CHAPTER 1 INTRODUCTION Broad Problem Area Over the course of the past year the Pakistani economy hastaken

such drastic turns that it has baffled even seasonedeconomists and researchers, one such change has been theunprecedented

success of the Karachi Stock Exchange,represented mostly by the KSE-100 index. Just to take anexample, in April 2003 the KSE-100 index stood a hundredpoints shy of the 3000 mark, a coveted position at thattime, and now little over an year later it

stands wellpast the 5000 point level. Such a radical change has naturally forced a lot of people to uncover thefundamental reasons behind the change. This research paperis an effort by the researcher to find out which are thefundamental determinants of the KSE index and what is theextent of their influence on it.

Background Of KSE The KSE is a relatively young (it was established soonafter independence in 1947) and small market. In 2002, ithad 758

stocks listed with a total market capitalizationof about $10 billion or 16% of GDP. The KSE captures 74%of the overall

trading volume in Pakistan. There are twosmaller stock exchanges covering the remaining 26%: TheLahore stock exchange (22%), and the Islamabad stock1

exchange (4%). The KSE-100 index, which is a weightedprice index of the top 100 companies listed on the stockmarket, is usually taken as a benchmark index in Pakistan. exchange (4%). The KSE-100 index, which is a weightedprice index of the top 100 companies listed on the stockmarket, is usually taken as a benchmark index in Pakistan. Rationale Of The Study There is a consensus among macroeconomists and finance theorists that stock market prices are driven bymacroeconomic variables, the so- called fundamentals inthe economy. Moreover, it is also agreed that the linkageis two-way; that is, feedback exists between the stockmarket and real activity. There has been a great deal of research into thephenomenon described above in the developed economies suchas the US, the UK, Germany, Japan etc, where researchershave come up with some very informative and insightfulresults. These results have helped them explain to somedegree the behavior of their stock exchanges and in turnhave helped them make better predictions about its currentand future performance. It is only logical that suchstudies be conducted for the Pakistani stock market sothat we too can benefit from the predictive power ofeconomic variables for our stock exchanges.

Research Questions Trying to investigate relations between the variables, theaim is to make it easier to try to answer the followinghypothesis:1. 2. 3. 4. Does Do Does Does industrial interest inflation inflation production rates affect the the KSE KSE index? index?

affect

affect affect

industrial interest

production? rates?

5.

Does

inflation

affect

the

KSE

index?

6. Do interest rates affect industrial production? In analysis of this paper ten years monthly data for the period 1994 until 2004 is taken for all variables.

Theoretical Framework To examine the relationship for the hypothesis listed, the

following multivariate model is specified:

U = (KSE, IPI, INF, STI)

Where,

KSE= KSE-100 Index IPI= Industrial Production Index of Pakistan INF= Inflation rate of Pakistan STI= Short Run Interest Rate of Pakistan, in percentage The Karachi Stock Exchanges 100 index (KSE), being anequally weighted price index, is calculated by taking theaverage of the prices of a set of 100 biggest companieslisted on the KSE. These companies are sufficientlyrepresentative of the Pakistani Stock Market, because ofthe weight of these companies; the KSE-100 index accountsfor majority of the total trading volume. The Industrial Production Index, (IPI), is included as a proxy for real economic activity in the Pakistani market.

Inflation (INF) is taken on a monthly basis from the Consumer Price Index. The Short Run Interest Rates (STI), corresponds to the Weighted average rate of return on 3 month or less fixed or term deposits (interest bearing and PLS) offered by All Scheduled Banks inPakistan in percent per annum.

Objectives Of The Study The objective of this paper is to investigate the relations among key economic variables such as: Inflation Interest rates Industrial production and the stock market index in the small Pakistani economy,where stock exchanges are less mature as compared to thosein e.g. US, Japan and the UK.

Definition Of The Terms The following terms have been used extensively in thereport and therefore it is appropriate to adequatelydefine them for the reader. Liner Regression: Linear Regression estimates t hecoefficients moreindependent of the linear that equation, best involving the one value or of

variables

predict

thedependent variable. Confidence intervals: depicts the models confidence in the result i.e. whether estimations have been made at 90%

or 95% etc, confidence intervals for each regression coefficient The Industrial Production Index, (IPI), is included as a proxy for real economic activity in the Pakistani market. Inflation (INF) is taken on a monthly basis from the Consumer Price Index. The Short Run Interest Rates (STI), corresponds to the Weighted average rate of return on 3 month or less fixe

R squared change: The change in the R2 statistic that isproduced by adding or deleting an independent variable. Ifthe R2 change associated with a variable is large, thatmeans that the variable is a good predictor of thedependent variable. Descriptives: Provides the number of valid cases, themean, and the standard deviation for each variable in theanalysis. Part and partial correlations: Convey the zero-order,part, and partial correlations. Values of a correlationcoefficient range from 1 to 1. The sign of t hecoefficient indicates the direction of the relationship,and its absolute value indicates the strength, with largerabsolute values indicating stronger relationships. Residuals: Depicts the Durbin-Watson test result for serial correlation of the residuals and casewise diagnostics for the cases meeting the selection criterion. Predicted Values: Values that the regression model predicts for each case.

Unstandardized: The value the model predicts for thedependent variable. The unstandardized coefficients arethe coefficients of the estimated regression model Standardized: A transformation of each predicted value into its standardized form. That is, the mean predicted6 value is subtracted from the predicted value, and thedifference is divided by the standard deviation of thepredicted values. Often the independent variables aremeasures in different units. The standardized coefficients or betas are an attempt to make the regression coefficients more comparable. Adjusted: The predicted value for a case when that case is excluded from the calculation of the regression coefficients. S.E. of mean An predictions: estimate of Standard the errors of the of

predictedvalues.

standard

deviation

theaverage value of the dependent variable. Prediction Intervals: The upper and lower bounds for both mean and individual prediction intervals. Mean: Lower and upper bounds for the prediction interval of the mean predicted result. Individual: Lower and upper bounds for the prediction interval of the dependent variable. Residuals: The actual value of the dependent variable minus the value predicted by the regression equation. Bivariate

Correlations: The Bivariate Correlati onsprocedure computes Pearson's correlation coefficient, withits significance levels. Correlations measure h owvariables are related. Pearson's correlation coefficientis a measure of linear association. 7 Correlation Coefficients: Correlation coefficients rangein value from 1 (a perfect negative A relationship) of 0 and +1(a perfect linear

positive

relationship).

value

indicatesno

relationship. Test of Significance: Dependent on either two-tailed orone-

tailed probabilities. If the direction of associationis known in advance, One-tailed is taken. If the directionof association is not known then Two-tailed test ofsignificance is taken. 8 CHAPTER 2 LITERATURE REVIEW The relationships among real, monetary and financ

Why Money Market Funds Break The Buck Posted: Nov 19, 2008 | Email Reprints

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INSURANCE

MUTUAL FUNDS

Money market funds are often thought of as cash and a safe place to park money that isn't invested elsewhere. Investing in a money market fund is a low-risk, low-return investment in a pool of very secure, very liquid, short-term debt instruments. In fact, many brokerage accounts sweep cash into money market funds as a default holding investment until the funds can be invested elsewhere.

Money market funds seek stability and security with the goal of never losing money and keeping net asset value (NAV) at $1. This one-buck NAV baseline gives rise to the phrase "break the buck", meaning that if the value falls below the $1 NAV level, some of the original investment is gone and investors will lose money.

This only happens very rarely, but because money market funds are not FDIC-insured, they can lose money. Find out how this happens and what you can do to keep your "riskfree" assets truly risk free.(To learn more about the FDIC read, Are Your Bank Deposits Insured? Insecurity and Bank Failure: in Will Your the Assets Be Protected?) Market

Even though investors are typically aware that money market funds are not as safe as a savings account in a bank, they treat them as such because, as their track record shows, they are very close. But given the rocky market events of 2008, many did wonder if their money market funds would break the buck. (For further comparison see, Money Market Vs. Savings Account.)

In the history of the money market, dating back to 1971, there was only one fund that broke the buck until the 2008 financial crisis. In 1994, a small money market fund that invested in adjustable-rate securities got caught when interest rates increased and paid out only 96 cents for every dollar invested. But as this was an institutional fund, no individual investors lost money, and 37 years passed without a single individual investor losing a cent. (Keep reading about this market in our Money Market tutorial.) In 2008 however, the day after Lehman Brothers Holdings Inc. filed for bankruptcy, one money market fund fell to 97 cents after writing off the debt it owned that was issued by Lehman. This created the potential for a bank run in money markets as there was fear that more funds would break the buck.

Shortly thereafter, another fund announced that it was liquidating due to redemptions,

but the next day the United States Treasury announced a program to insure the holdings of publicly offered money market funds so that should a covered fund break the buck, investors Track would be Record protected of to $1 NAV. Safety

There are three main reasons that money market funds have a safe track record.

The maturity of the debt in the portfolio is short-term (397 days or less), with a weighted average portfolio maturity of 90 days or less. This allows portfolio managers to adjust quickly to a changing interest rate environment, thereby reducing risk.

The credit quality of the debt is limited to the highest credit quality, typically 'AAA' rated debt. Money market funds can't invest more than 5% with any one issuer, except the government, so they diversify the risk that a credit downgrade will impact the overall fund.

The participants in the market are large professional institutions that have their reputations riding on the ability to keep NAV above $1. With only the very rare case of a fund breaking the buck, no firm wants to be singled out for this type of loss. If this were to happen, it would be devastating to the overall firm and shake the confidence of all its investors, even the ones that weren't impacted. Firms will do just about anything to avoid breaking the buck, and that adds to the safety for investors. (For more on this see, Get A Short-Term Advantage In The Money Market.)

Readying

Yourself

for

the

Risks

Although generally the risks are very low, events can put pressure on a money market fund. For example, there can be sudden shifts in interest rates, major credit quality downgrades for multiple firms, and/or increased redemptions that weren't anticipated. Another potential issue could occur if the fed funds rate drops below the expense ratio of the fund, which may produce a loss to the fund's investors.

To reduce the risks and better protect themselves, investors should consider the following:

Review what the fund is holding. If you don't understand what you are getting into, then look for another fund. Keep in mind that return is tied to risk - the highest return will typically be the most risky. One way to increase return without increasing risk is to look for funds with lower fees. The lower fee will allow for a potentially higher return without additional risk.

Major firms are typically better funded and will be able to withstand short-term volatility better than smaller firms. In some cases, fund companies will cover losses in a fund to make sure that it doesn't break the buck. All things being equal, larger is safer.

Confusion

in

the

Money

Market

Money market funds are sometimes called "money funds" or "money market mutual funds", but should not be confused with the similar sounding money market deposit accounts offered by banks in the United States.

The major difference is that money market funds are assets held by a brokerage, or possibly a bank, whereas money market deposit accounts are liabilities for a bank, which can invest the money at its discretion - and potentially in (riskier) investments other than money market securities. In a money market fund, investors are buying securities and the brokerage is holding them. In a money market deposit account, investors are depositing money in the bank and the bank is investing it for itself and paying the investor the agreed-upon return.

If a bank can invest the funds at higher rates than it pays on the money market deposit account, it makes a profit. Money market deposit accounts offered by banks are FDIC insured, so they are safer than money market funds. They often provide a higher yield than a passbook savings account and can be competitive with money market funds, but

may

have

limited

transactions

or

minimum

balance

requirements.

Conclusion Prior to the 2008 financial crisis, only one small institution fund broke the buck in the preceding 37 years. During the 2008 financial crisis, the U.S. Government stepped in and offered to insure any money market fund, giving rise to the expectation that it would do so again if another such calamity were to occur. It's easy to conclude then that money market funds are very safe and a good option for an investor that wants a higher return than a bank account can provide, and an easy place to allocate cash awaiting future investment with a high level of liquidity. Although it's extremely unlikely that your money market fund will break the buck, it's a possibility that shouldn't be dismissed when the right conditions arise. by Douglas Rice Douglas Franklin Rice educates individuals about financial matters in a variety of ways. For those interested in learning more from Rice, start with his blog, Taking Risks and Reaping Rewards, which uses current events to teach underlying financial concepts. Beyond that, more information about his books, seminars, and other services can be found at his personal website www.douglasrice.com. There you can collect your free copy of one of his books, "Reflections on Conventional Wisdom". Rice received his Doctorate in Business Administration concentrated in finance from Golden Gate University in San Francisco. He also holds both master's and bachelor's degrees in science an business administration. He remains at Golden Gate, teaching a variety of graduate and undergraduate courses in economics, finance and financial planning. Rice completed his CFP certification and Series 65 licensee and is a Registered Investment Advisor.

Read more: http://www.investopedia.com/articles/mutualfund/08/money-market-breakbuck.asp#ixzz1aqzOByz6

Money Market: Introduction

Printer friendly version (PDF format) Whenever a bear market comes along, investors realize (yet again!) that the stock market is a risky place for their savings. It's a fact we tend to forget while enjoying the returns of a bull market! Unfortunately, this is part of the risk-return tradeoff. To get higher returns, you have to take on a higher level of risk. For many investors, a volatile market is too much to stomach - the money market offers an alternative to these higherrisk investments.

The money market is better known as a place for large institutions and government to manage their short-term cash needs. However, individual investors have access to the market through a variety of different securities. In this tutorial, we'll cover various types of money market securities and how they can work in your portfolio. Next: Money Market: What Is It?

Table of Contents 1) Money Market: Introduction 2) Money Market: What Is It? 3) Money Market: Treasury Bills (T-Bills) 4) Money Market: Certificate Of Deposit (CD) 5) Money Market: Commercial Paper 6) Money Market: Banker's Acceptance 7) Money Market: Eurodollars 8) Money Market: Repos

Read more: http://www.investopedia.com/university/moneymarket/#ixzz1aqzkHhge

A Safer Money Market With Rule 2a-7 Posted: Aug 9, 2010 | Email Reprints

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INVESTMENT

MONEY MARKET

Lisa Smith Contact | Author Bio

Since their inception in the 1970s, money markets had been marketed as "safe" investments. This positioning is highlighted in the introductory text to The Money Market tutorial, which states, "If your investments in the stock market are keeping you from sleeping at night, it's time to learn about the safer alternatives in the money market." The focus on safety and solid returns was justified, as money market funds traditionally maintained a net asset value (NAV) of $1 per share and paid a higher rate of interest than checking accounts. The combination of a stable share price and a good interest rate made them stable places to store cash. This positioning held true until the Reserve Fund

broke the buck - a financial services industry phrase used to describe the scenario when a money market fund has its NAVs fall below $1 per share. While the Reserve Fund's meltdown directly hurt a relatively small number of investors, it revealed that the safety investors had relied on for decades was an illusion. If the Reserve Fund, which had been developed by Bruce Bent (a man often referred to as the "father of the money-fund industry"), couldn't maintain its share price, investors began to wonder which money market fund was safe. (To learn more about the Reserve Fund fiasco, read Money Market Mayhem: The Reserve Fund Meltdown.) The failure of the Reserve Fund called into question the definition of "safe" and the validity of marketing money market funds as "cash equivalent" investments. It also served as a stark reminder to investors about the importance of understanding their investments. Rule 2a-7

The Securities And Exchange Commission (SEC) recognized the threat to the financial system that would be caused by a systemic collapse of money market funds and responded with Rule 2a-7. This regulation requires money market funds to restrict their underlying holdings to investments that have more conservative maturities and credit ratings than those previously permitted to be held. From a maturity perspective, the average dollar-weighted portfolio maturity of investments held in a money market fund cannot exceed 60 days. From a credit rating perspective, no more than 3% of assets can be invested in securities that do not fall within the first or second-highest ranking tier. Increased liquidity requirements are also part of the package. Taxable funds must hold at least 10% of their assets in investments that can be converted into cash within one day. At least 30% of assets must be in investments that can be converted into cash within five business days. No more than 5% of assets can be held in investments that take more than a week to convert into cash. Funds must undergo stress tests to verify their ability to maintain a stable NAV under adverse conditions, and they are required to track and disclose the NAV based on the

market value of underlying holdings and to release that information on a 60-day delay after the end of the reporting period. Impact to Industry and Investors

The enactment of the legislation had no significant impact on investors. The NAV disclosure requirement has been a non event, as investors must go find the historical information. Fund companies are not required to provide it proactively. Yields on money market funds may be lower than they would be if the funds could invest in more aggressive options, but the difference is only a few basis points. (Learn more in Do Money Market Funds Pay?) Next Phase

Looking ahead, issues around the NAV and the NAV disclosure requirement are the most troublesome prospects for money market providers and for investors. The SEC is interested is seeing real-time disclosure of NAVs in money market funds and the creation of a privately funded liquidity facility that would provide support to failing funds. Real-time disclosure would be the next step along the path toward the SEC's goal of instituting a floating NAV for money market funds. Should a floating NAV be enacted, the value of holdings in a money market fund would rise and fall on a daily basis like the holdings in other mutual funds. The Bottom Line

A floating NAV would likely have a severe dampening affect on the money market fund business. Money market funds appeal to investors because they pay higher rates of interest than checking or savings accounts, and they maintain steady NAV of $1 per share. If the NAV floats, it can drop below the $1 share price, causing investors to lose money. Since the interest rate differential between a money market fund and checking or savings account is generally small, investors would have little incentive to invest in money market funds. (For related information, take a look at Why Money Market Funds Break The Buck.)

Read more: http://www.investopedia.com/articles/mutualfund/10/a-safer-money-market2a7.asp#ixzz1ar0Sp4Nw

Impact of Foreign Reserves on Karachi stock exchange Market of Pakistan Abstract This paper explains the relationship between foreign exchange reserves of Pakistan and KSE market capitalization on the basis of quarterly gathered data from fiscal year 2001 to 2009. Both of the variables under consideration are very important because foreign exchange reserve is one out of the major supports to stable the value of home currency against foreign currencies and market capitalization shows the overall investment in stock market. This study uses simple linear regression model to measure the relationship between these two important variables. Results of this study show that there is positive (not significant positive) relationship between variables. The results show that foreign exchange reserves of Pakistan have a positive impact on KSE Stock Market that is the principal stock market of Pakistan. Introduction This research is carried out to find the impact of foreign exchange reserves held by the State Bank of Pakistan on the investment and performance of stock markets of Pakistan. There are three stock exchanges (Karachi Stock Exchange, Lahore Stock Exchange and Islam-Abad Stock Exchange) operating in Pakistan. Karachi Stock Exchange (KSE) is premier, biggest and the most popular stock market of the country, so it is used as representative of all stock exchanges of Pakistan. About KSE KSE is hub of capital formation in Pakistan, established on September 18, 1947. KSE started with 5 companies with a paid up capital of Rs. 37 million. The first index was the 50 index and trading was done through open-out-cry system. In spite of political issues, social, financial and other problems, it played a key role in the economy of Pakistan. KSE 100-index showed a return of 40.19% and became the sixth best performer among the emerging markets in the calendar year 2007. It achieved a major milestone by touching of KSE-100 Index psychological level of 15,000 for the first time in its history and peaked 15,737.32 on 20 April, 2008. Moreover, the increase of 7.4 per cent in 2008 made it the best performer among major emerging markets (Gulf News, 2008). It was declared the "Best Performing Stock Market of the World for the year 2002" as declared by the international magazine "Business Week" Similarly, the US newspaper "USA Today" declared Karachi Stock Exchange as one of the best performing stock exchange in the world. As at June 1, 2009 there were 651 companies listed at KSE with market capitalization of US $ 26.48 billion having listed capital of US $ 9.65 billion. Exchange was owned by 200 member/brokers through electronic trading system. (Karachi Stock Exchange, 2009) Foreign Exchange Reserves

Foreign exchange is the currency of other countries and Foreign Reserves mean deposits of international currencies held by a central bank. Foreign reserves allow governments to keep their currencies stable, reserves are used as a tool of exchange rate and monetary policy, it facilitate for the payment of external debt and liabilities, it act as a defense against unexpected emergencies and economic shocks. To know about the relationship of foreign reserves with stock market is important because of above reasons and because international reserves accumulation has been the preferred policy recently adopted by developing economies to achieve financial stability. The aim of this policy is to increase liquidity and thus reduce the risk of suffering a speculative attack. (Cruz & Walters, June 2008). Foreign reserves can be enhanced by storing more and more international currency and this can be done through three ways, by increasing exports, by foreign remittance and by taking official grants or loans. If foreign reserves are increasing due to exports and remittances then the growth of reserves is positive but if it is increasing with the help of loans then growth will be negative. This research is not concerned with the positive or negative growth, this research examines only the foreign reserves held by central bank and their impact on stock market capitalization. Market Capitalization Market capitalization represents the aggregate value of a company or stock. It is obtained by multiplying the number of shares outstanding by their current price per share then by adding all the values, we get aggregate market capitalization. For example, if XYZ company has 200,000 shares outstanding with a share price of per share then the market capitalization is 200,000 x = ,000,000. KSE market capitalization represents the aggregate value of whole market, in this way by measuring KSE-All shares market capitalization we can measure the overall performance of Karachi stock exchange. Objective The purpose of this research is to know about the impact of foreign exchange reserves of Pakistan on KSE market capitalization on the basis of previous behavior of both variables with each other. Problem Statement The main focus of this study is to link the foreign exchange reserves of Pakistan with its Stock Markets to see a clear picture about them as it affects many other variables. Significance Significance of this research work is to provide the considered necessary information that will guide the stock brokers, agents, planners, government policy makers to make decision about the stocks and stock markets of Pakistan especially about KSE by looking at the trend of foreign

exchange reserves of Pakistan. The research will also try to add value for executives, directors, researchers and other students to know about the foreign reserves and stock markets of Pakistan. Literature Review In the following there are some studies related to this topic that has been conducted prior by other researchers. Hussain et al. (2009) analyzed the "Impact of Macroeconomics Variables on Stock Prices: Empirical Evidence in Case of KSE" they consider the quarterly data of several economic variables such as foreign exchange rate, foreign exchange reserve, industrial production index, whole sale price index, gross fixed capital formation, and broad money M2 , these variables are obtain from 1986 to 2008 period. The results shows that after the reforms in 1991 the influence of foreign exchange rate and reserve effects significantly to stock market whiles other variables like IIP and GFCF are not effects significantly to stock prices. This result also shows that internal factors of firms like increase production and capital formation not effects significantly while external factors like exchange rate and reserve are effects significantly the stock prices. Nishat and Shaheen analyze long-term equilibrium relationships between a group of macroeconomic variables and the Karachi Stock Exchange Index. The macroeconomic variables are represented by the industrial production index, the consumer price index, M1, and the value of an investment earning the money market rate. They used vector error correction model to explore such relationships during 1973 to 2004. Their results indicate a "causal" relationship between the stock market and the economy and show that industrial production is the largest positive determinant of Pakistani stock prices, while inflation is the largest negative determinant of stock prices in Pakistan. They found that macroeconomic variables Granger-caused stock price movements, the reverse causality was observed in case of industrial production and stock prices. Furthermore, he found that statistically significant lag lengths between fluctuations in the stock market and changes in the real economy are relatively short (Nishat & Shaheen, 2004). Bhattacharya et al. conduct a case study to analyze "Causal Relationship between Stock Market and Exchange Rate, Foreign Exchange Reserves and Value of Trade Balance". They used methodology of Granger non-causality recently proposed by Toda and Yamamoto (1995) for the sample period April 1990 to March 2001. In this study, the Bombay BSE Sensitive Index was used as a proxy for the Indian stock market. The three important macroeconomic variables included in the study are real effective exchange rate, foreign exchange reserves and trade balance. The analysis reveals interesting results in the context of the Indian stock market, particularly with respect to exchange rate, foreign exchange reserves and trade balance. The results suggest that there is no causal linkage between stock prices and the three variables under consideration (Bhattacharya & Mukherjee, 2001) . Dimitrova analyzed the relationship between stock prices and exchange rates using multivariate model. He focuses on the stock markets of United States and the United Kingdom over the period January 1990 through August 2004. This study developed the hypothesis that there is a link between the foreign exchange and stock markets. The researcher asserted that relationship is

positive when stock prices are the lead variable and likely to negative when exchange rates are the lead variable (Dimitrova, August 2005). Sohail et al. conducted a research on LSE, the intention of this study was to examine long-run and short-run relationships between Lahore Stock Exchange and macroeconomic variables in Pakistan. Monthly data from December 2002 to June 2008 was used in this study. The results revealed that there was a negative impact of consumer price index on stock returns, while, industrial production index, real effective exchange rate, money supply had a significant positive effect on the stock returns in the long-run (Sohail & Hussain, winter 2009). Robert Gay conducted study to investigate the time-series relationship between stock market index prices and the macroeconomic variables of exchange rate and oil price for Brazil, Russia, India, and China (BRIC) using the Box-Jenkins ARIMA model. But no significant relationship was found between respective exchange rate and oil price on the stock market index prices of either BRIC country and also there was no significant relationship found between present and past stock market returns (Gay, March 2008). Data explanation and Methodology Dependent Variable KSE Market capitalization is dependent variable in this study and simply picked up from the Economic Surveys of Pakistan and from the reports of State Bank of Pakistan at the end of quarter month from the fiscal year 2001 to 2009. Independent Variable A foreign exchange reserve of Pakistan is independent variable in this research and calculated by following equation. R = SDR + Fc + Nostro + TLR Where: R = Foreign exchange reserves SDR= Special drawing rights held by SBP Fc = Foreign Currency held by SBP Nostro = Accounts of SBP in foreign countries in foreign currencies. TLR = Total liquid reserves Methodology

To examine the relationship between the foreign reserves and KSE market capitalization following simple linear regression model has been tested. Y = 0 + 1 X1 + Where: Y = KSE market capitalization in billion Rs. 0 = Y intercept 1= Slope of the line X1 = Foreign Exchange Reserves in million US $ = Error variable Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1 .680 .463 .440 903.87372 Anova Model Sum of Squares df Mean Square F Sig. Regression 1.687E7 1 1.687E7 20.651 .000 Residual 1.961E7 24 816987.693 Total 3.648E7 25 Note. The data are adapted from "the SPSS software output" After analysis results show that the value of co-efficient of correlation (R) is equal to 0.680 which shows that there is positive (not significant positive) relationship between market capitalization and foreign exchange reserves, as it is looking in the following graph.

This graph shows that an increase in foreign reserves also reflecting in KSE market capitalization but not too much. The results show that the value of co-efficient of determination (R2) is equal to 0.463 which shows that 46.3% of the variation in the KSE market capitalization is explained by the variation

in the foreign exchange reserves. The remaining 53.7% is unexplained. The value of Anova table is significant (.000) which shows that the model is overall good fit. The value of Regression constant or intercept is -1227.56 this is the average market capitalization without independent variable. Here it shows that the average value of market capitalization is negative (below the X-axis line) with the value of 1227.56 billion Rs. when foreign exchange reserves are zero. The value of Regression co-efficient or slope is equal to 0.303 which shows that the KSE market capitalization will increase by 0.303 billion Rs. for an increase of one million $ increase in foreign exchange reserves of Pakistan. Conclusion Results of this study show that there is positive (not significant) relationship between the foreign exchange reserves and KSE market capitalization. The results show that 46.3% of the variation in the KSE market capitalization is explained by the variation in the foreign exchange reserves. The results of this study also match with the result of other researchers like Suliaman et al. conduct study to measure the impact of macroeconomic variables on stock prices and write that there is positive relation between foreign reserves and stock prices in Pakistan. In other countries there are different results like in India there is no relation between these variables as showed by one researcher, but this study shows the facts about the stock market of Pakistan.

References Bhattacharya, B., & Mukherjee, J. (2001). Causal Relationship Between Stock Market And Exchange Rate, Foreign Exchange Reserves and Value Of Trade Balance: A Case Study For India. Bloomsbury Information Ltd. (2009). Dictionary. Retrieved February 18, 2010, from Q Finance: http://www.qfinance.com/dictionary/foreign-currency-reserves Cruz, M., & Walters, B. (June 2008). Is the Acculmulation of International Reserves good for Development. Cambridge Journal of Economics . Dimitrova, D. (August 2005). The Relationship between Exchange Rates and Stock Prices Studied in Multivariate Model. Issues in Political Economy , 14. Elizabeth. (2006). the oxford dictionary of Phrase and Fable. Retrieved February 10, 2010, from Encyclopedia: http://www.encyclopedia.com/doc/1O214-StockExchange.html Encyclopedia. (2009). The Oxford Pocket Dictionary of Current English. Retrieved February 14, 2010, from Encyclopedia website: http://www.encyclopedia.com/doc/1O999foreignexchange.html

Gay, R. D. (March 2008). Effect of Macroeconomic Variables on Stock Market Rturns for Four Emerging Economies - Brazil, Russia, India and China. International Business & Economics Research Jornal , 7. Gulf News. (2008). Investment. Retrieved March 15, 2010, from gulfnews website: http://gulfnews.com/business/investment/pakistan-emerges-a-market-winner-1.97437 Hussain, D. I. (2009). Why does Pakistna have ato accumulate foreign reserves? Karachi Stock Exchange guarantee Limited. (2009). introduction. Retrieved February 2010, from Kararchi Stock Exchange website: http://www.kse.com.pk/aboutus/introduction.php?id=7&sid=7.01 Karachi Stock Exchange. (2009). introduction. Retrieved February 2009, from Kararchi Stock Exchange website: http://www.kse.com.pk Minitry of Finance Islamabad, Govt of Pakistan. (n.d.). Capital Markets. Economic Survey of Pakistan . Islamabad, Pakistan: Govt of Pakistan. Mohammad, S. D., Hussain, A., & Ali, A. (2009). Impact of Macroeconomics Variables on Stock Prices - Emperical Evidance in Case of KSE. European Journal of Scientific Research , 38 no. 1, 96-103. Nishat, D. M., & Shaheen, R. (2004). Macro-Economic Factors and Pakistani Equity Market. Reilly, F. K., & Brown, K. C. (September 2005). Investment Analysis and Portfolio Management (Eitghth ed.). Sohail, N., & Hussain, Z. (winter 2009). Long Run and Short Run Relationship between Macro Economic Variables and Stock Prices in Pakistan - The case of Lahore Stock Exchange. Pakistan Economic and Social Review , 47, 183-198. SPSS software. (2007, September 13). Regression analysis. State Bank of Pakistan. (2010, January). Foreign Reserves. Lahore, Pakistan: State Bank of Pakistan. Posts Related to Impact of Foreign Reserves on Karachi stock exchange Market of Pakistan

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[Stocks] Impact of Foreign Reserves on Karachi stock exchange Market of Pakistan October 13th, 2011 Posted in Penny stocks to watch Comments Off This paper explains the relationship between foreign exchange reserves of Pakistan and KSE This paper explains the relationship between foreign exchange reserves of Pakistan and KSE market capitalization on the basis of quarterly gathered data from fiscal year 2001 to 2009. Both of the variables under consideration are very important because foreign exchange reserve is one out of the major supports to stable the value of home currency against foreign currencies and market capitalization shows the overall investment in stock market. This study uses simple linear regression model to measure the relationship between these two important variables. Results of this study show that there is positive (not significant positive) relationship between variables. The results show that foreign exchange reserves of Pakistan have a positive impact on KSE Stock Market that is the principal stock market of Pakistan. This research is carried out to find the impact of foreign exchange reserves held by the State Bank of Pakistan on the investment and performance of stock markets of Pakistan. There are three stock exchanges (Karachi Stock Exchange, Lahore Stock Exchange and Islam-Abad Stock Exchange) operating in Pakistan.? Karachi Stock Exchange (KSE) is premier, biggest and the most popular stock market of the country, so it is used as representative of all stock exchanges of Pakistan. KSE is hub of capital formation in Pakistan, established on September 18, 1947. KSE started with 5 companies with a paid up capital of Rs. 37 million. The first index was the 50 index and trading was done through open-out-cry system. In spite of political issues, social, financial and other problems, it played a key role in the economy of Pakistan. KSE 100-index showed a return of 40.19% and became the sixth best performer among the emerging markets in the calendar year 2007. It achieved a major milestone by touching of KSE-100 Index psychological level of 15,000 for the first time in its history and peaked 15,737.32 on 20 April, 2008. Moreover, the increase of 7.4 per cent in 2008 made it the best performer among major emerging markets (Gulf News, 2008). It was declared the Best Performing Stock Market of the World for the year 2002 as declared by the international magazine Business Week Similarly, the US newspaper USA Today declared Karachi Stock Exchange as one of the best performing stock exchange in the world. ?As at June 1, 2009 there were 651 companies listed at KSE with market capitalization of US $ 26.48 billion having listed capital of US $ 9.65 billion. Exchange was owned by 200 member/brokers through electronic trading system. (Karachi Stock Exchange, 2009) Foreign exchange is the currency of other countries and Foreign Reserves mean deposits of international currencies held by a central bank. Foreign reserves allow governments to keep their currencies stable, reserves are used as a tool of exchange rate and monetary policy, it facilitate for the payment of external debt and liabilities, it act as a defense against unexpected emergencies and economic shocks.

To know about the relationship of foreign reserves with stock market is important because of above reasons and because international reserves accumulation has been the preferred policy recently adopted by developing economies to achieve financial stability. The aim of this policy is to increase liquidity and thus reduce the risk of suffering a speculative attack.?(Cruz & Walters, June 2008). Foreign reserves can be enhanced by storing more and more international currency and this can be done through three ways, by increasing exports, by foreign remittance and by taking official grants or loans. If foreign reserves are increasing due to exports and remittances then the growth of reserves is positive but if it is increasing with the help of loans then growth will be negative. This research is not concerned with the positive or negative growth, this research examines only the foreign reserves held by central bank and their impact on stock market capitalization. Market capitalization represents the aggregate value of a company or stock. It is obtained by multiplying the number of shares outstanding by their current price per share then by adding all the values, we get aggregate market capitalization. For example, if XYZ company has 200,000 shares outstanding with a share price of $ 25 per share then the market capitalization is 200,000 x $ 25 = $ 5,000,000. KSE market capitalization represents the aggregate value of whole market, in this way by measuring KSE-All shares market capitalization we can measure the overall performance of Karachi stock exchange. The purpose of this research is to know about the impact of foreign exchange reserves of Pakistan on KSE market capitalization on the basis of previous behavior of both variables with each other. The main focus of this study is to link the foreign exchange reserves of Pakistan with its Stock Markets to see a clear picture about them as it affects many other variables. Significance of this research work is to provide the considered necessary information that will guide the stock brokers, agents, planners, government policy makers to make decision about the stocks and stock markets of Pakistan especially about KSE by looking at the trend of foreign exchange reserves of Pakistan. ?The research will also try to add value for executives, directors, researchers and other students to know about the foreign reserves and stock markets of Pakistan. In the following there are some studies related to this topic that has been conducted prior by other researchers. Hussain et al. (2009) analyzed the Impact of Macroeconomics Variables on Stock Prices: Empirical Evidence in Case of KSE they consider the quarterly data of several economic variables such as foreign exchange rate, foreign exchange reserve, industrial production index, whole sale price index, gross fixed capital formation, and broad money M2 , these variables are obtain from 1986 to 2008 period. The results shows that after the reforms in 1991 the influence of foreign exchange rate and reserve effects significantly to stock market whiles other variables like IIP and GFCF are not effects significantly to stock prices. This result also shows that internal factors of firms like increase production and capital formation not effects significantly while external factors like exchange rate and reserve are effects significantly the stock prices.

Nishat and Shaheen analyze long-term equilibrium relationships between a group of macroeconomic variables and the Karachi Stock Exchange Index. The macroeconomic variables are represented by the industrial production index, the consumer price index, M1, and the value of an investment earning the money market rate. They used vector error correction model to explore such relationships during 1973 to 2004. Their results indicate a causal relationship between the stock market and the economy and show that industrial production is the largest positive determinant of Pakistani stock prices, while inflation is the largest negative determinant of stock prices in Pakistan. They found that macroeconomic variables Granger-caused stock price movements, the reverse causality was observed in case of industrial production and stock prices. Furthermore, he found that statistically significant lag lengths between fluctuations in the stock market and changes in the real economy are relatively short (Nishat & Shaheen, 2004). Bhattacharya et al. conduct a case study to analyze Causal Relationship between Stock Market and Exchange Rate, Foreign Exchange Reserves and Value of Trade Balance. They used methodology of Granger non-causality recently proposed by Toda and Yamamoto (1995) for the sample period April 1990 to March 2001. In this study, the Bombay BSE Sensitive Index was used as a proxy for the Indian stock market. The three important macroeconomic variables included in the study are real effective exchange rate, foreign exchange reserves and trade balance. The analysis reveals interesting results in the context of the Indian stock market, particularly with respect to exchange rate, foreign exchange reserves and trade balance. The results suggest that there is no causal linkage between stock prices and the three variables under consideration (Bhattacharya & Mukherjee, 2001) . Dimitrova analyzed the relationship between stock prices and exchange rates using multivariate model. He focuses on the stock markets of United States and the United Kingdom over the period January 1990 through August 2004. This study developed the hypothesis that there is a link between the foreign exchange and stock markets. The researcher asserted that relationship is positive when stock prices are the lead variable and likely to negative when exchange rates are the lead variable (Dimitrova, August 2005). Sohail et al. conducted a research on LSE, the intention of this study was to examine long-run and short-run relationships between Lahore Stock Exchange and macroeconomic variables in Pakistan. Monthly data from December 2002 to June 2008 was used in this study. The results revealed that there was a negative impact of consumer price index on stock returns, while, industrial production index, real effective exchange rate, money supply had a significant positive effect on the stock returns in the long-run (Sohail & Hussain, winter 2009). Robert Gay conducted study to investigate the time-series relationship between stock market index prices and the macroeconomic variables of exchange rate and oil price for Brazil, Russia, India, and China (BRIC) using the Box-Jenkins ARIMA model. But no significant relationship was found between respective exchange rate and oil price on the stock market index prices of either BRIC country and also there was no significant relationship found between present and past stock market returns (Gay, March 2008).

KSE Market capitalization is dependent variable in this study and simply picked up from the Economic Surveys of Pakistan and from the reports of State Bank of Pakistan at the end of quarter month from the fiscal year 2001 to 2009. A foreign exchange reserve of Pakistan is independent variable in this research and calculated by following equation. R = SDR + Fc + Nostro + TLR Where: R = Foreign exchange reserves SDR= Special drawing rights held by SBP Fc = Foreign Currency held by SBP Nostro = ?Accounts of SBP in foreign countries in foreign currencies. TLR = Total liquid reserves To examine the relationship between the foreign reserves and KSE market capitalization following simple linear regression model has been tested. Y = 0 + 1 X1 + Where: Y = KSE market capitalization in billion Rs. 0 = Y intercept 1= Slope of the line X1 = Foreign Exchange Reserves in million US $ = Error variable Model R R Square Adjusted R Square Std. Error of the Estimate 1 .680 .463 .440 903.87372 Model Sum of Squares df Mean Square F Sig. Regression 1.687E7 1 1.687E7 20.651 .000

Residual 1.961E7 24 816987.693 Total 3.648E7 25 Note. The data are adapted from the SPSS software output After analysis results show that the value of co-efficient of correlation (R) is equal to 0.680 which shows that there is positive (not significant positive) relationship between market capitalization and foreign exchange reserves, as it is looking in the following graph. This graph shows that an increase in foreign reserves also reflecting in KSE market capitalization but not too much. The results show that the value of co-efficient of determination (R2) is equal to 0.463 which shows that 46.3% of the variation in the KSE market capitalization is explained by the variation in the foreign exchange reserves. The remaining 53.7% is unexplained. The value of Anova table is significant (.000) which shows that the model is overall good fit. The value of Regression constant or intercept is -1227.56 this is the average market capitalization without independent variable. Here it shows that the average value of market capitalization is negative (below the X-axis line) with the value of 1227.56 billion Rs. when foreign exchange reserves are zero. The value of Regression co-efficient or slope is equal to 0.303 which shows that the KSE market capitalization will increase by 0.303 billion Rs. for an increase of one million $ increase in foreign exchange reserves of Pakistan. Results of this study show that there is positive (not significant) relationship between the foreign exchange reserves and KSE market capitalization. The results show that 46.3% of the variation in the KSE market capitalization is explained by the variation in the foreign exchange reserves. The results of this study also match with the result of other researchers like Suliaman et al. conduct study to measure the impact of macroeconomic variables on stock prices and write that there is positive relation between foreign reserves and stock prices in Pakistan. In other countries there are different results like in India there is no relation between these variables as showed by one researcher, but this study shows the facts about the stock market of Pakistan. Bhattacharya, B., & Mukherjee, J. (2001). Causal Relationship Between Stock Market And Exchange Rate, Foreign Exchange Reserves and Value Of Trade Balance: A Case Study For India. Bloomsbury Information Ltd. (2009). Dictionary. Retrieved February 18, 2010, from Q Finance: http://www.qfinance.com/dictionary/foreign-currency-reserves Cruz, M., & Walters, B. (June 2008). Is the Acculmulation of International Reserves good for Development. Cambridge Journal of Economics .

Dimitrova, D. (August 2005). The Relationship between Exchange Rates and Stock Prices Studied in Multivariate Model. Issues in Political Economy , 14. Elizabeth. (2006). the oxford dictionary of Phrase and Fable. Retrieved February 10, 2010, from Encyclopedia: http://www.encyclopedia.com/doc/1O214-StockExchange.html Encyclopedia. (2009). The Oxford Pocket Dictionary of Current English. Retrieved February 14, 2010, from Encyclopedia website: http://www.encyclopedia.com/doc/1O999foreignexchange.html Gay, R. D. (March 2008). Effect of Macroeconomic Variables on Stock Market Rturns for Four Emerging Economies Brazil, Russia, India and China. International Business & Economics Research Jornal , 7. Gulf News. (2008). Investment. Retrieved March 15, 2010, from gulfnews website: http://gulfnews.com/business/investment/pakistan-emerges-a-market-winner-1.97437 Hussain, D. I. (2009). Why does Pakistna have ato accumulate foreign reserves? Karachi Stock Exchange guarantee Limited. (2009). introduction. Retrieved February 2010, from Kararchi Stock Exchange website: http://www.kse.com.pk/aboutus/introduction.php?id=7&sid=7.01 Karachi Stock Exchange. (2009). introduction. Retrieved February 2009, from Kararchi Stock Exchange website: http://www.kse.com.pk Minitry of Finance Islamabad, Govt of Pakistan. (n.d.). Capital Markets. Economic Survey of Pakistan . Islamabad, Pakistan: Govt of Pakistan. Mohammad, S. D., Hussain, A., & Ali, A. (2009). Impact of Macroeconomics Variables on Stock Prices Emperical Evidance in Case of KSE. European Journal of Scientific Research , 38 no. 1, 96-103. Nishat, D. M., & Shaheen, R. (2004). Macro-Economic Factors and Pakistani Equity Market. Reilly, F. K., & Brown, K. C. (September 2005). Investment Analysis and Portfolio Management (Eitghth ed.). Sohail, N., & Hussain, Z. (winter 2009). Long Run and Short Run Relationship between Macro Economic Variables and Stock Prices in Pakistan The case of Lahore Stock Exchange. Pakistan Economic and Social Review , 47, 183-198. SPSS software. (2007, September 13). Regression analysis. State Bank of Pakistan. (2010, January). Foreign Reserves. Lahore, Pakistan: State Bank of Pakistan.

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Impact of U.S.-Pakistani Relations on KSE-100 on July 14, 2011 7:13 pm in Articles, KSE / 1 comment

Guest contribution provided by Forex Traders One of the most important aspects of trading financial markets is to understand underlying risks. When trading stocks, there are many types of risks ranging from micro-centered ones such as the integrity of a companys executive team to more macro-centered risks such as the overall health of a national economy. At times, event risk can be one of the most powerful drivers of financial markets both in the near term and in the long term, depending on the scope of impact and specific details of the news event. For example, when the devastating earthquake struck Japan in March 2011, financial markets around the world experienced a dramatically increased level of volatility for several days. Event risk includes natural disasters, wars, political tensions, geo-political developments, etc. Certain financial markets are tied to specific ongoing risk events. The Karachi Stock Exchange is one such market that is significantly impacted by a specific ongoing eventU.S.-Pakistani relations. Recent History of Tension Since the terrorist bombing on the Twin Towers on September 11, 2001, Pakistani-U.S. relations have been permanently changed. Prior to 2001, U.S.-Pakistani relations were really not much different than the United States relationship with several other similar countries. That all changed, however, when former President Bush announced a War on Terror and made it clear that Al Qaeda was the pronounced enemy. In our post-911 world, U.S.-Pakistani relations have been tense. The U.S. has demanded strong Pakistani support of the war on terror. The U.S. has threatened to cut off aid and other forms of funding to Pakistan unless certain efforts were made. In August of 2008, the U.S. had a major hand in forcing former Pakistani President Musharraf. Over the past 10 years, U.S.-Pakistani relations have tended to have a significant impact on the KSE 100.

In early 2009, a very interesting study was published which was titled, Impact of PakU.S. Relationship News on KSE-100 by Khan, Javed, and Ahmad. Basically, Khan, Javed, and Ahmad utilized the event study method of research and closely analyzed the real impact of significant U.S.-Pakistani news events on the KSE-100. Their conclusions were profound for stock market investors and those who track forex news. First of all, they analyzed a sample of events, all of which occurred post-911, and the evidence is clear that U.S.-Pakistani relations affect market direction. This is to be expected. The United States is arguably the most powerful nation in the world, and it makes sense that very good or very bad developments in the U.S.-Pakistani relationship would either significantly encourage or discourage investors. This is not surprising. What is surprising, however, is the degree of impact that good and bad events have. And this is what is very useful for stock market investors. Khan, Javed, and Ahmad found that negative developments in the U.S.-Pakistani relationship tended to drive the market down much faster and for a more prolonged period of time than equally positive developments tended to drive the market up. This market phenomenon should be considered by any serious investor. Since the U.S.Pakistani relationship is so volatile, negative news developments are a very real possibility, which should be considered by investors when developing an investment plan. Black Swan Events In recent years, the concept of the Black Swan Event has become a source of attention among financial market analysts and economists. Basically, a black swan event is something that has a low probability of occurring, and, therefore, most investors do not consider it when making financial decisions. The threat is that when a black swan event strikes, it often has the power to send financial markets into a sharp downward spiral, and if investors have not protected themselves by taking carefully calculated risks, an investment portfolio can suffer dramatic draw downs in a very short amount of time. It could be argued that the impact of U.S.-Pakistani relations on the KSE-100 is full of potential black swan events. Thus, investors should incorporate these potential risks in their portfolio decisions.

Interest Rates and Stock Prices

After last weeks run up in interest rates, its worth taking some time to understand the link between rates and stock prices. A stocks price is based on two primary things. One is the value of its assets. That could be things like cash and other investments, real estate and gold reserves. Book value is often cited as a measure of these sorts of items, but not a great one given accounting methods. The second source of stock pricing is earnings, specifically future earnings. A great deal of time and effort is spent forecasting those future earnings in order to determine what a stock is worth. Heres where the interest rate comes in. The value of $1 in a year is not the same as $1 today. Why? Because if you have $1 today you could invest it and earn a rate of return that would leave you with more than $1 in a years time. For example, at 10% if you invest $1 today you will end up with $1.10 in a year. As a result of this, we need to discount the value of the $1 received in a year to figure out how much we would invest today to get that amount. To do so we use the interest rate. The higher the rate, the lower the value of $1 earned a year from now in present terms (present value). For example, at 10% the value of $1 received in one year is $0.91. At 5%, the present value of that same $1 is a bit over $0.95. In order to approximate the value of a stock, analysts take forecasts of future earnings usually 5 five years and discount those figures back to see what they are worth today. Since the value of future earnings decreases as interest rates increase (and as you move further out in time), so too does the value of the stock in question. Heres an example. Assume Company X is expected to make $1 this year, $2 next year, $3 the year after, and so on out to $5 in year 5. Using a 10% interest rate, the value of those payments is $10.65. If we were to use a 5% rate, though, it would be $12.57. (You can calcuate the above figures using the NPV function in Excel.)

So where does the rate that we use come from? Well, in classical financial terms it would be the so called risk free rate. Thats the interest rate we could earn taking almost no risk of default on our investment. For all practical purposes, the risk free rate is normall the sovereign debt rate, such as that for the US Treasury secturity for the length of time in question. There are other alternatives, of course, but that really doesnt matter much for this discussion. The point is that as interest rates change, they impact stock prices through this valuation process..

Businesses and the stock market pay close attention to what the Fed decides because interest rates are so important. There are obviously some very practical concerns about interest rates, such as the cost of borrowing, the affect on consumer spending and so on. There is also a fundamental consideration that is the basis for beginning any process that leads to the valuation of a stock. It goes something like this: You have $X to invest and a wide range of options to consider. Safest Investment The safest investment you can make is in a U.S. Treasury Note because it is backed by the full faith and credit of the U.S. Government. Understandably, with this kind of rock-solid security, your return will be low. If the 10-year Treasury Note is yielding a risk-free 4.2%, what should a stock return to account for the greater risk? This return over the yield of the Treasury Note is called the risk premium. It is what you determine an investment must pay for the risk you are taking. There are several ways to calculate the risk premium and as many different proponents arguing their method is the best. If you would like to explore some of these methods, check out this article. Many investors consider 7% a good starting point for calculating risk premium. Given that assumption and 10-year Treasury Note yield at 4.2%, you should expect something in the neighborhood of 11% from your stock investment. Starting Point This is just the starting point. You might settle for less if investing in a solid blue chip and you might demand more from a high flying tech issue for the additional risk. Other factors might cause you to add to or take away from the risk premium you demand.

How does this relate back to interest rates where we started? A stocks required rate of return is made up of two parts: the risk-free rate and the risk premium. As the Fed adjusts key interest rates, the risk-free rate will change. If the Fed raises rates, the risk-free rate will rise also. If nothing else changes, the stocks target price should drop because the required return is higher. The reverse is true. If key rates fall, then the stocks target price should rise because the required return has dropped. Conclusion This relationship between stock valuation and interest rates is an illustration of how investors answer the question: What should I expect from an investment in this stock?