
The change in interest rate has a negative while change in exchange rate has a positive impact.
150 International Research Journal of Finance and Economics - Issue 50 (2010)

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