The Interplay between Interest Rate and Stock Prices: Evidence from Pakistan’s Financial Market

Abstract

This empirical study aims to examine the correlation between stock prices and interest rates in Pakistan. The existing literature had extensively explored the connection between stock prices and these financial variables, resulting in a variety of findings that underscore the complexity of their interaction. Some empirical evidence suggests a positive relationship between stock price fluctuations and changes in interest and exchange rates, indicating a significant association. However, a substantial body of research has also identified an inverse correlation between stock price fluctuations and changes in interest rates, further emphasizing the intricate nature of this relationship. This study utilizes data from the past ten years of the Pakistani Stock Exchange (KSE 100 index) to analyze this relationship. The findings reveal an inverse correlation between stock prices and changes in interest rate. Specifically, when stock prices are low, companies tend to avoid entering the capital markets unless the State Bank offers an alternative investment plan for the capital markets. Additionally, a firm's equity value is significantly influenced by variations in interest and exchange rates. Furthermore, the relaxation of Fiscal/Monetary policy can shrink both stock prices and interest rates as individuals have more disposable income to spend on goods or invest in stocks. This nuanced understanding of the association between monetary policy and stock prices is crucial for policymakers and investors. It highlights the need for strategic interventions by the State Bank to stabilize the market and foster an environment conducive to investment. Moreover, it underscores the importance for investors to consider the broader macroeconomic context when making investment decisions, as these financial variables play a pivotal role in determining market trends.