Impact Of Interest Rates On Stock Market In India.docx

A study on ‘….’

By Aarish Jain

VI Semester T.Y.B.F.M

Guide Prof. HARSHA

Project Report submitted to the University of Mumbai in partial fulfillment of the requirements of VI semester TYBFM degree examinations 2018-19

Mithibai Motiram Kundnani College, Mumbai – 400050

Mithibai Motiram Kundnani College, Mumbai – 400050

CERTIFICATE This is to certify that Mr.Aarish Jain has worked and duly completed his project work for the degree of Bachelor of Commerce (Financial Markets) under the faculty of Commerce in the subject of Mutual Fund and his project is entitled, “Impact of Interest rates on Stock market” under my supervision.

I further certify that the entire work has been done by the learner under my guidance and that no part of it has been submitted previously for any degree or diploma of any university. It is his own work and fact reported by his personal findings and investigation.

Date of Submission:

Name: Program Head Signature:

DECLARATION I hereby declare that Mr.Aarish Jain has worked embodied in this Project work titled “Impact of Interest rates on Stock Market” forms any own contribution to the research work carried out under the guidance of …… is a result of my own research work and has not submitted previously for any degree or diploma of any university.

Whenever reference has been made to previous work of others, it has been clearly indicated as such and included in the bibliography.

I hereby further declare that all information of the document has been obtained and presented in accordance with academic rules and ethical conduct.

Name and Signature

Certified by Name and Signature of Prof.:

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ACKNOWLEDGEMENT

To list who all have helped me is difficult because they are so numerous and the depth is so enormous.

I would like to acknowledge the following as being idealistic channels and fresh dimensions in the completion of this project. I take this opportunity to thank the University of Mumbai for giving me chance to do this project. I would like to thank my Principal, Dr.Vanjani for providing the necessary facilities required for completion of this project. I take this opportunity to thank our Coordinator Prof., for her moral support and guidance. I would also like to express my sincere gratitude towards my project guide Prof. , whose guidance and care made the project successful.

I would like to thank my College Library, for having provided various reference books and magazines related to my project. Lastly, I would like to thank each and every person who directly or indirectly helped me in the completion of the project especially my Parents and Peers who supported me throughout my project.

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INDEX Sr No.

Particulars

Page No.

1.

Executive Summary

6-8

Introduction

9-42

1.1 Interest Rates 1.2 Why Do Interest Rates Change? 1.3 Reasons for changes in Interest Rates 1.4 Advantages & Disadvantages of Interest Rate Effects 1.5 Data of Current Interest Rate 1.6 Impact of Interest Rates on Stocks 1.7 Rise in Interest Rates 2.

Research Methodology

43-47

2.1 Research Objective 2.2 Hypothesis Development 2.3 Scope of the Study 3.

Literature Review

48-57

4.

Data Analysis, Interpretation & Presentation

58-70

4.1 Data collection and Analysis 4.2 Analysis and Interpretation 5.

Conclusions & Suggestions

71-72

3

EXECUTIVE SUMMARY India has entered the high growth trajectory since the last many years. The economic growth rate during the last decade (2000s) was 7.3%, supported by robust growth in many segments in the industry and services sectors. Now, the per capita income in India doubles in very few years, domestic consumption is growing at a fast pace and consumer markets are expanding each day, savings and investment rates are now comparable to many competitive economies. India is a home to 1.21bn people, which is about 17.4% of the global population.

Stocks and gold are the major Investments avenues for Indians. As gold is one of prime financial assets which can be used as hedge against inflation, the close relationship between stock market and gold prices are to be observed and analysed. The aim of this study is to analyze the causal effects of Indian Stock Market on Gold prices and silver prices. . In past two decades, prices of gold have been highly volatile. It is not surprising, because gold prices are probably influenced by common macroeconomic fundamentals like, GDP, Growth Rate, Exchange Rate, Interest Rate, Inflation, SENSEX and Forex Reserves. So it is important to understand how bullion market is affected by Indian Stock market and Macroeconomic Indicators of India.

The study was carried out with an objective of studying the long term relationship between Indian Stock Market and Bullion Market and Cause and Effect Relationship between Indian Stock Market and Bullion Market. It also aimed at identifying the relationship of macroeconomic variables with Indian Stock Market and Bullion Market.

The scope of the study was confined to the impact of NSE Index & BSE SENSEX on Gold Prices for a ten year period. Also other macroeconomic variables, which have an indirect effect on the selected variables, were identified, using data of 20 years’ time period. The study period has its own contemporary economic, political, and social situations and environment which might affect the prices of the scripts and Gold.

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Thus, results are subject to overview of the situations and environment prevailing at that time.

This paper analyses the relationship between interest rates and stock prices in the context of India. The objectives of the paper are to investigate the impact of interest rates on stock prices and build a model for forecasting stock prices based on interest rates. Karl Pearson’s coefficient of correlation and linear regression model have been applied on the time series data of eleven sectoral indices published by National Stock Exchange and Bank rates published by Reserve Bank of India for a 10 year period from 2005 and 2014. Karl Pearson’s coefficient of correlation is tested for significance and coefficient of determination is also computed to assess the extent of fit of the regression model in forecasting the stock prices. The results show that six sectors (auto, bank, FMCG, financial services, IT and Pharma) out of eleven sectors were significantly impacted by the interest rate. The overall market represented by the market index (Nifty Fifty) was also impacted by the interest rate. Keywords: Interest rate, Stock prices, Karl Pearson’s coefficient of correlation, Linear Regression Model

The research is empirical in nature. The time tested data on the selected variables was collected. A causal research was carried out between the variables, using various econometric models. Judgmental sampling was used to consider the values of the selected variables for the above said period. The data regarding the selected variables were taken from various websites such as www.bseindia.com, www.nseindia.com, www.rbi.org.in, www.goldpricenetwork.com and www.moneycontrol.com.

First the Augmented Dickey Fuller Unit root method was used to test whether the selected variables are Stationary using log values of the variables. . Then Johnson co integration test has been employed in the present research work to study the long term relationship between Indian Stock Market Indices and Gold Prices. Granger Causality test was used to find the causal relationship between the variables. Further, to study the impact of other Macroeconomic Variables on the Indian Stock Market Indices and on gold price, Regression Analysis was applied.

The primary conclusion from both the Augmented Dickey Fuller illustrate that the variables are not stationary at level and so were differentiated to make them stationary 5

at lag 1 or lag 2, which is a pointer of long-run relationship or co integration relationship. Co integration test results indicate that there is no long-term co integration between Monthly average gold price, Silver price and Monthly closing levels of Nifty and SENSEX. So they can’t be predicted on the basis of each other. The granger causality test concludes that, Gold, Silver, Nifty and SENSEX do not Granger Cause each other. BSE SENSEX and NSE Index are not affected by gold price and silver price and vice versa, that determines the independency and maturity of Indian capital market. BSE SENSEX and NSE have low impact on the behaviour of gold pricing. But they affect gold price negatively. Rise in BSE SENSEX indicates the higher flow of capital to share market in comparison to gold market. Gold price in India was increased during the study period because of stock market reaction in India along with other macro-economic factors.

Empirical research using selected macroeconomic variables suggests that Call and Notice Money Rate has a negative significant impact on gold prices. Crude oil prices have a positive significant impact on gold prices. Foreign exchange rate of US Dollar has a positive significant impact on gold prices. Forex reserve has a positive significant impact on gold prices. GDP has a negative significant impact on gold prices. M3 has a positive significant impact on gold prices. It is found that none of the selected variables have a significant impact on Silver Prices. It is found that SENSEX has a positive significant impact on Nifty. It is found that GDP and Nifty has a Positive significant impact on SENSEX.

Empirical research using all variable in the scope of the research suggests that Only Foreign exchange rate and Forexrev are significant determinants of Gold price. Only FOREXREVG is a significant determinant of silver price .Only Foreign exchange rate is a significant determinant of nifty. None of the variables are found to have a significant impact on SENSEX.

Stock market is an important part of the economy of a country. The stock market plays a pivotal role in the growth of the industry and commerce of the country that eventually affects the economy of the country to a great extent. Furthermore it plays a vital role in the mobilization of capital in many of the emerging economies. This study will be useful for the investors who might be able to identify some basic 6

economic variables that they should focus on while investing in stock market and will have an advantage to make their own suitable investment decisions. One can infer from these results is that if a shock were to occur in the equity market it would have no significant affect on gold, making gold an attractive alternative for investors when uncertainty is high in the stock market. If one defines a safe haven as being an asset insulated from conditional mean and volatility spill over then investors choosing gold can be assured that it is completely insulated from shocks, negative or otherwise in the stock market. The stock prices are strongly negatively related to the price of gold indicating that investment demand for gold is significant and that people switch from stocks to gold at the time of the poor stock performances leading to rise in the price of gold. Put differently, since the long-run price of gold and inflation move together, investment in gold can serve as an inflationary hedge. The Volatility in gold prices is very less as compared to the equities market instilling confidence in the minds of the investors to possess gold proving it to be a strong asset class.

Investment in gold is considered as a best way to mitigate the risk and hedge the portfolio. Allocation of a portion of investment in Gold ETF would diversify the Portfolio risk. As the return in case of all Gold ETFs is more or less the same, inclusion of any Gold ETF in the portfolio of assets would diversify the risk. Investors can take benefit of the results and discussions in their investment strategies considering external and internal environment of the country. 

Interest rates are rising from all-time low levels across the world, worrying some equity investors who view higher rates as a threat to equity markets.



Changes in interest rates affect corporate earnings growth, equity valuations, investor risk appetite, and the level of the U.S. dollar, all of which have consequences for stocks.



The degree to which stock prices rise or fall during periods of rising interest rates depends greatly on why rates are rising in the first place.



Gradual increases in rates driven by optimism about economic growth tend to

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occur in environments in which earnings are strengthening and stocks are well-supported. 

Across countries and sectors, different segments of global markets respond differently to changes in interest rates, arguing strongly for diversification within equity portfolios.

It’s finally safe to say it: Interest rates are rising Over the past decade, investors have probably seen a number of pieces like this one, providing analysis and guidance on how to prepare their portfolios for the coming rise in interest rates. Much of that guidance was likely sound, still more of it wellintentioned. But there’s been one major problem: interest rates never rose, at least not for long. Of course, interest rates can increase over the course of a week, a month or even a year. But by our count there were at least five consensus “bottom” calls for interest rates between early 2009 and early 2015. Each of them was followed by a short period of rising rates, which inevitably gave way to a renewed fall in rates and, in most cases, a new all-time low.

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CHAPTER 1. INTRODUCTION

1.1 INTEREST RATES

The financial liberalization paved a new way for growth, development and volatile atmosphere to the Indian economy especially in terms of stock market. The Indian stock market has emerged as the most active stock market of the world during the last decade or so. It has also attracted the investors across the globe by expanding the horizons. It resulted in increase in terms of number of listed companies, shareholders, volume of trade and market capitalization.

The smoothing development process in Indian stock market continues to be remarkable. From 3,740 points on March 31st 1999, with in nine years; Bombay Stock Exchange (BSE) Sensitivity Index (SENSEX) had reached to 21,000 points in January, 2008. In India, only about two per cent of the total population does involve in stock markets operations. But the entire economy gets affected directly or indirectly, if something happens in the stock markets.

It shows clearly that there is a strong correlation between stock markets and real economy. For example, BSE total market capitalization as a percentage of India’s Gross Domestic Product (GDP), has increased from 4 per cent in 1978-79 to around 78 per cent in 2011-12. Thus, it is understood that the domestic economic fundamentals play a vital role in determining the performance of stock market.

Thus, it is observed that the stock market, being an important part of the financial system should have a systemic linkage with fundamentals of the economy. The economic reason behind the logic is the price of stock necessarily reflects all the future cash flows discounted by the appropriate discount rate.

The future cash flows depend on many economic factors like GDP growth, Wholesale price index (WPI), Interest rate, exchange rate fluctuations, global and domestic oil prices, etc (Naka, Mukherjee and Tufle (2001). The causal relationships between the 9

BSE Sensex and five specified macroeconomic variables was tested by Bhattacharya and Mukherjee (2002) applying the techniques of unit-root tests, cointegration and long-run Granger non-causality test proposed by Toda and Yamamoto and found that there are no causal linkage between the stock prices and money supply, national income and interest rate while the index of industrial production leads the stock price and there exists a two-way causation between stock price and rate of inflation.

There is a long-term equilibrium relationship among the macroeconomic variables and stock market indicators as shown by the studies of Golaka C Nath and Dr. Y.V. Reddy (2004) and Soumya Guha Deb and Jaydeep Mukherjee (2008) examined that there is strong causal flow from the stock market development to economic growth.

A bi-directional causal relationship is also observed between real market capitalization ratio and economic growth. It is also observed that there is high correlation between exchange rate and gold prices and it highly affects the stock prices. The effect of foreign exchange reserves and inflation in the stock price is only limited as found by Gagan Deep Sharma (2010). The present study is an attempt to examine the interaction between interest rate and stock returns in India.

The stock market doesn't generally like high interest rates. High interest rates can increase costs for companies across a wide range of measures. Increased costs can result in lower profits and subsequently lower stock prices. However, gradually rising interest rates might actually be beneficial for the stock market, as they may reflect positive trends in the underlying economy.

An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.

It is defined as the proportion of an amount loaned which a lender charges as interest to the borrower, normally expressed as an annual percentage.[1] It is the rate a bank or other lender charges to borrow its money, or the rate a bank pays its savers for 10

keeping money in an account.

Annual interest rate is the rate over a period of one year. Other interest rates apply over different periods, such as a month or a day, but they are usually annualised. Interest rates vary according to: 

the government's directives to the central bank to accomplish the government's goals



the currency of the principal sum lent or borrowed



the term to maturity of the investment



the perceived default probability of the borrower



supply and demand in the market



as well as other factors.

In the era of globalization and stabilization, one of the macroeconomic variables that have come into greater focus is the interest rate. This is consequent upon a strengthened integration of the domestic financial sector with the external sector. In India, the financial sector has undergone many changes since the stabilization program initiated in the early 1990s.

With financial liberalization in the economy, flexibility has been imparted to the movement of interest rates. The relationships between stock market returns and interest rate has been examined by researchers as it plays important role in influencing a country’s economic development .

Interest rates are determined by monetary policy of a country according to its economic situation. High interest rate will prevent capital outflows, hinder economic growth and, consequently, hurt the economy as interest rates is one of the most important factors affecting directly the growth of an economy.

The rational for the relationship between interest rate and stock market return are that stock prices and interest rates are said to be negatively correlated. Higher interest rate resulting from adverse monetary policy negatively affects stock market returns

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because higher interest rate reduces the value of equity and makes fixed income securities more attractive.

On the contrary, lower interest rates resulting from expansionary monetary policy boosts stock market. This is supposed to be a good sign for the economy as it is expected to enhance the efficiency in the financial system and thereby leading to the achievement of a higher growth rate. This policy stance is mostly backed up by the position of the monetarist and the financial liberalization school as opposed to the Keynesian school. According to the Monetarists, ‘a flexible interest rate policy responds to the changes in the market conditions (demand and supply of credit), thereby enabling the economy to withstand and control the macroeconomic instabilities as an inflexible interest rate policy is prone to macroeconomic fluctuations.

A rise in the interest rates affects the valuation of the stocks. The rise in the interest rates raises the expectations of the markets participants, which demand better returns that commensurate with the increased returns on bonds. In a low interest rate regime, corporate are able to increase profitability by reducing their interest expenses.

However in a rising interest rate regime, as interest expenses rise, profitability is affected. When interest rates rise, investors move from equities to bonds. Whereas when interest rates fall, returns on bonds fall while the returns on equities tends to look relatively more attractive and the migration of fund from bonds to equities takes place, and increasing the prices of equities.

Though financial economists, policy makers and investors have long-attempted to understand dynamic interactions between interest rate and stock prices, the exact patterns of the interactions remain unclear, the nature and strength of the dynamic interactions between them is of high interest and need to be evaluated empirically.

Therefore, the researcher examines the dynamic relationship between interest rate and stock prices in order to identify the impact of interest rate changes on stock prices with special reference to Indian Stock Exchange. 12

India Interest Rate In India, interest rate decisions are taken by the Reserve Bank of India's Central Board of Directors. The official interest rate is the benchmark repurchase rate. In 2014, the primary objective of the RBI monetary policy became price stability, giving less importance to government's borrowing, the stability of the rupee exchange rate and the need to protect exports. In February 2015, the government and the central bank agreed to set a consumer inflation target of 4 percent, with a band of plus or minus 2 percentage points, from the financial year ending in March 2017. This page provides India Interest Rate - actual values, historical data, forecast, chart, statistics, economic calendar and news. India Interest Rate - actual data, historical chart and calendar of releases - was last updated on March of 2019.

Actual

Previous

Highest

Lowest

Dates

Unit

Frequency

6.25

6.50

14.50

4.25

2000 - 2019

percent

Daily

Reserve Bank of India delivers a surprise rate cut in February’16. Taking market analysts by surprise, the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) cut all monetary policy rates by 0.25 percentage points at its 7 February meeting. The repo rate was therefore decreased to 6.25%, the marginal standing facility to 6.50% and the reverse repurchase rate to 6.00%. The MPC also officially changed its monetary policy stance from December’s “calibrated tightening”, which was supposed to rule out a rate cut, to “neutral”. This meeting was the first presided over by Governor Shaktikanta Das, who took up office on 10 December after his predecessor, Urjit Patel, resigned following pressure from the government to ease monetary policy.

13

The MPC’s decision was motivated by signs of a slowdown in global economic activity. This also largely explains why the RBI tweaked down its GDP growth forecast for FY 2019 (which ends in April) to 7.2% from 7.4%, and its FY 2020 forecast to 7.4% from 7.5%. Despite this, the domestic economy remains on a solid footing, with survey data showing private-sector economic activity in the October– December period growing at the fastest pace since current records began in 2015. Moreover, the RBI lowered its Q4 FY 2019 inflation forecast to 2.8% from its previous range of 2.7%–3.2%, as well as its H1 FY 2020 inflation forecast range to 3.2%–3.4% from 3.8%–4.2%. All in all, by cutting interest rates, Governor Das gave President Modi a rate-cut gift given that general elections in May are fast approaching.

The MPC did not give concrete indications regarding its next monetary policy moves. However, the fact that it changed its policy stance to “neutral” means it is now clearly willing to respond in an unconstrained manner to incoming macroeconomic data and forecasts. The governor reaffirmed this by stating that “the shift in the stance of monetary policy from calibrated tightening to neutral provides flexibility and the

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room to address challenges to sustained growth […] over the coming months, as long as the inflation outlook remains benign”. The next monetary policy meeting is scheduled for 2–4 April. FocusEconomics Consensus Forecast panelists expect the repo rate to rise going forward and end FY 2019 at 6.88% and FY 2020 at 6.93%. India- Interest Rate Chart

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1.2 WHY DO INTEREST RATE CHANGES? The Federal Open Market Committee, a division of the Federal Reserve Board, meets throughout the year to determine the course of monetary policy. One important aspect of this policy is the desired level of the federal funds rate. The fed funds rate is the rate that banks charge each other for overnight lending. However, this rate is also an important trigger for rates throughout the economy.

The Federal Reserve Board, known simply as "The Fed," changes the fed funds rate in an attempt to control inflation. Runaway inflation is bad for the economy, as it increases prices dramatically. This impacts both companies, which have to raise prices to keep up with their increased costs, and consumers, who may not be able to afford these raised prices. Increasing interest rates help harness inflation by reducing the money supply.

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1.3 REASONS FOR CHANGES IN INTEREST RATES Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates.

Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.

Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.

Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.

Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.

Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time to realize.

Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.

Banks: Banks can tend to change the interest rate to either slow down or speed up

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economy growth. This involves either raising interest rates to slow the economy down, or lowering interest rates to promote economic growth.

Economy: Interest rates can fluctuate according to the status of the economy. It will generally be found that if the economy is strong then the interest rates will be high, if the economy is weak the interest rates will be low.

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1.4 ADVANTAGES & DISADVANTAGES OF INTEREST RATES EFFECTS Advantages of Interest Rate Effects Slowly rising interest rates can have a beneficial effect on stock prices. Rates generally creep up when the economy is booming. For example, in 2018, in the midst of an expanding economy, the Federal Reserve Board indicated that economic conditions were such that rates could be raised. When the economy is expanding in this manner, companies are more profitable. Although costs may rise slightly if interest rates are gradually raised, profit growth generally exceeds these costs. Higher profits, in turn, typically lead to higher stock prices. One industry that specifically benefits from rising interest rates is the financial services industry. Banks make profits from paying depositors lower, short-term rates and lending that money out at longer, higher-term rates. When rates tick higher, banks are able to charge more for loans.

Disadvantages of Interest Rate Effects Higher interest rates increase the cost of borrowing for companies. This directly reduces corporate earnings. Further, higher interest rates may prevent companies from taking on additional debt for capital expenditures. Without expanding operations, it becomes harder for companies to grow their profits. Both of these factors can trigger lower stock prices. Higher market interest rates can also create a "buyers' boycott" of the stock market, as more attractive investment opportunities emerge. For example, Treasury bonds are considered a "risk-free" asset. If rates rise to the point that an investor can get a "riskfree" rate of 6 percent on a Treasury bond, for example, many investors will choose Treasury bonds over the stock market. While stocks have a higher long-term average return, they are also volatile and carry much higher risks than Treasury bonds. Fewer buyers mean less money to push up stock prices.

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1.5 DATA OF CURRENT INTEREST RATES The Reserve Bank of India lowered unexpectedly its benchmark interest rate by 25bps to 6.25 percent on February 7th and shifted its stance to "neutral", in an attempt to boost a slowing economy as inflation rate remains well below its mid-point 4 percent target. Interest Rate in India averaged 6.65 percent from 2000 until 2019, reaching an all time high of 14.50 percent in August of 2000 and a record low of 4.25 percent in April of 2009.

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Calendar

GMT

2018-08-01

09:00 AM

RBI Interest

Actual

Previous

Consensus TEForecast

6.5%

6.25%

6.5%

6.5%

6.5%

6.5%

6.75%

6.75%

6.5%

6.5%

6.5%

6.5%

6.25%

6.5%

6.5%

6.5%

Rate Decision 2018-10-05

09:00 AM

RBI Interest Rate Decision

2018-12-05

09:00 AM

RBI Interest Rate Decision

2019-02-07

07:00 AM

RBI Interest Rate Decision

2019-04-04

08:00 AM

RBI Interest

6.25%

6.25%

Rate Decision

RBI Unexpectedly Cuts Key Policy Rate to 6.25% The Reserve Bank of India lowered unexpectedly its benchmark interest rate by 25bps to 6.25 percent on February 7th and shifted its stance to "neutral" in an attempt to boost a slowing economy as inflation rate remains well below its mid-point target of 4 percent.

Excerpts from the RBI Press Release: In the fifth bi-monthly monetary policy resolution in December 2018, CPI inflation for 2018-19 was projected in the range of 2.7-3.2 per cent in H2:2018-19 and 3.8-4.2 per cent in H1:2019-20, with risks tilted to the upside. The actual inflation outcome at 2.6 per cent in Q3:2018-19 was marginally lower than the projection. There have been downward revisions in inflation projections during the course of the year, reflecting mainly the unprecedented soft inflation recorded across food sub-groups.

21

Turning to the growth outlook, GDP growth for 2018-19 in the December policy was projected at 7.4 per cent (7.2-7.3 per cent in H2) and at 7.5 per cent for H1:2019-20, with risks somewhat to the downside. The CSO has estimated GDP growth at 7.2 per cent for 2018-19. Looking beyond the current year, the growth outlook is likely to be influenced by the following factors. First, aggregate bank credit and overall financial flows to the commercial sector continue to be strong, but are yet to be broad-based. Secondly, in spite of soft crude oil prices and the lagged impact of the recent depreciation of the Indian rupee on net exports, slowing global demand could pose headwinds. In particular, trade tensions and associated uncertainties appear to be moderating global growth. Taking into consideration the above factors, GDP growth for 2019-20 is projected at 7.4 per cent – in the range of 7.2-7.4 per cent in H1, and 7.5 per cent in Q3 – with risks evenly balanced.

Headline inflation is projected to remain soft in the near term reflecting the current low level of inflation and the benign food inflation outlook. Beyond the near term, some uncertainties warrant careful monitoring. First, vegetable prices have been volatile in the recent period; reversal in vegetable prices could impart upside risk to the food inflation trajectory. Secondly, the oil price outlook continues to be hazy. Thirdly, a further heightening of trade tensions and geo-political uncertainties could also weigh on global growth prospects, dampening global demand and softening global commodity prices, especially oil prices. Fourthly, the unusual spike in the prices of health and education needs to be closely watched. Fifthly, financial markets remain volatile. Sixthly, the monsoon outcome is assumed to be normal; any spatial or temporal variation in rainfall may alter the food inflation outlook. Finally, several proposals in the union budget for 2019-20 are likely to boost aggregate demand by raising disposable incomes, but the full effect of some of the measures is likely to materialise over a period of time.

The MPC notes that the output gap has opened up modestly as actual output has inched lower than potential. Investment activity is recovering but supported mainly by public spending on infrastructure. The need is to strengthen private investment activity and buttress private consumption.

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India Money

Last

Previous

Highest

Lowest

Unit

Interest Rate

6.25

6.50

14.50

4.25

Percent

Cash Reserve Ratio

4.00

4.00

10.50

4.00

Percent

Money Supply M1

33425.70

32785.80

33425.70

80.15

INR Billion

Interbank Rate

6.36

6.40

12.97

3.10

Percent

Money Supply M2

34936.98

34510.22

34936.98

1127.49

INR Billion

Money Supply M3

150535.59

148946.83

150535.59

123.52

INR Billion

Foreign Exchange

402040.00

401780.00

426080.00

29048.00

Reserves Central Bank Balance

USD Million

18123.49

17616.33

23419.03

1624.31

Sheet

INR Billions

Loan Growth

14.60

14.40

18.70

4.10

Percent

Reverse Repo Rate

6.00

6.25

13.50

3.25

Percent

23

1.6 IMPACT OF INTEREST RATES Interest Rate in common terms signifies a fee that you will be charged for borrowing money, expressed as a percentage of the total amount of the loan. Usually, our spending decisions are likewise guided by the interest burden that we would be bearing.

Being familiar with the relationship between interest rates and the stock markets can help investors understand how changes might have an effect on their lives, and how to make better investment decisions.

Short Term and Long Term Impact In the short term – The instant impact of a 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 in a depleted stock price. In the long term – High-interest rate would have a more sector-specific impact. The sectors which are most impacted by high-interest rate are the real estate, automobile, and all the capital-intensive industries. So, any investment in these sectors must be taken with a considerable amount of caution during the situation of high-interest rates. So, definitely, the High-interest rate is not the best option for a country.

When the interest rate is very low, you would be obviously saving less and consuming more. The fixed deposits are no longer attractive. This might leave the banks with much lower money to lend out to the borrowers, and their profit margins would also be affected by a lower interest rate.

Hence there would be fall in consumption & investment actions in the economy. The government in such a scenario would certainly resort to the printing of currency to infuse more money in the economy. This would lead to an inflationary situation in the country. At very low-interest rate the inflows are likely to be reduced. The interest rate that moves markets is the federal fund’s rate. In the US, the Federal

24

Reserve increases or decreases interest rates to fight inflation or ensure it is less difficult for companies to borrow money. Investors have to figure out how to evaluate the impact of rate changes in stock prices. The Fed Funds Rate is the interest rate charged to the world’s largest banks when they lend money to each other overnight. Also known as the overnight rate, the federal fund’s rate is the way the Fed attempts to handle inflation. Other countries’ central banks do the same thing for the similar reason, e.g., in India RBI controls this rate and RBI announcements also have an impact on the Indian stock market.

Shares represent parts of a business and businesses are funded by loans. As a result, a rate rise will certainly itself decrease profitability by making their debt more expensive, cutting into their profits. They will spend more to service their debt, which means that the capital available for investment decreases. So in whole, a rate rise will probably generally signify businesses are less profitable due to increased borrowing rates.

25

26

1.6 CURRENT RBI BANK INTEREST RATES 2019 The interest rate we are talking about here is: Repo Rate: Repo rate is the rate at which RBI lends to its clients generally against government securities. Reduction in repo rate helps the commercial banks to get money at a cheaper rate and increase in repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. Reverse Repo rate is the rate at which RBI borrows money from the commercial banks. Why is this so important? It is a way for RBI to control inflation. If repo rate is high that means the cost of borrowing is high, leading to a slow growth in the overall economy. Currently, the repo rate in India is 8%. Markets don’t like the RBI increasing the repo rates. Increase in repo rate does not merely signify a change in the cost of capital for business, however, it also redistributes investment in favor of deposits which provide a higher rate of return. The same happens when the repo rate is cut.

And also, India’s central banking institution, The Reserve Bank of India controls the monetary policy of the Indian currency. The RBI was established on 01 April, 1935, to solve economic troubles after First World War. Major functions of RBI include supervising banks and financial institutions, managing exchange rates, act as banker’s bank, control inflation, maintain deflation level and detect fake currency. From time to time, RBI controls liquidity and money supply in the market and thereby ensures overall economic growth. Types of Interest rates fixed by RBI



Repo Rate: We all approach banks when we face a financial shortfall. Likewise, banks approach The Central Bank, which is The Reserve Bank of India in our country if they face financial crisis. Repo Rate or Repurchase Rate is the rate at which the RBI lends funds to commercial banks and other financial institutions within the country. Simply put, banks borrow funds from The Central Bank of India by selling government securities with a legal agreement to repurchase the securities sold on a given date at a predetermined price. The rate of interest charged by RBI 27

while they repurchase the securities is called Repo Rate. The current Repo Rate as fixed by the RBI is 6.25% p.a. On 7 February 2019, the RBI reduced the repo rate (key lending rate) by 25 basis points. This is the first time since August 2017 that the repo rate has been cut by the RBI. The reverse repo rate has also decreased to 6.00% from 6.25% and the Marginal Standing Facility Rate (MSF) and the Bank Rate has decreased to 6.50%.

History of Changes to Repo Rate The Reserve Bank of India has increased the Repo Rate from 6% p.a. to 6.25% p.a. on 6 June 2018. This hike in repo rate was the first in more than four years. The last time the repo rate was increased before this was in January 2014. The Reserve Bank of India increased the Repo Rate again on the 1st of August 2018 from 6.25% to 6.50%. Even the reverse repo rate was increased to 6.25% from 6%, and the Marginal Standing Facility Rate went up by 25 basis points to 6.75% from 6.50%. The change in repo rate will also effect changes in all other types of rates fixed by RBI and private banks, which are discussed in detail below. Here’s a snapshot of all the repo rate changes that have occurred since October 2005:



Reverse Repo Rate: When Reserve Bank of India faces a financial crunch, they invite commercial banks and other financial institutions to deposit their excess funds into RBI treasury and offers them excellent interest rates. Similarly, when banks have excess funds, they voluntarily transfer it to RBI as their money is safe and secure with them. Generally, Reverse Repo Rate is always lesser than Repo Rate. The current Reverse Repo Rate as set by the RBI is 6.00% p.a.



Marginal Standing Facility Rate (MSF): When banks face acute financial shortage, they can avail this special facility offered by RBI. In MSF, banks can borrow cash from RBI against their approved government securities. This option is preferred during emergency and critical situations only. MSF rate is always higher than Repo Rate as banks need the funds instantly. The MSF rate currently stands at 6.50% p.a 28



Bank Rate: Bank Rate is the rate of interest charged by The Central Bank of India against loans offered to commercial banks. Bank rate is usually higher than repo rate. Unlike repo rate, bank rate directly affects the end user, in this case the customer, as high bank rates mean high lending rates. When bank pay high interest rate to obtain loan from RBI, they in return charge the customer high interest rate to break even. Also known as “Discount Rate”, bank rate is a powerful tool used by the RBI to control liquidity and money supply in the market. The current Bank Rate is the same as MSF rate, i.e. 6.50% p.a.



Cash Reserve Ratio (CRR): In India, banks are required to retain a certain percentage of their deposits as liquid cash. However, banks prefer to deposit this liquid cash with the Reserve Bank of India, which is equivalent to having cash in hand. The percentage of the deposits that should be kept aside by banks is called Cash Reserve Ratio. CRR is fixed by The Reserve Bank of India. For example: If the bank deposit amount is Rs.100 and the CRR is 10% per annum, the liquid cash that the bank should have at all times is Rs.10. The remaining funds, which is Rs.90 in this case can be used for lending and investment purposes. RBI has the power to determine the lending capacity of the banks in India through CRR. They will increase CRR if they want to reduce the amount that the banks can lend and vice versa. The current CRR is 4% p.a.



Statutory Liquidity Ratio (SLR): At the end of every business day, banks are required to maintain a minimum ratio of their Time liabilities (when the bank has to wait to redeem their liabilities) and Net Demand (when bank can withdraw money from these accounts immediately) in the form of liquid assets like gold, cash and government securities. The ratio of time liabilities and liquid assets in demand is called Statutory Liquidity Ratio or SLR. The maximum SLR that The Reserve Bank of India can set is 40% p.a. However, the current SLR is set at 19.25% p.a.



Base Rate: The Reserve Bank of India sets a minimum rate below which banks in India are not allowed to lend to their customers. This minimum rate is called the 29

Base Rate in banking terms. It is the minimum rate of interest the banks are permitted to charge their customers. The new Base Rate as fixed by RBI is in the range of 8.95% - 9.45% p.a 

Marginal Cost of Funds based Lending Rate (MCLR): RBI made changes to the existing Base Rate system this year. They have introduced Marginal Cost of Funds based Lending Rate or MCLR which is a new methodology to set the lending rates for commercial banks. Previously, banks used to lend as per the Base Rate fixed by The Reserve Bank of India but with the introduction of MCLR, banks will have to lend using rates linked to their funding costs. Simply put, bank raises their funds through deposits, bonds and other investments. For the banks to function smoothly, there are costs involved like salaries, rents and other bills. Considering that banks also need to make profits every year, RBI has included the expenses of the bank and have come up with a formula which can be used by banks to determine their lending rate. With the reduction of repo rate, some banks have reduced MCLR up to 90 basis points. The current MCLR (overnight) fixed by the RBI stands in the range of 8.15% to 8.55%. 

Savings Deposit Rate:The interest rate earned by an account holder for the amount maintained in their savings account is called savings deposit rate. The current Savings Deposit Rate as set by the RBI is in the range of 3.50% to 4.00%.



Term Deposit Rate: Customers who deposit money into their account and agrees to fix it till a particular date is awarded with term deposit rate. The term deposit rates for senior citizens is usually 0.5% more than that for ordinary citizens. With effect from 30 January 2018, SBI's revised interest rates on Domestic Bulk Term deposits above Rs.10 crore ranges from 5.75% to 6.50% for '7-45 days' tenor to '5 years and up to 10 years' tenor, respectively. The interest rate of Term Deposits that the Reserve Bank of India has set ranges from 6.25% to 7.50%.



Call Rate: It is the interest rate paid by the banks for lending and borrowing funds for a maturity period of 1 to 14 days. Call Rate is also known as the interbank

30

borrowing rate. It deals with short-term lending between banks. . The Call Rate set by the RBI is in the range of 5.00% to 6.60%.

In conclusion, policy rates are subjected to change without any warning as RBI constantly monitors the supply of money in the economy and takes decisions accordingly. Updated On

Repo Rate

07 February, 2019

6.25%

01 August, 2018

6.50%

06 June, 2018

6.25%

07 February, 2018

6.00%

02 August, 2017

6.00%

04 October, 2016

6.25%

05 April, 2016

6.50%

29 September, 2015

6.75%

02 June, 2015

7.25%

04 March, 2015

7.50%

15 January, 2015

7.75%

28 January, 2014

8.00%

29 October, 2013

7.75%

20 September, 2013

7.50%

03 May, 2013

7.25%

17 March, 2011

6.75%

25 January, 2011

6.50%

02 November, 2010

6.25%

31

16 September, 2010

6.00%

27 July, 2010

5.75%

02 July, 2010

5.50%

20 April, 2010

5.25%

19 March, 2010

5.00%

21 April, 2009

4.75%

05 March, 2009

5.00%

05 January, 2009

5.50%

08 December, 2008

6.50%

03 November, 2008

7.50%

20 October, 2008

8.00%

30 July, 2008

9.00%

25 June, 2008

8.50%

12 June, 2008

8.00%

30 March, 2007

7.75%

31 January, 2007

7.50%

30 October, 2006

7.25%

25 July, 2006

7.00%

24 January, 2006

6.50%

26 October, 2005

6.25%

32

So how are interest rates related to the stock market? They are contrarily connected. As the interest rates go up, stock market activities tend to come down. If a company is observed as restricting on its growth spending or is making less profit – either via higher debt expenses or less revenue – then the estimated amount of future cash flows will drop. All factors otherwise being equal, this will reduce the price of the company’s stock.

If enough companies experience declines in their stock prices, the whole market, or the key indexes that many people equate with the market, will go down. With a lowered expectation of the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership significantly less suitable.

However, some sectors do benefit from interest rate hikes. The banking sector is likely to benefit most due to high interest rates. The Net Interest Margins for banks is likely to increase resulting in growth in profits & the stock prices.

Sectors like Pharma and IT are less affected by interest rates. The IT sector is more 33

influenced by factors such as currency rate fluctuations, rising attrition level, visa restrictions, competition from the large global players and margin pressures. While setting the interest rates the RBI has to strike a balance between growth and inflation. In a nutshell – if the interest rates are high that means the borrowing rates are high (particularly for corporations.On the other hand, when the interest rates are low, borrowing becomes easier. This means more money in the hands of the corporations and consumers. With increased money, there is certainly increased spending which means the sellers tend to increase prices leading to inflation.

In order to draw a balance, the RBI has to consider all the factors and should cautiously set a few key rates. Any fluctuations in these rates can lead to a financial chaos.

Nothing has to actually happen to consumers or companies for the stock market to react to interest-rate changes. Rising or falling interest rates also affect investors' psychology, and the markets are nothing if not psychological. When the Fed announces a hike, both businesses and consumers will cut back on spending, which will cause earnings to fall and stock prices to drop, everyone thinks, and the market tumbles in anticipation.

On the other hand, when the Fed announces a cut, the assumption is consumers and businesses will increase spending and investment, causing stock prices to rise.

However, if expectations differ significantly from the Fed's actions, these generalized, conventional reactions may not apply. For example, let's say the word on the street is the Fed is going to cut interest rates by 50 basis points at its next meeting, but the Fed announces a drop of only 25 basis points. The news may actually cause stocks to decline because assumptions of a 50-basis-points cut had already been priced into the market.

The business cycle, and where the economy is in it, can also affect the market's reaction. At the onset of a weakening economy, the modest boost provided by lower rates is not enough to offset the loss of economic activity, and stocks continue to decline. Conversely, towards the end of a boom cycle, when the Fed is moving in to 34

raise rates—a nod to improved corporate profits—certain sectors often continue to do well, such as technology stocks, growth stocks and entertainment/recreational company stocks.

The Bottom Line Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions: as a general rule of thumb, when the Fed cuts interest rates, it causes the stock market to go up; when the Fed raises interest rates, it causes the stock market as a whole to go down.

But there is no guarantee how the market will react to any given interest rate change the Fed chooses to make. The interest rate that moves markets is the federal funds rate. Also known as the discount rate, this is the rate depository institutions are charged for borrowing money from Federal Reserve banks.

The federal funds rate is used by the Federal Reserve (the Fed) to attempt to control inflation. Basically, by increasing the federal funds rate, the Fed attempts to shrink the supply of money available for purchasing or doing things, by making money more expensive to obtain. Conversely, when it decreases the federal funds rate, the Fed is increasing the money supply and, by making it cheaper to borrow, encouraging spending. Other countries' central banks do the same thing for the same reason.

35

News on 25th September 2018 Fed may hike rates by 25 bps on Wednesday; how it will impact Indian market

NEW DELHI: The Federal Reserve is likely to hike interest rates by 25 basis points on Wednesday, as strong employment and inflation in the US as well as strengthening economy have increased hopes for further policy tightening.

As two-day Federal Open Market Committee (FOMC) meeting began on Tuesday, there are expectations that the central bank will increase the rates to 2-2.25 per cent range from 1.75-2 per cent.

The apex bank is widely expected to increase rates for the third time this year. “Fed in its policy statement would consider raising rates by 25bps. The probability is almost 100 per cent of Fed raising the interest rate in the FOMC meeting,” said Motilal Oswal Financial Services.

US unemployment is at record low levels, as the rate of unemployment stood at 3.9

36

per cent in August. Inflation has also reached and sustained above the Fed’s 2 per cent target for some time now. The US economic growth is also booming on the back of tax cuts and pro-cyclical fiscal policy.

GDP grew above expectations by 4.2 per cent in Q2CY18. “Such a tax-cut fuelled economy with rising corporate profitability is pulling unemployment down, all the while widening the fiscal deficit and ballooning the alarmingly high national debt. The US treasury is likely to borrow extra $430 billion over last year,” said Edelweiss Investment Research in a report.

The brokerage further added that another factor that the Fed ought to consider is the continuously flattening yield curve. The Fed is seeking to hike rates so that a balance between sustained economic growth and economic risks such as inflation would be reached. However, reaching such a balance might result in an inversion of the yield curve, which is historically seen as an indicator of recession. If the Fed were to consider the risks of yield curve inversion they would have slow down the pace of rate hikes this year.

Market watchers across the globe will closely monitor commentary by Fed Chairman Jerome Powell on Wednesday. The FOMC policy statement will be released on Wednesday midnight and impact of the same will be seen on Thursday morning in India.

Indian markets On the impact on India, AK Prabhakar, Head of Research IDBI Capital said, “If Fed will increase interest rates then India will also follow the US central bank. Already rising interest rates have started to hit corporate as well as multiple sectors. For example, rising interest rates, as well as crude prices, have started to dent volumes in the auto sector. Rising interest rates will further strengthen the dollar and thereby may put further pressure on Indian rupee. Rising crude oil prices, as well as interest rates, will led to an outflow of foreign money. As a result, Indian markets may see some short-term pressure amid upcoming elections. One should prepare for 10-15 per cent cut in broader index.” 37

Rahul Goswami, Chief Investment Officer-Fixed Income, ICICI Prudential AMC on Monday told ET NOW that with crude oil at close to $80 a barrel and US Fed also hiking rates along with quantitative tightening continuing in US and other developed economies like UK or euro zone also expected to hike rates over a period of time. “We think that it definitely warrants caution for fixed income investors to exercise caution and remain invested in the shorter end of the curve and very little compulsion or very little interest for us to increase the duration risk in the portfolio at this point of time,” said Goswami.

38

1.7 RISE IN INTEREST RATES When the Fed increases the federal funds rate, it does not directly affect the stock market. The only truly direct effect is that borrowing money from the Fed is more expensive for banks. But, as noted above, increases in the federal funds rate have a ripple effect.

Because it costs them more to borrow money, financial institutions often increase the rates they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if these loans carry a variable interest rate. This has the effect of decreasing the amount of money consumers can spend. After all, people still have to pay the bills, and when those bills become more expensive, households are left with less disposable income. This means people will spend less discretionary money, which will affect businesses' revenues and profits.

But businesses are affected in a more direct way as well because they also borrow money from banks to run and expand their operations. When the banks make borrowing more expensive, companies might not borrow as much and will pay higher rates of interest on their loans. Less business spending can slow the growth of a company; it might curtail expansion plans or new ventures, or even induce cutbacks. There might be a decrease in earnings as well, which, for a public company, usually means the stock price takes a hit.

When evaluating the likely impact of rising rates on any asset—a stock, bond, or commodity—it is important to understand the context. Why are interest rates rising? Figure 2 shows that since the financial crisis, a combination of low inflation expectations and muted growth prospects has conspired to push Treasury yields down to levels not seen since the Eisenhower administration (1953–1961). Interest rates are the bond market’s way of telling the world how it feels about the future. When prospects are good, interest rates must move up to compensate investors who could make more money in riskier assets like equities. When rates move lower, they do so because there is demand for safer and more stable cash flow, even if the investment

39

offers a lower expected return.

Policymakers also play a key role in setting interest rates. Central banks target a level of short-term interest rates consistent with achieving policy goals such as price stability and full employment, and the bond market tends to follow suit. Since 2008, global central banks have been buying government bonds and other securities in the open market to increase the money supply and shrink the available pool of safe assets, enticing investors to take more risk elsewhere.

Interest rates can also respond to the way in which governments manage their budgets. A Treasury that overspends and takes on too much debt may be reined in from time to time by the bond market, which often but not always expresses its displeasure when borrowing is too high by charging governments a higher interest rate. Whether rates rise because of market forces or due to prodding from policymakers, changes in nominal interest rates can be broken down into two components: the change in expected growth—the real interest rate—and the change in inflation expectations. Whether stocks and other assets perform well or poorly in periods of rising rates can depend greatly on which component—growth or inflation—is driving the move higher

Ways that interest rates influence stock markets Because the risk-free rate of interest—the yield on cash held in a bank or on a U.S. government note—is usually the easiest available alternative to any other type of 40

investment, it’s often used to value or discount potential returns on stocks. One way to price a stock is to estimate the value of all its future earnings in today’s dollars and calculate how much investors would be willing to pay to receive their share of those earnings paid out as dividends. In order to make that calculation, we need to discount—i.e., divide future profits by the expected prevailing interest rate over the period. Using this methodology, a rise in interest rates would, in isolation, mathematically make shares of a company’s stock worth less today, likely resulting in a price decline.

Rising interest rates can also enhance or dampen investor risk appetite. We often see this reflected in the price-to-earnings (P/E) ratio, the number by which one would have to multiply a company’s earnings to find its price. If interest rates rise due to fears about higher inflation, investors might refrain from taking more risk if they expect an eventual economic slowdown to erode profit margins. They’d be less willing to pay a premium for future earnings, which would lead P/E multiples and stock prices to fall. If, however, rates rise because growth is improving, investors might be comfortable paying higher prices for the same company’s earnings stream. In this case, higher interest rates driven by economic optimism can be associated with increasing stock prices.

A third way interest rates tend to move stock prices is by changing corporate profitability. Higher interest rates typically create tighter credit conditions in the economy, which make it more difficult for firms to borrow money to hire workers and invest. When conditions are too restrictive, potential earnings growth may be limited. At the extreme, very high interest rates can lead to recession and a bear market— defined as a 20% or greater drop—for stocks. In some cases, rising rates can also boost earnings. Banks, for instance, rely on steep yield curves to borrow money short term at low rates and lend it over longer periods at higher rates.

This practice leads to higher profits when the gap between short-term and long-term rates widens. In recent years, prices of financial firms’ stocks have become more interestrate sensitive as rates have fallen to new lows. Lastly, interest rates can influence the strength of the U.S. dollar—and vice versa—which can dramatically affect the profitability of companies with significant operations or customer bases 41

overseas. Earnings growth among companies in the S&P 500® Index turned negative in 2015 partially because of a sharp rise in the U.S. dollar against the currencies of our major trading partners. This dollar rally occurred largely as a result of U.S. rates rising sharply relative to plummeting yields in much of the rest of the world.

42

CHAPTER 2. RESEARCH METHODOLOGY

2.1 RESEARCH OBJECTIVE The general objective of this study is to analyze the correlation between the stock market prices and interest rate movement in India.

From this above outlined general objective, the specific objectives are as follow:

i. To investigate the presence of causal relationship between stock market prices and interest rates movement.

ii. To examine the direction of the causal relationship between stock market prices and interest rate movement, that is determining whether the relationship is unidirectional or bi-directional.

iii. To examine the response to certain shocks, like political instability, in the Indian market.

43

2.2 HYPOTHESIS DEVELOPMENT

In order to shed some light on the continual debate on the interrelationship between the Interest rate and stock market, the present study aims to explore whether the changes in the Interest rates cause any dynamic effects on the Stock Market Returns or not. Accordingly, the null hypothesis that is to be tested by using the granger causality test is as follows:

H0 : there is no significant impact of changes in the interest rate on Indian Stock Market.

H1 : there is significant impact of changes in the Interest rate on Indian Stock Market. Upadhyay, Apeejay-Journal of Management Sciences and Technology, 4 (1), October - 2016 ISSN -2347-5005 42

In case of accepting the above null hypothesis, it means that there is not any significant effect of the changes in the interest rate on the Indian Stock Market during the examined period of time. Alternatively, in case of rejecting the null hypothesis and accepting the alternate, it means statistically significant relationship exists between the variables during the same period of time.

44

Index

1.

Hypothesis

Nifty

H0: Interest rate has no

Auto

impact on Nifty Auto

r

Significance

Hypothesis

At .05 level

accepted or

(2 tailed)

rejected

.817

Significant

Rejected

.746

Significant

Rejected

.114

Insignificant Accepted

.921

Significant

Rejected

.740

Significant

Rejected

.696

Significant

Rejected

.359

Insignificant Accepted

H1: Interest rate has an impact on Nifty Auto 2.

Nifty

H0: Interest rate has no

Bank

impact on Nifty Bank H1: Interest rate has an impact on Nifty Bank

3.

Nifty

H0: Interest rate has no

Energy

impact on Nifty Energy H1: Interest rate has an impact on Nifty Energy

4.

Nifty

H0: Interest rate has no

FMCG

impact on Nifty FMCG H1: Interest rate has an impact on Nifty FMCG

5.

Nifty

H0: Interest rate has no

Financial impact on Nifty Financial Services

services H1: Interest rate has an impact on Nifty Financial services

6.

Nifty IT

H0: Interest rate has no impact on Nifty IT H1: Interest rate has an impact on Nifty IT

7.

Nifty

H0: Interest rate has no

Media

impact on Nifty Media H1: Interest rate has an impact on Nifty Media

45

8.

Nifty

H0: Interest rate has no

Metal

impact on Nifty Metal H1:

-0.158

Insignificant Accepted

0.845

Significant

0.386

Insignificant Accepted

-0.443

Insignificant Accepted

Interest rate has an impact on Nifty Metal

9.

Nifty

H0: Interest rate has no

Pharma

impact on Nifty Pharma

Rejected

H1: Interest rate has an impact on Nifty Pharma 10.

Nifty

H0: Interest rate has no

PSU

impact on Nifty PSU Bank

Bank

H1: Interest rate has an impact on Nifty PSU Bank

11.

Nifty

H0: Interest rate has no

Realty

impact on Nifty Realty H1: Interest rate has an impact on Nifty Realty

46

2.3 SCOPE OF THE STUDY

This study focuses on the impact of the interest rate on stock prices. The period under investigation is 10 years i.e., from January 2005 to December 2014. Hence the bank rates and closing prices of the sectoral indices from 2005-14 are considered for the research.

Eleven sectors (auto, bank, energy, FMCG, financial services, IT, media, metal, pharma, PSU bank, realty) and one market index (nifty fifty) are selected and sectoral indices are collected for those respective sectors. The closing prices of these sectoral indices were considered and then correlated with interest rates to find out the correlation between the two variables i.e., interest rates and closing prices. These sectoral indices were collected from the data base of National Stock Exchange. Bank rates were collected from the data base of RBI. The statistical tool used for testing of the hypothesis is Karl Pearson’s coefficient of Correlation. Linear Regression has been used to develop a model for forecasting stock prices based on interest rate.

47

CHAPTER 3. LITERATURE REVIEW The relationship between stock market and various economic factors such as interest rate, inflation rate etc. have been examined by researchers as they play an important role in influencing a country’s economic development. Interest rates are determined by monetary policy of a country according to its economic situation. High interest rates will prevent capital outflows, hinder economic growth and consequently hurt the economy as interest rate is one of the most important factors affecting directly the growth of an economy.

In the light of external factors gaining importance, some studies have been conducted to understand the relationship and quantify the impact. Some significant studies have been reviewed here. Uddin and Alam (2009) in their study ‘Relationship between interest rate and stock price: Evidence from developed and developing countries’ seek evidence supporting the existence of share market efficiency based on the monthly data from January 1988 to March 2003.

In their study they show empirical relationship between stock index and interest rate for fifteen developed and developing countries using time series and panel regression. They also show that for all of the countries interest rate has significant negative relationship with share price and for six countries changes of interest rate has significant negative relationship with changes of share price. Senthil Kumar (2013) in his study ‘Effect of interest rate changes on stock returns of select Indian commercial banks’ investigates the long term effects of repo rate changes on seven public sector banks and six private sector banks using regression technique.

He found that any increase in the interest rate adversely affects the bank stock returns. Faff, Hodgson and Kremmer (2005) analyse the dual impact of changes in the interest rate and interest rate volatility on the distribution of Australian financial sector stock returns. In addition, a multivariate GARCHM model is used to analyze the impact of deregulation on the financial institutions sector. It was found that there is a consistent inter temporal tradeoff between risk and return over the different regulatory periods. Moreover, finance corporations were found be highly sensitive to new shocks across

48

the financial sector and deregulation increased the risk faced by finance corporations and small banks – effectively increasing the required rate of Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.7, No.21, 2016 18 return and explaining the continued rationalization of these sectors. Muthukumaran and Somasundaram (2014) in their study ‘An analytical study of interest rate and stock returns in India’ estimate causality relationship between interest rate and stock returns. Using the Granger Causality test they found that there exists short term relationship among the interest rate and stock returns. Their study implies that the interest rate neither affects stock returns nor stock returns affect the interest rate. Uddin and Alam (2010) in their study ‘The impact of interest rate on stock market: Empirical evidence from Dhaka stock exchange’ show empirical relationship between stock index and interest rate in Bangladesh based on monthly data from 1992 to June 2004.

They tested the stationary of market return and found that DSE index does not follow random walk model, which indicated that DSE is not efficient in weak form. They determine the linear relationship between share price and interest rate, share price and growth of interest rate, growth of share price and interest rate, and growth of share price and growth of interest rate through ordinary least-square (OLS) regression. They found that interest rate has significant negative relationship with growth of share price.

The stock market plays an important role in the economic development of any nation. Besides serving as an instrument for the mobilization of domestic capital for the corporate sector, the mere presence of the market boosts the international investment climate of a country. Theoretically, capital market not only knots the domestic macroeconomic indicators within an economy, but also with the outside economy as well. Trade, capital and other flows are all tied to it.

The relationship between interest rates and stock prices is of great interest to many academics and professionals since they play an important role in the economy. The literature review is organized into four main areas. The first is the review of the theories that affect the individual variables that form part of the research question, 49

namely share prices and interest rates. The second section summarizes the conceptual framework and the hypothesis that link share prices to interest rates. The third section reviews the empirical evidence.

Finally, this chapter concludes with how this research will contribute to the existing literature. 2.1 Share Price and Market Theories There are two broad theories that attempt to explain the movement in share prices in the stock market.

The first is the Efficient Market Hypohesis and the other is Behavioural Finance. Efficient Market Hypothesis 9 An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.

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The related random walk hypothesis of the early 1960s was an empirical result. Based on time-series analyses of past stock prices, researchers concluded that the prices behaved like geometric random walks. This threw cold water on the practice of technical analysis— the study of stock price charts to divine future price movements. It did not, however, rule out fundamental analysis—the study of a company’s business, its market and/or the overall economy to divine future price movements. Developed by Eugene Fama in the late 1960s and 10 early 1970s, the efficient market hypothesis went beyond the random walk hypothesis to reject both technical analysis and fundamental analysis.

Between 1965 and 1970, many empirical studies were performed on stock price behavior or investment managers’ performance. These culminated in 1970 with Fama’s second landmark paper, which appeared in the Journal of Finance and was titled ―Efficient capital markets: A review of theory and empirical work.‖ In it, Fama elaborated on his theory of efficient markets and reviewed the developing literature. Based on the terminology of his colleague Harry Roberts, he reported on empirical tests for three different levels of market efficiency:  A market has weak efficiency if prices fully reflect any information contained in past price data. Weak efficiency rejects technical analysis. It is essentially the random walk hypothesis but without as full a characterization of the stochastic process that describes price behavior.  A market has semi-strong efficiency if prices fully reflect all readily-available public information—past prices, economic news, earnings reports, etc. Tests of semistrong efficiency are those that study stock price movements following announcements, such as stock splits or earnings announcements.  A market has strong efficiency if prices fully reflect all public and privileged information. Privileged information includes knowledge available to a market maker, insider information available to corporate managers, or information that investment managers spend time and money to compile for their own use.

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Behavioral Finance Theory Behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. Behavioral finance is of interest because it 11 helps explain why and how markets might be inefficient.

Behavioral finance takes issue with two crucial implications of the EMH:

(1) that the majority of investors make rational decisions based on available information; and

(2) that the market price is always right.

Proponents of behavioral finance, or behaviorists, as they often are known, believe that numerous factors—irrational as well as rational—drive investor behavior. In sharp contrast to efficient markets theorists, behaviorists believe that investors frequently make irrational decisions and that the market price is not always a fair estimate of the underlying fundamental value. Refuting Fama’s crucial assertion that the market price is always right, behaviorists ―believe investor psychology can drive market prices and fundamental value very far apart (H. Shefrin). The origins of today’s school of behavioral finance are generally traced back to the work of two psychologists, Daniel Kahneman and Amos Tversky, on how people make decisions involving risk. In the 1980s behavioral finance researchers, such as Werner De Bondt, Robert J. Shiller, Andrei Shleifer, and Richard Thaler, to name a few, began to focus on the study of the time series properties of prices, dividends, and earnings.

The objective was to determine whether stocks exhibit volatility in excess of the amount predicted by the efficient market hypothesis. ―The [pricing] anomalies that had been discovered [in the 1970s] might be considered at worst small departures from the fundamental truth of market efficiency, but if most of the volatility in the stock market was unexplained, it would call into question the basic underpinnings of the entire efficient markets theory,‖ Shiller (2003) wrote.

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In 1981 Shiller published an article in the American Economic Review in which he documented evidence of price movements much greater than an efficient market would allow. Four years later Richard Thaler and Werner de Bondt (1985) published a study that concluded that the stock market tends to overreact to a long series of bad news. 12 Werner F. M. De Bondt and Richard Thaler published `Does the stock market overreact?' in the The Journal of Finance (De Bondt and Thaler 1985), effectively forming the start of what has become known as behavioral finance.

They discovered that people systematically overreacting to unexpected and dramatic news events results in substantial weak-form inefficiencies in the stock market. This was both surprising and profound. 2.2 Interest rate theories Interest rate is the price paid for money borrowed which is in turn invested in viable economic activities with a view of generating returns. Interest rate in any country is determined by a number of factors.

The key theory is the demand for money and supply of money framework. Some of the other factors include the growth in the economy, monetary policy driven by central banks, rate of inflation among others. 2.3 Theories linking interest rates and share prices Theoretical framework Fama (1981) argues that expected inflation is negatively correlated with anticipated real activity, which in turn is positively related to returns on the stock market. Therefore stock market returns should be negatively correlated with expected inflation, which is often proxied by the short-term interest rate.

In theory, the interest rates and the stock price have a negative correlation (Hamrita & Abdelkader, 2011). This is because a rise in the interest rate reduces the present value of future dividend’s income, which should depress stock prices. Conversely, low interest rates result in a lower opportunity cost of borrowing. Lower interest rates stimulate investments and economic activities, which would cause prices to rise. 13 Research hypothesis Null hypothesis There is no significant causality relationship between stock prices and interest rates Alternative hypothesis

There is a significant causality relationship between stock prices and interest rates 2.5 Empirical evidence Hamrita and Abdelkader (2011) examined the multi-scale 53

relationship between the interest rate, exchange rate and stock price using a wavelet transform in US over the period from January 1990 to December 2008. The exchange rate returns and stock index returns were found to have a bidirectional relationship in this period at longer horizons.

Findings from other research specifically point out that the interest rate changes affect the stock market in the long run and there is no significant influence in the short run. According to Amaresh Das (2005) on his study on the interrelationship between the stock prices represented by market index and interest rates measured by three month Treasury bills for monthly observation from 1985 to 2003 by sampling three Asian countries including Bangladesh, the codependence among variables shows that the relationship between stock prices and interest rate is not significant for Bangladesh and Pakistan except India.

The paper further documents that the time series data for Bangladesh and Pakistan reflects strongly common cycles. In related studies, Officer (1973) explained the drop in stock market volatility in the 1960s with a reduced variability in industrial production. Schwert (1989) and Hamilton and Lin (1996) discovered that stock market volatility increases in times of 14 recession and Glosten et al.(1993) find interest rates to be an important factor in explaining stock market volatility. Hasan and Samarakoon (2000) studies the ability of interest rates, measured by treasury bill rates of three maturities; 3,6 and 12 months which tracks the expected monthly, quarterly and annual returns in the Sri Lankan stock market for the period 1990 to 1997.

The stock return is measured by the continuously compounded monthly returns on the All Share Price Index (ASPI) and Sensitive price index. Through the application of the OLS method it was suggested that the short-term interest rates are positively related to future returns and they are able to reliably track expected returns prospects. The authors also concluded that the 12 months maturity is the most powerful tool to track monthly and quarterly expected return among all the three maturities.

In a study conducted by Lobo (2002) which examines the impact of unexpected changes in the federal funds target on stock prices from 1988 to 2001; Measures of 54

interest rate surprises are constructed from survey data and changes in the 3-month Tbill yield. It was discovered that surprises associated with decreases in the target cause stock prices to rise significantly. Surprises associated with increases in the target increase stock market volatility on the announcement day, with volatility reverting to pre-surprise levels on the day after the announcement.

This volatility pattern is only evident since 1994. An implication is that concerns about immediate disclosure causing persistent and heightened stock market volatility might be misplaced. Gazi and Mahmudul (2009) sought to find evidence supporting the existence of share market efficiency based on the monthly data from January 1988 to March 2003 and also shows empirical relationship between stock index and interest rate for fifteen developed and developing countries

For all of the countries it is found that interest rate has significant 15 negative relationship with share price and for six countries it is found that changes of interest rate has significant negative relationship with changes of share price. 2.7 Conclusion From the literature and empirical evidence review there is mixed findings. There are studies done by Hsing (2004), Arango (2002), Gazi and Mahmudul (2009) in different countries that have found a negative relationship between interest rates and share prices.

However, Lee (1997) found the relationship changing gradually from a significantly negative to no relationship, or even a positive although insignificant relationship. Gupta et. al (n.d) in their research failed to establish any consistent causality relationships between interest rates and share prices. Therefore, there is still no unanimity in the study of the relationship between interest rate and share prices.

This proposed research will contribute to the growing literature by employing the Toda and Yamamoto (1995) method in the Kenyan scene. Toda and Yamamoto (1995) proposed a simple procedure requiring the estimation of an ―augmented‖ VAR, even when there is cointegration of different orders, which guarantees the asymptotic distribution of the MWALD statistic. Hsing (2004) adopted a structural VAR model that allows for the simultaneous determination of several endogenous variables such as, output, real interest rate, exchange rate, the stock market index and 55

found that there is an inverse relationship between stock prices and interest rate. Lee (1997) used three-year rolling regressions to analyze the relationship between the stock market and the short-term interest rate.

He found that the relationship is not stable over time. It gradually changes from a significantly negative to no relationship, or even a positive, although insignificant relationship. 16 Ishfaq, M., Ramiz, Rehman & Awais, Raoof (2010) examined the relationship between stock return, interest rate and exchange rates in Pakistani economy over the period of 1998-2009. A multiple regression model was applied to test the significance of change in interest rate and exchange on stock returns.

The results indicated that both the change in interest rate and change in exchange rate have a significant impact on stock returns over the sample period . Hashemdah and Taylor (1988) found bi-directional relationship causality present in regression models between money supply and stock return. However, with respect to interest rates the result was inconclusive. Gupta et. al (n.d) studied the relationship between exchange rate, interest rate and stock prices in Indonesia.

The study was conducted for five year period from 1993 to 1997 which was divided into three sub periods. The overall evidence, however, failed to establish any consistent causality relationships between any of the macro economic variables under study.

Relationship of interest rate and stock returns has been widely examined by ardent researchers. In literature, French, et al. documented theoretically, that stock returns responded negatively to both the long term and short term interest rates. Choi and Jen reported that the expected returns on common stocks are systematically related to the market risk and the interest-rate risk. The findings of the study indicate that the interest-rate risk for small firms is a significant source of investors' portfolio risk and the interest-rate risk for large firms is "negative". Allen and Jagtianti pointed out that the interest rate sensitivity to stock returns has decreased dramatically since the late 80’s and the early 90’s because of the invention of interest rate derivative contracts used for hedging purposes. The empirical results of the divergent researches specify that growth rates of interest rates negatively affect stock returns with a significant lag 56

in short run dynamic model. Few recent studies carried out in Indian context, Bhanumurty and Agarwal observed that nominal interest rates adjust only to movements in the wholesale market prices but the relationship was not robust. They concluded that interest rate determination in India need not focus much on the domestic inflation rate, as there seems to be no strong co-movement between them. Bhatt and Virmani showed that short term interest rates in India are getting progressively integrated with those in the US even though the degree of integration is far from perfect.

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CHAPTER 4. DATA ANALYSIS, INTERPRETATION & PRESENTATION This chapter provides a summary of the data analysis, results of the study and the discussion on the results of the study. The chapter is organized as follows: section 4.1 describes the data analysis and the results of the study and section 4.2 discusses the implication of the findings of the study.

4.1 DATA COLLECTION & ANALYSIS

The data used for the present research work is principally secondary data. The data were collected from BSE and Reserve Bank of India (RBI). Other necessary information was collected from the Centre for Monitoring Indian Economy (CMIE) reports. The relevant literature was gleaned from books, journals and magazines. The impact of Interest rate and Stock returns in India is studied, by using monthly data from April 1997 to March 2014. This period is not only the economic reform period but also depicted a great deal of volatility. Variables Justification Dependent Variable Stock Returns Stock returns has been calculated by using following equation Rt = In (It / I t-1) Where, Rt = Return for month‘t’ It and I t-1 = Average values of BSE-Sensex Index for month‘t’ and t-1 respectively.

BSE SENSEX is taken as a proxy for equity returns. The SENSEX is the benchmark index of the Indian Capital Markets with wide acceptance among individual investors, institutional investors, foreign investors and fund managers. The BSE SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100.

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Independent Variables Interest rate Treasury bill rates have been used as proxy of interest rate. At present, the Government of India issues three types of treasury bills through auctions, namely; 91 days, 182 days and 364 days. The treasury bills are issued in the form of promissory note in physical form or by credit to Subsidiary General Ledger (SGL) account or Gilt account in dematerialized form.

Analytical Procedure The present study tried to analysis the relationship between interest rate and stock returns, to focus on ‘causality’ among the variables using the method developed by Granger. Statistical and econometric tools have been used to test and verify the results of the study for their accuracy. The tools namely descriptive statistics, correlation analysis, and Granger causality test have been used for examining the short-run interdependence between variables. The study uses three different tests, i.e., Augmented Dickey Fuller (ADF) test, Phillips-Perron (PP) test and Kwiatkowski, Phillips, Schmidt. and Shin (KPSS) test for finding unit roots in time series.

Hypothesis In order to answer whether the interest rate causes the stock returns, the following hypotheses are framed:

Ho: Interest rate does not cause stock returns Ho: Stock returns does not cause interest rate

Relationship between Interest rate and Stock Returns A rise in the interest rates affects the valuation of the stocks. The rise in the interest rates raises the expectations of the markets participants, which demand better returns that commensurate with the increased returns on bonds. In a low interest rate regime, corporates are able to increase profitability by reducing their interest expenses. However in a rising interest rate regime, as interest expenses rise, profitability is affected. When interest rates rise, investors move from equities to bonds. Whereas when interest rates fall, returns on bonds fall while the returns on equities tends to look relatively more attractive and the migration of fund from bonds to equities takes place, and increasing the prices of equities. 59

Interest rate and stock market are inversely related. As the interest rates go up, stock market activities tend to come down. Capital intensive industries would be heavily affected by high interest rates but when the interest rates decrease they would be gaining the most. It is better to avoid investments in sectors such as real estate, automobiles etc when the interest rates are rising. Companies with a high amount of loans in their balance sheets would be affected very seriously. Interest cost on existing debt would go up affecting their Earning Per Share (EPS) and ultimately the stock prices. But during low interest rate these companies would stand to gain. In a high interest rate scenario, companies with zero or near zero debts in their balance sheets would be the kings. Fast moving consumer goods (FMCG) is one sector that is considered as a defensive sector due to its low debt nature.

Sectors like Pharma and Information Technology (IT) are less affected by interest rates. The IT sector is more influenced by factors such as currency rate fluctuations, rising attrition level, visa restrictions, competition from the large global players and margin pressures. Certainly, IT sectors are not interest rate-sensitive. Pharma is considered as the defensive sector and investors can invest here during uncertain and volatile market conditions. Banking sector is likely to benefit most due to high interest rates. The Net Interest Margins for banks is likely to increase leading to growth in profits and the stock prices.

Relationship of interest rate and stock returns has been widely examined by researchers. In literature, French, K. R., Schwert, G. W. and Stambaugh, R. E. (1987), French, K. R., Schwert, G.W. and Stambaugh, R. E. (1987) documented theoretically, that stock returns responded negatively to both the long term and short term interest rates. Choi and Jen (1991) report that the expected returns on common stocks are systematically related to the market risk and the interest-rate risk. The findings of the study indicate that the interest-rate risk for small firms is a significant source of investors' portfolio risk and the interest-rate risk for large firms is "negative". Allen and Jagtianti (1997) pointed out that the interest rate sensitivity to stock returns has decreased dramatically since the late 80’s and the early 90’s because of the invention of interest rate derivative contracts used for hedging purposes.

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The empirical results of Muradoglu and Metin (2001) indicate that growth rates of interest rates negatively affect stock returns with a significant lag in short run dynamic model. Few recent studies carried out in Indian context, Bhanumurty and Agarwal (2003) observed that nominal interest rates adjust only to movements in the wholesale market prices but the relationship was not robust. They concluded that interest rate determination in India need not focus much on the domestic inflation rate, as there seems to be no strong co-movement between them. Bhatt and Virmani (2005) showed that short term interest rates in India are getting progressively integrated with those in the US even though the degree of integration is far from perfect.

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4.2 ANALYSIS & INTERPRETATION The short run causality between Interest rate and Equity returns is analyzed as below: Table - 1 Descriptive Statistics Levels

First Difference

Stock

Interest

Stock

Interest

Variables

Returns

Rate

Returns

Rate

Mean

8.932

1.881

0.009

-0.002

Maximum

9.916

2.542

0.193

0.294

Minimum

7.961

1.168

-0.279

-0.374

Std. Dev.

0.692

0.292

0.066

0.074

Skewness

0.076

-0.438

-0.615

-1.071

Kurtosis

1.356

2.702

4.465

9.243

Jarque-Bera

21.799

6.857

29.138

347

Probability

0.000

0.032

0.000

0.000

Sum

1715

361

1.632

-0.343

Observations

192

192

191

191

Table provides the summary statistics on the levels of the variables and first difference. Summary statistics include the mean and the standard deviation, minimum maximum, skewness and Kurtosis value for the period 1997-98 to 2012-13.The mean, median, maximum, minimum and standard deviation can determine the statistical behavior of the variables. It is observed from the table that Stock returns over the period of study is maximum at 9.916 with a minimum of 7.961, averaging at 8.932 with a standard deviation of 0.692 which clearly shows that there is no much fluctuations in the Stock returns over the period of study at levels. As far as interest rate is concerned the maximum stood at 2.542 and the minimum accounted for 1.168 with an average of 1.881 over the period of study. The standard deviation worked out to 0.292, thus indicating low fluctuations as for as interest rate is concerned. The table also shows that average monthly Stock returns as 0.9 per cent and the interest rate as 0.2 per cent.

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However, the standard deviations of the differences in these variables indicate that interest rate is more than Stock returns. For a normal distribution, the skewness must be zero and kurtosis at three. The results show that the frequency distributions of the variables are not normal. Jarque-Bera statistics also indicates that the frequency distribution of the underlying series does not fit normal distribution.

Table -2 Correlation Analysis Correlation Coefficient ( r ) between Interest rate and Stock returns

Series

r

t-Statistics

P-Value

Ho Hypothesis

-0.17

-2.23

0.03*

Rejected

-0.11

-1.47

0.14

Not Rejected

Level Interest rate

Specification First Difference

* Implies significant at 5% level.

Table 4.3 shows the correlation analysis between interest rate and stock returns for both level specification and first difference. At level specification, the correlation relationship between interest rate and stock returns is -0.17, which is significant at five percent level. It indicates a negative relationship between the variables in a long run. There is a danger of obtaining apparently significant correlation results from unrelated data. Such correlation are said to be spurious. To avoid that, correlation analysis between the first difference variables has also been computed. At the first difference, the correlation relationship between interest rate and stock returns is -0.11, which is insignificant.

It indicates that interest rate has very low negative correlation with equity returns. The results of the study indicate there is no relationship between interest rate and stock returns in India (r=0). But one point is worth enough to bring into consideration that a high or low degree of correlation certainly does not signify or rules out causality. It simply points towards the positive or negative linear relationship that exists between the two variables.

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It concludes that the proportion of variation in interest rate is weakly attributed to stock returns. Since correlation analysis is not a strong analysis to make conclusion of the study of hypothesis to see the effect of interest rate on stock return, the researcher sought the help of econometric models to bring more precision to the analysis.

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Table – 3 Unit Root Test Augmented Dickey-Fuller test Statistics Null Hypothesis: Variable is Not Stationary Variables

Level

First Difference Constant and

Constant and

Constant

trend

Constant

trend

Stock Returns

-0.6675

-2.2663

-10.0411

-10.0210

Interest rate

-1.5056

-1.2374

-11.8325

-11.8356

Test Critical Value (Mac Kinnon 1996) 1% Level

-3.4672

-4.0104

-3.4672

-4.0104

5% Level

-2.8776

-3.4354

-2.8776

-3.4354

10% Level

-2.5754

-3.1417

-2.5754

-3.1417

Phillips - Perron test Statistics Null Hypothesis: Variable is Not Stationary Variables

Level

First Difference Constant and

Constant and

Constant

trend

Constant

trend

Stock Returns

-0.6227

-2.1758

-10.0274

-10.0055

Interest rate

-1.9036

-1.6700

-11.8914

-11.8921

Test Critical Value (Mac Kinnon 1996) 1% Level

-3.4670

-4.0101

-3.4670

-4.0101

5% Level

-2.8775

-3.4351

-2.8775

-3.4351

10% Level

-2.5754

-3.1416

-2.5754

-3.1416

Kwaitkowshi-Phillips-Schmdist-skin test statistics Null Hypothesis: Variable is stationary Variables

Level

First Difference Constant and

Constant and

Constant

trend

Constant

trend

Stock Returns

1.5244

0.2070

0.0931

0.0770

Interest rate

0.3977

0.1262

0.1307

0.0719

0.2160

0.7390

0.2160

Test Critical Value (Mac Kinnon 1996) 1% Level

0.7390

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5% Level

0.4630

0.1460

0.4630

0.1460

10% Level

0.3420

0.1190

0.3420

0.1190

It is essential to test the economic time series data for stationary before proceeding for Granger Causality tests. The study uses three different tests, i.e., Augmented Dickey Fuller (ADF) test, Phillips-Perron (PP) test and Kwiatkowski, Phillips, Schmidt. and Shin (KPSS) test for finding unit roots in time series. ADF, PP and KPSS statistics are given in Table 4.4.

On the basis of ADF statistics, PP test and KPSS test both interest rate and Stock returns are found to be non-stationary at levels and stationary at first difference which is the common phenomenon in most of the economic time series.

Further, ADF statistics and PP test rejects null hypotheses of unit root in case of first differences of interest rate and Stock returns at one percent. Finally, KPSS test is also applied which reject null hypothesis at levels and accept the null hypothesis at first difference. Assuming, interest rate and Stock returns are non-stationary at levels and stationary at first differences on the basis of ADF, PP, KPSS tests are undisputedly declared that all the variables are integrated of order one,

Table - 4 Granger causality test

Null Hypothesis

Lags

F-

Prob.

Results

Statistics Interest rate does not cause Stock Returns 2

0.83964

0.4336

ACCEPT

Stock Returns does not cause Interest rate 2

1.55499

0.2141

ACCEPT

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Table - 5 Interest rate versus Equity returns Cause

Effect

Causality Inference

Relationship

Interest

Stock

Interest rate does not cause Stock returns No Relation

rate

Returns

Stock

Interest rate

Stock Returns does not cause Interest rate No Relation

Returns

The study implement the Granger Causality test to answer whether changes in interest rate cause changes in Stock returns or changes in Stock returns cause changes in interest rate, applying order one i.e. I (1). Table 4.5 represents the empirical results of Granger causality test between interest rate and stock returns. The test results suggest that, fail to reject the null hypothesis of interest rate does not cause stock returns as well as the null hypothesis of Stock returns does not cause interest rate. This implies that the interest rate neither affects Stock returns nor stock returns affect the interest rate.

The study indicates that the interest rate does not cause the Stock returns. It is consistent with the results of Mok (1993), Gjerde and Saettem (1999), Mukherjee and Naka (1995) and Humpe and Macmillan, (2009). The results was also consistent with the findings of many researcher is India like Bhattacharya and Mukherjee (2002), Pratnik and Vina (2004) and the results is contrary to Mukhopadhyay and Sarkar (2003), Debabrata Mukhopadhyay and Nityananda Sarkar (2003), Ray, Pranthik and Vani Vina (2004),Lakahmi R. Nair (2008), Shahid Ahmed (2008 ). The Stock returns does not cause interest rate. It is consistent with the results of Bhattacharya and Mukherjee (2002), Shahid Ahmed (2008) and the result is contrary to Ratanapakorn and Sharma (2007). Thus, it is observed that, stock market has no relation with the growth of Interest rate in India and vice versa.

This study used the secondary data for the weekly share prices and the interest rates for the period between the first week of 2004 and last week 2013. The data for share prices and interest rates were obtained from NSE and the CBK respectively. Based on the weekly data obtained we produced the two time series graph one for interest rates

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and the other for share prices and plotted independently.

By observing the trends on the two graphs in figures one ad two below, one for interest rates and the other share prices we note an important pattern and relationship. The two series trend in almost opposite directions. For instance, between the first few weeks of 2004 and the whole 2005 weeks the share prices trended upwards while the interest rates were trending downwards. Moreover for the period 2009 and the last weeks of 2010 the interest rate aloft as the share price within those weeks trended down. In the weeks of 2007/2008 mainly the last and the first 18 weeks of the years respectively share prices toppled sharply while the interest rates increased slightly. When taking the spearman correlation coefficient of the two variables the result is negative 0.058. This depicts a very weak negative correlation between 22 them

Toda Yamamoto method for causality test The result of the modified causality Wald test, obtained from the SUR estimation of level VAR model outlined in equations (1) and (2), are depicted in Table 1. The null hypothesis that interest rate do not Granger cause share price index was accepted at 95% significance level (see appendix 1). Similarly, the null hypothesis that share price index does not Granger cause interest rate was accepted at 95% level of significance (see appendix 2). The results shows that the beta-values are less than the test critical values, the study consequently fails to 24 reject the two null hypotheses. Therefore, this study doesn’t find evidence that there is a bidirectional causality relationship between interest rate and share price index.

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CHAPTER 5. CONCLUSION & SUGGESTION

5.1 CONCLUSION

The analysis of data and discussions show that there is an impact of interest rate on stock prices. From the data analysis it is found that six sectors- auto, bank, FMCG, financial services, IT, pharma- out of eleven sectors and one market index (Nifty Fifty) were significantly impacted by the interest rate. Five sectors which did not show significant correlation with interest rate were energy, media, metal, PSU bank and realty.

The present study tried to estimate causality relationship between Interest rate and Stock returns. The impact of Interest rate and Stock returns in India is studied, by using monthly data from April 1997 to March 2019. The study finds a Short run causality observed between Interest rate and stock returns revalued the following, that there is no causality between Interest rate and stock returns. The study implies that the Interest rate neither affects Stock returns nor a Stock return affects the interest rate. Thus, the present study empirically proves, stock market has no relation with the growth of interest rate in India and vice versa.

From the previous studies and my findings now it is easy to say that interest rate has a negative impact on stock market, higher the interest rate lower the efficiency of stock market, it is because if investors are getting higher without taking any risk then why should they invest in stock market, so for a better economy the ruling state should lower its interest rate so that economy of that country gets developed. It is not the only factor that has negative impact on stock market there can be many other factors for example inflation rate etc which are having negative impact on stock market.

Based on the evidence obtained, this study can conclude that there is no significant causal relationship between interest rate and share price. This study also shows that the market does respond to certain shocks, as in this case, political instability.

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5.2 SUGGESTION

This study considered only two variables, interest rates and share prices. However, the inclusion of other macroeconomic variables likes inflation money supply and exchange rate which might bring about a different effect to the study. This is important as the government will be able to set up polices that will be helpful in developing the stock market. Additional variables can therefore be considered in another study. Also the significance of the results of this study could possibly be improved upon by applying daily primary data. The use of more frequent observations may better capture the dynamics of stock prices and interest rates interrelationships.

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QUESTIONNAIRE 1. Is interest rate the best tool that keeps the liquidity position in the economy stable over a period of time? 

Yes



No



Can’t say

3. Have you ever bought or sold Bank sector stocks in your portfolio on account of a rise Bank Interest Rate? 

Yes



No



Sometimes

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4. Is the long term rate of interest an important factor in regard to policies of Capital Extension? 

Yes



No

5. Is this a sufficient real rate to attract depositors in a big way from other assets such as gold and real estate to what is offered by banks? 

Yes



No

6. Will the fed rate hike affect the Indian stock market? 

Yes



No

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