Impact of US Dollar Exchange Rate and Interest Rate Volatility on Stock Market Capitalization in Pakistan: Empirical Evidence from 2007 to 2016

Abstract

This study examines the impact of US dollar exchange rate and interest rate volatility on Pakistan’s stock market capitalization during 2007–2016, focusing solely on annual macroeconomic indicators. In emerging economies like Pakistan, fluctuations in key macroeconomic indicators can significantly shape stock market performance. Despite extensive global research, limited evidence exists on their combined long- and short-run effects in the Pakistani context. The research adopts a quantitative time-series design using annual data from the Pakistan Stock Exchange (market capitalization), the State Bank of Pakistan (interest rates), and international financial databases (PKR/USD exchange rate). Key statistical tools include the Augmented Dickey-Fuller (ADF) test for stationarity, Johansen cointegration for long-run relationships, Error Correction Model (ECM) for short-run dynamics, Ordinary Least Squares (OLS), and Granger causality tests. The study models log-transformed variables and ensures robust diagnostics through multicollinearity and residual testing. Exchange rate volatility had a significant positive long-term impact on market capitalization, while interest rate volatility showed a weaker, negative effect. In the short run, only exchange rate movements were significant. Granger causality confirmed that both variables influence market capitalization, with 22% of disequilibrium corrected annually. Policymakers should prioritize exchange rate stability and adopt measured interest rate policies to support stock market growth and investor confidence.