Interest Rate Volatility and Stock Returns: A GARCH (1,1) Model

Abstract

The present study attempts to examine the dual impact of changes in interest rate and interest rate volatility on the mean and variance of portfolio stock returns. The study period is from 1st April 1996 to 30th August 2014 covering a total period of approximately 18 years. Sample used in the study consist of portfolio of financial and non-financial firms listed in the S& P CNX 500 equity index. The effect of interest rate changes and volatility on distribution of stock returns is analyzed using the GARCH (1,1) model.

The effect of interest rate changes is found to be higher for financial firms as compared to non-financial firms. Interest rate volatility is found to be the significant factor affecting mean and variance of non-financial firms stock returns. Overall, the effect of interest rate volatility on stock returns and conditional stock returns volatility is evident from the results. If interest rate becomes more volatile it would also increase the volatility of conditional stock returns. When the interest rate volatility is included in the variance equation it is found that in case of those firm's where interest rate sensitivity coefficient is not significant, coefficient of interest rate volatility is significant implying that if changes in interest rate are small then these firm's are able to hedge themselves but if volatility of interest rate increases beyond a limit, it would also make the conditional returns of these firms' more volatile.

Keywords: Stock returns, Interest rate, GARCH (1,1), Financial Sector and Non-Financial Sector