Master of Science in Economics
Faculty / School
Faculty of Business Administration (FBA)
Department of Economics
Date of Submission
Dr. Mohammad Nishat, Institute of Business Administration, Karachi
MSECO Research Project
In this report an attempt is made to establish the relationship of stock market returns with interest rate and exchange rate in short run as well as long run, and to measure the impact of change in the interest rate and exchange rate on the stock market returns. In order to achieve the above purpose, various econometric techniques such as multiple regression, cointegration, error correction model, analysis of variance decomposition, and impulse response function are applied on the monthly time series data of stock market return, interest rate, and exchange rate for the period from July 1998 to June 2014. Apart from that, using Granger causality test, causal relationships are also established between stock market returns and interest rate and exchange rate. Having applied the cointegration technique, it turns out that there is an insignificant long run relationship between interest rate and stock market returns and 1%-point increase in interest rate would result into 15.16% fall in stock market returns. While there is highly significant positive long run relationship between exchange rate and stock market returns and 1% increase in exchange rate would result into 3.285% increase in stock market returns. Vector error correction model also confirmed the existence of long run association among the variables (stock market returns, interest rate and exchange rate) but reported negative relationship of interest rate and exchange rate with stock market returns in the short-run. It further revealed that in the short-run approximately 1.2% deviation of stock market returns is corrected in every month. Variance decomposition showed that volatility in stock market returns is mostly caused due to its own shock and returns are endogenous in nature. Whereas the explanatory power of interest rate and exchange rate for causing volatility in stock market returns is quite low. Impulse response function also highlighted that both interest rate and exchange rate negatively impact the stock market returns in the short run yet reaction of stock market returns to interest rate hike is not very much noticeable whereas reaction of stock market returns on exchange rate hike is quite significant. In the end, it is established by the granger causality test that there is one-way causal relationship between the stock market returns and interest rate, and between exchange rate and stock market returns.
Khawaja, R. D. (2015). Interest rate, exchange rate and stock returns (Unpublished graduate research project). Institute of Business Administration, Pakistan. Retrieved from https://ir.iba.edu.pk/research-projects-mseco/18
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