EMU Equity Markets’ Return Variance and Spill Over Effects from Short-Term Interest Rates

Abstract

The DCF (Discounted Cash flow) Model provides the theoretical background for the possible impact of interest rate changes on equity prices. This paper examines the spillover effects from the movement of short term interest rates to equity markets within the Euro area. The empirical study is carried out by estimating a Markov Switching GJR-M model with a Bayesian based Markov Chain Monte Carlo (MCMC) methodology. The result indicates that stock markets in the Euro area display a significant two regimes with distinct characteristics. Within a high variance, low mean state (a bear market regime), stock returns have a negative relationship with the volatility, and the volatility process responds asymmetrically to shocks to equity returns, especially to bad news. The other regime (a bull market regime) appears to be a high mean, low variance state, within which the returns have a positive relationship with the volatility, and the volatility is lower and more persistent. We find also that there is a significant impact of fluctuations in the short term interest rate on the conditional variance and conditional returns in the EMU countries. Such impact is asymmetrical, and it appears to be stronger in the bear market and when the interest rate changes upward. The results are of importance to EMU monetary policy makers stabilizing the inflation and output through the interest rate, and to financial market participants making effective investment decisions and formulating appropriate risk management strategies.