Why rate cut pushes up equity values

B. Venkatesh

THE US Federal Reserve cut the fed funds rate -- the rate at which banks lend to other banks in the US -- by half per cent on January 3, 2001.

The cut in the fed funds rate sent the US stock market soaring. The Nasdaq recorded the largest single-day gain in history while the Dow Jones Industrial Average rose about 300 points.

Why did equities climb after the rate-cut? Because the rate cut leads to lower borrowing cost, meaning higher profits for companies. Higher profits translate into higher earnings per share and hence, higher equity values.

To explain, let us move to the Indian market. Suppose you have Rs 10,000 to invest and need to choose between ICICI bonds or Infosys shares. How will you evaluate your decision to invest in Infosys?

If you are using your savings, your cost of investing in Infosys share is the interest rate you would have earned had you bought ICICI bonds. Why? Given your investment of Rs 10,000, you will be unable to invest in ICICI bonds if you buy Infosys. The interest rate on ICICI bonds is said to be your opportunity cost.

This opportunity cost helps in deciding whether Infosys is worth buying at the current price. How? Suppose you expect Infosys to move to, say, Rs 12,000 in a year's time, you discount it at the opportunity cost to get its present value. If this value is lower than the current price, you buy Infosys.

What if the interest rate on ICICI bond falls from, say, 10 per cent to 9 per cent? The discount rate to evaluate your investment in Infosys also falls. The present value of Infosys, therefore, rises from Rs 10,900 (Rs 12,000/1.10) when the rate was 10 per cent to Rs 11,000 (Rs 12,000/1.09) when the rate is 9 per cent. The equity value, thus, rises as the discount rate falls.

Now, back to the US market. The interest rate on debt instruments will fall due to the lower fed funds rate. This lowers the investors' opportunity cost, raises the present value of future earning stream due to the lower discounting rate and pushes up equity values. This is the theoretical explanation for the climb in equity values. But equity prices are also influenced by a host of subjective factors.