Effects of interest rate, exchange rate and their volatilities on stock prices evidence from banking industry of Pakistan.docVIP

Theoretical and Applied Economics Volume XIX (2012), No. 8(573), pp. 153-166 Effects of interest rate, exchange rate and their volatilities on stock prices: evidence from banking industry of Pakistan Syed Tehseen JAWAID Iqra University, Karachi, Pakistan jawaid.t@.pk Anwar Ul HAQ Iqra University, Karachi, Pakistan anwarhaq@ Abstract. This study investigates the effects of exchange rate, interest rates, and their volatilities on stock prices of banking industry of Pakistan. Cointegration results suggests the existance of significant negative long run relationship between exchange rate and short term interest rate with stock prices. On the other hand, positive and significant relationship exists between volatilities of exchange rate and interest rate with stock prices. Causality analysis confirms bidirectional causality between exchange rate and stock prices. Whereas, unidirectional causality runs from short term interest rate to stock prices. Sensitivity analysis confirms that the results are robust. It is suggested that investors should invest in banking sector stocks when exchange rate and interest rates are highly volatile. The result also supports the view that exchange rate and interest rate can be used as an indicator for investment decision making in banking sector stocks. Keywords: interest rate; exchange rate; GARCH; cointegration. JEL Codes: C32, G11, G21, E43. REL Code: 11B.  154 Syed Tehseen Jawaid, Anwar Ul Haq 1. Introduction Interest rate and foreign exchange rate risks are two important economic factors affecting the common stocks (Hyde, 2007, Vazz et al., 2008). Interest rate has a more direct effect on financial market, an increase in interest rate leads investing decisions to make a change in the structure of investment, generally from capital market to fixed income securities. Variability in interest rates directly generates a m