Tuesday, October 7, 2008

Interest Rates and stock markets

Interest is nothing but the cost you have to pay for the use of someone else's money. Credit users know this scenario quite well - they borrow money in order to buy something. When it comes to the stock market and the impact of interest rates, the term usually refers to something else.

The interest rate that applies to investors is the RBI bank rate. This is the cost that banks are charged for borrowing money from the RBI. It is the way the RBI attempts to control inflation.

What is Inflation?

Inflation is caused by too much money chasing too few goods (or too much demand for too little supply), which causes prices to increase. By influencing the amount of money available for purchasing goods, the RBI can control inflation.

Basically, by increasing the bank rate, the RBI attempts to lower the supply of money by making it more expensive to obtain.

Effects of an Interest Rate Increase

When the RBI increases the bank rate, it becomes more expensive for banks to borrow money from the RBI.

The first indirect effect of an increased bank rate is that banks increase the rates that they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if they carry a variable interest rate. This has the effect of decreasing the amount of money consumers can spend, after paying the loan installments and bills for food, utilities and other essentials. This means that people will have less money to spend, which will affect the revenues and profits of businesses.

Businesses are also affected - When the banks make borrowing expensive, companies might not borrow as much and will pay a higher rate of interest on their existing loans. Less business spending can slow down the growth of a company, resulting in a decrease in profit.

Stock Price Effects

Changes in the bank rate thus leads to less spending and impacts corporate turnover & profits. If, a company is seen as cutting back on its growth spending or is making less profit - either through higher debt expenses or less revenue from consumers - then the estimated amount of future cash flows will drop. This will lower the price of the company's stock. If enough companies experience a decline in their stock prices, the whole market, or the SENSEX, will go down.

Investment Effects

For investors, a declining market or stock price is not a desirable outcome. Gains come from stock price appreciation, the payment of dividends - or both. With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable.

Furthermore, investing in stocks can be viewed as more risky compared to other investments in such as scenario. When the RBI raises the bank rate, freshly issued government securities, such Treasury bills and bonds, which considered as the safest investments will usually experience a corresponding increase in interest rates. In other words, the "risk-free" rate of return goes up, increasing the demand for these investments.

When people invest in stocks, they need to be compensated for taking on the additional risk involved in such an investment, or a premium above the risk-free rate. The desired return for investing in stocks is the sum of the risk-free rate and the risk premium. As the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same or becomes lower, investors might feel that stocks are not going to reward them adequately for the risk they have to take. Hence when the risk-reward for investing is against the investor, he will sell leading to fall in prices of stocks.


Since around the last quarter of 2007 – rise in inflation, interest rates & all input costs along with the consistent lowering of GDP forecasts have clearly indicated the need for lowering expectations of returns from stocks. The risk-reward for investors in debt has improved and for stocks and real estate it has deteriorated. The recent volatility in gold prices, clearly hold no attraction as a haven for capital looking at a "flight to safety". The government finances are not in good shape. It is expected that the benchmark "risk-free" rate in the form of the 10 year GoI bond yield is likely to go up by 0.5 to 1%. This would definitely lead to increase in cost of all forms of capital with the highest impact being in the cost of equity which as our explanation confirms will lead to moderation in return expectations and hence valuations.


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