Interest Rate Levels and Stock Prices

Interest rates contain two effects on corporate profits:

a) Since interest rate is a cost, and like the higher the rate of interest the lower the firm's profit other things held constant.

b) Interest rates affect the level of economic activities that affect the level of corporate profit.

If interest rates increase sharply, investors can get higher returns in the bond like money market that induces them to sell shares as like stocks and transfer the funds from stock market to money market like Treasury bills.

Interest rates affect stock prices obviously due to the effect on profit however even more significantly they have an effect because of the competition in the market between bonds and shares.

Such transfers in response to increase in interest rates reduces demand for shares in the stock exchange and this obviously depresses the share prices as like in mid and late 1993 the CBK intervened in the short term market where it floated Treasury Bills whose interest rate was as high as 88% well above the returns that can be expected from high yield stocks.

Accordingly, investors removed or misdirected their money or funds from the stock market into Treasury Bills. The conclusion was a stagnation of stock prices of quoted firms. Accordingly as CBK attained its objective of decreasing the money supply in the economy the interest rates declined well beneath 30% and the immediate effect was a re-build in demand for shares and the share prices shot up instantly about February 1994.