Theoretical Studies of the Sensitivity of Stock Returns Finance Essay

This chapter reviews the theoretical and empirical studies, regarding the sensitivity of stock returns of banks to interest rates and foreign exchange rates. In the course of review, the studies focussing on the interest rate are evaluated first, followed by an exploration of the studies focusing on foreign exchange rates. Finally, the empirical research that explores the effects of both interest rate and foreign exchange rates on stock returns for financial institutions are considered to help present a more accurate outline of the research that has been carried out in this field to date; and thus, help highlight this area of research for further investigation. It was observed during the preliminary research that in the past few decades, several studies have analyzed the effects of fluctuations of interest rates on the stock returns of commercial banks in the United States.

2.2 Theoretical Background

"The impact of market interest rates on commercial bank stock returns have increasingly concerned bank managers, investors, policy makers, and academicians as financial market conditions have become more volatile and profit margins have dwindled in recent years" (Elyasiani and Mansur 2004). Most authors have thus assessed the impact of foreign exchange risk on bank stock returns using multifactor models (e.g Chamberlain et al. (1997); Choi and Elyasiani (1997) and Elyasiani and Mansur (1999)). It was observed that the studies carried out by Martin & Mauer, 2003; suggested that perceptions adopted on interest rates by the financial institutions served to broaden the CAPM-based market model by including an exchange rate factor. But according to Edmister and Merriken (1988) the interest rates and exchange rate changes have a direct effect on the revenues and costs of financial institutions and that most of the largest banks in the US have a major proportion of their operations in foreign countries (Madura and Zarruk 1995). Thus, the interest rate and exchange rate changes are only likely to substantially affect their revenue and cost streams beyond the protection that is afforded and allowed by hedging (Joseph and Vezos 2006). In the earlier years, Booth and Officer (1985) and Bae (1990) tested the effect of current and unanticipated changes in interest rate. Fraser, Madura and Weigand (2002) examined the effect of unanticipated interest rate changes. Booth and Officer, 1985 also found out that the underlying phenomenon is not present in the non financial portfolio. In contrast, Lloyd and Shick (1977) and Chance and Lane (1980) found no incremental explanatory power for interest rate changes. Therefore, all these studies strongly supported a negative effect of both current and unanticipated interest changes on bank stock returns. King and Wadhwani (1980) discussed the "volatility transfer" hypothesis. The volatility transfer hypothesis claims that there can be an increase in financial markets volatility levels, due to change in stocks, which in turn will lead to contagion effects. It can be surmised that the financial institutions are able to avoid this negative influence in their domestic markets, by operating in foreign operations. But it may at times lead to an extra factor of risk being introduced. Similarly, financial institutions are also said to be more unique due to the regulations and policies imposed in relation to their activities, which makes them more exposed to the fluctuations in interest rates. Thus summarizing - financial institutions may invest abroad to reduce risk in the domestic market. "Stock market volatility differs dramatically across international markets. [Studies on] US, UK and Japanese markets evidenced the differences in return volatility due to market thinness and share turnover. With a view to know the interdependence of stock markets located all over the world and to realize the risk returns of global diversification, this study presents the volatility in the international scenario. However, volatility is one of the most important aspects of financial market developments, providing an important input for portfolio management, option pricing and market regulations" (Mollah and Mobarek 2009). Any fluctuations that take place in the area of interest rates, tends to have a significant influence on the stocks of the company (Knif and Pynnonen 2007). Needless to highlight, the eventual implications of these influences can be observed in the form of changes in stock returns. When interest rates experience an increase, the risk involved in investment also goes up; causing the required rate of returns to climb up, especially if the stocks are to remain attractive to consumers.

2.3 Interest Rates

A major cause of the numerous bank failures in the 1970s and 1980s was the high volatility of interest rates and the strong interest rate sensitivity of banking institutions (Verma and Jackson). Interest rate is assumed to be one of the most important among factors that affect the stock returns and the profitability of banks in the short term; as well as in the long run (Simlai 2009). "In particular, the volatility of the short-term interest rate has two opposing effects on the yield curve; the premium effect and the convexity effect. The premium effect inserts a positive impact on the long term interest rate. An increase in the volatility of the short-term interest rate induces higher expected rates for the longer maturities; whereas on the other hand, the convexity effect inserts a negative impact on the long term interest rate. An increase in volatility of the short-term interest rate increases the convexity, thereby reducing the yield for longer maturities. Thus, the premium effect dominates at the short end of the yield curve while the convexity effect dominates at the long end of the curve" (Elyasiani and Mansur 2004). The significance of this phenomenon is incorporated in the fact that interest based income is a key source of income for commercial banks. It therefore comes as no surprise; that the interest rate risk is a major source of risk that commercial banks are exposed to (Amoako-Adu and Smith 2002). Changes in interest rates can also affect a bank's profitability by increasing its cost of funding, reducing its returns from assets, and lowering the value of equity in a bank. Moreover, recent decades have ushered in a period of volatile interest rates, leaving the investors with more unpredictable environment to work in (Joseph and Vezos 2006). A modern day investor's primary concern is now concerned around the impact of interest rates on commercial bank revenues, costs and profitability. In terms of the bank's perspective, the fact that most commercial banks choose to lend long and borrow short, implies that the bank profits can decrease in case of an increase in short-term interest rate and a decrease in long-term interest rates (Elyasiani and Mansur 2004). In contrast to this a bank can be expected to benefit from a decrease in short-term interest rate and an increase in long-term interest rate. During the past years, several studies have analyzed the effects of fluctuations of interest rates on the stock returns of commercial banks in the U.S. Most studies found that bank returns exhibit a negative correlation with the changes of interest rates, while others found no significant association between the movements of the interest rates and the returns of the commercial banks (Zhu 2001). Less evidence exists regarding the factors that explain the interest sensitivity of bank stock returns across firms and through time. A bank's interest rate risk is assumed to be conditioned on the following three bank specific characteristics: change of net interest income, change of net income, and notional amounts of interest rate derivatives. These factors are observable and can be easily measured. They are useful indicators for investors to anticipate how sensitive a bank's performance to interest rate risk is. If a bank successfully controls its interest rate risk, its net interest income and net income should be immunized against interest rate fluctuations. In addition to this; as banks are increasingly employing derivatives to hedge their financial risks; the national amount of interest rate derivatives for the purpose of non-trading is also analyzed. Since the financial market conditions have become more volatile in recent years, the effect of interest rate changes on bank stock returns has increasingly concerned investors, banking authorities, academicians and policy makers (Verma and Jackson 2008). The interest rate variable, thus calculated is very important for the valuation of common stocks of financial institutions; because the returns and costs of financial institutions are directly dependent on the interest rates. Various authors have, therefore, examined the empirical sensitivity of stock returns of financial institutions to the changes in market interest rates (Choi, Elysiani and Kopecky 1992). Studies carried out by Edmister and Merriken (1989); as stated earlier, claimed that changes in the interest rates have a direct influence on both the revenue and expenditure of a financial institution, and as a result, this influence has an effect on the stock returns of the same financial institutions. In 1988, Kane and Unal employed a switching regression technique and found out that the interest rate sensitivity of bank, savings and loan stocks varied significantly over time. In particular, they found out that the interest rate beta shifted down sharply in the early 1980s and went back up a few years later (Kane and Unal 1988). Interest rate sensitivity of commercial bank stock returns has also been the subject of considerable research, for years now. Stone (1974) proposed a two factor model for incorporating both the market return and interest rate variables as return generating factors. Lloyd and Shick (1977) and Chance and Lane (1980) found out that the interest rate index contributed little to the return generating process of stocks of financial institutions. These findings, however, were challenged by Lynge and Zumwalt (1980), Flannery and James (1984) Booth and Officer (1985), Scott and Peterson (1986), and Bae (1990), all of whom reported considerable adverse interest rate sensitivity in stock returns of financial institutions; Elyasiani and Mansur (1999). Early studies on interest rate sensitivity, which used the two index model, focussed primarily on the exposure of interest rates on financial institutions. Even now, the exposure of the financial institutions to fluctuations of interest rates has been the subject of many empirical researches. Most of the researches carried out, employ a two-factor model, focussing on two aspects: the association between the bank stock returns and the interest rate changes. Most studies conducted on a regular basis found out that the bank stock returns are negatively related to the changes in interest rate while others found no significant relationship between these two variables. Lynge and Zumwalt (1980) tested the interest rate sensitivity of bank stock returns by estimating several multi index models containing short- and long-term debt return indices. Song (1994) made the first study to employ the ARCH-type methodology in banking. Song analysed the ARCH-type modelling as the appropriate framework for analysis of bank stock returns. According to his results, market and interest rate risk measures of banks did indeed vary significantly over time (Elyasiani and Mansur 1998). Saunders and Yourougou (1990) examined periods of relatively stable and volatile interest rates and provided evidence that the interest rate sensitivity varied over time. Kwan (1991) also developed a two-index random coefficient model of bank stock returns to examine the time-varying interest rate sensitivity of banks (Verma and Jackson 2008). Scott and Peterson (1986) conducted a study in order to examine the changes in interest rates and found out that they have different effects of stock returns and equity values on either hedged or un-hedged financial institutions. They also found out that the stock returns of financial institutions that do not use hedging techniques have a greater sensitivity to changes in interest rates than those that use these techniques. This quality enabled the un-hedged financial institutions, to balance the maturities of both their assets and liabilities and therefore; not get much affected by the fluctuations of interest rates. Mitchell (1989) argued that banks can control their interest rate risk by matching the interest sensitivity asset and liability. Kwan (1991) developed and tested a random two-factor model. His study provided evidence for the sensitivity of bank stock returns that were positively related to the maturity mismatch between the bank's assets and liabilities. The equilibrium price for bearing interest rate risk is also found to vary over time in tandem with the interest rate volatility (Elyasiani and Mansur 1995). Several studies differentiated between long-term and short-term interest rates, concluded that long-term interest rates have more impact on bank stock returns than short term interest rates (Akella and Chen 1990; Mansur and Elyasiani 1995). Flannery et al. (1997) analysed and found out that the market risk and interest rate risk are priced factors of securities.

Foreign Exchange Rate

There have been very few studies carried out, that examine the effects of foreign exchange( FX) rate risk on the stock returns of financial institutions compared to the interest rate risks. On the international side; the advent of the flexible exchange rate system in the 1970s and the growing internationalization of the economy, including the banking sector, has introduced another macro financial variable, the exchange rate, as a potential determinant of bank stock returns. (Choi et al.1991). Euromoney (Sept. 1995) has also reported that the foreign exchange market has undergone significant structural changes over the past years. The exchange rate fluctuations that are much larger and tend to persist longer than assumed,the inability of central banks to defend or stabilize their currencies through intervention, the declining role of fundamental factors in explaining the behavior of the market, the steady growth in the use of foreign currency derivatives, the growing size of the market because of rapid globalization, and the increasing use of automated trading and real-time information have all been believed to have, but the least, contributed to the increase in the volatility of the market. Exchange rates most directly affect the banks with foreign currency transactions and foreign operations. Even without such activities, exchange rates can affect banks indirectly through their influence on the extent of foreign competition, the demand for loans, and other aspects of banking conditions. (Chamberlain, Howe and Popper,1997). The area in relation to foreign exchange rate exposures is somewhat under researched when compared to the interest rate exposure and it has been found out that the studies for exchange rate exposures provide a mixture of results and inconsistent conclusions. Adler and Dumas (1984) were the first to measure exchange rate exposure as the coefficient of a linear regression of stock returns on exchange rates. Adler and Dumas (1984) show that even firms whose entire operations are domestic may be affected by exchange rates, if their input and output prices are influenced by currency movements. It is widely believed that changing exchange rates affect the competitiveness of firms engaged in international competition. A falling home currency promotes the competitiveness of firms in home country by allowing them to undercut prices charged for goods manufactured abroad (Luehrman,1991). Jorion (1990) carried out a study in order to analyse the FX rate exposure of multinationals in the US. The results observed that there was little evidence to claim a strong relationship exists between the stock returns of a firm and the variances of exchange rates. According to the studies of Bodnar and Gentry (1993), it has been found that there is little correlation between the value of a firm and the fluctuations in FX rates, and that the level of foreign involvement and the characteristics of the industry, do have an effect on this relationship, which is said to be positive. Financial institutions that hold assets and liabilities in different foreign currencies, is suggested by the economic theory to have an influence from the variation on FX rates. Chamberlain et al (1997) researched the FX rate sensitivity of US financial institutions and of Japanese banks, using daily and monthly data in the study. They concluded that there was quite a number of US financial institutions that are sensitive to changes in the exchange rates compared to the Japanese banks. Although the studies carried out has failed to provide a supporting reason as to why there are differences in FX rate levels of the two countries, it has been claimed that the variance may be because of the economic factors.

2.7 Interest Rate and Foreign Exchange Rate Sensitivity

Choi et al (1992) extended the above existing models to include exchange rate risks and to assess the interest rate and exchange rate sensitivities in the pre- and post-1979 periods. As studies show, interest rates were stronger before 1979 while exchange rate sensitivity occurred only significantly for money centre banks i.e. after 1979. In addition, these authors also found out that the market factor volatility varied significantly through time and its variation was priced into the expected returns of different securities (Elysiani and Mansur 1998). Since the internationalisation of many financial and banking markets is still incomplete it is likely that both the interest rate and exchange rate sensitivity would vary among financial institutions and the extend to that variation would depend on both the nationality and financial operations of these institutions (Joseph and Vezos 2006). The risks involved thus; will only occur whenever the bank's assets and liabilities are mismatched and the interest rate and foreign exchange rate change unexpectedly (Joseph and Vezos 2006). Saunders and Yourougou (1990) contrasted by arguing that the effect of interest rate changes on bank and non-bank firms during periods of relative interest rate stability (pre-October 1979) and high interest rate volatility (post-October 1979) varied. They reported that the interest rate effects varied substantially over time (Bartram and Bodnar 2007). Yourougou (1990) also specifically found out that, during the period of relative interest rate stability; the interest rate sensitivity was low and insignificant for both banks and non-banking firms, while in the post-October 1979 period; interest rate risk exerted a significant impact on common stocks of financial intermediaries, but not the industrial firms. This in turn suggested for an exchange rate index to be included in the already developed model of bank stock returns (Joseph and Vezos 2006). Wetmore and Brick, 1994 later experimented with a three-index model. They found that a structural shift occurred in some of the coefficients of all banks. Another shift occurred in the market risk coefficient for all banks. Their findings showed that the market, interest rate and foreign exchange rate indices were still unstable, making estimates of risk differ by bank type and period; because, as foreign exchange risk declines, interest rate risk also increases. They similarly found out that the exchange rate risk is positively related to the foreign or LDC loan exposure and negatively to off- balance sheet exposure. Financial institutions can hedge to mitigate some of these risks mentioned above, but the hedging done tends to be sometimes partial or incomplete (Grammatikos et al., 1986). Choi and Elyasiani (1997) conducted a study in which they concentrated on the sensitivity of bank returns to interest rate and the FX rate exposures via an off- balance sheet contract. From their study, they found that the financial institutions were less exposed to interest rate variations than FX rate variations, which was similar to the previous studies conducted by other authors. They also found that for both the interest rate and FX rate exposures, the betas differ over time as well as across banks. In contrast, a number of empirical studies have been done on the financial institution's stock sensitivity, though the earlier studies were based more on the interest rate changes (Stone, (1974); Lynge and Zumwalt (1980); Kwan (1991)). According to Flannery and James, 1984 the empirical results tended to show strong evidence of interest rate sensitivity (Akalla and Chen (1990). Choi et al (1992) examined the exchange rate exposure of banks and found the evidence of foreign exchange exposure, when they aggregate bank returns. However, their aggregation precludes them from linking the estimated exchange rate exposure to individual firm characteristics (Chamberlain et al, 1997). It would thus not be inappropriate to surmise that "bank stock returns are interest rate sensitive, the direction of the effect is negative, and the magnitude of interest rate sensitivity is portfolio-specific and model-dependent. In particular, bank stock return sensitivities are found to be stronger for the long term interest rate than the short-term interest rate and the volatilities of the short-term interest rate and the long term interest rate are found to play an important role in determining bank equity returns and return volatility" (Elyasiani and Mansur 2004). The previous studies have found the effect of both interest rate and FX rate changes on financial institutions stock returns; typically employing the standard OLS methods, although some employed the ARCH/GARCH- type estimation methods to control the ARCH effects (Nwogugu 2005).

Conclusion

It has thus been found, that the effects of both interest rate and FX rate risks are being measured together, even though the studies do not have any consistent results. Although vast majority of studies carried out do support the hypothesis of a relationship existing between stock returns of financial institutions and interest rate and FX rate risks, the level of its importance and the extent of this relationship are still widely discussed. This dissertation will try to overcome the limitations of the previous studies. Many researchers have carried various studies on the effect of both the interest rate and foreign exchange rate changes on the stock returns of financial institutions, the previous studies found out the effect of both the interest rate and FX rate changes on financial institutions stock returns; typically employing the standard OLS methods, although some others employ ARCH/GARCH- type estimation methods to control the ARCH effects. The studies carried out, that examined the effects of both factors have in large supported the claims that when measuring the effects of both factors, it should be done mainly using a single model. The OLS estimation method has sometimes generated inefficient estimates due to the volatility clustering and the ARCH effects in the empirical data (see, Baillie and Bollerslev, 1989). ARCH/GARCH-type models are generally found to be better than the standard OLS regression method. Thus for this dissertation we will be using the GARCH model for the various estimations. The GARCH model was preferred over the ARCH models because, according to Brooks (2002), the former is more of a complete model and thereby avoids over fitting, as the current conditional variance can be influenced by an infinite number of past squared errors. In addition, the GARCH-type models are less likely to breach non-negativity constrains and are more appropriate for the type of data and estimations in this research compared to traditional linear regression. Thus for the purpose of this dissertation the GJR-GARCH model will be used for the estimations. Another limitation that has been seen, is that most of the research that has been previously carried out, used monthly and weekly data, which might have been a casual factor for the results of these studies, not being able to fully capture all the movements that occured in indexes of the interest rate , FX rate and stock return. In this study, daily data will be used, as it can be argued that it is more representative of the fluctuations that occur on a daily basis, and thus will enable us to identify an accurate relationship between the three factors.

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