Effects Of Interest Rates On Stock Market Capitalization

Abstract

Is stock market capitalization susceptible to changes in interest rates or not? This paper tends to examine and explain this relationship in the context of Pakistan. When cost of debt financing (i.e. interest rate) increases, profits of geared companies are likely to go down, which might cause lower earnings and dividends per share. Deflated earnings and dividends might then lead to lowering of expectations about future benefits from the shares of such companies and would negatively effect share prices, thus lowering market capitalization of stock exchange. This paper examines the relationship between interest rate changes and stock market capitalization. Single-variate regression models are used to analyze the response of weekly market capitalization of Karachi Stock Exchange (KSE) to changes in Repo Rate and KIBOR. Contrary to most of the previous empirical studies, our findings indicate that whenever there has been a general rise in the interests rates, namely, State Bank's Repo rate and KIBOR, market capitalization of KSE surprisingly though, increased. The findings of this research, on the one hand, do not stand supportive to most of the previous researches on the same topic, however, that could be because those researches were mostly carried out in developed capital markets. But, the research does support the notion that in developing countries banks and non-banking financial institutions make huge investments in the stock markets. As increase in interest rates increases the liquidity of banks and non-banking financial institutions and consequently when more funds are invested in the stock market that increases market capitalization