Interest Rate Exposure Research Articles

Interest Rate Exposures of Non-Banks: Market Concentration and Monetary Policy Implications

Interest Rate Exposures of Non-Banks: Market Concentration and Monetary Policy Implications

Cross‐country linkages between ASEAN and non‐ASEAN‐RCEP member states: A global VAR analysis

AbstractThe complex global value chains underlying the Regional Comprehensive Economic Partnership (RCEP) raise an important question on the macroeconomic (output, inflation, exchange rate, and interest rate) exposure of ASEAN to output shocks in the non‐ASEAN‐RCEP members, within the context of expanded regional architecture. This paper uses quarterly data from 1995 to 2018 to estimate a global vector autoregressive (GVAR) model, specially constructed for the RCEP. The GVAR model disentangles the effects and spillovers from output shocks originating in the non‐ASEAN‐RCEP through various trade channels – direct and indirect, and total exports and foreign value‐added (FVA). The model also quantifies the impact of global (the price of oil and materials) shocks on ASEAN through trade linkages. The output shocks in the non‐ASEAN‐RCEP have persistent effects on output growth in ASEAN when transmitted through the intermediary FVA channel than the export channel. The FVA channel is also important for propagating global shocks in the form of oil and material prices. The findings confirm that output in ASEAN is also highly exposed to output shocks originating in the non‐ASEAN‐RCEP economies. The FVA trade channel is vital for explaining the spillovers from the regional output shocks and global price shocks.

Financial Risk Management and Transmission Mechanism of Monetary Policy: An Empirical Evidence from Pakistan

Monetary policy plays a vital role in achieving development for any country. This study attempts to analyze the impact of the monetary transmission mechanism on unhedged interest rate exposure in the case of Pakistan. The study used time series data from 1980 to 2020 and applied the ARDL model to check the short-run and long run association between all the variables. First, URE (Unhedged interest rate exposure) was calculated and then estimated the factors affecting it. The study also used the perfect foresight model for addressing household behavior. The outcomes indicated that all exchange rates, interest rates, and money supply positively impact unhedged interest rate exposure, and they are significant both in the short and long-run. The interest rate substantially affects unhedged rate exposure more than the money supply. Development expenditures and money supply are negatively associated with income inequality; unhedged interest rate exposure is positively associated with income inequality.

Investors' responses to macroeconomic news: the role of mandatory derivatives and hedging activities disclosure

Purpose The purpose of this study is to investigate how changes in the firm's information disclosure practices impact the way investors process macroeconomic news. Specifically, the authors examine the role of derivative instruments and hedging activities disclosure, as required by SFAS 133, in shaping invertors response to good and bad interest rate news. In addition, the authors examine whether the effect of SFAS 133 on investors' response to good and bad interest rate news varies between firms with higher and lower earnings volatility.Design/methodology/approach This study uses data on all US public firms over the period from 1990 to 2019. The authors mainly apply multivariate regression and a difference-in-difference approach to test their hypotheses.Findings The results show a significant decrease in the asymmetry of responses to good and bad interest rate news for users of interest rate derivatives following the adoption of SFAS 133. However, in contrast to this finding, the authors also find that the adoption of SFAS 133 has no impact on the asymmetry of responses to good and bad interest rate news for nonusers of interest rate derivatives. Consistent with the ambiguity theory, the finding suggests that SFAS 133 indeed decreases investors’ uncertainty (ambiguity) about the cash flow implications of changes in the interest rate. The authors also find that the decrease in the asymmetry of response to good and bad interest rate news after the adoption of SFAS 133 is greater for users of interest rate derivatives with higher than lower earnings volatility. This implies that derivatives and hedging activities disclosure, as required by SFAS 133, are more important for firms with higher than lower earnings volatility. The finding is consistent with the idea that investors demand more accounting information when underlying earnings volatility is higher. In a set of additional analyses, the authors find that the effect of SFAS 133 on investors' response to good and bad interest rate news varies depending on the level of analyst coverage and interest rate exposure. Specifically, the authors find that the decrease in the asymmetry of response to good and bad interest rate news after the adoption of SFAS 133 is greater for users of interest rate derivatives with higher interest rate exposure and lower analyst coverage.Practical implications The findings of this study help market participants including regulators and standard setters to understand the impact of mandatory disclosure practices on investors' reaction to macroeconomic news. Moreover, the findings of the study help managers to understand the influence firm-specific characteristics (e.g. earnings volatility, analyst coverage and interest rates exposure) on the effectiveness of mandatory derivative instruments and hedging activities disclosure.Originality/value To the best of the authors' knowledge, this is the first paper to explore how firm-specific information environment affects the way investors process macroeconomic news. This study contributes to the literature by providing the empirical evidence that derivatives instruments and hedging activities, as required by SFAS 133, affect investors' response to good and bad interest rate news. In doing so, the results provide insights about how firm-specific information environment affects the way investors process macroeconomic news. This study shows that the cross-sectional variation in earnings volatility, analysts’ coverage and interest rate exposure affects the impact of SFAS 133 on investors' response to good and bad interest rate news. The findings are not only the notable addition to the existing literature on the topic but also can aid to market participants including policy makers, regulators, standard setters and managers to understand the influence of firm-specific characteristics on the effectiveness of mandatory derivative instruments and hedging activities disclosure. Finally, the findings contribute to the general debate about the effectiveness of SFAS 133 by showing that the adoption of SFAS 133 indeed decreases information ambiguity.

American Enterprise Institute Roundtable: Government Policies Reshape the Banking System

The U.S. federal government response to the 2008 financial crisis, including new laws, prudential regulations, and Federal Reserve monetary policies, has left a lasting impact on the U.S. banking industry. Along with a nearly 50% drop in the number of independent depository institutions since 2000, the industry has become much more concentrated in a few large “systemically important” institutions. At the same time, the largest banks have responded to incentives provided by increased regulatory requirements and the Fed's zero interest rate policy by reducing their lending to the private sector and increasing both their real estate holdings and their reliance on deposits to fund them.For the five well‐known banking scholars who take part in this AEI‐organized discussion, such recent changes have troubling consequences for both the industry and the broader economy. After economic historian Richard Sylla describes a 100‐year movement of U.S. banking toward a system characterized by a few large banks with extensive branch systems, bank authority Alex Pollock points to the growing role and influence of the Federal Reserve and government‐sponsored enterprises in the “banking credit system.” And bank consultant Bert Ely points to a number of large and growing industry risks. Along with their unprecedented real estate holdings, Ely notes the massive holdings of U.S. government debt by both the Fed—which is identified as having an enormous interest rate mismatch and exposure—and the banks it supervises. At the same time, low interest rates have been squeezing banks’ margins and reducing their capital cushions to absorb losses that may arise from the pandemic.Charles Calomiris, who recently stepped down as Chief Economist of the OCC, views such extreme consolidation as an unhealthy trend—one that, along with banks’ growing dependency on deposits (and hence government guarantees and support) and reliance on real estate lending have become the main components of a “three‐legged stool” that are making large banks and banking systems throughout the world ever more subject to government influence. As a result of such dependence, the U.S. banking system is becoming more vulnerable to economy‐wide “shocks” such as the expected effects of a sharp increase in interest rates or a sudden plummeting of real estate prices. As Calomiris argued in his famous book (with Stephen Haber), U.S. banks—and indeed banks in most nations, thanks to “political bargains” with their governments that seem inevitable—appear to be becoming ever more “fragile by design.”

Early evidence on the performance of hedged exchange traded funds

ABSTRACT This study provides early evidence on the performance of Hedged Exchange Traded Funds (HETFs), which were introduced around 2006. These securities track and enable retail investors to access two hedge fund strategies: global macro and long/short equity. Using monthly data of HETFs that survived until December 2017, the paper shows that most of the individual HETFs and HETF portfolios have significant tracking error risk; despite the survivorship bias, the sample of HETFs fails to produce positive average returns and underperforms both 1-month T-bill and S&P500. Moreover, their alphas adjusting for multiple risk factors related to hedge fund returns were negative. We further find that adding individual HETFs and HETF portfolios could not improve the Shape ratios of traditional stocks and/or bonds portfolios, suggesting that HETFs themselves have high market and interest rate exposures.

The Transmission of Monetary Policy under the Microscope

We investigate the transmission of monetary policy to household consumption using administrative data on the universe of households in Norway. On the basis of identified monetary policy shocks, we estimate the dynamic responses of consumption, income, and saving along the liquid asset distribution of households. For low-liquidity but also for high-liquidity households, changes in disposable income are associated with a sizable consumption reaction. The impact consumption response is closely linked to interest rate exposure, which is negative at the bottom but positive at the top of the distribution. Indirect effects of monetary policy gradually build up and eventually outweigh the direct effects.

The interest rate exposure of euro area households

We estimate the “unhedged interest rate exposure” (URE) of euro area households. The URE, defined by Auclert (2019), is a welfare metric that captures the extent to which households are exposed to changes in real interest rates, and allows an assessment of the redistributive effects associated with monetary policy decisions.We examine the distribution of UREs along the net wealth, income, age and housing status distributions for the euro area as a whole and for individual countries, and document substantial heterogeneity across these dimensions. Households at the lower end of the net wealth distribution, younger households and mortgagors have negative interest rate exposure and would lose out from an increase in interest rates, all else being equal. Wealthy households, higher income and older households, as well as outright homeowners would stand to benefit.The heterogeneity of exposures across euro area countries is largely attributable to the differences in the prevalence of adjustable rate mortgages (ARMs). Averaging across households in euro area countries, households in Austria, Germany, Italy and Malta stand to benefit from an increase in the interest rate, whereas households in Cyprus, Ireland, the Netherlands, Portugal and Spain would lose out.

The use of swaps by local administrations: the case of Italian regions, 2007–2014

PurposeThis study contributes to the literature on local administrations' debt and attempts to answer the following research questions: (1) What effects do swaps produce on regions' debt? (2) Have swaps been used to finance discretionary debt?Design/methodology/approachThe paper investigates the debt burden as influenced by economic, financial and political variables and forces with panel data techniques, and tests whether swaps have been used to financing debt due to unfunded expenditures.FindingsPanel data results of 15 Italian regions over the 2007–2014 period shows that regions with higher debt exhibited a higher interest rate exposure and have employed derivatives hoping to counterbalance the reduced resources received from the central state, in line with other European countries' experience (i.e. France and Greece).Research limitations/implicationsThe scarcity of official data and information on swaps has limited the empirical investigations in the literature but did not reduce the losses of local administrations.Originality/valueThis study creates the first database on swaps purchased by Italian regions to investigate their impact on their debt. Results show that highly indebted regions with reduced funds from the central state and diminished local resources are more likely to use swaps to fund their debt. Italian regions heavily depended on long-term debt to finance their non-healthcare services, rather than current revenues; swaps have been used to finance discretionary (non-healthcare) debt.

Interest Rate Exposure and Stocks Returns during Global Financial Crisis: Evidence from Islamic and Conventional Markets

This study aims to assess the impact of interest rate change on stocks returns and volatility of Islamic and Conventional stock market indices during global financial crisis for the period from 04 January, 2005 to 30 December, 2015.The stock indices of China (SSE), India (BSE) and Pakistan (PSE) as conventional, and Malaysia (DJIM), Indonesia (JKII) and Dow Jones World Islamic Index (DJWI) (Benchmark) as Islamic markets are employed into consideration, respectively. The volatility and conditional correlation are examined through GARCH (1, 1) and Multivariate-DCC GARCH, respectively. The results indicate that Islamic stock indices had low interest rate exposure and less stocks volatility than that of conventional stock indices during the global financial crisis period. This research has important implication for investors that they may consider Islamic stock markets as a safe haven during financial crises.

The Effects of Exchange Rate and Interest Rate Exposure on the Stock Returns and Volatility of Turkish Insurance Companies

This study examines the impact of exchange rate and interest changes on stock returns and volatility of Turkish insurance companies using the EGARCH model for the period of 01/01/2009 to 15/04/2020. The results show: (i) while interest rate has a negative and significant effect on the conditional stock return, its effect on the volatility of stock returns of insurance companies is limited; (ii) however, the exact opposite is true for the exchange rate risk. The exchange rate risk exerts an important impact on the volatility of insurance stock returns but it has no effect on the mean stock returns of insurance companies; (iii) the findings also indicate that the volatility of insurance stock returns are highly persistent over time and they are more sensitive to old news than recent surprises; (iv) positive and negative news have an asymmetric effect on volatility implying that positive innovations (good news such as a market) have a larger impact on current conditional variance (current volatility of returns) than negative innovations (bad news such as market stagnation) of the same magnitude; (v) finally, the volatility of insurance portfolio’s and insurance companies’ stock returns has risen significantly during the financial crisis of 2008 compared to the rest of the sample period.

Household balance sheet channels of monetary policy: A back of the envelope calculation for the euro area

This paper formulates a back of the envelope approach to study the effects of monetary policy on household consumption expenditures. We analyze several transmission mechanisms operating through direct, partial equilibrium channels—intertemporal substitution and net interest rate exposure—and indirect, general equilibrium channels—net nominal exposure, as well as wealth, collateral and labor income channels. The strength of these forces varies across households depending on their marginal propensities to consume, their balance sheet composition, the sensitivity of their own earnings to fluctuations in aggregate labor income, and the responsiveness of aggregate earnings, asset prices and inflation to monetary policy shocks. We quantify all these channels in the euro area by combining micro data from the HFCS and the EU-LFS with structural VARs estimated on aggregate time series. We find that the indirect labor income channel and the housing wealth effect are strong drivers of the aggregate consumption response to monetary policy and explain the cross-country heterogeneity in these responses.

The Transmission of Monetary Policy under the Microscope

We investigate the transmission of monetary policy to household consumption using administrative data on the universe of households in Norway. Based on identified monetary policy shocks, we estimate the dynamic responses of consumption, income, and saving along the liquid asset distribution of households. For low-liquidity but also for high-liquidity households, changes in disposable income are associated with a sizable consumption reaction. The impact consumption response is closely linked to interest rate exposure, which is negative at the bottom but positive at the top of the distribution. Indirect effects of monetary policy gradually build up and eventually outweigh the direct effects.

Consumption Heterogeneity: Micro Drivers and Macro Implications

This paper explores the microfoundations of consumption models and quantifies the macro implications of consumption heterogeneity. We propose a new empirical method to estimate the response of consumption to permanent and transitory income shocks for different groups of households. We then apply this method to administrative data from Denmark. The large sample size, along with detailed household balance sheet information, allows us to finely divide the population along relevant dimensions. We find that households that stand to lose from an interest rate hike are significantly more responsive to income shocks than those that stand to gain. Following a 1-percentage-point interest rate increase, we estimate that consumption growth decreases by a 1/4 percentage point through this interest rate exposure channel alone, making this channel substantially larger than the intertemporal substitution channel that is at the core of representative agent New Keynesian models.

How do firms manage their interest rate exposure?

PurposeThis paper aims to identify how non-financial firms manage their interest rate (IR) exposure. IR risk is complex, as it comprises the unequal cash flow and fair value risk. The paper is able to separate both risk types and investigate empirically how the exposure is composed and managed, and whether firms increase or decrease their exposure with derivative transactions.Design/methodology/approachThe paper examines an unexplored regulatory environment that contains publicly reported IR exposure data on the firms’ exposures before and after hedging. The data were complemented by indicative interviews with four treasury executives of major German corporations, including two DAX-30 firms, to include professional opinions to validate the results.FindingsThe paper provides new empirical insights about how non-financial firms manage their interest rate exposure. It suggests that firms use hedging instruments to swap from fixed- to floating-rate positions predominantly in the short-to medium-term, and that 63 [37] per cent of IR firm exposure are managed using risk-decreasing [risk-increasing/-constant] strategies.Practical implicationsInterviewed treasury executives suggest that the advanced disclosures benefit various stakeholders, ranging from financial analysts and shareholders to potential investors through more meaningful analyses on firms’ risk management activities. Further, the treasury executives indicate that the new data granularity would enable firms to carry out unprecedented competitive analyses and thereby benchmark and improve their own risk management.Originality/valueThe paper is the first empirical study to analyze the interest rate activities of non-financial firms based on actually reported exposure data before and after hedging, rather than using proxy variables. In addition, the new data granularity enables a separate analysis of the cash flow and fair value risk to focus on the non-financial firms’ requirements.

Interest rate exposure of European insurers

This paper focuses on analysing the sensitivity and behaviour of some of the leading insurers currently operating in the Euro area to changes in benchmark interest rates. The methodology used is the Quantile Regression (QR) approach and the period analysed covers from 2003 to 2015 around the recent global financial crisis. The empirical results show that European insurance market returns have a statistically significant sensitivity to interest rate variations and that there are important differences according to the period analysed, being the sensitivity most pronounced in extreme market conditions.

The Strategic Use of Swaps by Italian Regions

Swaps have been extensively employed by Governments and local administrations to manage their debt and related costs, but the financialisation of the public sector had insufficient attention in the literature. This study creates the first database on swaps underwritten by Italian regions to investigate their impact on total debt and their strategic use, i.e., impact on discretional debt. Panel data results show that regions with higher debt exhibit a larger interest rate exposure and have employed derivatives for strategic purposes in attempts to counter balance the reduced resources received from the central state, in line with other countries’ experience. Implications of results for regulators and governance of risks are provided.

Exchange Rate Risk in the U.S. Stock Market: A Pooled Panel Data Regression Approach

This paper focuses on revisiting an old issue by advanced econometrics analysis: the risks in the U.S. stock market. We analyze the firm's exposure to exchange rate, interest rate, and market shocks by the pooled regression with the error cross-section dependency. We not only examine the exchange market, and interest rate exposure to U.S. firm values in 396 samples, but we also investigate those patterns to the firms within each of the 10 specific industries by which way we may detect the direction of capital flows before and after two well-known financial crises that occurred in 2001 and 2008. All empirical results show the significant industry-specific sensitivity to these three risks which are in marked contrast to the findings that have been assessed thus far in current literature. Our results indicate: (i) in which industry the capital flows go (industry-specific effect) before and after crises; (ii) which currency, market index, and interest rate play a more important role in the sensitivity to U.S. firm stock returns before and after crises; and (iii) the prospect on hedging portfolio setting for investors before and after crises, which is consistent with the finding of Campbell {it et al.} (2010) and Lusting {it et al.} (2011).

Interest rate derivatives and risk exposure: Evidence from the life insurance industry

Our primary aim in this study is to determine the relation that exists between the use of interest rate derivatives by public-traded life insurance firms and their exposure to interest rate risk. Based upon the annual reports and 10-K filings of US life insurers, covering the years 2000–2016, we find that those insurers with greater inherent exposure to interest rate risk also have a propensity for extensive engagement in the use of interest rate derivatives. We further reveal that life insurers with a propensity for the extensive use of such instruments during the 2000–2009 sub-period tend to have greater observable exposure to interest rate risk. However, during the 2010–2016 sub-period life insurers that use more interest rate derivatives tend to have smaller interest rate exposure. Since restructuring the balance sheet of a life insurer is costly, our results suggest that managers probably use derivatives as a means of modifying their risk tolerance to achieve the same results of direct duration matching.

Does interest rate exposure explain the low-volatility anomaly?

Abstract We show that part of the outperformance of low-volatility stocks can be explained by a premium for interest rate exposure. Low-volatility stock portfolios have negative exposure to interest rates, whereas the more volatile stocks have positive exposure. Incorporating an interest rate premium explains part of the anomaly. We also find that the interest rate risk premium in equity markets exhibits time variation similar to bond markets, but that the level of the interest rate premium, as estimated from the cross-section of stocks, is much higher than the premium observed in the bond market.