An Investigation of the Impact of Interest Rates and Interest Rate Volatility on Australian Financial Sector Stock Return Distributions

Abstract

This paper extends the existing literature by analysing the dual impact of changes in the interest rate and interest rate volatility on the distribution of Australian financial sector stock returns. In addition, a multivariate GARCH-M model is used to analyse the impact of deregulation on the financial institutions sector. It was found that there is a consistent inter-temporal trade off between risk and return over the different regulatory periods. Moreover, finance corporations were found to be highly sensitive to new shocks across the financial sector and deregulation increased the risk faced by finance corporations and small banks - effectively increasing the required rate of return and explaining the continued rationalisation of these sectors. Furthermore, deregulation has changed the fundamental relationship between interest rates and large bank stock excess returns from positive in the pre-deregulation period to negative in the post-deregulation period. This reflects the changing institutional environment from one of controlled credit rationing to a more competitive environment.

Keywords: Interest rate risk, Australian financial sector, Regulatory change, GARCH-M