Impact Of Change Of Interest Rates On Performance Of Market Returns
Financial markets play a crucial role in the foundation of a stable and efficient financial system of an economy. Numerous domestic and international factors directly or indirectly affect the performance of the stock market. This paper explores the possible relationship a stock market’s performance and interest rates within a country. Interest rates are determined by monetary policy of a country according to its economic situation. High interest rate will prevent capital outflows, hinder economic growth and, consequently, hurt the economy as interest rates is one of the most important factors affecting directly the growth of an economy.
The objective of Sensitivity of bank stock returns to market, interest and exchange rate risks, by Jongmoo Choi, Elyas Elyasiani, Kenneth Kopecky, was to use the multifactor model to examine empirically the joint sensitivity of the rates of return of common large US banking institutions to interest rate, exchange rate and market risk factors. The variables studied were Interest rate, Exchange rate, banking stocks over the period 1975-1987. They hypothesized that consideration of exchange rates as a factor affecting bank stock returns is new, as is the micro international banking model that provides empirically testable hypotheses about the sensitivity coefficients of bank stock returns to the underlying market, interest and exchange rate risk. Through their findings, they accepted the null hypothesis, that the exchange rates do have an impact on the returns of the banking stocks independent of the interest rates and other market factors. The sign and significance of the estimated coefficient for the exchange rate, however, does differ depending on the time period covered, the nature of the banking business (money center or regional bank), and whether the risk factors are defined in actual or unexpected terms.
Causal Relations Among Stock Returns, Interest rates, Real activity and Inflation (USA, 1992) by Bong-Soo Lee investigated, using VAR, the causal relations and dynamic interaction between stock returns, interest rate, inflation, real activity. They studied variables: Stock returns, Interest rate, Inflation, growth industrial production during 1947-1987. Their hypothesis was, negative correlation between stock returns and inflation is not a causal relation but that it is proxying for a positive relation between stock returns and real activity and is induced by a negative relation between real activity and inflation. They had mainly two findings: Nominal interest rates and inflation are strongly positively associated for all lags and leads, as expected from the Fisher hypothesis. Real interest rates and inflation are negatively associated
Inflation is negatively associated with, in particular, subsequent growth in industrial production. Nominal interest rates and growth in indus- trial production are also negatively associated, which suggests that when the nominal interest, rate rises because of inflationary expectations, it will likely be associated with a lower growth in industrial production.
Sensitivity of banks stock returns distribution to changes in the level and volatility of interest rates (USA, 1998) by Elyas Elyasiani and Iqbal Mansur employed the generalized autoregressive conditionally heteroskedastic in the mean (GARCH-M) methodology to investigate the effect of interest rate and its volatility on bank stock return. They studied Interest rate, interest rate volatility, banking stock returns during 1979-1982. They hypothesized that appropriate framework for analysing bank equity returns and risk is the ARCH type modelling strategy. Using features of ARCH and GARCH type models, they found that the non-linear dependence and the excess kurtosis exhibited by the excess return series suggest that ARCH type model is the appropriate framework for analysing bank equity returns.
Economic forces and stock market (USA, 1986) by Nai-Fu Chen, Richard Roll, Stephan A. Ross wanted toidentify the different macroeconomic variables that affect the returns of the stock market and how the market reacts to changes in each of these variables. They studied inflation, Long term government bonds, oil prices, industrial production, stock returns. Using the efficient-market theory and rational expectations intertemporal asset-pricing theory, their findings were that several of the economic variables were seen having a significant impact on the stock returns. The most significant variables were industrial production, changes in risk premium and shifts in the yield curve.
The FED’s policy decisions and implied volatility (Finland, 2010) by Sami Vähämaa, Janne aimed to contribute to the literature by examining the effects of the Federal Monetary Policy decisions on the returns of S&P 500. The variables studied were VIX implied volatility index, monetary policy decisions of the federal reserve, federal fund future prices, index returns through 1994-2007. Their hypothesis was that stock market uncertainty is significantly affected by monetary policy decisions. The empirical findings reported in this paper demonstrate that stock market uncertainty is significantly affected by monetary policy decisions. Consistent with the prior literature, we find that implied stock market volatility generally tends to decrease after FOMC meetings. However, our results also indicate a positive relationship between monetary policy surprises and implied volatility, thereby suggesting that positive target rate surprises may increase stock market uncertainty. Furthermore, the findings suggest that target rate decisions made in unscheduled FOMC meetings have a stronger effect on implied volatility than scheduled policy decisions.
Is the correlation in international equity returns constant: 1960-1990?, by François longin, Bruno solnik, was published in 1995 in the Journal of International Money and Finance, Vol. 14, No, 1, pp. 3-26, 1995 in France. Their objective was to test the hypothesis of a constant international conditional correlation, investigating various types of deviations. They studied the correlation of monthly excess returns for seven major countries over the period 1960-90 by using a multivariate GARCH (1, 1) model. Tests of specific deviations lead to a rejection of the hypothesis of a constant conditional correlation. And found out that the correlation rises in periods of high volatility.
Interest rate changes and stock returns: A European multi-country study with wavelets, by R. Ferrer, V. J. Bol´os, R. Ben´ıtez, was published by the la Universidad de Valencia in July 2014. This paper investigates the linkage between changes in 10-year government bond yields and stock returns for the major European countries in the time-frequency domain by using a number of cross-wavelet tools in the framework of the continuous wavelet transform, mainly the wavelet coherence and phase-difference. They used wavelet analysis for analysis as their main tool. The results reveal that the degree of connection between 10-year bond rate movements and stock returns differs considerably among countries and also varies over time and depending on the time horizon considered. In particular, the UK shows the greatest interdependence between long-term interest rates and equity returns across time and frequencies, while the relationship is much weaker for several peripheral European countries such as Portugal, Ireland and Greece. The highest level of connection is observed for most countries since the onset of the recent global financial crisis. In addition, the significant linkage is mainly concentrated at investment horizons from one to two year.
The pricing of interest-rate risk: evidence from the stock market, by Richard J. Sweeney and Arthur d. Warga, published in the Journal of Finance in 1986, studied the issue of whether firms are required to pay an ex ante premium to investors for bearing the risk of interest-rate change. For this the main variables they studied were interest rates and market movements. They used a two-factor apt model with the market and yield changes on long-term government bonds. By doing so they came to the conclusion that changes in government bond yields clearly affect ex post returns to electric utilities, and that this phenomenon is concentrated to a much larger extent in this particular industry than in NYSE firms as a whole.
The effects of federal funds target rate changes on S&P 100 stock returns, volatilities, and correlations, authored by Helena Chulia-Soler, Martin Martens, and Dick van Dijk in April 2009, was published by the ERIM report series research in management. They studied the study the effects of FOMC announcements of federal funds target ratedecisions on individual stock returns, volatilities and correlations at the intra-day level. The variables studied were federal funds target rate and individual stock prices. They found that the stock market responds differently to positive and negative surprises. First, the average response to negative surprises is larger. Second, in case of bad news the mere occurrence of a surprise matters most, whereas for good news its magnitude is more important. These new insights were found by them due to the use of intraday data. Financial and IT stocks showed the strongest reaction, whereas utilities stocks respond the least.
The effect of interest rate changes on bank stock returns, by John J. Vaz, Mohamed Ariff, Robert D. Brooks, was published in 2008 in the journal, “Investment Management and Financial Innovations. ” This study examines the effect of publicly announced changes in official interest rates on the stock returns of the major banks in Australia during the period from 1990 to 2005. The major variables they studied were interest rates and stock returns for a sample period from 1990 to 2005. They used a market model, event study methodology for their analysis. The hypothesis was as follows:
H1: The cumulative abnormal returns of the selected banks' stock returns will be negatively (positively) affected by RBA announced increases (decreases) in cash rates.
H2: The market will exhibit strong anticipatory effects and significant abnormal returns will be measured in the days leading to the event with little or no significance in the post event period.
H3: Bank stock returns have asymmetric responses to changes in interest rates affected by the RBA's policy.
The major findings were that Australian bank stock returns are not negatively impacted by the announced increases in official interest rates, and banks experience net-positive abnormal returns when cash rates are increased.
Eight variables affect market performance: Interest Rate, Inflation, Exchange Rate, Index of Industrial Production, Money Supply, Gold Price, Silver Price and Oil Price. Money supply and Inflation have a positive relationship among themselves. However, Money Supply and Inflation have a dual effect on stock returns. First, increase in Money Supply will increase Inflation, which will again increase expected rate of return. Use of high expected rate of return will decrease value of the firm and will result in lower share prices. Secondly, increase in Money Supply and Inflation increases future cash flow of the firm, which in turn, increases expected dividend, and will increase stock prices. For this reason, the relationship between Money Supply, Inflation and Stock Return need to be investigated. A depreciation of the domestic currency against foreign currencies increases export, therefore exchange rate should have a negative relationship with the stock return. But, at the same time, depreciation of domestic currency increases the cost of imports which indicates a positive relationship between them. Hence, the relationship between exchange rate and stock returns needs to be checked. The Index of Industrial Production reflects the growth rate of industries. Positive relationship is expected between the Index of Industrial Production and Stock return. Gold and silver are used as investment avenues. Increase in gold and silver prices attracts investors towards the commodity market, which might decrease investor preference towards the equity market. This indicates that a negative relationship is expected between gold and silver, and stock market returns. For oil supply, India is dependent on the international oil market. Therefore, higher international oil prices increase cost of production, which might decrease profit of firms, and hence decreases stock prices. Therefore, the expected relationship between oil price and stock price is negative.
