Table of Contents
Most financial theorists tend to define an interest rate as the part of a given loan that is charged on the total amount of loan that was given to a borrower and expressed as a percentage. On the other hand, the theorist defines stock index as the act of measuring a given stock markets value. It is usually a tool used by financial managers and investors to provide a description of the market and make a comparison based on the return of investments. Due to the freedom in capital movements and the currently existing arrangements of fixed exchange rate, the interest rate in Gulf Corporation Council has kept close track of the interest of the United States dollar. The strengthening of GCC macroeconomics balance has resulted in more declines in the differentials of interest rate. In the early 1970s, most GCC countries kept restrictive interest rate regulations, but with time, the aspect has reduced progressively since the interest rate is now determined largely by individual country’s market force (Zafar & Durran, 2008). Nevertheless, some GCC still puts some restrictions through placing ceilings on the rate of deposit and caps on the rate of lending. Since the inflation rates of GCC countries are low, there has been a positive movement in terms of interest rate, with the majority of the regions having real rates above 2% (Zordon, 2005)
The major impacts of macroeconomics variables on stock indices have often formed the growing subject of empirical and theoretical investigations. The main issue on this study has always been the nature and size of the impact. According to economic theories, stock prices should be a reflection and in line with the expectations of corporate performance in the future. Therefore, to comprehend a given country’s policies on macroeconomics, dynamic interactions and casual reflections among the stock market and the macroeconomic factors should be considered. Furthermore, investors have a formed opinion that a country’s policy on interest rate has a great influence on stock price volatility. Therefore, the main aim of this paper is to determine a statistical relationship between the variables interest rate and stock price, thereby bringing out a comprehensive outcome on how interest rate impacts on stock price in the United Arab Emirates.
The theory of finance defines an interest rate as the measurement of the value of money, which happens to be one of the key determinants of stock prices. Interest rate plays an important role in any country’s economy and acts as a vital macroeconomic variable that can be defined as the overall cost of money. Therefore, any change or fluctuation in interest rate can result in investors having difficulties, which can further affect a firm’s profitability leading to stock price fluctuations. Stock prices are highly sensitive to fundamental changes in the economy and expectations of changes in the future prospects (Al-Qenae & Wearing, 2002). The expectations are mostly influenced by the macro and micro fundamentals that may be formed adaptively or rationally on economic fundamental concepts. One major assumption that is often made is the one that fundamentals of a domestic economy always play a determining role in the overall performance of the stock market. Therefore, the impact of stock prices on interest rate has been empirically and theoretically examined by many studies and a large number of researchers.
In their study, Flannery and James (1984) tried to examine the underlying factors of stock return sensitivity to the interest rate in an attempt to comprehend banks characteristic that usually give rise to the kind of sensitivity. In the process, they confirmed that there is a negative relationship between the stock returns and the interest rate whether in the long term or short term aspect. Furthermore, they asserted that a mixture of liabilities and assets was a vital factor in giving explanation of stock return sensitivity to unexpected changes in interest rate. In addition, a literature study done by Campbell (1985) indicated that interest rate structure is vital in predicting the aspect of stock returns. In their investigations into the relationship between stock return and sensitivity of interest rate within United Arabs Emirates, Bashir and Hassan (1997) provided sufficient evidence to indicate that the stock return for commercial banks is sensitive to interest rate.
A study by Gan, Zhang and Lee (2006) further suggested that there is a negative long-term relationship between interest rate an stock prices. Shrestha and Liu (2008) made an effort to determine the long run relationship existing between interest rate and stock price in China through the use of analysis called heteroscedastic cointergration, and found out that a relationship existed between the interest rates and the stock market. On the contrary, from the analysis of short-run relationship, Pilinkus and Boguslankas (2009) made a conclusion that there is a negative influence on the stock market prices by the short-term interest rates. Another study conducted by Hassan and Samarakoon (2000) aimed to examine the interest rate ability as given by the Treasury bill within the three maturity periods. The process was arranged to track the expected annual, quarterly or monthly returns within Sri-Lanka stock market between the period from 1990 to 1997. In contrast to observations derived from other studies conducted on foreign markets, the study indicated that Sri Lanka’s short-term interest rates have positive correlation with future stock returns since they have the ability to track the stock returns efficiently. Therefore, interest rate’s effect on future stock returns tends to become stronger and larger based on whether it matures within a month or quarterly.
The interest of researchers on the given topic has recently attracted more attention through various literature thereby creating further evidence on the existence of a negative relationship that exists between interest rates and stock returns. According to Bulmash and Trivoli (1991), there is a positive correlation between the current United States stock price and the stock price of the past periods while the stock price and the Treasury bill rate have a significant negative relationship. A more recent research study by Uddin and Alam (2009) comprehensively examined the evidence that tries to support share market existence based on the data between interest and stock prices in fifteen developing and developed countries.
The study discovered that the interest rate and stock prices have significant negative correlation in almost all the six countries. In addition, there was a further negative relationship between change in interest rates and subsequent change in stock price within the six given countries. The study further indicated that the countries will benefit efficiently through demand pull of more investors in the stock market if there is a considerable control of interest rate within these countries. A comprehensive study by Ehrmann and Fratscher (2004) made an attempt to analyze equity market reactions to the US monetary policy, with the main emphasis placed on the relative contributions of the interest rate channel and credit within the 1994 to 2003 period. Their conclusion was that individual stocks are greatly affected by monetary policies in a more diversified manner. In another study, Cifter and Ozun (2007) applied the Granger casual test in testing the Istanbul stock market to examine the impact of interest on stock prices. The conclusions provided by the study showed that the ISE 100 Granger cause-effect is a result of the interest rate based on a time effect scale of 9 days. The researchers further concluded that the strength placed by the interest rate effect on stock prices tends to increase as time scale increases. They further stated that interest rate changes highly impact on technological volatility and have a decreasing influence on the volatility of composite and financial indices
A further study was carried out by Ajay and Mougoue (1996) to try and examine the long and short run relationship that exist between interest rate and stock prices. The study was carried out in eight different developed economies. Their study revealed that in both the UK and the US, the currencies depreciated as a result of the increase in the markets stock prices. This effect was explained by the fact that a rise in the stock market gives a good indicator of an economy that is expanding, which goes together with the expectation of high inflation forcing the demand for the given currency to drop and depreciate. In regard to the effect of the currency on the countries stock market, the two researchers discovered that the depreciation in the currency results into a stock price decline in the short run. Eventually, the decline causes the negative relationship between the macroeconomic variables. According to the authors, the negative relationship is the result of a future increase in inflation rate making investors have doubts about the future of firms and eventually resulting in drop in stock prices. A case study in South Korea by Konan and Leon (2008) discovered a significant and negative relationship between stock prices and intterest rates within the country.
The above studies are all supportive indicators towards the view that interest rates form the most vital determinant of stock prices. The research provides a new dimension from the past studies as it focuses mostly on the empirical analysis of the relationship between interest rate and stock price within the United Arab Emirates, which is a member country of the GCC. Furthermore, the study will present an empirical proof to show that the stock market of the UAE does not have a strong reaction interest rate change while at the same time providing an explicit explanation towards the lack of relation.
Research Problem Statement
The problem in this research project will be to determine whether or not there is a relationship between the interest rates and the stock prices in the United Arab Emirates.
The section states the goal that the researcher will strive to achieve by the end of this study. The general objective of this study will be to gain insight by analyzing the relationship between interest rates and stock prices in the GCC regions. The study objective will be based on past data mainly from the United Arabs Emirates stock markets.
Hypothesis of the Study
The following hypothesis will be tested at 95% level of significance:
Ho: Interest rate has a strong impact on stock prices within the UAE
H1: Interest rate has no impact on stock prices within the UAE
Ho: Interest rate has a strong association with stock price
H1: There is no relationship between interest rate and stock prices within the UAE.
Justification of the Study
Today, most financial institutions are more concerned about their market performance. Stability of such institutions gives them an upper hand in the market. Investors would not risk their lifetime efforts in firms that are perceived to be on the verge of collapsing; to be specific, investors put more hope on firms that are listed on their respective stock market at good stock pricing and of which they can follow their trade proceedings. As such, it is in the interest of these firms to be more aware of different components of their trade affecting their stock market performance.
Scope of the Study
The scope of the study is limited to the GCC regions, with concentration on the United Arabs Emirates stock market community. It will correlate the variable interest rates on stock prices of the firms trading on this stock market for the past 20 years.
Assumptions of the Study
The following assumptions were taken into consideration:
- All the firms under consideration in the analysis are assumed to have been trading in the stock market for at least 20 years.
- The data from the stock market is assumed to be uniformly distributed
The chapter contains the steps that are necessary for the execution of the study to achieve the study objective. It also indicates how the gathered information will be analyzed and presented. It briefly indicates the contents of the study that includes the Research Design, Target Population, Sampling Techniques, Sample Size, Data Collection Methods, Research Procedures and Methods of Data Analysis
The United Arabs Emirates has three active stock markets that include the Abu Dhabi Security Exchange, the Dubai Financial Market, and the Nasdaq Dubai, which are the areas of concern.
The target population refers to the respondents that the researcher is focused on, and it forms the sampling frame; the selection is based on the view that the data accessed from the stock market for the past 20 years is accurate i.e. not misleading and sufficient for the analysis, and will help achieve the set objectives. Therefore, the population of interest in this study is the United Arabs Emirates past records for interest rates and stock prices of a good section of the trading firms for the given set period.