Equity Returns of Financial Institutions and the Pricing of Interest Rate Risk

Posted: 1 May 2005

See all articles by Sotiris K. Staikouras

Sotiris K. Staikouras

City University - Cass Business School; ALBA Graduate Business School

Abstract

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.

Keywords: Financial institutions, Stock returns, Interest rate risk, APT, Risk premia, Kalman filter, Nonlinear SURE

JEL Classification: C32, G12, G21, G22

Suggested Citation

Staikouras, Sotiris, Equity Returns of Financial Institutions and the Pricing of Interest Rate Risk. Applied Financial Economics, Vol. 15, pp. 499-508, 2005, Available at SSRN: https://ssrn.com/abstract=709082

Sotiris Staikouras (Contact Author)

City University - Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

ALBA Graduate Business School ( email )

Athinas Ave. & 2A Areos Str.
Vouliagmeni 166 71, Athens
Greece

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