IMPACT OF INTEREST RATE ON STOCK MARKETS

A Project submitted in partial fulfillment of

Bachelor of Business Studies (BBS)

Submitted By:
Shubhneet Aneja
Examination Roll Number 11067234158
Bachelor of Business Studies
Shaheed Sukhdev College of Business Studies
University of Delhi
1

Certificate of Authenticity
I hereby declare that this research paper titled Impact of Interest Rates on Stock Markets,
prepared under the guidance of Dr. Rohini Singh is an original piece of work. It has not been
copied or plagiarized from any source what so ever and has not been submitted earlier to any
other institution.
References have been credited to the persons who have worked on this topic previously. All
efforts made in this project have been personally made by me and any similarity to any past or
present work is purely coincidental.

Acknowledgement
I express my gratitude to Dr. Rohini Singh, my project guide for her guidance and support
throughout. She has been a continuous source of motivation throughout the period of the
project and showed the right path towards the goals set in the beginning. The knowledge and
the insight that she has provided to the project was most valuable.
Besides this, the research material published by various government organization and Business
Schools has helped me gain the basic understanding of concepts involved in the project.

Table of Contents
Certificate of Authenticity ...................................................................................................................2
Acknowledgement..............................................................................................................................3
Table of Contents ...............................................................................................................................4
Abstract .............................................................................................................................................5
Introduction.......................................................................................................................................6
Literature Review ...............................................................................................................................8
Data and Methodology .....................................................................................................................10
Scope of Study..................................................................................................................................12
Findings and Analysis ........................................................................................................................13
Correlation Analysis ......................................................................................................................13
Regression Analysis.......................................................................................................................14
T Bill 91 Days and SENSEX........................................................................................................14
T- Bill 364 Days and Sensex ........................................................................................................15
G-Sec10 and Sensex...................................................................................................................16
G-Sec5 and Sensex ....................................................................................................................17
T-Bill 91 Days and Nifty ..............................................................................................................18
T Bill 364 and Nifty..................................................................................................................19
G-SEC10 and Nifty .....................................................................................................................20
G-SEC5 and Nifty .......................................................................................................................21
Conclusion .......................................................................................................................................22
References .......................................................................................................................................24

Abstract
This study analyses the relationship between interest rates and stock markets. The study takes
returns on SENSEX and Nifty as the dependent variables and the month-end yields on 10-year
government security, 5 year government security and treasury bills (91-364 days) as the
independent variables. The study is conducted for the period of 10 years, (Nov. 2002- Oct. 2012
for GSEC10YR and GSEC5YR and Jan. 2004- Dec. 2013 for 91-days TB and 364 days TB) using
monthly data. Here, the 10 year and 5 year bond rates are used as long term interest rates and
91 days and 364 days bond rates are used as short term interest rates. Statistical tools like
Correlation and Regression have been used to analyze the relationship between stock returns
and interest rates, and also to test the statistical significance of the same. The study finds that
there is a negative relationship between the interest rates and stock market indices.

Introduction
Stock market is an important part of the economy of a country and has become an important
indicator of the performance of the Indian economy over the years. The stock market is
significant for any economy as it plays a major role in the growth of the industry and commerce
of the economy. That is reason why everybody including government, industry and even the
central banks of the country keep a close watch on the happenings of the stock market. The
stock market is important from both the industrys point of view as well as the investors point
of view. . The stock market works with the sentiments of participants, which depend on several
factors, making it a very sensitive segment of the economy. Globalization and financial sector
reforms have added to the sensitivity by increasing determinants of the stock market
movement manifold. Among the several other important determinants, one whose relationship
with the stock market is of great concern and needs to be carefully studied is interest rates.
In theory, the relationship between interest rates and stock prices is negative. This is due to the
cash flow discounting model according to which, present values of stocks are calculated by
discounting the future cash flows at a discount rate. If the discount rate increases, then present
values of stocks decline and vice versa. This discount rate is a risk adjusted required rate of
return and equal to the level of interest rates in the economy. Therefore, an increase in interest
rates lowers present values of stocks directly. In addition, rising interest rates reduce cash flows
by reducing the profitability of firms. Due to these two reasons, present values of stocks decline
and so do current stock prices.
The relationship can also be positive due to the following reasons. First, if interest rates
increase in response to the economy growing too rapidly then corporate earnings should also
be growing rapidly and so should stock prices. Second, higher interest rates suggest higher
anticipated inflation. This leads to a likely increase in corporate pricing power because of which
higher growth rates of earnings per share are witnessed by firms. Therefore, when the discount
factor is increased in the stock valuation formula, the earnings per share are affected and
increased. Third, a positive relationship can be explained in terms of a changing risk premium.
For example, a drop in interest rates could be the result of increased risk or/and precautionary
saving as investors move away from risky assets such as stocks towards less risky assets like
bonds.

The above discussion reveals that the relationship between interest rates and stock prices can
either be positive or negative. This aspect of the market aroused my interest in undertaking a
study that analyses the relation between stock markets and interest rates.
This study tries to understand the impact of interest rates on the SENSEX and NIFTY, both of
which are seen as important benchmarks of Indias economic health. Here the bond rates of 10
year and 5 years is taken as long term interest rates and bond rates of T-Bills of 91 days and 364
days is taken as a measure of short term interest rate in the economy.
The study attempts to analyze the impact of the above mentioned independent variables on
the dependent variables, SENSEX and Nifty for the period of November 2002 to October 2012
for GSEC10YR* and GSEC5YR bonds* and January 2004 to December 2013 using monthly data.
The basic objectives of the study are:

To understand the relationship, if any, between stock markets and the long term and
short term interest rates.
To analyze the degree to which stock markets move because of the changes in interest
rates.

*Data beyond October 2012 cannot found on www.rbi.org.in and hence is not included.

Literature Review
This section highlights the intricacy in the relationship between interest rates and stock prices
by making a survey of select previous studies which was carried out to develop greater insights
into the subject.
Chankradhara Panda (2008) investigated whether interest rates matter for stock markets in the
Indian context. He used the monthly averages of the SENSEX and NIFTY to measure stock
process in April 1996-June 2006. For the same period, the month-end yields on 10-year
government security and treasury bills (15-91 days) are used to measure long-term and shortterm interest rates, respectively. The paper finds that there is a long-run relationship between
interest rates and stock prices. Both long-term and short-term interest rates affect stock prices.
The long-term interest rates are found to affect stock prices negatively, whereas short-term
interest rates affect stock prices positively. In addition, the SENSEX is found to be more
responsive to changes in interest rates than the NIFTY.
Wing-Keung Wong, Habibullah Khan & Jun Du (2005) studied the long- run equilibrium
relationships between the major stock indices of Singapore and the United States and selected
macroeconomic variables by means of time series data for the period January 1982 to
December 2002. The results of various co-integration tests suggest that Singapores stock prices
generally display a long- run equilibrium relationship with interest rate and money supply (M1)
but the same type of relationship does not hold for the United States. The same methodology
for different subsets of data covering shorter time periods is applied to capture the short-run
dynamics of the evolving relationship between stock indices and macroeconomic variables. It is
found that before the Asian Crisis of 1997, stock markets in Singapore moved in tandem with
interest rate and money supply, but this pattern was not observed after the crisis. In the United
States, stock prices were strongly co-integrated with macroeconomic variables before the 1987
equity crisis but the relationship was impaired thereafter and eventually disappeared with the
onset of 1997 Asian Crisis.
Ndri. Konan Lon (2008) tried to investigate the effects of interest rates volatility on stock
market returns and volatility using weekly returns on the KOSPI 200 and the NCD 91-day yield
over the period from 31 January 1992 to 16 October 1998. A GARCH(1,1) augmented with
interest rates and assuming a students t-distribution for error terms is used to test these
relationships. Conditional market return is found to have a negative and significant relation
with interest rates while the conditional variance of returns has a positive but not significant

relationship with interest rates. These results indicate that interest rates have a strong positive
power for stock returns, and a weak predictive power for volatility.
Md. Gazi Salah Uddin & Md. Mahmudul Alam (2009) carried out a study that seeks 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. Stationarity of market return is tested and
found none of this stock market follows random walk model, means not efficient in weak form.
To investigate the reasons of market inefficiency, relationship between share price and interest
rate, and changes of share price and changes of interest rate were determined through both
time series and panel regressions. 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.

Data and Methodology

The basic purpose of the study is to understand the relation between the stock market and the
interest rates. For the purpose of this, the month-end yields on 10-year government security, 5year government security and TB-91-364 are used to proxy for long-term and short-term
interest rates, respectively. The closing price for each month for SENSEX and Nifty is taken to
calculate the arithmetic return. The choice is made with the obvious belief that these two
indices are the pulse of the Indian stock market. Since the data on GSEC10YR and GSEC5YR
bonds cannot be found on the RBIs website beyond October 2012, some changes are made
while calculating correlation and doing regression analysis. So, for calculating correlation data
from November 2002 to October 2012 is used for all the dependent and independent variables.
But while doing regression analysis, latest data available is used to do the calculations. Data
from November 2002 to October 2012 is used in case of GSEC10YR and GSEC5YR bonds and
data from January 2004 to December -2013 is used in case of T-Bills of 91 days and 364 days
period. Data on stock prices are obtained from the BSE and NSE websites. The data of 5 and 10year government securities and TB-91-364 are obtained from various issues of Handbook of
Statistics on the Indian Economy and RBI Bulletin published by the RBI.
To accomplish the purpose of the study Correlation and Regression models have been used.
First of all correlation is calculated among all the variables to determine if there is any
movement of the variables along with Sensex and Nifty. The Pearson correlation is +1 in the
case of a perfect positive (increasing) linear relationship (correlation), 1 in the case of a perfect
decreasing (negative) linear relationship (anti-correlation), and some value between 1 and 1 in
all other cases, indicating the degree of linear dependence between the variables. As it
approaches zero there is less of a relationship (closer to uncorrelated). The closer the
coefficient is to either 1 or 1, the stronger the correlation between the variables. Correlations
can also suggest possible causal or mechanistic relationships; however, statistical dependence
is not sufficient to demonstrate the presence of such a relationship.
Then in order to determine the degree of dependence of Sensex and Nifty on interest rates and
to judge the statistical significance of the same we will use a statistical tool that develops a
mathematical relationship between the dependent variable and the independent variables. This
statistical tool is known as regression. We will first, calculate the degree of dependence of
Sensex and Nifty (if any) individually with the independent variables using:

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Where,
yi is the dependent variable
0 is the intercept
i is the change in dependent variable given a unit change in the independent variable
i is the error term
The results so obtained shall then be tested for statistical significance. Statistical significance is
tested by determining the p-values at any level of significance (the probability of rejecting the
null hypothesis if it is true). We shall measure the statistical significance at 5% level of
confidence. A result is said to be statistically significant if the value is less than 0.05. It means
that the series is so rare that it cannot be explained by chance variation alone. If the result is
accepted under 5% level of significance, it means that in the long run we run the risk of making
the wrong decision 5% of the times and if the hypothesis is rejected then it means that there is
a risk of rejecting a true hypothesis in 5 out of every 100 occasions.

11

Scope of Study
The study is confined to study the relationship between stock prices and the interest rates. The
study is limited to only two stock indices, i.e. Sensex and Nifty. The study covers the period of
ten years* using monthly data in order to iron out the effects of short run imbalances. The data
relating to various interest rates was obtained from RBI website. The month end prices for
Sensex and Nifty were acquired from the BSE and NSE website, respectively. There were 120
observations for the interest rates. However, for calculating the return on Sensex and Nifty, we
required 121 observations. Percentage change of stock prices over the previous months closing
value was calculated for both Sensex and Nifty. Correlation and regression analysis were then
performed on these percentages changes.

*T-Bills 91 days and 364 days analysis done from January 2004 to December 2013
*GSEC10YR and GSEC5YR bond analysis done from November 2002 October 2012
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Findings and Analysis

Correlation Analysis
To understand the relationship between various dependent and independent variables,
correlation analysis was carried out.

G-SEC10
G-SEC10
G-SEC5
T-364
T-91
Sensex
Nifty

1
0.9872
0.8152
0.7232
-0.1931
-0.1798

G-SEC5
1
0.8617
0.7841
-0.2201
-0.2036

T-364

1
0.9762
-0.2535
-0.2309

T-91

Sensex Nifty

1
-0.2575
1
-0.2316 0.9915

From the above table we can see that all the independent variables i.e. yield on G-SEC10, GSEC5. T-364 and T-91 are highly correlated with each other. For the same reason, we cannot
perform multiple regressions on the data since that would lead to the problem of
multicollinearity.
We also observe that there is a negative correlation between stock indices and the various
interest rates. This shows that interest rates and stock indices move in opposite directions.
Also, correlation coefficients are higher for Sensex than Nifty in each of the variables.

*all data values are from November-02 to October-2012

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Regression Analysis
T Bill 91 Days and SENSEX
Ho: Changes in yields of T-91 has no impact on Sensex
H1: Changes in yields of T-91 has an impact on Sensex

Regression Statistics
R Square
0.042
R square value indicates that 4.2% variation in the dependent variable, that is, Sensex, is
explained by the independent variable, T-91.

Intercept
T-91

Coefficients
6.721
-0.816

P-value
0.007
0.025

The table tells us that when the percentage change in T-91 is 0, then percentage change in
Sensex shall be 6.721%. Also, 1% change in T-91 causes Sensex to move by 0.8% in opposite
direction as that of the change in yield on T-91. This relation is however, statistically significant
as p-value is less than 0.05. This means that we reject the null hypothesis that there is no
significant impact of changes in T-91 on Sensex.

14

T- Bill 364 Days and Sensex

Ho: Changes in yields of T-364 has no impact on Sensex
H1: Changes in yields of T-364 has an impact on Sensex

Regression Statistics
R Square
0.036
R square value indicates that 3.60% variation in the dependent variable, that is, Sensex, is
explained by the independent variable, T-364.

Intercept
T-364

Coefficients
7.436
-0.896

P-value
0.013
0.037

The table tells us that when the percentage change in T-364 is 0, then percentage change in
Sensex shall be 7.43%. Also, 1% change in T-364 causes Sensex to move by 0.89% in opposite
direction as that of the change in yield on T-364. This relation is however, statistically significant
as p-value is less than 0.05. This means that we reject the null hypothesis that there is no
significant impact of changes in T-364 on Sensex.

15

G-SEC10 and Sensex

Ho: Changes in yields of G-SEC10 has no impact on Sensex
H1: Changes in yields of G-SEC10 has an impact on Sensex

Regression Statistics
R Square
0.034
R square value indicates that 3.40% variation in the dependent variable, that is, Sensex, is
explained by the independent variable, G-SEC10.

Intercept
G-SEC10

Coefficients
11.967
-1.391

P-value
0.021
0.045

The table tells us that when the percentage change in G-SEC10 is 0, then percentage change in
Sensex shall be 11.967%. Also, 1% change in G-SEC10 causes Sensex to move by 1.391% in
opposite direction as that of the change in yield on G-SEC10. This relation is however,
statistically significant as p-value is less than 0.05. This means that we reject the null hypothesis
that there is no significant impact of changes in G-SEC10 on Sensex.

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G-SEC5 and Sensex

Ho: Changes in yields of G-SEC5 has no impact on Sensex
H1: Changes in yields of G-SEC5 has an impact on Sensex

Regression Statistics
R Square
0.044
R square value indicates that 4.4% variation in the dependent variable, that is, Sensex, is
explained by the independent variable, G-SEC5.

Intercept
G-SEC5

Coefficients
12.068
-1.449

P-value
0.008
0.022

The table tells us that when the percentage change in G-SEC5 is 0, then percentage change in
Sensex shall be 12.06%. Also, 1% change in G-SEC5 causes Sensex to move by 1.44% in opposite
direction as that of the change in yield on G-SEC5. This relation is however, statistically
significant as p-value is less than 0.05. This means that we reject the null hypothesis that there
is no significant impact of changes in G-SEC5 on Sensex.

17

T-Bill 91 Days and Nifty

Ho: Changes in yields of T-91 has no impact on Nifty
H1: Changes in yields of T-91 has an impact on Nifty

Regression Statistics
R Square
0.034
R square value indicates that 3.40% variation in the dependent variable, that is, Nifty, is
explained by the independent variable, T-91.

Intercept
T-91

Coefficients
6.242
-0.751

P-value
0.015
0.044

The table tells us that when the percentage change in T-91 is 0, then percentage change in Nifty
shall be 6.24%. Also, 1% change in T-91 causes Nifty to move by 0.75% in opposite direction as
that of the change in yield on T-91. This relation is however, statistically significant as p-value is
less than 0.05. This means that we reject the null hypothesis that there is no significant impact
of changes in T-91 on Nifty.

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T Bill 364 and Nifty

Ho: Changes in yields of T-364 has no impact on Nifty
H1: Changes in yields of T-364 has an impact on Nifty

Regression Statistics
R Square
0.029
R square value indicates that 2.90% variation in the dependent variable, that is, Nifty, is
explained by the independent variable, T-364.

Intercept
T-364

Coefficients
6.888
-0.83

P-value
0.025
0.048

The table tells us that when the percentage change in T-364 is 0, then percentage change in
Nifty shall be 6.88%. Also, 1% change in T-364 causes Nifty to move by 0.83% in opposite
direction as that of the change in yield on T-364. This relation is however, statistically significant
as p-value is less than 0.05. This means that we reject the null hypothesis that there is no
significant impact of changes in T-364 on Nifty.

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G-SEC10 and Nifty

Ho: Changes in yields of G-SEC10 has no impact on Nifty
H1: Changes in yields of G-SEC10 has an impact on Nifty

Regression Statistics
R Square
0.029
R square value indicates that 2.90% variation in the dependent variable, that is, Nifty, is
explained by the independent variable, G-SEC10.

Intercept
G-SEC10

Coefficients
11.390
-1.318

P-value
0.031
0.043

The table tells us that when the percentage change in G-SEC10 is 0, then percentage change in
Nifty shall be 11.39%. Also, 1% change in G-SEC10 causes Nifty to move by 1.31% in opposite
direction as that of the change in yield on G-SEC10. This relation is however, statistically
significant as p-value is less than 0.05. This means that we reject the null hypothesis that there
is no significant impact of changes in G-SEC10 on Nifty.

20

G-SEC5 and Nifty

Ho: Changes in yields of G-SEC5 has no impact on Nifty
H1: Changes in yields of G-SEC5 has an impact on Nifty

Regression Statistics
R Square
0.038
R square value indicates that 3.80% variation in the dependent variable, that is, Nifty, is
explained by the independent variable, G-SEC5.

Intercept
G-SEC5

Coefficients
11.412
-1.363

P-value
0.015
0.035

The table tells us that when the percentage change in G-SEC5 is 0, then percentage change in
Nifty shall be 11.41%. Also, 1% change in G-SEC5 causes Nifty to move by 1.36% in opposite
direction as that of the change in yield on G-SEC5. This relation is however, statistically
significant as p-value is less than 0.05. This means that we reject the null hypothesis that there
is no significant impact of changes in G-SEC5 on Nifty.

21

Conclusion
This study seeks to understand an important question of whether interest rates impact stock
markets by studying the nature of relationship and the direction of movement between interest
rates and stock prices in India for a period of 10 years. The closing prices of the BSE Sensex and
Nifty are used to measure stock prices. The month-end yields on 10-year government security,
5 year government security and TB-91-364 are used to proxy for long-term and short-term
interest rates, respectively. By using correlation and regression analysis, the study has following
major findings.

The interest rates affect the stock prices negatively, i.e. they move in opposite
directions.
Based on the values of Beta, long term interest rates cause more fluctuation in stock
prices as compared to the short term interest rates i.e. the value for beta is higher in
case of long term securities than treasury bills.
Short term interest rates explain the change in stock prices more than the long term
interest rates i.e. value of R square is highest for T-91 and least for G-SEC10 in all cases.
In addition, the BSE Sensex is found to be more responsive to changes in interest rates
than the NSE Nifty.

The reasons for such conclusions can be explained as:

In theory, the relationship between interest rates and stock prices is negative. This is due to the
cash flow discounting model according to which, present values of stocks are calculated by
discounting the future cash flows at a discount rate. If the discount rate increases, then present
values of stocks decline and vice versa. This discount rate is a risk adjusted required rate of
return and equal to the level of interest rates in the economy. Therefore, an increase in interest
rates lowers present values of stocks directly. Even a relatively small rise in interest rates can
have a major effect on present values if it is spread out over several years. In addition, rising
interest rates reduce cash flows by reducing the profitability of firms. Due to these two reasons,
present values of stocks decline and so do current stock prices. The inverse holds true as well.
Apart from the above theoretical reason, there are other few reasons, which account for the
negative relationship between interest rates and stock prices. First, interest rates are risk free
returns on bonds and as interest rates on bonds rise, bonds become more attractive and stocks
less attractive. Consequently, there is a change in the asset allocation in favor of bonds rather
than stocks. This moves funds from the stock market to the bond market, which invariably
increases the demand for bonds and reduces the demand for stocks. As a result, the prices of
22

stocks fall. The opposite is true when interest rates fall and funds are shifted from the bond
market to the stock market.
Second, corporate profitability is hit because of increase in interest rates in two ways: (i)
companies earnings net of interest rates fall; and (ii) consumers' demand for the products
decreases they pay more to borrow money. As the profitability decreases stock prices decline
and vice versa.
Third, if interest rates increase then investors' expectations about the economy and company
earnings, which drive the stock market, turn negative. This pushes stock prices down and the
reverse is true as well.
The findings in this paper correspond to a certain period, methodology employed and variables
chosen. The findings may change if these change. Therefore, the generalization of the findings
in this paper can be done with certain caveats.

23

References

E.4. CHAKRADHARA PANDA, Do Interest Rates Matter for Stock Markets? Economic &
Political Weekly, Vol. 43, No. 17, April 26, 2008; pp. 107-115.

Ndri. Konan Lon, The Effects of Interest Rates Volatility on Stock Returns and
Volatility: Evidence from Korea, International Research Journal of Finance and
Economics, ISSN 1450-2887 Issue 14 (2008)
Wing-Keung Wong, Habibullah Khan & Jun Du, Money, Interest Rate, and Stock Prices:
New Evidence from Singapore and the United States U21 Global, No. 007, July 2005

Md. Gazi Salah Uddin & Md. Mahmudul Alam, Relationship between Interest Rate and
Stock Price: Empirical Evidence from Developed and Developing Countries International
Journal of Business and Management, Vol 4, No. 3, March 2009
http://rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=13872
http://rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=14761

http://rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=4994
http://www.bseindia.com/stockinfo/indices_main.aspx?indi=BSE30%20%20&fromDate
=01/1/2002&toDate=15/04/2012&DMY=M

http://www.nseindia.com/products/content/equities/indices/historical_index_data.htm

24