The impact of interest rates on stock prices in the UAE.

• Author: Farsio, Farzad

1. INTRODUCTION

   In the finance theory, all else constant, changes in interest rates and movements in stock prices are negatively correlated. There are several reasons for this negative relationship. First, in the framework of the discounted cash flow model, as interest rates increase, the discount rate used to determine the intrinsic value of stocks will increase. This increase in the discount rate reduces the present value of cash flows, and thus leads to lower stock prices. Secondly, as interest rates increase, firms' borrowing costs will increase. The increase in cost of borrowing reduces net income and cash flows, present value of cash flows, and thus leads to lower stock prices. Third reason stems from the competition between bonds and stocks. A higher interest rate may cause some investors to switch from stocks to bonds and thus sell their stocks. As stockholders sell their shares, supply of stocks will increase and stock prices will decrease.

   The impact of interest rates on stock prices has been widely examined by researchers. Campbell (1987) and Shanken (1990) found that nominal one-month T-bill yield is negatively correlated with future stock returns. Bren' et al (1989) provided evidence that the one-month interest rate is helpful in predicting the sign and the variance of the excess return on stocks. Rigobon and Sack (2004) presented empirical evidence that increases in the short-term interest rate negatively impact stock prices, with the largest effect on the NASDAQ index. Engle (2004) analyzed changes in unconditional volatility across 50 financial markets for 50 year's daily data. His results implied that along with the long term volatility of other macroeconomic variables, changes in interest rates was also a primary cause of unconditional stock market volatility. Ehrmann and Fratscher (2004) analyzed the reaction of equity markets to U.S. monetary policy with a special focus on the relative contributions of the credit and the interest rate channel for the period 1994 to 2003. Their results held that monetary policy affects individual stocks in a strongly diversified manner. Cifter and Ozun (2007) applied Granger causality test to daily closing values of the Istanbul Stock Exchange 100 index and compounded interest rates to examine the impact of changes in interest rates on stock returns. Their results proved interest rate as Granger cause of ISE 100 index starting with 9 days time-scale effect. They also concluded that the strength of the effect of interest rates on stock return increases with higher time scales.

   Ndri. Konan Leon (2008) found that stock market return is negatively and significantly related to interest rates in South Korea. Vardar' et al (2008) found that conditional volatility in Istanbul Stock Exchange was significantly related to interest rates in all stock indices except for service and industrial sector. They concluded that changes in interest rates would have an increasing impact on volatility of technology sector and a decreasing impact on volatility of financial and composite indices.

   All of the above studies support the view that interest rate is one of the most significant determinants of stock prices. This study provides a new empirical analysis of the interest rate/stock prices relationship in the UAE. We present empirical evidence that the UAE stock market does not react strongly to changes in interest rates. We will also provide explanation for this lack of causal relation. Our findings have one important implication: it would be a mistake to rely solely on interest rate forecasts and trends to make investment decisions in the UAE stock market.

   In this paper, following a brief review of general factor determinants of stock prices in section 2, section 3 focuses on factors affecting stock prices in the UAE. In section 4, methodology and empirical results are presented, which are followed by concluding remarks in section 5.

2. GENERAL FACTOR DETERMINANTS OF STOCK PRICES

   According to the principles of asset valuation and based on the Discounted Cash Flow model (DCF), a company's intrinsic...