The Impact of Interest Rate Volatility on Stock Returns Volatility: Empirical Evidence from Pakistan Stock Exchange

Apprehension pertaining to Stock return volatility always has been producing the appreciable significance in the various current research works and it has been lucrative to many researchers for forecasting stock market volatility. This study is about the forecasting of stock returns volatility on the basis of interest rate volatility in the well established Pakistan Stock Exchange (PSX). The stock returns are calculated on the basis of KSE 100 index and interest rate volatility is calculated on the basis of monthly treasury bills rate during a period of 1994 to 2016. Various volatility models like Auto Regressive Conditional Heteroscedasticity (ARCH) and Generalized Auto Regressive Conditional Heteroscedasticity (GARCH) were used to predict stock return volatility on the basis of interest rate volatility in Pakistan. ARCH model is one of the well known methods to forecast the error term in the data and which will certain our forecast regarding stock prices. In the Pakistan Stock Exchange the ARCH (1, 1) has been statistically significantly proved. The GARCH (1, 1) model is also used to estimate the stock volatility. This model shows the short run volatility affect the lagged stock returns and is contributing to the overall volatility. The sum of α and β is less than 1 so the short run volatility is positively related to the overall stock volatility. The GARCH (1, 1) model has outperformed the other volatility models in the case of Pakistan Stock Exchange.