Sensitivity of Bank Equity Returns to the Level and Volatility of Interest Rates

Abstract

This study attempts to determine whether the level and volatility of interest rates affect the equity returns of commercial banks. Short-term, intermediate-term, and long-term interest rates are used. Volatility is defined as the conditional variance of respective interest rates and is generated by using the ARCH estimation procedure. Two sets of models are estimated. The basic models attempt to determine the effect of contemporaneous and lagged interest rate volatility on bank equity returns, while the extended models incorporate additional contemporaneous macroeconomic variables. Contemporaneous interest rate volatility has little explanatory power, while lagged volatilities do possess some explanatory power, with the lag length varying depending on the interest rate series used and the time period examined. The results from the extended model suggest that the long-term interest rate affects bank equity returns more adversely than the short-term or the intermediate-term interest rates. The findings establish the relevance of incorporating macroeconomic variables and their volatilities in models determining bank equity returns.