Short-Term Interest Rates and Expected Stock Returns: Evidence from Sri Lanka

Abstract

This study examines the ability of interest rates, as measured by Treasury bill yields, to track expected monthly, quarterly and annual returns in the Sri Lankan stock market during the 1990-97 period. Different from the findings in most prior studies on foreign markets, the results indicate a positive relation between interest rates and expected returns. Interest rates reliably track expected returns and the effect becomes larger and stronger with longer maturity Treasury bill yields, particularly in monthly and quarterly return horizons. The explanatory power also tends to increase with return horizon, except in annual returns. Treasury bill yields explain up to 4%, 11%, and 7% of monthly, quarterly, and annual expected returns respectively. The 12-month Treasury bill yield is found to have the most power to track monthly and quarterly expected returns. However, the behaviour of the Sri Lankan stock market suggests that the apparent strong statistical relationship is potentially spurious.

Keywords: Stock returns, Interest rates, Emerging markets, Sri Lanka

JEL Classification: G12, G14, G15