Measuring Stock Market Volatility in an Emerging Economy

Abstract

The pattern of volatility in a given time series is due to various micro and macro economic factors attached to that security. An understanding of volatility and its causes is important in determining the cost of capital of the security and in assessing investment and leverage decisions in case of emerging economies especially where the market consists of risk?averse investor. This study thus examines the volatility of different sectors in Colombo Stock Exchange (CSE) and how the macro economic factors affect on the volatility by fitting Autoregressive Conditional Heteroskedasticity (ARCH) and the Generalized ARCH (GARCH) using monthly time series data of 20 sectors in CSE for the period 2005-2010. Results found that sixteen out of twenty sectors in CSE has a significance volatile (p<0.05) and both ARCH and GARCH terms on the fitted models for individual sectors were significant (p<0.05). The volatility of composite stock returns of volatile sectors was then regressed against Narrow Money Supply (M1), Broad Money Supply (M2), Inflation (I) and Interest Rate (IR). It was found that inflation and interest rate are the two significantly influencing macro economic factors (p<0.05) on the stock market volatility of emerging economies like Sri Lanka.