The effect of inflation and interest rates on stock market returns of firms listed at the Nairobi Securities Exchange

Abstract

Stock markets promote savings and investments by encouraging investors with surplus funds to invest them in additional financial instruments that better matches their liquidity preferences and risk appetite. The equity markets form a major component in the financial sectors of developing countries such as Kenya, which underlines their potency in contributing to economic growth and development. For investors, the bottom line is the returns they earn from their investments in the equity markets. This study thus sought to investigate the effect of inflation and interest rates on market returns at the Nairobi Securities Exchange. Applying secondary data from the Nairobi Securities Exchange and Central Bank of Kenya, this descriptive time series correlation study models monthly market returns as the dependent variable and monthly inflation rates, monthly interest rates, monthly spot exchange rates and month end market liquidity as the independent variables in an ordinary least squares (OLS) regression model. The study suggests that 66.9% of variations in markets returns are explained by variations in the dependent variables. The study establishes weak positive relationship between market liquidity and market returns. Statistically significant negative relationship is found between Inflation rates and market returns. There are also statistically significant positive relationship between interest rates and market returns as well as between spot exchange rates and market returns. The study thus recommends that policy makers should address any policy gaps that exist on the exchange rate, interest rate and inflation rate management which affects market returns and discourages investments at the bourse.