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Equity returns of financial institutions and the pricing of interest rate risk

  • Sotiris Staikouras

This study investigates the issue of whether financial intermediaries' common stock returns incorporate a risk premium for their inherent exposure to unexpected changes in interest rates. A wide range of financial institutions is employed to test the hypothesis that the interest rate risk is priced by capital markets. In addition, the above sample is extended by incorporating firms from the non-financial sector. A two-factor model with the market portfolio and the changes in market yields, as exogenously specified risk variables, is employed. The model is estimated via a seemingly unrelated regression estimation (SURE) framework with both cross-equation restrictions and within equation nonlinear constraints on the parameters. The findings indicate that financial institutions' equity returns incorporate a risk premium for their exposure to market yields' surprises. The return generating function of the insurance business could be further explained by an additional factor such as currency movements. It is also empirically supported that the market premium drops out from the estimation process. When commercial and industrial firms are included in the estimation process, the findings unveil a reduction in the magnitude of the interest rate risk premium.

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Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

Volume (Year): 15 (2005)
Issue (Month): 7 ()
Pages: 499-508

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Handle: RePEc:taf:apfiec:v:15:y:2005:i:7:p:499-508
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  1. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
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  7. McElroy, Marjorie B & Burmeister, Edwin, 1988. "Arbitrage Pricing Theory as a Restricted Nonlinear Multivariate Regression Model: Iterated Nonlinear Seemingly Unrelated Regression Estimates," Journal of Business & Economic Statistics, American Statistical Association, vol. 6(1), pages 29-42, January.
  8. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
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