Posts Tagged ‘Exchange’

A Brief Look at the Fascinating World of Forex Exchange Rates

Thursday, September 2nd, 2010

A Brief Look at the Fascinating World of Forex Exchange Rates

One of the primary methods of making a profit on the foreign exchange or the Forex market is to be able to purchase and sell currencies in such a way that whatever fluctuations there may be in the prices will end up helping you to earn a tidy profit. Therefore, understanding the meaning and nature of foreign exchange rates is crucial to your success in Forex trading and though it might, on the surface, appear to be a simple matter that anybody can learn, in reality it isn’t all that straightforward a subject and therefore requires some in-depth knowledge prior to a person being able to succeed in Forex trading.


A Rich History


Actually, there is a rich history behind the foreign exchange rates so you need to understand the importance of understanding why things happen the way that they do on the Forex market and also educate yourself in making the right decisions so that you can capitalize on your knowledge.


So, to actually comprehend foreign exchange rates, you must be certain of what they in fact really are A definition of foreign exchange rates would be that they are the value of one currency as it relates to a second currency.


Therefore, when the exchange rate between two different currencies is listed as being a first currency fetching 1.20 of the second currency, then the foreign exchange rate is 1:1.2. Additionally, you will also need to comprehend why currencies have values that are different and this can be best explained by the fact that after the valuation of currencies throughout the world moved away from ‘gold standards’, the prices of currencies started to be pegged against the US dollar, and other currencies fluctuated upwards or downwards as they related to this currency in a range of not more than a single percentage.


Hence, this was the start of foreign exchange rates and it was commonly referred to as fixed exchange rate. Since these changes in the method that the trade is carried out in recent times, both the fixed exchange rates and the gold standard have been abandoned so the forex exchange rates are now typically known as fluctuating exchange rates.


In reality it means that presently forex exchange rates are influenced by the forces of the market and when demand for a specific currency exceeds its supply then the Forex exchange rates will end up going higher for the currency being demanded, and the opposite would occur should the demand decrease.


Now that the US dollar is the base currency in Forex trading, the US government merely prints additional dollars and then sells these new dollars to various countries in the form of debts, though due to rising oil prices as well as stronger world economies, currently the US dollar is losing its vice like grip as the predominant currency of the world which is eroding the exchange rates of the dollar and the United States closest trading allies are affected as well.

Listen to Corbin Newlyn as he shares his insights as an expert author and an avid writer in the field of finance. If you would like to learn more go to Forex Trading advice and at Forex Broker tips.

This is the VOA Special English Economics Report, from voaspecialenglish.com America’s economy has started to grow again. Now what about jobs? The government says productivity jumped in July, August and September. That meant companies produced more with fewer workers. Also, new claims for unemployment aid fell at the end of October to the lowest number since January. But eight million jobs have disappeared since the recession began in December of two thousand seven. Jack Strauss at Saint Louis University in Missouri says recent recoveries have been slow to create jobs. Experts debate the reason for these so-called jobless recoveries. But Professor Strauss says a banking crisis is especially hard to recover from, because there is less money to lend to support growth. Banks have been holding bigger safety reserves. On November fourth, the Federal Reserve kept its target rate near zero for overnight loans between banks. The central bank said levels are likely to remain “exceptionally low … for an extended period.” Low interest rates and growing federal deficits have weakened the dollar. But that also lowers the price of American exports, which could help drive job creation. Yet where exactly will future jobs come from? Investor Warren Buffet says America’s “future prosperity” depends on its rail system. On November third, his Berkshire Hathaway company agreed to buy the nation’s second-largest railroad, the Burlington Northern Santa Fe. The forty-four billion dollar deal …

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What is Currency Exchange Rate?

Friday, August 27th, 2010

What is Currency Exchange Rate?

Basically, the exchange rate between two currencies indicates how much one currency is worth in terms of the other. For example: an exchange rate of 102 Japanese yen (JPY, ¥) to the United States Dollar (USD, $) means that JPY 102 is worth the same as USD 1.
The foreign exchange market is one of the largest and most dynamic markets in the world. According to some estimates, almost 2 trillion USD worth of currency is traded every day.
Another term that you will come across in foreign investments as well as travel is the spot exchange rate. This refers to the current exchange rate. The forward exchange rate implies an exchange rate that is quoted and traded today but for delivery and payment on a fixed date in future.
You can’t just find the exchange rate you are looking for and understand what it means. An exchange rate quotation is given by stating the number of units of “term currency” or “price currency” that can be bought in terms of 1 unit currency. For instance, if a quotation says the EURUSD exchange rate is 1.5877 (1.5877 USD per EUR), the term currency is USD and the 1 unit currency or base currency is EUR.
Before you plan your travel abroad, make sure that you are aware of the market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is:
EUR – GBP – AUD – NZD – USD – (any other currency)
If you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars have to be paid to receive 1 Euro.  You must also know that in some areas of Europe and in the non-professional market in the UK, EUR and GBP, the GBP is quoted as the base currency to the Euro.
Exchange rate quotations may be direct or indirect. A direct quotation means that 1 foreign currency unit = X home currency units whereas an indirect quotation means that 1 home currency unit = X foreign currency units.
The most important factor for any individual planning to travel abroad or participating in the foreign exchange market is to take note of the fluctuations in the exchange rate. Using direct quotation, if the home currency is strengthening then the exchange rate number decreases. On the other hand, if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.
After reading this, you surely have a better idea about the meaning and importance of the exchange rate for a single person as well as the economy as a whole. If you want to know more, just go online and search for websites that offer information about the currency exchange rate. This is a great way to update yourself about the current exchange rate before you plan your travel money requirements.

 

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Do Interest Rates Drive The Foreign Exchange Markets?

Wednesday, August 18th, 2010

Do Interest Rates Drive The Foreign Exchange Markets?

Interest Rates defined: Interest rates are LIBOR-based for currencies of disbursement plus a spread which is dependent on the complexity of the transaction and the risk profile of the applicant.

The Forex, or foreign currency exchange, is all about money. Money from all over the world is bought, sold and traded. On the Forex, anyone can buy and sell currency and with possibly come out ahead in the end. When dealing with the foreign currency exchange, it is possible to buy the currency of one country, sell it and make a profit. For example, a broker might buy a Japanese yen when the yen to dollar ratio increases, then sell the yens and buy back American dollars for a profit.

The foreign exchange market, sometimes known as the Forex market, is one that is affected by several things. The market itself is becoming one of the most popular forms of trading today. It once was reserved for the richest of the rich, however today with lower minimums; this is a market that draws people from all financial levels. The attractive thing about this market is both its leverage and it liquidity. Many people with a grand background in the Forex system can take very little money and turn it into a lot using the foreign exchange market. However, when you have expertise in the foreign exchange market, you must also be aware of things that affect it. Being aware of these things is part of making logical and rational decisions of trading.

Interest rates are something that drives the foreign exchange market. While currency prices are what the market is all about, interest rates have a direct affect on those prices. Therefore, to be able to understand the current foreign exchange market, one must understand the current conditions of each individual interest rate. While economic and political conditions are also among the things that greatly affect the Forex, there is nothing that affects it more than interest rates. Something to remember is that money often follows interest rates. When the interest rates raise, investors will want to capitalize high returns and you will see money flowing into the country. When one country’s interest rates rise, their currency is seen as being stronger than other currencies. This happens because investors seek more of that currency to profit more. Otherwise, it is seen as a good thing when interest rates rise and a bad thing when they fall.

Government participation in the Forex is not an uncommon action. Sometimes governments will flood the foreign exchange market with their own domestic currency. This action may seem foolish to someone who knows nothing about the foreign exchange market, however to those who know it well, it makes perfect sense. When governments flood the Forex with their own domestic currency, they are attempting to lower the price. When they buy their own domestic currency, they are attempting to raise the price. One might know this strategy as Central Bank intervention. Governments do this to help their overall economy. This is a type of action that keeps the foreign exchange market strong and steady. When you have extremely large players making appearances to keep everything as fair as possible, you create an attractive market.

While interest rates can drive the market for a short time, the nature of the foreign exchange market makes it difficult for them to drive it for a long period of time. The design of the market, with it being large in size and volume, restricts interest rates from having complete control over the system. Many times however, experts try to figure out when interest rates will rise or fall. The most common thing they do in order to keep up with rates is to pay attention to economic inflation indicators. Sometimes investors and experts will also listen to speeches from politicians and other influential people. They can pick apart clues in order to make a guess before the announcements are made. Most of the time, there is a little advance notice before interest rates move.

As you can see, the influences of interest rates on the foreign exchange market are strong. They can help determine which countries’ currencies are the strongest. This of course is relative to all other currencies in the market at the time. When you think about the rise and fall of interest rates, you can remember that when interest rates fall, it is typically a good thing for investors and for domestic currency. When rates fall, it is not such a great thing. When rates stay low for an extended period of time, the market may seem a little dull, however the great thing about the foreign exchange market is that when government gets involved, which it usually does at these down times, there is hope for improvement. So, if you are beginning to learn about the foreign exchange market, don’t forget to pay attention to the rise and fall of interest rates around you in order to make the best investment decisions possible.

For more articles from this auctor on this subject visit his article syndication
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The Exchange Rate And Its Impact On Forex

Wednesday, August 18th, 2010

The Exchange Rate And Its Impact On Forex

Understanding how exchange rates work and how they affect Forex markets is essential if you’re going to last as a Forex market trader. Exchange rates, Euros, dollars, yens, marks, francs,floating exchange rates, pips, points – the whole concept of the exchange rate can be daunting for a beginner trader
What the heck is an exchange rate?

The exchange rate refers to the relative worth of one type of currency against another. To make it simple, let’s use an example with a simple exchange rate that everyone is familiar with – the exchange rate of dollars to dimes. Suppose you have 10 one-dollar bills. You know that each of those dollar bills is worth 10 dimes. You could, if you wanted, go to the bank and exchange your 10-dollar bills for 100 dimes. The exchange rate would be expressed as DOL/DIM=.10 or DIM/DOL=10. In other words, you can exchange one dollar for 10 dimes or 10 dimes for one dollar.

This example can be expanded to include foreign currencies. Instead of dollars and dimes though you’re dealing with Euros, yen, pounds and francs. EUR/USD=1.1023 means that each euro is worth .1023 (the fourth decimal point is used due to the large volume of trading). In reverse, that would be expressed as USD/EUR=.9071. In other words, if you want to trade US dollars for Euros, it will cost you ,102.30 to get 1000 Euros.

Exchange rates do however move up and down and here’s how that works. The dollars and dimes example can be used to illustrate the point. For example your local store has decided that it will now only accept payment in dimes. If you want to buy a loaf of bread your dollar bills are now worthless. In order to buy that loaf, you’re going to have to find 17 dimes for your two dollars. What happens when there becomes a shortage of dimes. You find a source of dimes and you negotiate. You tell the person holding the dimes that you’ll give them two dollars for 17 dimes. In doing so you’ve changed the currency exchange rate from DOL/DIM=.10 to DOL/DIM=.11. That means every dollar is now worth 11 dimes instead of ten – and if you want to buy 0 worth of dimes, you’ll get 90 dimes, not 100.

The same holds true for the international currency market. If you want to buy goods in Japan, you need to trade with Japanese money. If all you have is dollars, then you need to exchange your dollars for yen. If lots of people are trying to buy yen at the same time, then you’re going to end up paying (exchanging) more dollars for less yen and the products that you’re buying are going to cost you more.

When a country’s economy is strong, people know that they’ll make more money if they invest in businesses and products in that country. In order to buy products or invest money there, they need to exchange their currency for that country’s currency. If there’s a rumour that a major industry in that country is about to fail, people will want to get out – and will start trading in their yen for dollars or Euros or Aussies – whichever is the best exchange rate you can get.

It’s all about supply and demand. There are a couple of other factors that influence exchange rates. One of those is the interest rate. When you hold currency, you earn interest in that country’s currency at their prevailing rate. If the interest rate is higher for yen than for dollars, then people will trade in their dollars for yen in order to earn a higher rate. A second factor is the inflation rate. When the inflation rate in a country is high, people don’t want to hold that country’s currency since the value of the money is going down. Likewise, if the inflation rate is low, people are more likely to want the country’s currency because the value isn’t expected to go down.

One other important factor in the exchange rate is trade with other countries. If world prices for a country’s exports go up in relation to their imports, they’ll be making more on what they sell than they are spending for what they buy. You can see this most clearly in the price of oil. The US buys a large percentage of its oil from Canada. As the price of oil on the world market increases, the exchange rate of Canadian dollars to US dollars goes down – Canadian dollars become more valuable because the Canadian economy is growing stronger.

Floating currency exchange rates are intricate. When you research the subject further you’ll be able to better understand more in-depth writings on the subject.

David Mclauchlan has a great variety of Forex related articles for you at his Forex Directory. Visit it now at www.Forex-Article-Directory.com

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Money Market – US Dollar Exchange Rate

Thursday, August 12th, 2010

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The Complex Nature of Exchange Rates in Forex Trading

Wednesday, August 11th, 2010

The Complex Nature of Exchange Rates in Forex Trading

An exchange rate is simply a score for one currency against another and represents the number of units of one currency that need to be exchanged for a single unit of another currency. The exchange rate is thus the price of one currency against another and, given the number of world currencies today, within the US alone there are literally dozens of exchange rates. Now that seems simple enough but, unfortunately, it is not quite that easy.

Quite apart from these simple exchange rates, which are sometimes referred to as ‘spot’ rates, there are also a whole range of ‘trade weighted’ or ‘effective’ rates which show the movement of one currency against an average of several other currencies. There are also exchange rates which are used in markets such as the forwards markets in which delivery dates are set at some point in the future, rather than at the time of the initial transaction. In other words, there is no such thing as an exchange rate, but are in fact a series of different exchange rates depending upon the nature of the transaction.

The foreign exchange market is driven largely by supply and demand and the exchange rate between any two currencies at any moment in time is influenced substantially by the interaction of the various players in the market. In a few cases currencies are still fixed, or the exchange rate is set by the monetary authorities, and when this is the case the country’s central bank will normally intervene if required and either buy or sell the currency to keep its exchange rate within a narrow and defined band. In the vast majority of cases however, and certainly in the case of the US, currencies are allowed to float and central banks do not normally, and certainly not routinely, intervene to support their currency. Accordingly, the exchange rate for a particular currency against other currencies is determined by players, large and small, who are buying and selling the currency at any particular moment in time.

The mix of participants in the market is important and will affect different currencies to varying degrees. Some buyers and sellers deal in the market purely in support of international trade and are operating in the ‘goods’ market buying and selling currency to pay for merchandise being traded across national borders. Other dealers are buying and selling currencies in support of ‘portfolio investment’ and are trading in bonds, stocks and other financial instruments across national borders. Yet another group of currency traders are operating in the ‘money’ market and are trading short term debt across international borders.

As if this were not complicated enough, this mix of traders whether they are paying for imports, investing, speculating, hedging, arbitraging or simply seeking to influence exchange rates are also focusing their attention of a variety of different timeframes in their trading which will range from a matter of minutes to several years.

Against this background it is no wonder than predicting exchange rates is a complex business. Doing so however is vitally important since exchange rates influence the behavior of all of the participants in the market and, in today’s open market, also influence interest rates, consumer prices, economic growth, investment decision and so much else. It is for this reason that the forex market plays such a critical role in determining exchange rates.

LearningForexTradingOnline.com examines all aspect of forex trading from finding the best forex training to the value of free forex charts

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How do credit cards calculate the exchange rate?

Thursday, August 5th, 2010

Question by Gaspard: How do credit cards calculate the exchange rate?
I know many credit cards can add on a 2-3% surcharge for using a credit card overseas but what rate do they charge for the currency conversion?

Do they take the market rate at the exact time of the transaction or do they use the market rate at the close of the business day?

Or do they use a rate determined each morning and posted on the sponsoring bank website – to which it’s better to check their rates before making a purchase.

Best answer:

Answer by jwishz
It is based upon spot market the date of the transaction plus their procesing fee

Know better? Leave your own answer in the comments!

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How does increase in interest rates lead to an increase in exchange rates?

Saturday, July 31st, 2010

Question by Coco Bunny: How does increase in interest rates lead to an increase in exchange rates?
Can someone explain it to me plainly? ALSO, I’m wondering if it works vice versa – does lowering interest rates lower the exchange rate?

Best answer:

Answer by degenerate_428
Hello,
Yes you are correct in what you are saying. I will use and example as it’s easier to follow the reasoning. An increase in the interest rates is always good news for savers – if the IR is 2% and you put £10 into the bank you will earn 20p if the IR is 3% you earn 30p. Now think about this with larger amounts of money, you could earn alot more by putting your money into a bank where the IR is higher. Let’s say you have US$ and the UK Bank of England increases its IR from 2% to 3%. When you move your money, you are increasing the supply of US$ in the market (ECO 101: increase in supply lowers the price), you are also wanting UK£ (increase in demand for £ increases the price) – put these two factors together and you will find that the £ gains strength. When a currency becomes stronger it means it is worth more of the other currency it is compared against. £1 = $ 1.5 –> £1 = .6
The increase in the IR will lead to the £ strengthening against the $ leading to it being worth more $. The opposite is also true.
Hope this helps.

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Fixed Versus Floating Exchange Rate

Sunday, July 25th, 2010

Fixed Versus Floating Exchange Rate

An exchange rate is the price at which one country’s currency trades for another on the foreign exchange market There are 2 extreme regimes of exchange rates – floating exchange rate and fixed foreign exchange rate.

Floating Exchange Rate

The floating exchange rate is a market-driven price for currency, whereby the exchange rate is determined entirely by the free market forces of demand and supply of currencies with no government intervention whatsoever.

Broadly, the floating exchange rate regime consists of the independent floating system and the managed floating system. The former is where exchange rate is strictly determined by the free movement of demand and supply. For managed floating system, exchange rate is also determined by free movement of demand and supply but the monetary authorities intervene at certain times to “manage” the exchange rate to prevent high volatilities.

Pros & Cons of Floating Exchange Rate

The floating exchange rate boasts various merits. Firstly, there is automatic correction in the floating exchange rate as the country simply lets it move freely to the equilibrium of demand and supply. Secondly, there is insulation from external economic events as the country’s currency is not tied to a possibly high world inflation rate as is under a fixed exchange rate. The free movement of demand and supply helps to insulate the domestic economy from world economic fluctuations. Thirdly, governments are free to choose their domestic policy as a floating exchange rate would allow for automatic correction of any balance of payment disequilibrium that might arise from the implementation of domestic policy.

Nonetheless, there are also specific concerns about the exchange rate being unstable and uncertain under the floating exchange rate regime. Also, speculation tends to be higher in the floating exchange rate regime, hence leading to more uncertainty especially for traders and investors.

Fixed Exchange Rate

For a fixed exchange rate, the government is unwilling to let the country’s currency float freely, and they state a level at which the exchange rate will stay. The government takes whatever measures that are necessary to maintain the rate and prevent it from fluctuating. There are two methods which exchange rate could be applied to the price of currencies, a fixed exchange rate and a pegged exchange rate.

Under the fixed exchange rate system, a decrease in the exchange rate which is infrequent are called revaluations. While an increase in the exchange rate are called devaluations. A devaluation in a fixed exchange rate will cause the current account balance to rise, making a country’s export less expensive for foreigners and also discourage import by making import products more expensive for domestic consumers,. This will leads to an increase in trade surplus or a decrease in trade deficit. The opposite happens in a revaluation

Pros & Cons of Fixed Exchange Rate

Despite its rigidity, the fixed exchange rate regime is still used for several reasons. First, there is certainty in fixed exchange rate. With it, international trade and investment becomes less risky. Second, there is little or no speculation on a fixed exchange rate.

However, a fixed exchange rate contradicts the objective of having free markets and it is not able to adjust to shocks swiftly like the floating exchange rate.

Shu Wei Wong works as a planner/strategist. She writes just about anything that interest her or writes on issues highly related to her field of work, especially on strategy and leadership. Find more of her thoughts at http://360strategyleadership.blogspot.com/

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Impact of Risk Free Rate on Stock Retuns Evident From Karachi Stock Exchange Pakistan

Saturday, July 24th, 2010

Impact of Risk Free Rate on Stock Retuns Evident From Karachi Stock Exchange Pakistan

Abstract

The current study looked at the relationship between risk free rate and stock market return. A five year monthly basis time series data from 2003-2007 of T-bills and KSE-100 index were taken for research study. For the analysis of data, simple regression model approach was applied. Stock market return was taken as dependent variable whereas Risk free rates as independent variables. Also, Pearson Correlation Matrix was also obtained through correlation model. The results suggested that risk free rates had no effect on dependant variable. Furthermore, no correlation between risk free rate and stock market return was found. Consequently, a bivariate relationship cannot exist between risk free rate and stock market return. A multiple regression model of the risk free rate and stock market return exhibits a strong autocorrelation, indicating that the stock market return is a function of more variable than risk free rate.

1. Introduction:

The risk free rate is the return on the security or a portfolio of securities that is free from default risk. Theoretically, the return on a zero-beta portfolio is the best estimate of the risk free rate. The CAPM predicts the relation ship risk of an asset and its expected return. This relationship is very useful in two important ways. First, it produces a benchmark for evaluating various investments. Second, it helps us to make an informed guess about the return that can be expected from an asset that has not been traded in the market.

Risk free rate is an increasingly essential ingredient of every return computed on financial assets. The security market line (SML) predicts a simple linear relationship between expected return and standard deviation while capital market line (CML) contributes a relationship between risk free rate and straight line emanating from risk free rate(Rf) to tangential to the efficient frontier.

Investors combine their uncorrelated securities help to lesson the risk of a portfolio. They want to know the reasonable level of risk reduction about their portfolios. Research studies look at what happens to portfolio risk as randomly selected stocks are combined to form equally weighted portfolios. When we begin with single stock, the risk of the portfolio is only the standard deviation of that one stock. As the number of randomly selected stocks held in the portfolio is increased, the total risk of the portfolio is reduced.

The total risk of comprise systematic risk and unsystematic risk. Systematic risk is due to risk factors that affect the overall market- such as changes in the nation’s economy, world energy situation, world political and economic situation. This kind of risk is not diversifiable even the well-diversified portfolio expose to this type of risk. The second component, unsystematic risk, is unique to particular company. It is independent to all factors regarding systematic risk. Investors always want to be compensated for taking systematic risk. They should not, however, expect the market to provide any extra compensation for bearing avoidable, diversifiable, unsystematic risk. It is this logic that lies behind capital asset pricing model (CAPM).

2. Significance of study:

This study aims to investigate the relationship between risk free rate (T-bills) and market return of Karachi stock exchange KSE-100 index. There was a controversy among the investors; some were of the view that Risk Free Rate affects the market positively while others were of the view stock market return moves independently irrespective of Risk Free Rates.

Thus in order to resolve this controversy, current study was conducted with the following objectives.

3. Objectives of study:

The following objective would be fulfilled during the study:

·        To see quantitative impact of Risk Free Rate on Stock market return.

·        To workout the correlation between risks free rate and stock market return.

·        Suggestions and recommendation for investors.

4. Literature Review:

Peter Easton at el (July 2000) elaborated the empirical estimation of the expected rate of return on a portfolio of stocks. They inverted residual income valuation model to obtain an estimate of the expected rate of return for a portfolio of stocks. They used analogous approach in estimation of internal rate of return on a bond using market value and coupon payments. They contributed through the use of stock price and accounting data to simultaneously estimate the unique implied growth rate and internal rate of return. They recommended adjusted growth rate for valuation return of stocks. They proved that estimated market premium over the risk free rate is closer to the historical premium that that obtained by other studies using earning forecast data.

Roger G. Ibbotson (July 2002) estimated long run stock market return participating in the real economy. He decomposed the 1926-2000 historical equity return into supply factors including inflation, earnings, dividends, price to earning ratio, dividend payout ratio, book value, return on equity and GDP per capita. He concluded that the growth overall economic productivity is in line with the growth of corporate productivity measured by earnings. The bulk of return comes from dividend payment and nominal earning including inflation and earning growth. In order to calculate incremental risk and return, bonds have been used as reference point.

Christian Lundblad (February 2004) discussed risk-return tradeoff which is fundamental to finance. Previous studies found weaker relationship between the risk premium on the market portfolio and variance of its return in spite of the positive relationship. He explained this weakness is due to the fact of small nature of available data, as an extremely large number of time- series observations are required to precisely estimate this relationship.  His main focus was on large span of data of each component required to compute the risk-return trade off which is indispensable for theory of finance.

Hui Guo and Robert F. Whitelaw (April 2005) developed evidence of intertemporal capital asset pricing model (ICAPM) and proved with the positive the relationship between stock market risk and return and  the extent to which stock market volatility moves stock prices. They provided new evidence on the risk-return relation by estimating a variant of Merton’s (1973) intertemporal capital asset pricing model (ICAPM). They identified the two components of expected return- the risk component and the component due to the desire to hedge changes in investment opportunities. They proved that the estimated coefficient of relative risk aversion positive, statistically significant.

Rong Huang at el (May 2005) in the study of BM company, used residual-income valuation model simultaneously to estimate relationship between long term growth rate in abnormal earnings and cost of capital. They related forward, earnings-to- price (FEP) and book- to-market ratio in a linear fashion. The slope coefficient on BM is the long-term growth rate of abnormal earnings (g), and the constant term is the effective cost of capital, i.e., the difference between the cost of capital (r) and the growth rate in abnormal earnings. To empirically implement this valuation representation, they used the analysts’ one-year-ahead earnings forecasts to compute FEP and  regressed  the difference between FEP and the risk free rate (rf) on BM diminished by one, such that the intercept captures the firm-specific risk premium (rp) and the slope coefficient captures the firm-specific, long-term growth in abnormal earnings (g). They extracted the risk-free rate from FEP to account for the covariance in FEP and the risk-free rate.

Mika Vaihekoski (2007) discussed how to compute risk free rate from money market instruments, especially for test of capital asset pricing model and event studies. He used US T-bills and CDs for calculation. He presented two alternative approaches: the interest compounding approach and price difference approach. He concluded that the price difference approach is superior to commonly used compounding method. He did event studies and time series with the help of US T-bills whereas they are used for calculation of risk free rates.

Tamal Datta Chaudhuri (April 2008) used a structural approach to stock market return, risk-free rate and Capital Asset Pricing Model (CAPM). He developed a structural model, which shows interdependent relationship between risk free rate and stock market returns. It gives a new macroeconomics structural features which shape the price movement in stock exchange. He used a Granger test and a Sims test to prove the interdependence of two variables. He suggested that instead using of exogenous values of stock market returns and risk free rate, one should use estimated values of these variable form reduced form equation of Capital Asset Pricing Model (CAPM). He tested and proved with the data of individual companies.

5. Methodology:

5.1              Data collection

In order to conduct the current study all the stock markets of Pakistan were proposed, to be taken for study purpose. The stock markets in Pakistan were

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