RESEARCH PROPOSAL

Abstract
We empirically investigate the sensitivity of Pakistan commercial bank stock returns and
profitability to changes in interest rates. We find a statistically significant negative relationship
between bank stock returns and changes in interest rates over the period 2005 to 2010. While the
relationship is not significant over the past five years. Furthermore, Banks profitability appears
not to be significantly affected by changes in interest rates over our sample period. Our results
suggest that Pakistan Banks are relatively well immunized against interest rate risk. This may be
due to an appropriate matching between the duration of assets and liabilities (on balance sheet
management).
Key word: interest Rate; Bank; Stock Return; Profitability.

Introduction
Pakistans financial sector consist of commercial banks, foreign banks, development finance
institutions, micro finance companies(leasing companies, investment banks, discount houses,
housing finance companies, venture capital companies, mutual funds). Modarabas, stock
exchanges and insurance companies. At 39 scheduled banks, seven development finance
institutions and five micro finance banks are operating in Pakistan (Government of Pakistan
2006) while their activities are regulated and supervised by the State Bank of Pakistan (SBP).
In the financial sector of Pakistan commercial banks are important component and play
an important role in the financing of the national economy. Commercial bank can be defined as
an institution, which receives deposits and advances loans. In Pakistan commercial banking
sector comprises of four public sector banks 20 local private banks 11 foreign banks (state Bank
of Pakistan 2006). A number of functions are performed by the commercial banks. They play an
important role by enhancing the productive capacity of the economy by mobilizing the saving of
the people. For the creation of credit, commercial bank accepts deposits from the people in the
form of demand deposits and time deposits. For making deposits, they provide facilities to their
consumer by opening different type of accounts. For attracting customers, banks provide interest
on their deposits. Time deposits have high rate of return as compared to demand deposits. So
banks are the financial intermediaries that sell their own obligation and buy the obligations of
other. A modern and growing country requires a modern banking sector too tackle to the needs of
the country. Development of the banking sector helps in the promotion of industrialization in
developing countries by facilitating the mobilization of capital for large investment.

Interest rate is assumed to be of the most important factors that affect the bank stock returns and
the profitability of bank, Interest income is a key source of income for commercial banks. For
example, during the past 10 years, 51 % of total revenues of Pakistan banks came from interest
income. Hence interest rate risk is a major source of risk to which commercial banks are
exposed. Intuitively, changes in interest rates can affect a banks profitability by increased its
cost of funding, reducing its returns from assets, and lowering the value of equity in a bank.
Moreover, recent decades have ushered in a period of volatile interest rates, confronting the
investors with more unpredictable environment to work in.
Consequently, investors primary concern is the impact of interest rates on commercial bank
revenues, cost, and profitability. On the one hand, the notion that commercial banks lend long
and borrow short implies that bank profit may decrease in case of an increase in short-term
interest rate and a decrease in long term interest rate; on the other hand, a bank will benefit from
a decrease in short-term interest rate and an increase in long-term interest rate. As a result,
provided that markets are efficient, we expect negative effects of short-term interest rates on
bank stock returns and profitability. Meanwhile, we assume positive impact of long-term interest
rate changes on bank stock returns and profitability.
During past years, several studies have analyzed the effects of fluctuations of interest rates on the
stock returns of commercial banks in the Pakistan. Most studies find that bank returns exhibit a
negative correlation with the changes of interest rates, while others find no significant
association between the movements of the interest rates and the returns of the commercial banks,
less evidence exists regarding the factors that explain the interest sensitivity of bank stocks
returns across firms and through time.

In this paper we examine the interest rate sensitivity of common stock returns and profitability of
commercial banks.
Furthermore, we also study the asset-liability management of the banks. In the last decades,
banks employ a wide variety of interest rate hedging techniques. The most popular among these
techniques are interest sensitive.
This study wills insight how the impact of interest rate by the state bank hits commercial banks
profitability and stocks returns.

Statement of the problem

Effects of interest rate changes on banking stock returns and profitability.

Objectives of the Study

To identify the actual interest rate changes in common stock return of commercial bank.
To check the effects of interest rate changes on the bank profitability.
To identify the effect of interest rate changes on banks net income.

Significance of study
This research is an attempt to explore that how commercial banks gets effected by the interest
rate charged by the State Bank of Pakistan and its effects either increase or decrease the
profitability and stock returns. So after the completion of this research the researcher and the
organization will come to know well about the impacts of interest rate.

Literature review
The exposure of financial institutions to fluctuations of interest rates has been the subject of
much empirical research. Most of the researches employ two-factor model and focus on two
aspects. The association between the bank stock returns and the interest rate changes and
measures the banks exposure to interest rate.

Stone 1974 propose the two factor model as an extension of the capital asset pricing model. He
suggests a model involving a debt market facto and an equity market factor. He justifies the
model by arguing that individual equity securities have different levels of interest rate
sensitivities and it is a useful framework quantifying systematic interest rate risk. He indicates
that incorporating an index for the returns in a debt market might increase the explanatory power
for the stock returns that exhibit considerably sensitivity to interest rate, such as the stock returns
of banks, gold, public utilities, etc.
The evidence on the relationship between bank stock returns and interest rate changes is mixed.
Most studies find that bank stock returns are negatively related to the changes in interest rate
while others find no significant relationship between these two variables. Lynge and Zumswalt
1980 test the interest rate sensitivity of bank stock returns by estimating several multi-index
models containing short and long term debt return indices. In their sample covering 1969-1975,
61 of the 57 commercial banks exhibit significant interest coefficient for short term index and
75% have significant coefficient for the long term index booth and officer 1985 and Boe 1990
test the effect of current and unanticipated changes in interest rate. Fraser, Madura and weigand
2002 examine the effect of unanticipated interest rate changes. All these studies lend strong
support for a negative effect of both current and unanticipated interest changes on bank stock
returns. Booth and officer also find that this phenomenon is not in the non-financial portfolio.
In contrast, Lloyd and Shick 1977 and Chance and Lane 1980 find no incremental explanatory
period for interest rate changes. Some authors contribute to the debate by proposing some
methodological refinements. For instance, Chen and Chan 1989 find some asymmetrical interest
rate sensitivity during phases of the interest rate cycle.

Rapid changes in financial exercise industries make it important to determine the efficiency of
financial institutions. Banks play and important role in the financial markets of the developing
countries and it is very important role in the financial markets of the developing countries and it
is very important to evaluate whether banks operate efficiently or not. There are many research
studies that try to look into the efficiency of banks operating within a country and across the
countries. These studies can be differentiated on the bases of used methodologies, considered
variables, type and number of banks included in the sample.
Many theoretical and empirical studies indicate that in the development of the economy,
financial sector plays an important role. A number of economists linked the efficiency and
development of the financial institution with economic growth (Mc Kinnon, 1973; Levine, 1997;
Trusu, 2000; Ahmed and Bebe, 2007).

Delimitation
The study will be delimited to Local commercial banks operating in Rawalpindi and Islamabad.

Hypothesis
The research study will be conducted to test the following hypothesis
H1:

interest rate has got negative effects on commercial banks profitability.

H2:

Interest rate has got negative effects on commercial banks stock returns.

Interest rate is independent variable while profitability and stock returns are dependent variable.

Method of the study

The population of this research will be about the 20 local commercial banks operating in the twin
cities Rawalpindi and Islamabad.

Sample size
The sample for this study will be drawn from 7 organizations in the banking sector. This sector
has been selected for the sample because during the last five years interest rate is higher in this
sector as compare to the other sectors in Pakistan. The studied banks would be enlisted in the
Islamabad Stock Exchange (ISE).

Instrumentation
The instruments which will be used during the research by the researcher will be

Questioner
Interviews
Secondary data
Internet

Data Collection
For the collection of the data both sources Primary and Secondary will be used. Researcher
will collect the data through personal interactions, questionnaire and through some previous
records of the banks and internet.

Data Analysis
Following statistical methods will be used for data analysis.

Descriptive statistics and inferential statistics

Descriptive statistics and inferential statistics tools will be used for data analysis.

Total risk ratio, relative risk, systematic risk and historical return will be calculated.

Correlation and Regression

Correlation and regression analysis will be carried out to determine the relation ship between
dependent and independent variables and to determine the impact of independent variables on
dependent variable.

Profitability Ratios
Following are the profitability ratios, return on equity, return on assets, earning per share etc.

SPSS
Statistical Package for Social Sciences (SPSS) will be used for all calculations.

Bibliography
Investment Analysis and Portfolio Management 8th Edition.
Authors Frank K. Reilly and Keith C. Brown
Write the complete references of the articles of literature review