THE RELATIONSHIP BETWEEN SHARE PRICES AND INTEREST RATES

The objective of this research is to examine how changes in interest rates represented by the weighted average lending rate by commercial banks in Kenya and stock prices proxied by the N

THE RELATIONSHIP BETWEEN SHARE PRICES AND INTEREST

RATES: EVIDENCE FROM KENYA

Dan Chirchir1

1

School of Business, University of Nairobi, Nairobi, Kenya

Correspondence: Dan Chirchir, Department of Finance and Accounting, School of Business, University of Nairobi, P.O Box 30197-00100, Nairobi, Kenya Tel: +254 723 838534 E-mail: dchirchir@uonbi.ac.ke

Abstract

The changes in interest rates do have a diverse effect across the economic spectrum in any country The sectoral and economy wide effects of interest rates may ultimately be reflected in the stock prices Policy makers, scholars, economists, business owners, regulators and the general Kenyan public are grappling with figuring out the relationship

of stock prices and interest rates

The objective of this research is to examine how changes in interest rates (represented by the weighted average lending rate by commercial banks in Kenya) and stock prices (proxied by the NSE 20 share index) are related to each other for Kenya over the period October 2002- September 2012

The research used Toda and Yamamoto (1995) method to determine the relationship between stock prices and interest rates This method is applicable “whether the Vector Auto Regression (VAR) may be stationary (around a deterministic trend), integrated of

an arbitrary order, or cointegrated of an arbitrary order” (Toda, Yamamoto, 1995, pp

227)

The results therefore indicated that there is no significant causal relationship between interest rate and share price As regards the sign of causality, negative causality exists in both directions

Table of Contents

Chapter One 1

Introduction 1

1.1 Background 1

1.2 Research Problem 1

1.3 Research Objective 2

1.4 Value of the Study 2

Chapter Two 3

2 Literature Review 3

2.1 Introduction 3

2.2 Share price and markets theories 3

2.3 Interest rate theories 4

2.4 Theories linking interest rates and share prices 4

2.5 Research hypothesis 5

2.6 Empirical evidence 5

2.7 Conclusion 6

Chapter Three 8

3 Research Methodology 8

3.1 Introduction 8

3.2 Research design 8

3.3 Population and sample design 8

3.4 Data collection 9

3.5 Data analysis 9

Chapter four 11

4 Data Analysis, Results and Discussions 11

4.1 Introduction 11

4.2 Data analysis and results 11

4.3 Discussion 14

Chapter five 16

5 Summary, Conclusion and Recommendations 16

5.1 Summary of findings 16

5.2 Conclusion 16

5.3 Limitations of the study 165.4 Recommendations 16

References 17List of Tables

Table 1: Results of the Augmented Dickey-Fuller unit root test in levels 13Table 2: Results of the Augmented Dickey-Fuller unit root test in first difference 13Table 3: Results of the Toda-Yamamoto Causality Test 14

List of Figures

Figure 1: Graphical analysis of share prices series 12Figure 2: Graphical analysis of interest rates series 12

LIST OF ABBREVIATIONS

AIC Akaike Information Criterion CBK Central Bank of Kenya

CBR Central Bank Rate

DMAX Maximum order of intergration EMH Efficient Market Hypothesis MWALD Modified WALD

NSE Nairobi Stock Exchange

VAR Vector Auto Regression

Research gap

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, Chevalier and Sayekt (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

1.2 Research Problem

Undoubtedly, the changes in interest rates do have a diverse effect across the economic spectrum in any country For instance, interest rates will impact the cost of doing business The sectoral and economy wide effects of interest rates may ultimately be reflected in the stock prices On the converse, performance of companies and businesses

in Kenya may impact on economic growth The economic growth may eventually affect levels of interest rates Policy makers, scholars, economists, business owners, regulators

and the general Kenyan public are grappling with figuring out the relationship of stock prices and interest rates

1.4 Value of the Study

1 The results of this study will help investors to manage well their portfolios of investments

2 The findings can be used by regulators such as CBK in managing the interest rate policy

3 This linkage of stock price and interest rates has implications for the management

of publicly owned companies in Kenya

4 The empirical findings of this proposed research will contribute to the body of knowledge

Chapter Two

2 Literature Review 2.1 Introduction

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 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, the chapter concludes with summary of how this research will contribute to the existing literature

2.2 Share price and markets theories

The pricing of shares in a stock market is one of the most important subjects in finance The investors and other stakeholders in the capital market are interested in understanding the factors that affect the movement of share prices There are two broad theories that attempt to explain the movement in share prices in stock market The first is the Efficient Market Hypothesis which basically contends that all information affecting a share price is reflected immediately in its price At the heart of this hypothesis is the assumption that investors are rational The other theory is behavioural finance which contends that investors are not always rational and that their behavior affects the share prices The two theories are discussed below:

Efficient Market Hypothesis

Fama (1965) published his dissertation arguing for the random walk hypothesis He defined market efficiency as follows: "In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices

of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its inherent value."

Behavioral finance theory

The assumption that investors are rational and behave in a rational manner is at the core

of the EMH Over the years another school of thought has emerged This school of thought hypothesizes that investors are not always rational and therefore the study of market efficiencies and security pricing should take into account the behavior of investors This school of thought has evolved into a branch of finance known as behavioural finance

Sewell (2005) defined behavioural finance as the study of the influence of psychology on the behaviour of financial practitioners and the study of subsequent effect of markets Belsky and Gilovich (1999) referred to behavioural finance as behavioural economics in that "Behavioural economics combines the twin disciplines of psychology and economics

to explain why and how people make seemingly irrational or illogical decisions when they spend, invest, save, and borrow Much of economic and financial theories presume that individuals act rationally and consider all available information in the investment decision-making process

2.3 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

2.4 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

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 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

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 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

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

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

Chapter Three

3 Research Methodology 3.1 Introduction

Research methodology refers to the procedures to be adopted to obtain answers to the research question and the tasks needed to complete the different components of the research process This chapter is organized as follows: section 3.2 deals with research design, section 3.3 defines the population and sample, section 3.4 covers data collection, and section 3.5 addresses data analysis

is applied to the first k VAR coefficients to investigate causality

3.3 Population and sample design

The two variables used in the research are interest rates stated as the monthly weighted average lending rate by commercial banks in Kenya and the NSE share index The NSE share index used in the study is NSE 20 share index This index tracks the performance of the shares of twenty companies as selected by the management of NSE from time to time The sample data is based on the NSE stock index values for the time periods between October 2002 and September 2012 The prevailing interest rates for the same time period

of between October 2002 and September 2012 are selected for use in the research The 10

year period provides 120 data points which are considered adequate In addition it is the most recent 10 year period at the time of this research

3.4 Data collection

The data used in this research is secondary data The monthly data on the NSE share index (1964=100) was obtained from the NSE Monthly data on the average interest rate was obtained from CBK

3.5 Data analysis

Traditionally to test for the causal relationship between two variables, the standard Granger (1969) test has been employed This test states that, if past values of a variable Y significantly contribute to forecast the value of another variable Xt+1 then Y is said to Granger cause X and vice versa To analyze Granger causality between interest rate and stock market price the research will use Toda, Yamamoto (1995) procedure, as explained below:

Toda and Yamamoto Model

The integrated properties of the stock price series and interest rates series are not important in Toda and Yamamoto method, providing that the risk of misspecification of the order of integration of the series is minimized Thus, the causality relationship between series which are integrated different orders can be investigated In order to apply Toda and Yamamoto method, firstly, the VAR order, k, and the maximum order of integration of the variables, dmax, should be determined in the VAR model The sum of k and dmax, is taken into consideration as the total order of VAR, that is (k+dmax)th order

of VAR is estimated Then, in order to employ causality test, modified Wald test (MWALD), proposed by Toda and Yamamoto (1995), is applied to the first k VAR coefficients to investigate causality This test has an asymptotic chi square (χ2) distribution when a VAR (k + dmax) is estimated A Monte Carlo experiment, presented

in Zapata and Rambaldi (1997), provides evidence that the MWALD test has a comparable performance in size and power to the likelihood ratio and WALD tests if (i) the correct number of lags for estimating k + dmax is identified and (ii) no important