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rate minus the inflation rate. It is the rate of interest an investor expects to receive after subtracting inflation.
The relationship between real and nominal interest rates can be described in the equation Brealey and Meyer, 2000
�
2.6
Where r is the real interest rate, i is the inflation rate, and R is the nominal interest rate.
1. Relationship between interest rate and stock return
Interest rate are important variables in for macroeconomic to understand because they link the economy of the present and the economy of the future
through their effects on saving and investment Mankiw, 2007 p.369. Keynes reanalyzed about the effect of interest rate on investment decision. The increase of
interest rate could increase the exchange rate, but this can make the price of stock decrease. Keynes also stated the negative relationship between interest rate and
stock price. This happen because if the interest rate increases, people tend to invest their money in the form of deposit, and thus make investment in capital
market weakened.
The relationship between interest rate and investment decision also explained by Fisher in his Theory of Investment1930. Through the IS and LM curve, if the
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interest rate increase, the cost of investment will increase and thus make company‟s profit decrease. A decrease in profit will make a dividend for the
stockholder decrease too, which affected the stock price to be decreasing as well.
2. SBI Bank Indonesia Certificate Rate
In the past two centuries, interest rates have been variously set either by national governments or central banks. In Indonesia, the interest rate is set by the
Central Bank of Indonesia, namely BI rate. The SBI Rate is announced by the Board of Governors of Bank Indonesia in each monthly Board of Governors
Meeting. It is implemented in the Bank Indonesia monetary operations conducted by means of liquidity management on the money market through SBI Rate to
achieve the monetary policy operational target.
The monetary policy operational target is reflected in movement in the Interbank Overnight ON Rate. It is then expected that bank deposit rates will track the
movement in interbank rates, with bank lending rates following suit.
While other factors in the economy are also taken into account, Bank Indonesia will normally raise the BI Rate if future inflation is forecasted ahead of the
established inflation target. Conversely, Bank Indonesia will lower the BI Rate if future inflation is predicted below the inflation target.
The benchmark interest rate in Indonesia was last reported at 6.50 percent. In Indonesia the interest rate decisions are taken by The Central Bank of Republic of
Indonesia. The official interest rate is the Discount rate. This is the rate at which
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central banks lend or discount eligible paper for deposit money banks, typically shown on an end-of-period basis. From 2005 until 2010, Indonesias average
interest rate was 8.76 percent reaching an historical high of 12.75 percent in December of 2005 and a record low of 6.50 percent in August of 2009. The graph
below represents the interest rate in Indonesia from December 2005 to August 2009.
Figure 2.1 Indonesia Interest Rate G. Exchange Rate
According to Jeff Madura 2007, p.78, exchange rate between two countries specifies how much one currency is worth in terms of the other. It is the
value of a foreign nation‟s currency in terms of the home nation‟s currency.
According to traditional approach, exchange rates lead stock prices. This approach states that stock price is expected to lead exchange rate with a negative correlation
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since a decrease in stock prices reduces domestic wealth, which leads to lower domestic money demand and interest rates Aydemir and Demirhan, 2009. Also,
the decrease in domestic stock prices leads foreign investors to lower demand for domestic assets and domestic currency. These shifts in demand and supply of
currencies cause capital outflows and the depreciation of domestic currency. On the other hand, when stock prices rise, foreign investors become willing to invest
in a country‟s equity securities. Thus, they will get benefit from international diversification. This situation will lead to capital inflows and a currency
appreciation Granger et al. 2000;Pan et al. 2007. Exchange rates can affect stock prices not only for multinational and export
oriented firms but also for domestic firms. For a multinational company, changes in exchange rates will result in both an immediate change in value of its foreign
operations and a continuing change in the profitability of its foreign operations reflected in successive income statements. Therefore, the changes in economic
value of firm‟s foreign operations may influence stock prices. Domestic firms can also be influenced by changes in exchange rates since they may import a part of
their inputs and export their outputs. For example, a devaluation of its currency makes imported inputs more expensive and exported outputs cheaper for a firm.
Thus, devaluation will make positive effect for export firms Aggarwal, 1981 and increase the income of these firms, consequently, boosting the average level of
stock prices Wu, 2000.
1. Relationship between exchang rate and stock return
