Granger Causality of Interest Rate and Exchange Rate on Stock Volatility at Chicago Options Market

Abstract

This paper investigates the Granger Causality test to determine the correlation between interest rates and exchange rates with the composite stock volatility measurement of different companies under the Chicago Board Options and Exchange. Using the daily sector data for all observed variables from the St. Louis Fed over the period of 2007-2012, as well as introducing the technique of autoregressive lag model, I have examined whether the current and the previous values of a particular volatility index, interest rate, and exchange rate could have significant Granger Causality effects to the return behavior of those other indices, interest rates, and
exchange rates. A two-way Granger Causality test was performed within the R studio, and the estimated result makes it essential to understand how the stock volatility indices behave over the contemplated time, especially with the following changes in interest rate and exchange rate, thus forecasting one another. The result further indicates, in most cases, interest rates positively Granger cause the stock market volatility indices more than in comparison with the exchange rates within the time period, although both of them are identified as major determinants of stock
price volatility.