APRIL, 2011

This dissertation is submitted in part requirement for the Degree of MSc in Banking, Finance and Risk Management at the Glasgow Caledonian University.

I declare that this dissertation is my own original work and has not been submitted elsewhere in fulfilment of any requirement of this or any other award.

Signature……………………… Date………………………….


DEDICATION This dissertation is firstly dedicated to the Almighty God. His mercies are truly new every morning. The dedication will not be complete without me mentioning the name of my lovely wife Shirley Ankong and my beautiful princess Stacey. They are so dear to me.



I would like to express my deepest appreciation to my supervisor, Dr. Steven Walters, whose guidance and advice made this dissertation a success. I really appreciate your time and support. Thank you so much. My special thanks also go to all friends and family members especially my big brother Charles for his support and all those who in diverse ways have contributed in making this piece of work a reality. May God richly bless you all.


ABSTRACT........................................................................................................................1 INTRODUCTION..............................................................................................................2 Aims of the dissertation.......................................................................................................3 Research question................................................................................................................5 Dissertation structure...........................................................................................................5 CHAPTER ONE: THE GHANA STOCK MARKET.......................................................7 Introduction..........................................................................................................................7 Background ........................................................................................................................8 History and Development of the Ghana Stock Market.......................................................9 Ghana Stock Market Regulation and Supervision.............................................................11 Information Disclosure Requirement…………………….................................................12 Public Knowledge of the Securities Market......................................................................14 CHAPTER TWO: LITERATURE REVIEW....................................................................16 Introduction........................................................................................................................16 2.1 Effect of Interest Rate on Stock Price Movements......................................................17 2.1.1 Level and Movement of Interest Rates.....................................................................18 2.1.2 The Behaviour of Interest Rates in Sub-Saharan Africa………………….…………......19 2.1.3 Effects of Interest Rates on Stock Prices in Emerging Markets….............................22 2.1.4 Effects of Interest Rates on Stock Prices in Developed Markets.............................25 2.2 Effects of Inflation on Interest Rates...........................................................................27 2.3 The effect of Inflation on Stock Prices........................................................................28 IV

2.4 The effect of Inflation on Stock Returns……………..................................................30 2.5 The Efficient Market Hypothesis (EMH)....................................................................32 CHAPTER THREE: RESEARCH METHODOLOGY....................................................35 Introduction........................................................................................................................35 3.1 Research Approach.....................................................................................................36 3.1.1 Scientific Approach..................................................................................................36 3.1.2 Research Strategy………………………………………………………….………37 3.2Data...............................................................................................................................38 3.2.1 Data Description.......................................................................................................38 3.2.2 Collection of Data....................................................................................................39 3.3 Model Summary...........................................................................................................40 3.3.1 Model Specification..................................................................................................40 3.3.2 Model Justification...................................................................................................42 3.4 Analytical Tools..........................................................................................................43 3.4.1 Correlation Analysis.................................................................................................43 3.4.2 Multicollinearity.......................................................................................................44 3.5 Model and Data Criticism............................................................................................44 CHAPTER FOUR: DATA ANALYSIS AND PRESENTATION...................................46 4.1 Results..........................................................................................................................46 4.2 Correlation Test Results and Analysis.........................................................................47 4.3 Descriptive Statistics Results and Analysis.................................................................48 4.4 Regression with Multiple Factor................................................................................50 4.4.1 Effect of Interest Rate and Inflation on Share prices...............................................50 V

4.4.2 Hypothesis testing and Analysis..............................................................................50 4.5 Single Factor Regression Analysis.............................................................................54 4.5.1 Regression Analysis of the effect of Interest Rate on Share Prices........................54 4.5.2 Regression Analysis of the effect of Inflation on Share Prices...............................56 4.5.3 Regression Analysis of the effect of Inflation on Interest Rate..............................59 CHAPTER FIVE: DISCUSSIONS AND CONCLUSION.............................................61 5.0 Discussions and Conclusion…………………………………….………….….….…61 5.1 Implications and Recommendation.............................................................................62 5.2 Limitation....................................................................................................................63 5.3 Reliability and Validity...............................................................................................63 5.5 Suggestion for further Research..................................................................................64 REFERENCES..................................................................................................................65 APPENDICES..................................................................................................................76


Table 3.0: Summary of description and source of data…….……….…………………27 Table 4.0: Summarised results of the correlation test................................................... 53 Table 4.1: Summary of descriptive statistics of the sample.......................................... 54 Table 4.2: Regression results of stock prices, interest rates and inflation.................... 57 Table 4.3: Regression results for stock prices and interest rates................................... 62 Table 4.4: Regression results stock prices and inflation............................................... 65 Table 4.5: Regression of relationship between earnings and interest.............................68


Figure 4.1: GSE All-Share Index stock prices and interest rates movement .................. 54 Figure 4.2: GSE All-Share Index stock prices and inflation levels ................................. 58 Figure 4.3: Interest rates and the level of inflation movement …………........................ 67


The study basically seeks to empirically examine the role of interest rates and inflation in the movement of stock prices in Ghana from 1995 to 2009. The GSE All-Share Index is used to represent the Ghana Stock Market whereas the Consumer Price Index and 91 days Treasury bill rates are proxied for inflation and interest rates respectively. Considering the fact that the Ghanaian economy is characterised by high interest rates as well as high inflation pressures, it is important for investors to know whether stock prices in Ghana are impacted heavily by inflation or interest rates. However, the results of the empirical tests conducted revealed that the GSE All-Share Index is driven by interest rates but not inflation as initially anticipated.


INTRODUCTION The relationship that exists between macroeconomic variables and the development of stock markets has been the subject of discussion over the past decade both in the literature of practitioners‟ and academia. According to Shiller (1988), changes in stock prices reflect changes in investor‟s expectations about future values of certain macroeconomic variables that directly affect the pricing of equities. Fundamentally, some macroeconomic variables such as exchange rate, interest rate, and inflation are believed to determine stock prices (Glen, 1995). It is also largely expected that government fiscal policy and other macroeconomic events have a significant effect on general economic activities in an economy including the stock market. This has therefore become a source of motivation for many researchers to study the dynamic relationship between stock prices and macroeconomic variables. More significantly, preliminary studies have been done using different approaches to investigate such links between stock prices and macroeconomic variables. A more typical example of this is the study by Chen et al. (1986), who used the Arbitrage Pricing Theory which is developed by Ross (1976) to establish how macroeconomic variables explain movements in the US stock market. In a related study, researchers such as Cheung and Ng (1998), McMillan and Humpe ( 1997), Mukherjee and Naka (1995), Kwon and Shin (1999) and Mayasmai and Koh (2001) did employ cointegration analysis to explain the link between earnings and macroeconomic variables in developed countries like Japan, US, Australia, Canada and other European countries. Yet, it has been extremely difficult for some researchers to identify whether changes in stock prices may be attributed to either nominal interest rate changes or inflation


movements or both. It is therefore worthy to undertake an empirical study that examines whether certain macroeconomic fundamentals are capable of driving the behaviour of financial aggregates. The purpose of this study is to make contributions to the existing literature by examining whether it is interest rates or inflation or both that are responsible for the movement of stock prices in an economy with high inflation pressures such as the Ghanaian economy. While previous studies have analysed the relationship between macroeconomic factors and stock return volatility, no such study has been limited to stock prices, inflation and interest rates. To attribute an increase or a decrease in stock prices to either inflation or interest rates or both is without doubt very crucial for investors in the Ghana Stock Exchange (GSE) due to the divergent views that have been put forward to examine the relationship between stock prices, inflation and interest rates as well as other macroeconomic variables. Aims of the dissertation The core objective of this Dissertation is to empirically determine the impact of interest rate and inflation on stock prices of the Ghana Stock Exchange All-share Index from 1995 to 2009. The GSE All-share Index is the main stock index computed on the Ghana Stock Exchange even though the Databank Stock Index (DSI) is the first ever stock index computed by the Databank Group on the GSE. Besides being the main stock index, its choice of selection is also motivated by data availability. “Investing in stocks without doing the important stock market research first would be like throwing your money away on lottery tickets with the hope that you might get lucky” (, 2010)


Any research into a stock market is deemed very important to investors, analyst, and portfolio managers who normally rely on the outcomes to identify and to pursue their investment objectives and opportunities. In their analysis of the economy as a whole, Ologunde et al. (2006) posit that the stock market makes it possible for the economy to ensure long-term commitments in real capital. As such, the level of efficiency measurement of the stock market is very important to investors, policy makers and other major players, who ensure long-term real capital in an economy. Clearly a mature stock market efficiency level is perceived across the globe as a barometer of the economic health and the prospect of a country as well as a register of the confidence of domestic ddand global investors. It is worth noting that such ventures offer countless opportunities for determining the future behaviour of stock prices as well as reducing probability of high losses in the market (Chuppe, 1992). Undoubtedly, management of corporate

institutions will find the results of this research useful in determining how the firms‟ performance translates into value for their current and prospective investors. Moreover, regulators in the stock market can use the findings as bases for improving transactions on stock exchanges. Finally, the usefulness of such an endeavour to corporate and institutional management as well as governments cannot be overemphasised since the variation in price among common stocks is of considerable interest for the discovery of profitable investment opportunities, for the guidance of corporate financial policy, and for the understanding of the psychology of investment behaviour.

This research begins by providing a brief overview of stock price movements and the important factors affecting the stock price variations especially macroeconomic variables.


The second part of the study will identify and discus the relationship between stock prices and the level of interest rates and inflation. The final part of this work is therefore intended to discuss the implication of this relationship in investment decisions. Most significantly, to determine whether investment decisions can be based on interest rates levels as well as inflation or both. The research question The main research question that this study intends to address is: Do interest rates and the level of inflation of the Ghanaian economy have any significant impact on stock prices of the GSE All-share Index? In answering the above question, an attempt will be made to addressing the following questions:  Is there any significant relationship between interest rates, inflation and stock prices?  Is there any significant relationship between the level of interest rates and the level of stock prices?  Is there any significant relationship between the level of inflation and the level of stock prices?  Is there any significant relationship between interest rates and the level of inflation?

Dissertation structure The dissertation is structured into five different chapters as already outlined above: The concentration of chapter one is on the Ghanaian Stock Market. The main indices on the Ghana Stock Exchange comprise the GSE All Share index and the Databank stock


index (DSI). According to Adam and Tweneboah (2008), three other new indices comprising the SAS index (SASI), SAS Manufacturing index (SAS-MI) and the SAS Financial index (SAS-FI) have also been published by Strategic African Securities Limited. However, this study will be based on the GSE All-share Index. Primarily, the discussions will be centered on the background, development, and current structure of the GSE. Since the purpose of this study is intended to assess the impact of interest rates and the level of inflation on stock price movements on the GSE All-share Index, the background, function, and regulation of the underlying Ghana stock market, most especially that of the All-share Index is deemed a necessary step to addressing the research questions posed above. Certainly, the first part of this chapter looks at how interest rates are determined by the Central bank of Ghana and how it can be influenced by the level of inflation and their impact on stock prices. In addition to this, a review of the relevant literature will be done on the extensive work covered by other researchers in Chapter two. Chapter three is expected to cover the methodology and data, model description, justification, and analytical tools selected for this study. Chapter four will however dwell on interpretation, presentation and analysis of results whereas. Chapter five provides a conclusion, limitations, and recommendation of the dissertation.



1.0 Introduction Good investors always look to investing in an efficient market (Ologunde et al, 2006). The prevalence of stock markets around the globe therefore comes as no surprise particularly with the word „investment‟ having become a household name in virtually every part of the world. There is no doubt (Yucel and Kurt, 2003) how history has shown that stocks have facilitated the expansion of companies. Clearly, the great potential of the recently founded stock markets have become increasingly apparent to both the investors and the companies alike. The devastative effect brought on the world‟s economies by the great crash of the stock market in1929 is a clear indication of the importance of its role in the development of human race (Taylor and Tongs, 1989). Arguably, (Frank and Young, 1972) the most notable and the oldest exchanges can be found in London (The London Stock Exchange), New York (The New York Stock Exchange) and in Mumbai (The Bombay Stock Exchange). Again, stock exchanges such as the Osaka Stock Exchange in Japan, the Singapore Exchange (SGX) in Singapore, the Frankfurt Stock Exchange in Germany, the Hong Kong Stock Exchange etc have also succeeded in carving a niche for themselves. However, the Ghana Stock Exchange though relatively young has been recognised to compete with the big guns not only in the developing world but with the developed as well. It therefore came not as a surprise when the Ghana Stock Market was voted in 1993 and 1994 as the sixth and best performing emerging market respectively. Certainly, the Ghana stock market has evolved over the years, with interesting story to tell. This section provides a brief background to the formation of Ghana Stock Exchange


in general, and its development of the GSE All-Share Index in particular. This is then followed by an analysis of how trading activities are being regulated by the stock exchange. Finally, a critical look at the main functions of the stock exchange will be fundamental to the study.

1.2 The Background of Stock Markets Arguably, stock markets have always been at the forefront in every facet of the world‟s economy whether booms or recessions alike. It is for this reason that newspapers and financial publications have always had in their headlines information about the Dow Jones, FTSE 100, NASDAQ, rising stock indexes, falling stock indexes, buying and selling (Levine, 1990). It is therefore tempting (Dailami, 1992) to think of a stock market as an impersonal mechanism somewhere in the sky, and imposing its mandates on us at will. However, this is not usually the case. In reading the history of stock markets, it is common for one to come across the words of the famous economist Thomas Sowell that: “markets are as personal as the people in them” (Sowell, 1987). What this means is that, stock markets and their performance reflect the dominant concerns, fears, and hopes of the investing public. Contrary to the divergent views which have been expressed, stock markets did not begin as the super-sophisticated, simultaneous and worldwide trading exchanges as we see today. It is believed that the first institution that assumed the responsibility of a stock market did not emerge until 1531, in Antwerp, Belgium. Hence, as has been noted (Popiel, 1988:67), this was, “…the first stock market, sans stock.” Because the buying and selling of corporate shares had by then not began, brokers and lenders always gathered there to deal in business, government as well as even individual 8

debt issues (Popiel, 1988). The turn of events came not until the 1600′s, when Britain, France, and the Netherlands had chartered voyages to the East Indies. It is believed (Imperial Gazetteer, 1931) that on realizing that the few explorers could not afford to conduct an overseas trade voyage, limited liability companies were set up to raise money from investors, who received a share of profits commensurate with their investment. As was famously reported (Imperial Gazetteer, 1931) in India, the earliest British voyages to the Indian Ocean were unsuccessful and this resulted in lost ships. Accordingly, the financier‟s personal belongings were seized by creditors. This brought a group of London merchants together to form a corporation in September of 1599 with the intention to limit each member‟s liability to any amount they personally invested. Certainly, in case the voyage failed, nothing more than the stated amount could lawfully be seized. This development therefore led to the Queen granting the merchants a fifteen year charter in 1600, referring to it as “The East India Company.” The newly adopted approach as it is believed proved successful, leading to the subsequent grant of charters by King James I to more trading companies by 1609 which triggered business growth in other oceanbordering European countries (Imperial Gazetteer, 1931).

Thus the Dutch East India Company was actually recognized as the first to allow outside investors to purchase shares entitling them to a fixed percentage of the company‟s profits. In addition to that, they were also the first company to issue stocks and bonds to the general public, through the Amsterdam Stock Exchange in 1602 according to Popiel (1988). Figure 1.0 in the appendix A however shows the role of the investor, intermediary and businesses or governments. As depicted in the appendix (figure 1.0), stock exchanges as financial markets, provide the platform for household consumers who 9

want to save for future expenditure and for firms to raise capital for different investment purposes (Benita and Lauterbach, 2004).

1.3 History and Development of the Ghana Stock Exchange The idea of establishing a stock exchange in Ghana was hatched way back in 1968. This initiative as it is believed led to the promulgation of the Stock Market Act of 1971, which laid the foundation for the establishment of the Accra Stock Market Limited (ASML) in 1971. Lack of support from the then government, coupled with unfavourable macroeconomic environment as well as the unstable nature of the political environment were seen among the few obstacles that undermined the smooth take off of Accra Stock Market Limited. The problems which have just been enumerated above meant that the initial idea remained a mirage. Notwithstanding these obvious challenges at the initial stages, an over the counter trading in foreign-owned corporate shares were carried out by two prominent brokerage firms prior to November 1990 when the Ghana Stock

Exchange was established. These were National Trust Holding Company Ltd (NTHC) and National Stockbrokers Ltd, now known as Merban Stockbrokers. In an effort to recover from its economic woes, Ghana with the help of the IMF and World Bank had to undergo structural reforms in 1983 to remove distortions in the economy. It is noted that these financial reforms included but not limited to deregulation of interest rates, credit control removals, and floating of exchange rates. Clearly it had become necessary for Ghana to have a stock market after the financial liberalization and the divestiture of a number of state owned enterprises. The Ghana Stock Exchange was finally incorporated as a private company under the Ghana companies‟ code, 1963(Act179) in July 1989. 10

However, in 1994, the status of the company had to be changed to a public company under the company‟s Code. The Ghana Stock Market as it is believed was finally recognised as an authorized stock exchange under the stock Exchange Act of 1971.Trading activities began on the floor of the exchange on November 12, 1990. Although the exchange interestingly began trading with only 13 listed companies, in 1991, the number had increased to 19 in 1995. The number of listed companies had however astronomically risen to 32 in 2007(GSE Quarterly Report, 2007). The surge in the number of listed companies has also had an enormous impact on market capitalization. The Ghana stock market though relatively young has chucked remarkable successes. The exchange was voted the sixth and the best performing emerging market in 1993 and 1994 respectively. The two main indices on the exchange are the Databank Index and the GSE All-share Index. The GSE capital appreciated by 116% in 1993 and gained 124.3% in its index level in 1994 (GSE quarterly bulletin, 1995). However, high levels of inflation and interest rate accounted for its poor performance in 1995 in which the growth in index was only 6.3%. The exchanges market capitalization at the end of 2004, stood at US$ 2,644 million. Meanwhile, the yearly turnover ratio just fell from an all-time high of 6.5% in 1998 to 3.2% in 2004. An even more remarkable feat was achieved by the exchange in October 2006 with a market capitalization of $11.5billion. The Ghana Stock Exchange conducts trading every working day and all trading activities are expected to be carried out on the floor of exchange except Ashanti Gold shares which can both be traded through the GSE and over-the-counter after GSE trading hours though all such trades must be subsequently reported to the GSE at the next trading session.


1.3.1 The Ghana Stock Market Regulation and Supervision The call for protection and security by investors in the capital market has been on the ascendency in recent years due to the volatility of capital markets. It is expected that capital markets most especially the emerging ones should operate within a framework of rules and regulations enacted in order to make sure that there is order and fair play in the dealings of securities. Clearly, the development of stock markets depends on the extent to which these laws are enforced by the various regulatory agencies in any country. In Ghana for instance, various laws have been made especially for the protection of the securities‟ market. These include the Securities Industry Law (SIL) 1993 (PNDCL 333). The main purpose of this law is to spell out the establishment of the Securities Regulatory Commission and the manner in which the commission should function. Basically, there are two provisions for regulating firm‟s dealings on the exchange as well as its membership. These provisions are the Ghana Stock Exchange Listing Regulation 1990 LI 1509 and the Ghana Stock Exchange Membership Regulations 1990 LI 1510. Meanwhile, in addition to maintaining the surveillance over the securities market, the Securities Regulatory Commission (SRC) also functions to ensure order and equitable dealings in securities. The SRC therefore has the power to license stock markets, unit trusts, mutual funds, and securities dealers and investment advisers as well. This body is also given the mandate to ensure the protection of the securities market against unlawful practices like insider trading. In view of this, takeovers, mergers and acquisition of companies are subject to the proper scrutiny, approval and regulation of the commission. Mention could also be made of the Companies Code of 1963 (Act 179), the Bank of Ghana Act, 1963 (Act 182), the Banking Law of 1989 (PNDCL 225) and the Financial


Institutions (Non-Banking) Law, 1993 PNDCL 328 as the other laws that govern the securities market directly or indirectly. Certainly, the existence the of varied rules and regulations in the Ghanaian market is an indication of the fact that the legal and regulatory framework of the securities market as well as that of the stock market are adequately taken care of compared to those of even more advanced nations. The question regarding any evidence of legal enforcement in the stock market was perfectly answered when three notable brokerage firms namely the Databank Brokerage Limited, EBG Stock Brokers and SDC Brokerage Ltd. were suspended and fines imposed on them, in early December 1995 for going contrary to the rules governing the operations of the financial market. While Databank Ltd was only suspended from dealing on the floor of the stock market for a number of trading days, the memberships of EBG Stock Brokers and SDC Brokerage, Ltd. in the council of the Ghana Stock Market were terminated. 1.3.2 Information Disclosure Requirement The disclosure of very important and relevant information about securities to the public is not only crucial for pricing efficiency but for market confidence as well. It is worth noting that investors can only make sound judgements about the value of securities only when they are fully informed of relevant facts on the ground. Therefore, against this background, there is the need to ensure that the disclosure policies governing listed companies on the Ghana Stock Exchange, as stipulated in the Legislative Instrument (LI) 1509, is quite understandable. Interestingly, various regulations under this legislative instrument have been clear on information that should be disclosed to the general public. Regulation 55 for instance requires every company that is listed to make available to the public every information necessary for informed decisions. Additionally, all listed firms


must take reasonable steps to ensure that all investors in the company's securities have equal access to such information. On the other hand, regulation 56 requires a listed firm to make immediate public disclosure of any information that is material concerning its dealings. Listed firms are also required by law to release vital information to the public in a manner designed to achieve its intended purpose of full disclosure. Regulation 57 however contends that if companies listed become aware of a rumour or report, which may be true or otherwise, and that the information is likely to have or has had effect on the trading of the company's securities or might have a bearing on investment decisions, then the firm is required to publicly clarify the rumour or report as soon as possible. The disclosure of information on financial reports is also well covered in Regulations 43 and 44. While Regulation 43 binds companies listed to give to the exchange a half-yearly report immediately the figures are available and in any event not later than six months after the end of the first half-yearly period in the financial year, Regulation 44, requires listed companies to give to the exchange a preliminary annual financial statement immediately the figures are made available and in any event not later than three months after the end of the financial year. Among the information that should be disclosed in both half-year and annual financial statements include turnover, consolidated operating profit/loss, income from associated companies, extraordinary items, minority interests, operating profit as percentage of turnover, operating profit as percentage of issued capital and reserves at end of year, earnings in cedis per ordinary share and dividends, as well as any amount payable per share and the date payable. More so, if a firm wants to be listed on the exchange, the disclosure requirements demand that the company provides any information about its background especially its history, line of business, capitalization,


the distribution of shares such as authorized and issued capital, and the distribution of shareholders. It is also expected that other relevant information such as dividend records, fiscal year end, date of annual meetings and any pending legal actions be disclosed.

1.3.3 Public Knowledge of the Securities Markets Unlike the developed world, lack of knowledge and unfamiliarity with negotiable instruments in emerging markets is very high and this is obviously expected to be a significant constraint to the development of the securities markets in the developing world. Ghana is thus not an exception to this scenario. However, many steps were taken in the case of Ghana to ensure that this trend did not continue into the future. Various short term courses have been organised by the GSE and are being run on a continuous basis throughout the year to help educate all participants about securities. In all, five of such courses are designed to meet the needs of both professionals and non-professionals on various aspects of the securities industry on monthly basis. These include courses such as Basic Securities, Advanced Securities, Securities Selling and Investment Advice, Securities Trading, and Directors Course. The basic securities course is targeted at those who are interested in knowing about the securities market in Ghana. Basically, the advanced securities course is a foundation course for professionals in the securities market place, as well as others in law, banking, accounting, insurance, finance and economics, who require an in-depth understanding of the securities markets, instruments, trading, legal issues and analysis of financial statements. The securities selling and

investment advice course is specifically designed for those individuals who are seeking licensing as sales representatives and investment advisors. The securities trading course is


also a specified course for professionals who want to have an in-depth knowledge of trading on the stock exchange as well as those who intend to seek licensing as authorized dealers of stockholding firms. Rather strangely, the directors' course, though rarely organised, is considered the most important course designed especially for directors of stock broking firms. The course covers the roles and responsibilities of stock broking firms in accordance with the regulations and laws of the securities industry and the Ghana Stock Exchange. Once again it must be emphasised here that the efforts of the GSE in this area are commendable. This therefore explains why, 1,682 people have been taken through the five courses over the four-year period from 1991 to 1994. Nonetheless it is interesting to note that this effort has not been emulated by other African stock exchanges, such as the Lagos, Nairobi, Harare exchanges etc. Apparently, the effort of the GSE is unique and hence it is expected to help foster growth and development of the Ghana stock market. In spite of the remarkable successes that have been chucked, many are of the view that the goal is far from being reached especially looking at the level of knowledge of the total population. There is therefore the need for other institutions, such as the universities, banks, brokerage houses, etc. to augment the effort of the GSE through similar training programmes. The belief is that only through such collective effort can pave the way for educational programmes to make a positive impact.


CHAPTER TWO LITERATURE REVIEW 2.0 Introduction Numerous writers have over the years conducted extensive empirical study regarding the effect of several macroeconomic variables on the performance of stock markets, focusing on investors' perspectives by looking at stock prices and returns. Yet, very little attention has been paid to real interest rates and inflation especially in emerging markets like that of Ghana even though these factors are considered very important. Moreover, there are other important issues regarding the extent to which real interest rates and inflation may impact on the sound performance of stock markets, in terms of the degree of trade, capital issues and the dominance of major companies. There is therefore no doubt that such issues need to be investigated. The view (Pill, 1997) has also been expressed in particular regarding how crucial the results of such study can be especially in terms of success in economic reform in emerging markets. An emerging stock market can thus be seen as an important vehicle in a country's strategy to facilitate the flow of investment into the business environment in order to accelerate economic growth and reduce external debt (Ploeg, 1996). The focus of this chapter is to provide a critical review of the related literature on the subject under discussion. In doing this, a critical assessment of the strengths and weaknesses of past studies focusing on stock price movements will be considered. The first part of this investigation will center on the impact of interest rates on the movement of stock price. The second part also explores the effect of the level of inflation on stock


prices. The third part looks at the relationship between interest rates and inflation and how this (relationship) together with company fundamentals can affect stock price movements in Ghana. The final analysis will be based on some stock pricing models with the emphasis on efficient market hypothesis. 2.1 The effect of interest rates on stock price movements. The importance of interest rates to businesses and the stock market in macroeconomic theory cannot be overemphasized. In financial theory, it is stated that interest rates, though has been changing frequently is fundamental to the valuation of a company and as such plays an important role with regards to how we put a price on stocks. Yet, it is not uncommon to hear that anyone who is ever looking for a topic to kill a conversation in order to be left alone to think about his/her investment should consider talking about interest rates (McClure, 2011). Simply put, an interest rate is essentially nothing but the cost an individual or a person has to pay for the use of another person‟s money. Homeowners for instance pay interest on the money they borrow to purchase a home and are therefore very familiar with this term. Another class of people who are also very intimate with this scenario are credit card users. These people borrow money for the short term to finance their purchases and in return pay interest for the privileges enjoyed. However, the term interest rate means a different thing all together when it comes to the stock market. In the US for instance, what concerns investors is the Federal Reserve‟s federal funds rate as this is the cost that US banks are charged for borrowing money from the Federal Reserve banks. In other countries, this rate is determined by their respective central banks (Saunders and Cornett, 2008).


Quite recently, the number of academic studies concerning the relationship between interest rate and stock prices has been phenomenal. Many researchers have undertaken empirical tests in considering the effect of interest rates on share prices. However, a survey of the available literature reveals divergent views of the researchers on the issue of the link between the two variables. Before delving deep into some of these views, a cursory look at the factors affecting interest rates is deemed very remarkable for this study. 2.1.1 The level of Interest rate Movements The change in interest rate impacts on economic decisions, such as whether to save or consume and given the effect of changes in interest rates on the value of firms, much effort is being made to discover the factors responsible for this change (Jones et al., 1993). Primarily, the government of any nation has a say in the behaviour of interest rates. In most instances the monetary policy committee within the central banks of the respective countries are given the responsibility to determine the level of interest rates (Saunders and Cornett, 2008). But the central bank in the United States is called the Federal Reserve (the Fed) which often comes out periodically to announce how the monetary policy will influence interest. This activity is carried out by the seven member board of governors as well as the five presidents of the Federal Reserve Bank through the use of open market transactions (Jones et al., 1993). This as he explained basically involves buying securities such as treasury bonds and bills which are already in circulation or selling new ones. In effect, the activity of the board depends on what it aims to achieve. Thus whenever the government wants to slow down growth in the economy, it sells securities to banks and the general public in order to drain the system of


liquidity. This arguably renders banks with less disposable funds for lending. On the other hand, the Fed (government) can also stimulate the economy through the purchase of more securities thereby injecting more money into banks for lending purposes. For example (Cornett and Saunders, 2008), the Fed had to lower interest rates aggressively in 2001 when the US economy showed signs of weakness. Interestingly, the Fed continued to keep interest rates down even at a time when the economy had began to recover citing inflation as a lesser concern than deflation. This therefore brings about the issue of the relationship between interest rates and inflation regarding interest rate movement which will be discussed later under this very chapter. Apart from the activities of central banks which have been recognised as the main culprits as far as changes in interest rate is concerned the forces of demand and supply do also have a part to play in determining movements in the level of interest rates (Saunders and Cornett, 2008). It is noted that the level of interest rates is a factor of the supply and demand, hence an increase in the demand for credit (loanable funds) will lead to a correspondent increase in interest rates and vice versa. In converse, an increase in the supply of credit will reduce interest rate while a decrease in the supply of credit will bring about interest rates increases (Jones et al., 1993). In his explanation, he intimated that the supply of credit is increased by an increase in the amount of money available to borrowers. He stated for example that money is always lent to a bank whenever a new account is opened. The bank can therefore lend out any excess money. The more banks can lend, the more credit there is in the economy. Consequently, as the supply of credit increases, the cost of borrowing (interest rate) decreases and vice versa.


2.1.2 The Behaviour of Interest Rates in Sub-Saharan Africa (SSA) Liberalization of interest rates has been one of the main policy goals of structural adjustment in SSA. According to Agenor and Montiel (1996:152) interest rate ceilings bring about a “wedge between the social and private rates of return on asset accumulation, thereby distorting intertemporal choices in the economy”. Villanueva (1988) also stresses the importance of interest rate reforms by pointing to the implications these interest rate reforms have on monetary control and mobilization of savings. Interest rate liberalizing simply involves an abolition or reduction of controls on both lending and deposit rates. (Villanueva, 1988). It is believed that two opposing effects on the relation between savings and interest rates can be concluded. Firstly, it is expected that an increase in real interest rates will cause consumers to defer present consumption and increase savings. Again, there is bound to be an increase in income as a result of the increase in interest rates. Undoubtedly, this increase in income increases demand as well as consumption. Dornbush and Reynoso (1989) thus argue that the net effect of increased interest rates on savings is not very clear. However, they noted that switching from negative to positive interest rates can have a very important impact on financial savings. Accordingly, the effect stems from the fact that with negative interest rates, potential savers may choose to save in more tangible assets or export capital elsewhere in abroad. Meanwhile, it has been strongly contended (World Bank, 1994) that the rationale behind interest rate liberalization in SSA is to align interest rates toward market equilibrium in order to implicitly encourage savings but Dornbush and Reynoso (1989) recognises the lack of empirical evidence of a strong relationship between the rate of interest and the supply of savings. In spite of this,


McKinnon (1973) emphasises the need for high equilibrium interest rates contrary to the Keynesian view that low interest rates promote investments as well as growth. In effect, his (McKinnon, 1973) view suggests that any interest rate ceiling stifles savings and increases current consumption as well. Glower (1994) observes that liberalization is likely to lead to an in interest rate variability which will be higher than what should be expected in the post reform level of interest rate. Without a doubt, the experiences of SSA point to the fact that low positive real interest rates have not been achieved after liberalization. As stated by Montiel (1995, 75), “countries have tended either to continue to have negative interest rates or high positive rates.” In confirming this statement, the World Bank (1994) notes that Cote d'lvoire and Senegal had kept high positive interest rates for deposits for the period 1990-91. Interestingly, countries like Ghana, Kenya and Uganda around the same period were recognised as being in the „acceptable range‟ whiles Zimbabwe was classed in the „highly negative‟ category. These double standards prompted Stiglitz and Weiss (1981) to advance arguments against high interest rates. In their argument, the writers emphasised that any attempt to charge higher interest rates adversely impacts on a bank‟s loan quality due to the incentive and adverse selection effects. According to them, it increases the overall riskiness of the portfolio of assets while reducing the returns on all projects and as such it makes less risky projects less profitable. The effect of this therefore is that firms will be motivated to switch to more risky projects in an environment of rising interest rates. The other instance they posit is that, banks will have no choice than to screen borrowers. However, if the screening device used is interest rate, they are most likely to take on very


risky borrowers. The reason behind this argument is that high interest borrowers may be less worried about the prospect of nonpayment. Though one would expect banks to monitor the behaviour of borrowers, information is deemed not only expensive but imperfect as well. What this brings to mind is that the rational profit maximizing bank will definitely practice credit rationing which eventually defeats the general assumption made in financial liberalization literature, about the ability of interest rate liberalization to eliminating credit rationing. Not long ago, a research conducted by Nissanke (1990) on a number of SSA countries revealed that interest rate deregulations have had little or no impact on savings and for that matter stock price. Similarly, Choo and Khatkhate (1990) also observed the

behaviour of interest rates of 5 countries in Central Africa and declared the link between interest rate and savings to be ambiguous. Figure 2 in appendix E shows a graphical trend of real interest rate for deposits and domestic saving rates in each of the nine countries studied by Nissanke. He found that no clear links are seen to exist between real interest rates and savings rate for these countries. Hence, there is no doubt that these revelations have interesting bearings on the issue of whether changes in interest rate can impact on stock prices. 2.1.3 The effect of Interest Rates on Stock Prices in Emerging Markets The economic development in most developing countries has been slow during the past two decades compared to the western world. Per capita income in these countries grew by less than 1% per year between 1960 and 1979. Within the last decade, more than 15 countries recorded a negative rate of growth of income per capita (Adam and Tweneboah, 2008). This dismal economic performance has largely been attributed to structural


weakness as well as domestic policy inadequacies. However, it is worth emphasising how many researchers have shifted attention to look at the capital markets of some of these developing economies due to their huge investment potential lately. Interestingly, most of these studies were devoted to looking in to how interest rates affect stocks in these emerging markets. Preliminary research has been carried out by numerous scholars using different methods to investigate the relationship between stock prices and macroeconomic variables like interest rates (Adam and Tweneboah, 2008). In an attempt to emphasise the importance of the behaviour of interest rates as macroeconomic variable to emerging markets like Ghana, Pill (1997) argued that interest rates have a positive relationship with economic growth. This was explained to mean that an economic reform program that centers on financial deregulation will permit an increase in real rate of interest to a fairly positive, equilibrium level. A similar study which adopted different approaches found that higher real interest rates have a positive impact on financial activities which will in turn lead to growth and development in the economy (Landi and Saracoglu, 1983; Gelb, 1989; Pill, 1997). Meanwhile, Asprem (1989) argues that the positive relationship that has been heralded by most researchers only exists in a small illiquid and financial market. Nonetheless, the argument of Shiller and Beltratti (1992) in favour of the positive relationship is on the grounds that a change in interest rate could carry out information about certain changes in future fundamentals like dividends. Barsky (1989) on the hand failed to agree with the authors on their explanation of the positive link between interest rates and stock prices and posits that the positive relationship between interest rates and stock prices should only be attributed to the changing risk premium. He argued that a fall in interest rates could result from an


increased risk being taken by investors or perhaps more investors are taking precautionary measures by trading off risky assets (stocks) for less risky ones (bonds). This argument is therefore in line with the view of Apergis and Eleftheriou (2001) on their study of the Greek market. Moreover, Alagidede (2008) is of the view that the risk perception has been the greatest obstacle to an increased access to capital in almost all developing countries. The author thinks that the size and the illiquid nature of emerging stock markets has been the major difference between stock market performance in developing countries and that of the developed world. Just as has been the norm of most academic research, several other researchers through the use of empirical studies have come out with views which are in contrast to the views stated above. One of such views was made known in Apergis and Eleftheriou (2001) where the writers examined the relationship between interest rates and stock prices in Greece and declared that an inverse relationship exists. Accordingly, the relationship between the two is the reason why investors change the structure of their portfolios. They pointed out that in the event of an interest rate increase, investors being rational are expected to alter their investment portfolio to favour bonds hence a reduction in stock prices. This is so because a decline in interest rates always leads to an increase in the present value of future dividends (Hashemzadeh & Taylor, 1988). Additionally, the research of Omran and Pointon (2001) investigated the effect of interest rates on the performance of the Egyptian stock market and found that there is a long-run relationship between interest rates and stock market performance. The writers however contend that real rates of interest seem to have been a neglected variable in literature. In his work, Spiro (1990) also examined the link between real interest rates and stock market


performance in some developing countries and concluded that an inverse relationship exist between real rate of interest and stock market performance. In a related study, Zhou (1996) explored the relationship between interest rates and stock prices in some selected emerging markets using regression analysis and confirmed that interest rates have a significant impact on stock prices, especially in the long-run. However, he disagrees with the general view that expected stock returns move one-for-one with ex ante interest rates. In his analysis, he explained that long-run interest rates are always the cause of the variation in price-dividend ratios and concluded that stock market volatility is related to the volatility of the long-term bond yields as a result of the changing forecast of the discount rates. Quite recently, Jefferis and Okeahalam (2000) studied the stock markets of South Africa, Botswana and Zimbabwe and observed that high interest rates in these emerging markets always depress stock prices through the substitution effect, thus stock prices are deemed less attractive compared to interest bearing assets such as bonds. Two years later, Arango (2002) after studying the impact of interest rates as measured by the interbank loan rates on the performance of the Bogota stock market discovered that an indirect relationship exist between stock prices and interest rates but he did admit also that the interbank loan interest rates were to some extent affected by the government‟s monetary policy initiatives. Notwithstanding, he concluded by reporting that the results were in no way supporting efficiency on the main Columbian stock market. Hsing (2004) repeated the studies and observed an indirect relationship between interest rates and stock prices. However, it is worth noting that his work adopted a value at risk (VAR) model which is structured to accommodate several endogenous variables like exchange rates, output, real rates of interest as well as stock market index. As stipulated earlier, the work


of Uddin and Alam (2007) on the Dhaka Stock Exchange can be termed as a multidimensional study. The anthors examined the relationships between interest rates and stock prices, changes in interest rates and stock prices, interest rates and changes in stock prices, and changes in interest rates and changes in stock prices and declared in all cases that interest rates have a greater impact on stock prices and that changes in interest rates have a significant negative relationship with changes in stock prices on the Dhaka exchange. Indeed, divergent views have been expressed on the subject under discussion in terms of whether or not a relationship exist between interest rates and stock prices as well as the extent of the impact of interest rate changes on stock performance on several emerging stock markets around the globe. However, the intention here is to also find out if such relationships exist on the Ghanaian market through an empirical framework.

2.1.4 The effects of Interest Rates on Stock Prices in Developed Markets Like developing economies, so many views have also been aired with regards to the interactions that exist between interest rates and stock prices in the developed world. The ensuing discussion therefore dwells on some of the views espoused on the subject by some scholars in an attempt to establish a relationship between interest rates and stock prices in more advanced stock markets. The most notable among them is the observation made by Fama (1981) in his study of the relationship between interest rates and stock prices. The writer contends that expected inflation is inversely related to anticipated real activity which also has a direct relationship with stock market returns. He further stressed that stock market returns


should have an inverse relationship with anticipated inflation which is often proxied by short term interest rates. Uddin and Alam (2007) on the other hand think that the effect of long-term interest rates on stock prices starts from the present value model through the influence of the long-term interest rates on the rate of discount. Campbell (1987) repeated the study of Fama (1981) but instead used the yield spread and stock market returns in his analysis in order to establish a relationship. He pointed out that the same variables that have been employed in the prediction of excess returns in the term structure of interest rates could also predict excess stock returns and concluded that a simultaneous analysis of the earnings on bills, bonds and stocks should be beneficial. It is however worth mentioning that the results of his study have been agreed to have supported the term structure of interest rates in predicting excess returns on the stock market of US. Thereafter, Lee (1997) tried to observe the relationship between short-term interest rates and stock market returns by forecasting excess returns on the Standard and Poor 500 index with short term interest rates through the use of a three-year rolling regression analysis. The author observed that the relationship is not stable over time and emphasised there is bound to be a gradual change from a significantly negative to no relationship or possibly a positive relationship though insignificant. Meanwhile, Officer (1973) notes that the volatility of the market factor of the New York Stock Exchange has a direct link with the volatility of macroeconomic variables. Harasty and Roulet (2000) studied the stock markets of 17 developed countries and discovered that stock prices are cointegrated with earnings as well as the long term interest rates in each of the countries studied except that of Italy where he used short term interest rates. Yet, Schwert, (1989) is of the view that the volatility of the returns on stock is directly related to interest rates though


Fama and Schwert (1997) and Geske and Roll (1983) had previously established a negative relationship between changes in interest rates and stock returns. Clearly, the varied studies on the relationship between interest rates and stock prices in more advanced stock markets have been mixed just like that of the developing countries. 2.2.1 The effect of Inflation on Interest Rates The importance of any study regarding the impact of inflation on interest rates movements to investors and policy makers has never been in doubt (Leiderman and Svensson, 1995; Bernanke, et al., 1998). Specifically, it is believed that timely and accurate forecasts of inflation expectations are vital in helping monetary authorities to set short term real rates of interest at the appropriate level as well as providing observers a tool to analyse as to whether a central bank‟s inflation targeting is credible (Bernanke, et al., 1998). Yet, this acclaimed important subject has received very little attention in terms of empirical evidence. Among the very few studies which attempted to establish a relationship between the rate of inflation and interest rates is the Fisher Effect (Fisher, 1930). In his study of the relationship between inflation and interest rates through the International Fisher Effect, Madura (2008) for instance used an illustration which compared two countries. He explained that, if inflation for instance is expected to rise in the near future in Canada, more people in Canada will want to spend now instead of saving in order to escape future price increases. As such, they will be willing to borrow now to purchase goods before prices go up. What this mean is that the high expected inflation leads to a small supply of savings (loanable funds) whilst the demand for loanable funds increases hence an


increase in nominal interest rates. Accordingly, Canada‟s nominal interest rates should exceed the expected inflation rate in order to motivate Canadians to save. Further, he stressed that if inflation is expected to be very moderate or fall in future in the US, people in the United States will be more than willing to save than to spend since they are less concerned with possible price increases due to changes in inflation. In effect, since inflation is not a major concern, the supply of loanable funds is expected to increase whereas the demand for loanable funds falls resulting in a decline in nominal interest rates. In sum, the above illustration of the Fisher effect suggests two main components of the nominal interest rates: expected inflation rate and the real rate of interest (Madura, 2008). The writer pointed out that the real rate of interest is equivalent to the nominal interest rate minus the expected inflation rate. He however admitted that the real rate of interest cannot be directly observed. Prior to this, Mundell (1963) used the Pigou real wealth effect to establish a relationship between the real rate of interest and expected inflation and reports that an inverse relationship exists between the two. Similarly, the work done by Leiderman and Svensson (1995) observe that innovations in the real rate of interest and inflation reveal a strong negative relation which implies that nominal interest rate adjustments lag the inflation changes and conclude his study is consistent the revelations of Barr and Campbell (1997), Pennacchi (1991) and Summers (1983). Santomero (1973) however contends that a change in the growth rate of labour productivity may bring about a positive correlation between the expected real rate of interest and expected inflation but


admits that introducing progressive income taxes may cause further dependencies between the variables under consideration. 2.2.2 The effect of Inflation on Stock Prices Vast empirical literature have in no doubt cast some doubts on Fisher‟s (1930) hypothesis, which reports that nominal asset returns move directly with the expected inflation in order for real stock returns to be determined by real factors which are independent of the rate of inflation. In effect, Fisher (1930) is of the view that assets which represent claims to real assets such as stocks, should offer a hedge against inflation but empirical evidence from most studies on the relationship between stock prices and the level of inflation especially during the period of post-world war II have been contradictory. Various researches conducted between the periods of the 1970s and the early 1980s (Lintner, 1975; Bodie et al., 2005; Fama and Schwert, 1977; Jaffe and Mandelker, 1976; Nelson, 1976; Fama, 1981) and more recently Spirou (1999) have given a clear testimony of this fact. Apart from these, other early works also showed a negative relationship between the level of inflation and real stock prices as the dividend price ratio reflects (Modigliani and Cohn, 1979; Feldstein, 1980). Similar researches quite recently by Sharpe (2002) and Campbell and Vuolteenaho (2004) have also revealed that an inverse relationship exist between stock prices and the rate of inflation. Rather controversially, the study of Apergis and Eleftheriou (2001) is also in disagreement with the Fisher effect. The authors argued that nominal interest rates do not vary exactly with inflation since they only reflect expectations of future inflation instead of current inflation.


Generally, inflation seems to have a significant impact on stock prices through the effect on future earnings as well as the manner in which investors discount their future earnings. Clark (1993) in an attempt to explain the first channel admitted that inflation reduces investments and future earnings thereby retarding growth on the economy. However the emphasis of the observation made by Huisinga (1993) and Zion et al. (1993) was centered on the ability of inflation to lower the stability of relative prices thus leading to greater uncertainty of investment and productivity. More emphatically, there exist an inverse relationship between uncertainty and real economic activity and this by implication means stock prices and inflation are negatively associated (Friedman, 1977). The writer believes that the unpredictability of inflation is noted to bring about higher risks which are associated with investment and production processes of the corporate sector. Schwert (1981) buttresses this point by recognising that inflation uncertainty implies a non-optimal allocation of investment that leads to a decline in stock price. Again, it is believed that higher inflation tends to result in higher taxes on corporate earnings as well as higher taxes being paid by shareholders (Feldstein & Summers, 1979) Meanwhile, the second channel stresses that the discount factor comprises two main components which include the risk free component and that of the risk premium. Accordingly, the latter is due to investors‟ requirement of a positive return on their capital in addition to a risk premium as a form of compensation for the risk undertaken by investing stocks (Apergis & Eleftheriou, 2001). Finally, Malkiel (1982) posits that if inflation could lead to a higher discount rate, then it is expected that the present value of future earnings will decline as well as stock prices. 2.2.3 The effect of Inflation on Stock Returns


Many findings from empirical studies relating to the link between stock returns and inflation are seen to be puzzling since they go contrary to economic theory as well as common sense. For instance, the more heralded negative relation between real stock returns and unexpected inflation is inconsistent with the classical view of monetary neutrality where inflation cannot affect the values of real assets (Geske and Roll, 1983). Although many attempts have been made in order to resolve the so called empirical anomalies regarding the kind of relationship that should exist between inflation and stock returns, it looks as if the negative relation between real stock returns and unexpected inflation is gaining grounds with varied reasons assigned it. Feldstein and Summers (1979) for instance pointed out that the inverse relation between real stock returns and inflation sterns from the redistributive effect of unanticipated inflation as a result of nominal contracting. In their explanation, the authors did contend that since taxes are levied on nominal income in the US, higher inflation will always lead to higher tax liability resulting in a fall of real after-tax income on equity for a given real before-tax income. They are of the view that unexpected inflation leads to a fall in the value of equity but stressed that rational investors only incorporate the effect of expected inflation in valuing equity. In a similar way, Fama (1981) did argue that the inverse relation being postulated by several empirical researchers is spurious since stock prices and the rate of inflation are always driven in opposite direction by random shocks in real activity. He thinks that a positive shock in real activity should lead to an increase in the demand for money as economic agents make adjustments to the increase in economic activity. For a given level of money supply, the rise in the demand for money should be satisfied through a


reduction in current spending thereby leading to a fall in prices of commodities. Obviously, equity prices are expected to increase with the shocks as a result of investors‟ expectation of better business in the future (Fama, 1981). The above view expressed by Fama (1981) receives support from Geske and Roll (1983) who later demonstrates that the negative relation between real stock returns and inflation can be replicated by a countercyclical monetary policy. However, Hasbrouck (1984) reports that the explanation offered by Fama and Geske and Roll only emphasises the negative correlation between real stock returns and unexpected inflation since any covariance between inflation and real stock returns starts from random shocks to real activities and as such must be unexpected. A rather contrasting observation however is that unlike the numerous empirical studies on the relation between real stock returns and unexpected inflation, literature on the association of real stock returns and expected inflation is in limited supply. Besides this, it is believed that the intuition behind the limited explanations offered has not been appealing and thus lacking empirical support (Fama, 1981). For example, the implication of the financing hypothesis by Lintner (1975) is that, firms dilute returns on equity by raising working capital during periods of inflation in an attempt to maintain working capital to sales ratio. However, this view has not been consistent with the observed phenomena that firms respond aggressively to inflation increases by reducing cash balances, tightening credit as well as delaying payments. 2.2.4 The Theory of Efficient Markets Numerous evidence during the 1960‟s show that investment strategies which are based on detailed analysis do not actually seem to work better than simple buying and selling


strategies. Many attempts to explain this rationale therefore lead to the efficient market hypothesis. The efficient market hypothesis posits that market prices of stocks already incorporate all relevant information. Most adherents of this theory claim that this is achieved through competition among market participants who compete for relevant information about companies quoted on stock markets. What this means is that price changes of stock can only be possible if new information becomes available thus portraying the fact that prices of securities follow a random pattern since availability of new information to the market is highly unpredictable. It is from this idea that three forms of market efficiency have been identified based on classifications of what constitute relevant information. These include the weak, semi-strong and the strong form of market efficiency (Fama, 1970). Accordingly, the strong form suggests that prices of securities reflect all private and public information. But evidence provided by Seyhun (1998) points out that, insiders make profit from trading on information which is yet to be made available to the public and as such the writer argues that the strong form of market efficiency does not hold as he describes the market as an uneven playing ground. On the other hand the semi-strong form claims that stock prices only reflect information in the public domain. Seyhun (1998) further states that such a situation eliminates any under or overvaluation of securities, thus going through company accounts as well as the financial press does not give investors an upper hand in terms of profits. The point being made here is that any new information is quickly incorporated into prices of securities (Patell and Wolfson, 1984). With regards to the weak form of market efficiency, it suggests that security prices are made up of all information regarding the history of that security. However, Fama (1991) built on this idea by including predictions of future returns by


using accounting and macroeconomic variables. Most critics are therefore of the view that the predictive power of the weak form of market efficiency raises doubts about its existence. Meanwhile the whole debate surrounding the extent or the degree of market efficiency is still ongoing. More especially, the problem of the joint hypothesis has compounded the issue of market efficiency (Fama, 1991). According to the writer, any tests of market efficiency should be subjected to an asset-pricing model and stressed that any evidence to the contrary could be attributed to the fact that the market is inefficient or incorrectness regarding the model in use. It is highly believed that the divergent views aired on the subject provided more theoretical basis for the majority of the financial market research in the seventies through to the eighties (Keown & Pinkerton, 1996). Stock prices during the said period were seen to follow a random walk model and variations in predicting stock returns if any at all were found to be insignificant thus providing an evidence that seemed to have been consistent with the efficient market hypothesis (Harvey, 1991). The author further postulates that typical results from event studies only point to the fact that stock prices adjust to new information not long after an event announcement and this as he explained is consistent with the theory of market efficiency. Yet, many are the critics who have raised questions that play down the existence of such a theory. Roll (1988) for instance contends that most price movements for individual stocks cannot be related to public announcements. A revelation similar to this is found by Cutler et al. (1989) in their analysis of the aggregate stock market. The authors observed that the relationship between the greatest aggregate market movement and public release of information if any should be insignificant. Recently, analysis of the determinants of returns done by Haugen


and Baker (1996) in five countries discovered that none of the factors associated with the sensitivities to macroeconomic variables were important determinants of expected stock returns. Indeed, much of the controversy surrounding the theory has been the result of anomalies detected in capital markets. Prominent among them is the January effect where Rozeff and Kinney (1976) found evidence of higher returns in January as compared to other months. As Roll (1984) puts it, these anomalies are nothing but a clear indication that information alone does not move stock prices. It is therefore not surprising that many researchers have resorted to investigations in order to come out with alternative theories that can best describe stock market behaviour. Kuhn (1970) could not therefore have put it better when he stated that discovery commences with the awareness of anomaly.


CHAPTER THREE RESEARCH METHODOLOGY 3.0 Introduction The choice of a research method is indeed very important since it plays a very significant role in determining the kind of conclusion that will be drawn about a phenomenon in a given piece of research work (Miles & Huberman, 1994). Without any doubt, it has an impact on what can be said about the cause as well as the factors affecting the phenomenon. This chapter is basically meant to discuss the intended approach to be used in answering the research question and to address the purpose of the study as outlined in the introductory chapter. As pointed out earlier, the purpose of this dissertation is to empirically examine the impact of interest rates and the level of inflation on stock prices of the GSE All-Share Index for the periods running from 1995 to 2009. As such, the following hypotheses are intended to be tested to achieve this aim.  H1: There is a significant negative relationship between prices of stock and interest rates and inflation on the GSE.  H2: There is significant negative relationship between prices of stock and interest rates.  H3: There is significant negative relationship between prices of stock and the level of inflation.  H4: There is significant positive relationship between interest rates and the level of inflation.


Sequentially, the chapter begins by discussing the type of approach adopted for the study followed by the kind of data utilised in carrying out this work. The research model for data presentation will also be analysed along with the tools to be used and finally, attention will be drawn to any limitations discovered regarding the model used. 3.1 Research Approach This section deals with a brief discussion on the different types of approaches as well as the research Strategy.

3.1.1 Scientific Approach Basically, there are two main approaches that researchers adopt in an attempt to undertake an investigation (Trochim, 2006). These are inductive and deductive approaches. An adoption of any of the above approaches for a study depends on what the researcher in question desires to achieve. For instance, Bryman and Bell (2007) posit that researchers who use an inductive approach (bottom-up) move from specific observations to a broader generalisations and theories. This form of research is therefore based on a reasoning which transforms specific observations into a general theory. It begins with a specific observation by the researcher who detects a pattern and regularities, formulate tentative hypotheses which can be explored and end up developing conclusions or theories which are general. Thus a researcher who observes a pattern in a society may form hypotheses on it and use data collection methods such as surveys or experiments to verify these hypotheses in order to reach a conclusion.


On the contrary, researchers who use deductive approach (top-down) work by moving from a general theory to a specific hypothesis which is suitable for testing. Here, a researcher begins to think up a theory about a topic of interest and then narrows it down into a more specific hypothesis that can be tested. In some instances, researchers further narrow down theories by collecting observations to address the hypothesis which aids them to confirm the original theories (Trochim, 2006). In summary, an inductive research is seen to be more open-ended and exploratory in nature especially at the beginning whereas a deductive research is narrower in nature and is about testing or confirming hypotheses. Since this study examines how changes in interest rates and inflation affect stock prices based on existing theories by testing hypothesis through a review of the relevant literature, the deductive approach is considered to be an appropriate way to objectively answer the research question. 3.1.2 Research Strategy The diversity in the science of research methodology paves way to discovery, growth, and empowerment, yet it is the research itself that should determine the method of research (Becker, 1998; Ulmer & Wilson, 2003). Undoubtedly, the research questions and objectives should be able to give a direction as to what approach to adopt as researchers go in search of where and how to get their data. For example, research questions that require qualitative studies often seek to inquire into processes which are related to change or seeking knowledge through various means while quantitative studies typically deal with examining relationships among variables as measured by central


tendencies in a set of data. Studies done by Davies (2003) and Cresswell (2003) however suggest that any research requires either qualitative or quantitative data or both. Strauss and Corbin (1990) point out that qualitative research is a type of research that produces findings not arrived at by means of statistical procedures or other means of quantification. This type of research therefore follows an inductive approach. Creswell (2003) in contrast to this view observe that quantitative methods are used mainly to verify theories or explanations, identify variables under study, relate variables in hypothesis, use statistical standards of validity and reliability as well as employing statistical procedures for analysis. Hence this it follows a deductive approach of research. Though numerous views have been given regarding the suitability of the two, Gerhardt (2004) explains that evaluating the strength and weakness of each of the strategies in itself involves a qualitative research. However, since this study examines how changes in interest rates and inflation affect stock prices based on existing theories by testing hypothesis through a review of the relevant literature, quantitative data is considered more appropriate to objectively answer the research question. 3.2 Data This aspect of the dissertation seeks to outline the different types of data to be used for the analysis in an attempt to finding an answer to the research question. In addition to this, the various sources and locations from which data is obtained will also be discussed. 3.2.1 Data Description The main aim of this study is to look at the impact of interest rates and inflation on stock prices of the GSE All-Share Index lasting from 1995 to 2009. To achieve this, the study intends to employ time series data covering the stated period. The analysis of this


empirical study will make use of quarterly stock prices (SP) as measured by the GSE AllShare Index, the level of inflation represented by (IF) is defined by the consumer price index while the Bank of Ghana treasury bill rate (IR) is used as the rate of interest and all spanning the same period. As stated earlier, the choice of the GSE All-Share Index is purely motivated by the availability of data. A negative relationship is expected between the rate of inflation and stock prices since high levels of inflation lead to an increase in the cost of living by shifting resources from investment to consumption. Further, DeFina (1991) contends that the contraction of nominal interest rates disallow immediate adjustment of firm‟s revenues and costs that prevent cash flow to grow at the same rate as inflation. Similarly, an inverse relationship is expected between the Treasury bill rates and stock prices since an increase in interest rates decreases the opportunity cost of holding money and as such investors substitute the holding of interest bearing assets for stocks leading to a fall in stock prices. However, the Treasury bill rate is being used as a measure of interest rates in this work because investments in Treasury bills is regarded as an opportunity cost for holding stock. 3.2.2 Data Collection The data and other information gathered for the purpose of this study are mainly obtained from secondary sources. Data on the theories as well as the relevant literature have are derived from books, the internet and journals from the Glasgow Caledonian University library‟s database. Other sources include the IMF Direction of Trade Statistics Yearbook where data on statistics were obtained, the Bank of Ghana quarterly bulletins and reports where data on the GSE are obtained. Data on treasury bills and inflation rates were obtained from IFS statistics. Data on stock indices were however were collected from the


Research department of the GSE. For the purpose of this study, nominal figures are employed. It is also worth noting that all time series data are quarterly values covering the period of study which result in 60 observations. The study would have preferred monthly data to quarterly data but the difficulty in accessing these data, demands that quarterly data be used for the purpose of this study. However, the duration of study was chosen because it covers the most active period of trade on the GSE. The table below provides a summary of the various sources from which data are collected for the study. Table 3.0: Description of source of data Variable lnSP Concept Description Source

Natural log of GSE GSE All-Share Index Index

All-Share GSE Research




of 91 day Treasury bill IFS Statistics rates of Consumer Index Price IFS Statistics

Interest Rates lnIF Natural Inflation log

3.3 Model Summary This section gives a brief discussion on the various types of models chosen and why they have been selected for the study. 3.3.1 Model Specification In an attempt to empirically establish a relationship between the dependent variable (stock prices) and the independent variables (inflation rates and interest rates), several


tests have been carried out to test the hypotheses set out earlier in this study. A preliminary test is done by using the ordinary least square regression analysis. However, since regression is only effective at establishing relationships between data points which are linear, a correlation test initially (see table 4.0) to confirm the linearity is carried out. The results as shown by the correlation coefficients (r) are indicative of the fact that the relationship between the GSE All-Share Index, interest rates and inflation could not be linear. The equation one below is thus derived from the relationship between the dependent and the independent variables. SP = β0 * (IRt)β1 * (IFt) β2 ………………………………….....…………….……………..1 But the application of the ordinary least square regression analysis is only possible if equation two as shown below could be established between the variables. SPGt = β0 + β1IRt + β2IFt + e1……………………………………………..…………………….…………….……….....2 Hence, in order to make the above equation workable, the data in question is converted by applying natural logarithm to make it linear. The conversion thus results in equation three as indicated below. lnSPGt = β0 + β1lnIRt + β2lnIFt + e1………………………………………………..……………………………….3 Where: lnSPGt = natural log of stock prices represented in this study by the GSE All-share Stock Index at time t, lnIRt = natural log of interest rates at time t, lnIFt = natural log of the rate of inflation at time t, β0, β1 and β2 = constants of the above regression equation, e1 = the white noise error term. Secondly, another regression equation as set out below is also developed to test the hypothesis (H2): there is a significant negative relationship between stock prices and interest rates.


lnSPGt = β0 + β1 lnIRt + e1…………………………………………………………………………………...……………4 Where: lnSPGt = natural log of stock prices represented in this study by the GSE All-share Stock Index at time t, lnIRt = natural log of interest rates at time t, β0 and β1 = constants of the regression equation in question, e1 = the white noise error term. In testing the third hypothesis (H3): there is a significant negative relationship between stock prices and the rate of inflation, the regression equation established below is adopted. lnSPGt = β0 + β1 lnIFt + e1………………………...…………………………………5 Where: lnSPGt = natural log of stock prices represented in this study by the GSE Allshare Stock Index at time t, lnIFt = natural log of the rate of inflation at time t, β0 and β1 = constants of the regression equation under scrutiny, e1 = the white noise error term. Lastly, the sixth equation as seen below is applied in testing the hypothesis (H4): there is a significant positive relationship between interest rates and the rate of inflation. lnIRt = β0 + β1 lnIFt + e1 ………………..….….,………………………………………6 Where: lnIRt = natural log of interest rates at time t, lnIFt = natural log of the rate of inflation at time, β0 and β1 are the constants of the above regression equation, e1 = the white noise error term. A confidence level of 95% at 5% significance level has been specified for the purpose of this study. The results from the linear regression model helped in measuring the relationship between the dependent variable and the independent variables as well as testing the hypotheses that have been developed early on in the study. The implication of the above equation for the study is that if all the four hypotheses are accepted then, the test gives significant statistical evidence that the relationship between dependent and


independent variables is positive at 95% confidence level. On the contrary, if all the hypotheses are not accepted, the dependent variable in the above regression equation will be deemed to be influenced by factors other than those variables stipulated. Therefore, Saunders et. al. (1997) suggests that p-values are key in determining whether or not the above hypotheses should be accepted. 3.3.2 Model Justification Arguably, the most commonly used form of regression is the linear regression. However, the ordinary least square regression is the most common type of linear regression. It simply makes use of values from an existing data set which consists of measurements of the values of two variables say X and Y to develop a model that is useful for forecasting the value of the dependent variable Y for a given value of X (independent variable) and this obviously is in line with the objective of this study which seeks to examine the extent to which changes in interest and inflation (independent variable) could impact on stock price movements (dependent variable) so that analysts can make accurate predictions on the dependent variable in future using these independent variables. Though the ability of a linear regression to explore the relationship of an independent variable that marks the passage of time to a dependent variable when in line has never been questioned, Berenson et al. (2008) are of the view that multiple regressions should be established in order for the significance and the magnitude of the effect of the independent variables on the dependent variables to be felt and identified. Further, the Rsquared (r2) is believed to show the percentage of the total variation in the dependent variable that is explained by all the independent variables.


However, the overall significance of the model can be examined by the F test which reports a linear relationship between all of the independent variables in total and the dependent variable, while the significance of the estimated coefficients are explained by the t-statistics, with a threshold value of ±1.48 which is equivalent to a p-value of 0.1 (Berenson et al., 2008). 3.4 Analytical Tools An extensive review of the relevant literature has revealed countless tests that have been used to establish relationships between several variables. More importantly, many statistical tests have been carried out to examine the correlation between stock prices and a variety of macroeconomic variables. This study which seeks to examine the impact of interest rates and inflation on the GSE All-Share Index is therefore not an exception as it intends to use statistical methods such as SPSS in order to produce some regression model results, descriptive statistics, correlation analysis, multicollinearity and goodness of fit since the data collected for the purpose of this study are in the form of time sequence. 3.4.1 Correlation Analysis The objective of carrying correlation analysis in statistics is to determine the extent to which a change in the value of one variable will affect the other. For instance, for the purpose of this study, correlation analysis could be done to assess the impact that movements or variations in interest rates and the rate of inflation could have on stock prices. However, it is very important to note that correlation is never causation (cause and effect relationship) because it is possible for two attributes to be correlated but both could be


the cause of another variable. Nevertheless, the determination of any causal relationship may require a very extensive experiment to be carried out. What is therefore very crucial is that in an attempt to conduct a study such as this, there is the need to compute the correlation coefficient (r) which measures the strength of any relationship that should exist between the variables under study. A value of +1 depicts a positive relationship while an inverse relationship will always be indicated by -1. However a value of zero indicates no relationship. 3.4.2 Multicollinearity Multicollinearity is a statistical phenomenon that occurs when there is a high correlation between variables under consideration in such a way that it becomes very difficult to estimate their individual regression coefficients with precision. It is therefore believed that whenever variables exhibit such a characteristic, they are deemed to measure the same attribute or carry the same information. However, what should be made clear here is that multicollinearity does not in any way reduce the predictive power of the regression model as a whole but what it does is that it affects the individual predictors with regards to their calculations. Besides what has been identified above, the possibility of multicollinearity among study variables could also be assessed through correlation analysis. Thus a correlation coefficient of either 0.75 or high among variables could be a sign of multicollinearity. 3.5 Model and Data Criticism Linear regression analysis is very important for exploring linear relationships between dependent and independent variables that mark a passage of time. However, whenever the trend gets nonlinear, linear regression fails to capture any relationship between the


dependent and the independent variables. In addition to this anomaly, linear regression fails to identify seasonal, cyclical, and counter cyclical trends in time series data. The effects of changes in direction of data which are in time series as well as the rate of change are also believed not to be captured by linear regression. Other critics are also of the view that a problem occurs when time series values at one point can be determined or are influenced by previous time values (Berenson et al., 2008). Another criticism is centered on the secondary nature of the data used for the purpose of this study considering the fact that such data are sometimes altered to suit specific purposes. However, looking at the nature of the study, there is no way data on stock prices, interest rates and consumer price indices could be gathered apart from the sources identified in the study. Besides, the GSE Research is regarded as one of best when it comes to credible sources of data in the sub-region.


CHAPTER FOUR DATA ANALYSIS AND PRESENTATION OF RESULTS 4.0 Introduction This chapter intends to analyse the data collected for this study. The study uses the ordinary least square linear regression model. The results from the statistical tests of significance and association of the four working hypotheses will be presented an analysed in this chapter.

4.1 The Results
Recall that the objective of this dissertation is to establish a relationship among stock prices, interest rates and inflation in Ghana. In order to achieve this purpose, data on the GSE All-share Index, interest rates (Treasury bill rates), and inflation rates (CPI) for a fifteen-year period beginning from 1995 to 2009, have been gathered (see appendix C). The study therefore adopts the approaches of descriptive statistics, correlation and linear regression analysis to establish linear dependence. Below is the summary of the linear regression models for the purpose of testing the hypotheses outlined earlier in the study. lnSPGt = β0 + β1lnIRt + β2lnIFt + e1…………………………………………….………….1 lnSPGt = β0 + β1 lnIRt + e1 ……………………………………...…………………………2 lnSPGt = β0 + β1 lnIFt + e1……………………………………..…………………………..3 lnIRt = β0 + β1 lnIFt + e1……………….….………………..……………………………4
In the above equations, β0, β1, and β2 represent the beta values or the regression coefficients which measure the significance of the independent variables to the dependent variable. For the purpose of this study, relationships between the dependent and the independent variables have been established by setting the coefficients of the various regression models to a 95% confidence level as well as a significant level of 5%. The output of the regression is therefore


displayed in appendix E. The application of natural log was however meant to make the data linear. 4.2 Correlation Test Results and Analysis

The impact of one variable on another variable can be predicted with a high degree of certainty if we can establish that the variables are correlated. As such, correlation analysis has been done where past data of the variables under study are subjected to an initial assessment in order to find out if there is any form of connection between them as well as the extent of that connection. It is believed that the stronger two variables are related, the more closely their scores will lie on the regression line and therefore the accuracy of their prediction. Apart from this, such a test is undoubtedly very useful in identifying the high possibility of multicollinearity between the predictor variables since such a situation can cause problems in trying to draw conclusions about the relative contribution of each explanatory variable to the success of the regression model. The Pearson‟s coefficients of determination are used to test the relationships between stock prices and interest rates, stock prices and inflation and interest rates and inflation in order to quantify the direction and magnitude of the relationship between each of the pairs. The closer the correlation coefficient is to 1, the stronger two variables are related. A key feature of this association is depicted in table 4.0 below where a very strong negative relationship (-0.80) is seen between stock prices and interest rates. This could be attributed to the fact that an increase in interest rate provides an incentive for investors to hold interest bearing securities instead of holding stock hence the falling prices of stocks. Similarly, the coefficient of -0.65 (rounded to two decimal places) as depicted on the same table shows a moderate negative correlation between stock prices and the rate of inflation. The implication of this is that as inflation goes up, stock prices fall. In contrast to these two 51

findings, a strong positive relationship is seen to exist between interest rates and the rate of inflation according to the table. However, the magnitude of the association between the two variables (0.73) implies an existence of multicollinearity which is likely to bring about distortions in the results of the t-statistics and thereby leading to wrong

conclusions being established between the variables under consideration (Keller, 2005). But as has been postulated (Dirk and Bart, 2004), the existence of multicollinearity does not have an effect on a fitted model provided that the independent or explanatory variables follow the same pattern of multicollinearity as the data on which the linear regression model is related. They however pointed out that a limit of 0.75 in absolute terms should exist before such conclusions could be valid. Hence, for the purpose of this study, both interest rates and inflation could be used to make valid explanations of stock prices since their coefficient of 0.73 is within this limit. Table 4.0: Summary of results from the correlation test. Variable lnSP lnIR lnIF lnSP 1.00 -0.80 -0.65 1.00 0.73 1.00 lnIR lnIF

4.3 Analysis and Results of Descriptive Statistics. Table 4.1 as shown below presents the results of descriptive statistics for the data covering stock prices, inflation and interest rates. This comprises a report of the sample mean, median, standard deviation, skewness, range, minimum and maximum values, sum and the number of observations. However, the discussion intends to dwell only on few of


the parameters mentioned above. The intention here is to try and create a mental picture of the sort of data being utilised in the study. The high standard deviation displayed by the GSE All-share Index gives a testimony of how volatile the stock market has been over the years of the study. Second behind the deviation of the All-share Index is the standard deviation of the rate of inflation which is not surprising looking at the high inflation pressures experienced during the years under review though this could be argued to be relatively small compared to that of the stock prices. This value is followed closely by that of interest rates since interest rates in Ghana are heavily impacted by the level of inflation. Given that the data is evenly skewed judging from the table, the mean will undoubtedly give a valid conclusion of the data when used as a measure of central tendency compared to the median and the mode. However, the legitimacy of the mean value with regards to it being a fair representation of the data can be questioned looking at the minimum and the maximum values of the stock prices. Rather surprisingly such an argument could not be made about the mean values of interest rates and inflation since a mere observation of these figures from the table shows how evenly they are distributed. Another interesting observation made is that though stock prices have been consistent in terms of increases over the years, similar trends have not been witnessed with regards to interest rates and inflation. Arguably these variables have not followed a consistent path as depicted in table 5.0 in the appendix C.


Table 4.1: Summary of descriptive statistics of variables from 1995 to 2009. Variable Mean Median Standard Deviation Skewness Minimum value Maximum value Sum SP (GH. CEDI) 3120.86 1183.57 3062.21 0.90 298.00 10,691.85 187,251.55 IR (%) 0.27 0.26 0.11 -0.01 0.09 0.46 16.07 IF (%) 0.23 0.17 0.15 1.77 0.09 0.70 13.90

4.4 Multiple Factor Regression Analysis An initial analysis is done through the ordinary least square multiple linear regression analysis by using SPSS (see appendix B) to test the coefficients of all the equations involving stock prices, interest rates and inflation. The objective is to make predictions as to how best interest rates and inflation can explain movements in stock prices. In addition to this, a t-statistics is also carried out to determine the relative significance of each of the variables in the models (Sykes, 2006). In order to draw a valid conclusion with regards to the statistical significance of the findings, the models are tested for fitness by conducting F-statistics. A further test is done in ANOVA to determine whether any direct manipulation of the predictor variables could cause a change in the dependent variable contrary to what would have happened if these had not been tempered with. The importance of these tests of significance cannot be overemphasised since they help to determine the probability of a relationship between variables (Kennedy, 1997).


4.4.1 Analysis of the effects of Interest Rates and Inflation on Stock Prices The main model employed for the study is the ordinary least square linear regression model to test the initial hypothesis as to whether there is a significant relationship between interest rates and inflation and stock prices. In other words, the objective of this study is to determine whether stock prices in Ghana are mostly driven by interest rates or inflation. In carrying out this exercise, the GSE All-share Index is used as the dependent variable whereas Treasury bill rates and consumer price indices proxied for nominal interest rates and inflation respectively make up the independent variables. As stated earlier, quarterly data are used for the fifteen-year period generating a total of sixty observations. 4.4.2 Hypothesis Testing and Analysis In order to achieve the stated objective of the study, a linear regression at 95% confidence level and a significant level of 5% is run. This is done to test the initial hypothesis (H1) as to whether there is a significant relationship between interest rates inflation and stock prices. To accept the hypothesis, the following conditions outlined below must be evidenced;  H1: β ≠ 0, generally show the existence of a relationship.  H1: β > 0, shows a direct relationship  H1: β < 0, shows an inverse relationship Looking at table 4.2, it is observed that the beta for interest rates is -1.65 but that of the rate of inflation -0.29. Since none of the coefficients of determination is equivalent to zero (β = 0), the above hypothesis should be accepted since each of them fulfils one of the conditions above. Stated differently, a linear relationship exists between interest rates,


inflation and stock prices. However, the negative signs in front of these coefficients (betas) signify an indirect or an inverse relationship between the explained variable (stock prices) and the explanatory variables (interest rates and inflation). What this means is that as interest rates and inflation go up, prices of stock during the years under review decrease and vice versa. To be specific, a percentage increase in both interest rates and inflation leads to a fall in stock prices of 1.65 and 0.29 respectively. In the case of interest rates, the negative relationship could be attributed to the fact that an increase in interest rates (T bills) increases the opportunity cost of holding money and as such a trade-off by investors between stocks and interest bearing assets. The belief is that high Treasury bill rates serve as an incentive for the public to invest in government securities (Adjasi et al., 2008). With regards to inflation, it is seen to increase the cost of living. Moreover, an increase in the cost of living shifts resources from investments to consumption thereby resulting in a reduction in the demand of investment assets and consequently a fall in the demand for stocks (Adam & Tweneboah, 2008). Besides this, it is also expected that government will respond to the rising levels of inflation by introducing policies which tighten the economy. For instance, the monetary policy committee could respond through an increase in the nominal risk-free rate of interest leading to a rise in the discount rate of the stock valuation model. The table below shows the regression results for the effect of interest rates and the level of inflation on stock prices.


Table 4.2: Summary of regression results of interest rates, inflation and stock prices Variable Constant lnIR lnIF Coefficient 4.61 -1.65 -0.29 T-statistic 14.99 -6.14 -1.16 P-value 0.000 0.000 0.25 H1: β ≠ 0 H1: β ≠ 0 Accept Accept Hypothesis Decision

R2 = 0.64, F-Statistics = 52.68, F-Probability* = 0.000, df =59, Adjusted R2 = 0.63 The above scenario can best be described by catching a glimpse of figure 4.1 as seen below. This typically depicts the inverse relationship between interest rates and stock prices for the period being reviewed. It could be observed that stock prices are showing very low figures during the early 1990‟s when interest rates peaked. For instance, prices of stock showed a figure of 298.00 in the first quarter of 1995 which is an all-time low considering the period of study when interest rates peaked relatively at 33%. Contrary to this, stock prices rose to an unprecedented 4,818 Ghana cedis in 2006 when interest rates stood at only 9.53%. Similarly, a plot of inflation rates against stock prices as represented by figure 4.2 leads to a result similar to that of interest rates as portrayed by the beta values shown on the above table. The regression model derived from the above table is thus stated as: lnSPGt = 4.61-1.65 lnIRt - 0.29 lnIFt + et. …………………………………….………………………………………1 Further tests are therefore carried out to determine how well the above model fits the data gathered for the fifteen-year period. An overall fitness is checked by using the F-statistics along with the Fischer distribution. The purpose of this test is to check the statistical significance of the regression equation above. Usually an F-value which is bigger than 4.0 is deemed significant hence with 95% confidence level, it can be concluded that the


model aids an understanding of the interaction between stock prices, interest rates and inflation as depicted on the table above. Moreover, a small p-value of approximately 0.000 above provides evidence that at least one of the independent variables is important in explaining the variations in stock prices in Ghana thereby suggesting the acceptance of the hypothesis that there is a significant relationship between stock prices, interest rates and inflation. Another way of discovering the significance of the regression model to the study is the R2. It tells the percentage of variation in stock prices explained by interest rates and the level of inflation. Normally, its values range from 0 to1 but a higher R 2 value is an indication of a good fit for the data by the model. Again with an R 2 value of 0.64, it can be concluded confidently that the model is valid. Having confirmed the validity of the regression model, a test to find out the relative importance of each of the predictor variables is conducted. In other words, there is the need to find out whether it is interest rates or inflation that does a better job in explaining movements in stock prices. Generally, any explanatory variable that has zero as its coefficient is regarded not to contribute meaningfully in predicting the value of the variable which is being explained. Nonetheless, a close look at table 4.2 indicates that each of the independent variables at least plays a role towards the variation in stock prices. However, what is certain therefore is that the degree of importance of interest rates and inflation to movements in stock prices vary looking at their coefficients from the regression model. A t- statistics is then conducted to establish the relative importance of interest rates and inflation on stock price movements. As a general guide, a t-value which is bigger than 2 in absolute terms signifies the importance of the independent variable to the dependent variable. Hence, t-values of 6.14 and 1.16 for interest rates and


inflation respectively indicate that comparatively, stock prices in Ghana are driven not by inflation but by interest rates which contrasts the findings of Apergis and Eleftheriou (2001) who conducted a similar study on the Athens stock market and concluded that Greek stocks are driven by inflation. Therefore, with a confidence level of 95%, it can be concluded that interest rates exert greater influence on stock price movements in Ghana as compared to inflation. But, there is 5% possibility of deviation from normal as far as this prediction is concerned. Yet, further to this assertion is the belief that t-values when used provide more accurate prediction in comparison with regression coefficients since it factors in the error. However, the revelation of this study follows the findings of Firth (1979); Luintel and Paudyal (2006) and Adam and Tweneboah (2008) at a confidence level of 95%. 4.5 Single Factor Regression Analysis This section of the chapter presents a critical analysis of the results of the single factor regression model. This comprises the test of hypotheses two to four as presented earlier in the study. 4.5.1 Analysis of the effects of Interest rates on Stock prices The review of the numerous literature regarding the relationship between interest rates and stock prices indeed has provided divergent views as to the direction of movement but what is certain is that most analysts seem to agree that interest rates have a significant impact on stock prices. For instance, the study of Apergis and Eleftheriou (2001) found a positive relationship between stock prices and interest rates but concluded that the relationship is statistically insignificant. In an attempt to test the hypothesis of whether


there is a significant relationship between interest rates and stock prices in Ghana, the regression model below is derived (see Table 4.3). lnSPGt = 4.76 –1.88lnIRt+e1………………..….................................................................. 2 Below is a presentation of the summary results of the regression of interest rates on stock prices. Table 4.3 Summary regression results for stock prices and interest rates Variable Constant IR Coefficient 4.76 -1.88 T-statistics 17.06 -10.17 P-value 0.000 0.000 H2: β ≠ 0 Accept Hypothesis Decision

R2 = 0.64, F-Statistics = 103.43, F-Probability* = 0.000, df =59, Adjusted R2 = 0.63 An initial conclusion as to the relationship between interest rates and stock prices is drawn by analysing the correlation test results presented earlier in the study. The R value of -8.0 shown by the result indicates a strong negative relationship between interest rates and stock prices. This is seen to be consistent with the result established by the single regression model presented above both in direction and in magnitude. The coefficient of determination displayed by the single regression model as presented in table 4.3 confirms how significant statistically interest rate is to the movement of stock prices. It also an indicative of the fact that an indirect relationship exists between the two variables. This trend is best portrayed by figure 4.1 below over the period of the study.


graph of interest rates and stock prices
50 i 45 n40 r t35 a 30 e 25 t r20 e e15 s s10 t 5 0 31 Dec. 09 31 Mar. 09 30 Jun. 08 30 Sep. 07 31 Dec. 06 31 Mar. 06 30 Jun. 05 30 Sep. 04 31 Dec. 03 31 Mar. 03 30 Jun. 02 30 Sep. 01 31 Dec. 00 31 Mar. 00 30 Jun. 99 30 Sep. 98 31 Dec. 97 31 Mar. 97 30 Jun. 96 30 Sep. 95 12000.00 10000.00 8000.00 6000.00 4000.00 2000.00 0.00 p r i c e s s t o c k Interest Rates Stock Index


The above figure clearly shows that the performance of GSE All-Share Index was not very encouraging from 1995 to 2003 when interest rates were at their peak. This because attractive interest rates favour investments in interest bearing assets such bonds. However, the story was different after 2003 as depicted above indicating clearly an indirect relationship between the two variables. Also, a close observation of table 4.3 shows an F-value of 103.43 which is highly significant statistically compared to the benchmark value of 4.0. Therefore, it can be concluded that interest rates provide meaningful explanation to the movement in stock prices. Put differently, it can be said that the regression equation involving stock prices and interest rates will be very useful to investors when used as basis for making investment decisions but at an error level of 5%. Besides the F-value, the p-value of approximately 0.000 indicates that the prediction of stock prices in Ghana based on interest rates will be correct at 95% level of confidence. Again, the significance of R 2 is indeed a confirmation of the important role that interest rates play in explaining


variations in stock prices. To be specific, the value of 0.64 representing R2 on the table above signifies that about 64% of the variation in the GSE All-share Index is caused by interest rates all things being equal. This finding is similar to that of Adam and Anokye (2008) in their study of the impact of macroeconomic variables on stock prices in Ghana but contrary to the conclusions drawn by Asprem (1989); Barsky (1989) and Shiller and Beltratti (1992) who state that there exist an insignificant relationship between stock prices and interest rates. 4.5.2 Analysis of the effects of Inflation on Stock Prices Like the relationship between interest rates and stock prices, the study of the impact of inflation on stock prices has attracted extensive and varied views. However, the review of the literature revealed that not much of such studies are done in emerging markets like that of Ghana. This therefore has been the motivation behind the test of the hypothesis as to whether a significant relationship exists between inflation and the GSE All-share Index. The findings of this work began by doing a correlation test depicted in table 4.1 above. The table shows -0.65 as the correlation coefficient depicting a moderate association between inflation and stock prices. Thus unlike the correlation between stock prices and interest rates which is deemed to be very strong, inflation does not have much impact on stock prices in Ghana. Nonetheless, the direction of movement by the two explanatory variables has been consistent throughout the study as shown by the negative sign preceding their coefficients. In addition to the correlation test, a single model regression analysis is also run to further determine the impact of inflation on stock prices. The results of the analysis has been summarised on table 4.4 below. Table 4.4: Summary of regression results of the impact of inflation on stock prices


Variable Constant IF

Coefficient 5.13 -1.43

T-statistics 13.57 -6.44

P-value 0.000 0.000



H3: β ≠ 0


R2 = 0.41, F-Statistics = 41.49, F-Probability* = 0.000’ df =59, Adjusted R2 = 0.41 Based on the table above, the regression model below is derived: lnSPGt = 5.13 - 1.43 lnIFt + e1………………………………………................................. 3 A quick look at the table above depicts an F-value of 41.49 at 0.000 probability which is highly significant when compared to the standard value of 4.0. This thus confirms the validity of the model as a best fit for the data. The implication is that inflation plays a role in explaining the variation of stock prices in Ghana but not as significant as interest rates. In order to be double sure of this conclusion, the analysis is extended to cover the use of R2. The value 0.41 shown beneath table 4.4 for R2 implies that only 41% of the variation in the GSE All-share Index can be accounted for by variations in inflation. Though this revelation casts some doubts on the reliability of inflation in predicting stock movements by investors, the small p-value of approximately 0.000 produced by this analysis is rather encouraging. This value suggests that inflation is statistically significant regarding its impact on the GSE All-share Index hence also suggesting the acceptance of the hypothesis that inflation has an impact on stock price in Ghana though not very significant compared to interest rates. Besides these, the t-statistics for the regression coefficient, of 6.44 in absolute terms significantly differs from zero at 95% confidence level hence implies that inflation contributes significantly to the variations in the GSE Allshare Index. Nonetheless, figure 4.2 below is an indicative of the fact that the relationship


between inflation and stock prices is similar to that of interest rates and stock prices regarding the direction of movement.

graph of inflation and stock prices
i n f l a t i o n 80 70 60 50 40 30 20 10 0 31 Dec. 09 31 Dec. 08 31 Dec. 07 31 Dec. 06 31 Dec. 05 31 Dec. 04 31 Dec. 03 31 Dec. 02 31 Dec. 01 31 Dec. 00 31 Dec. 99 31 Dec. 98 31 Dec. 97 31 Dec. 96 31 Dec. 95 12000.00 10000.00 8000.00 6000.00 4000.00 2000.00 0.00 p r i c e s s t o c k Inflation Rates Stock Index

r a t e s


The above simply shows that the rational investor will trade-off stocks for interest bearing securities in an environment of high inflation pressures. The conclusion drawn here is consistent with that of Fisher‟s (1930) hypothesis which acknowledges an impact of inflation on stock prices but departs from this study regarding the direction of movement. Contrary to the negative relationship established in this study between the two variables, Fisher (1903) is of the view that inflation should move onefor-one with stock prices in order for stock prices to provide a hedge against inflation. Yet many findings as revealed by the extensive review of the related literature violate this view.

4.5.3 Analysis of the effect of Inflation on Interest Rates


This section of the study tries to look at the relationship between the two predictor variables (inflation and interest rates) in order to assess the impact such a relationship is likely to bring on the dependent variable (stock prices). The preliminary assessment of such linkage is done through the use of correlation test results depicted in table 4.1 earlier in the study. The correlation coefficient of 0.73 clearly indicates how strong inflation and interest rates are related. Apart from being highly related, the correlation coefficient (r) signifies a positive relationship between the two variables. This therefore implies that an increase in inflation brings about a corresponding increase in interest rates and vice versa all things being equal. This trend is also clearly depicted in figure 4.3 as shown below.

graph of interest rates and inflation
i n t e r e s t r a t e s 80 70 60 50 40 30 20 10 0 31 Dec. 09 31 Dec. 08 31 Dec. 07 31 Dec. 06 31 Dec. 05 31 Dec. 04 31 Dec. 03 31 Dec. 02 31 Dec. 01 31 Dec. 00 31 Dec. 99 31 Dec. 98 31 Dec. 97 31 Dec. 96 31 Dec. 95 50 45 40 35 30 25 20 15 10 5 0 i n f l a t i o n

r a t e s

Inflation Rates Interest Rates


The figure above indicates that the monetary policy committee of the Bank of Ghana is more often than not tempted to adjust interest rates upwards whenever inflation is high and vice versa. The relationship is therefore direct. To find out about the magnitude of increase or a decrease any change in inflation could bring on interest rates, interest rates are regressed on the level of inflation. The summary results of the regression on interest rates and inflation is presented below in table 4.5 65

Table 4.5: Summary results of the impact of inflation on interest rates Variable Constant lnIF Coefficient -031 0.69 T-statistics -2.17 8.12 P-value 0.034 0.000 H4: β ≠ 0 Accept Hypothesis Decision

R2 = 0.53, F-Statistics = 65.88, F-Probability* = 0.000, df =59, Adjusted R2 = 0.52 The following regression model is therefore derived from the above table: lnIRt = -0.31 + 0.69 lnIFt + e1……………....................................................................... ..4 In effect, what the above model portrays is that a percentage increase in inflation leads to a change of 0.69 in interest rates suggesting the acceptance of the hypothesis which states that a significant relationship exist between interest rates and inflation. This confirms the consistency of the results of both the correlation test as well as the regression test with regards to the link between the two variables. Further to these tests, R 2 shows a value of 0.53 which implies that about 53% of the variation in interest is attributable to inflation changes. In addition, the significance of the F-value of 65.88 goes to explain how important inflation is in explaining changes in interest rates. Another strong point that could be made regarding the strength of the correlation between interest rates and inflation is the p-value from the above table. Interestingly the results of this study seem to agree with the findings of Fisher (1930) as well as that of Madura (2008) who built on Fisher‟s hypothesis in his analogy as reflected already in the literature above. However, for the purpose of this study, the degree to which interest rates is correlated to inflated could possibly have a negative impact on the overall outcome as regards the objective of the study due to the presence of mulcollinearity.


CHAPTER FIVE 5.0 Discussions and Conclusion The role of the stock market in economic development is indeed one of the most controversial and well-debated subjects in the world of finance and economic theory. While its contributions have been very crucial towards the development of most developed economies, such cannot be said about the role it plays in developing markets. It is therefore with this conviction that this dissertation seeks to investigate the factors that are responsible for movements in stock prices in a developing economy like Ghana so that policy makers can take into consideration these factors in formulating policies with a view to fostering economic development. The study as stated earlier, is intended to determine the effect of interest rates and inflation on the GSE All-share index covering the periods from 1995 to 2009. For this purpose, quarterly data on the All-share index (stock prices) were utilised as the dependent variable whereas the Treasury bill rates and the consumer price index proxied for interest rates and inflation respectively were used as the independent variable. Basically, the study employed regression, descriptive statstics and correlation to examine the impact of interest rates and inflation on stock prices. The results of both the correlation and regression tests revealed that the GSE All-share index is inversely related to interest rates and inflation. The implication of this revelation is that the stock prices of Ghana do well under conditions of low interest rates and for that matter inflation. Besides this and perhaps most importantly, the study also revealed although both interest rates


and inflation account for variations in stock prices, the impact of inflation on stock price movement in Ghana is insignificant as compared to interest rates. Therefore, the empirical evidence presented by the study above is suggestive of the fact stock prices in Ghana are driven primarily by interest rates and not inflation all things being equal in spite of the close relationship established between the two independent variables in the study. This conclusion however implies that substantial increases in stock prices with the resultant higher economic growth can only be achieved if proper policies are put in place by policy makers to ensure that interest rates are kept at their lowest level possible. 5.1 Implications and Recommendations It is worth noting that interest rates and inflation have attracted much attention in financial economics in both developed and developing economies because of their implications in financial markets and most importantly the stock market. However, so many variables apart from interest rates and inflation can have a significant impact on stock prices. In effect, what this finding is suggesting is that though the empirical evidence of this study could be used as basis for making investment decisions, investors and corporate management are advised to analyse other macroeconomic variables critically since these variables when considered could make a significant impact to the outcome of the study. Nevertheless, interest rates and inflation are believed to increase the value of the firm via its stocks in the long term, but it important to stress once again the two variables only form a small percentage of the factors that can influence movements of stock prices in Ghana. This therefore goes to suggest that a fall in interest rates does not necessarily mean that stock prices will go up and vice versa. Yet the importance of these two


variables in such a study cannot be overemphasised. It is therefore recommended that the monetary policy committee of the Bank of Ghana (BoG) should adopt the appropriate interventionist strategies at the right times to ensure these factors are stabilised for economic growth to thrive. On the other hand regulators of the stock market are also expected to benefit from these findings since the factors that influence the movement of stock in itself is an important step towards a sound regulatory framework as regards the stock market.

5.2 Limitation of Study Like many other studies carried out, this study has its own short comings and limitations that admittedly, could have an impact on its findings. Recall that only interest rates and inflation were employed in this study as the explanatory variables but in reality, stock prices are affected by many variables other than those used. Other macroeconomic variables such as exchange rates, foreign direct investment, trade deficit and money supply are noted to cause variations in stock prices. This study is therefore susceptible to the omitted variable bias as the many omitted variables become part of the noise term. Besides this, the ability of the regression equation to capture relationships between the dependent and the independent variables in situations where the dependent variable over time is nonlinear could be questioned. It is noted that the GSE All-share index though sought from a reliable source could be a victim of such circumstances. Furthermore, the possibility of multicollinearity cannot be overemphasised. Both the correlation and regression tests conducted revealed high correlation between interest rates


and inflation and since these two variables are independent of the analysis, being highly related could potentially affect the findings. Finally, the secondary nature of the data gathered as well as the estimation of the tstatistics which is deemed too simple to be able to illustrate any calculation of statistical significance is also identified. 5.3 Validity and Reliability Validity in a quantitative research such as this seeks to find out if the instrument used in the research actually measures what the researcher intends to evaluate (LaCoursiere, 2003). Hence, a research is said to be valid if its measure is scrutinised to ensure it is applicable under varying circumstances using probabilities. However, the flexibility with which the models were applied as well as the accuracy of the data collected from GSE and the IMF database raises no question marks about the credibility of the study. The validity of the study makes it reliable as well. Though often used in conjunction with validity, reliability simply means the rate at which the outcome of the study could be repeated in case it is replicated (Ulmer & Wilson, 2003). Having used SPSS to analysed the data which were collected from very credible sources and the fact that the findings have been consistent with conclusions drawn from other researches as revealed by the literature means that the work is reliable. Besides also being reliable, the results can be generalised with regards to the relationship between interest rates and inflation and their impact on stock prices and how investors should be expected to react towards changes in any of these variables. 5.4 Suggestions for further Study


The findings of this work have been consistent but for future studies purposes, other researchers may wish to take into consideration several other macroeconomic variables since the limited number of variables used in this study have been cited as a limitation. Finally, it is being suggested that this research is repeated in other emerging markets using similar data over the period of this study in order to establish the consistency or otherwise of the study.

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Appendices Appendix A- List of figures


Figure 1.1:

Sector representation of S&P500 index Sector Representation in Percentages
16.18% 3.23% 3.75% 3.44% 9.23%

9.52,% Telecom Svc Utilities

11.51,% 19.82% 11.64%

Cons Disc Cons Staples Energy 11.68% Financials

Figure 2.1 Interest rates levels in the United States

Figure 2.2: Movements in US Treasury Constant maturity Index


Figure 2.3 US government bond yield against Inflation

(Adapted from the

10 Interest rates (%) 8 6 4 2 0 1985



2000 year




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