Unexpected Changes In Interest Rates Research Articles

An Assessment of Bank Financial Management in Lieu of Measuring and Managing Interest Rate Risk Case Study of BFFSL

Unexpected changes in interest rates can significantly alter a bank’s profitability and market value of equity. Interest rate risk encompasses this volatility. Depending on the cash flow characteristics of the Bank’s assets and liabilities, interest rate changes may raise or lower net interest income and the market value of assets and liabilities.

High-Frequency Identification of Monetary Non-Neutrality: The Information Effect*

We present estimates of monetary non-neutrality based on evidence from high-frequency responses of real interest rates, expected inflation, and expected output growth. Our identifying assumption is that unexpected changes in interest rates in a 30-minute window surrounding scheduled Federal Reserve announcements arise from news about monetary policy. In response to an interest rate hike, nominal and real interest rates increase roughly one-for-one, several years out into the term structure, while the response of expected inflation is small. At the same time, forecasts about output growth also increase|the opposite of what standard models imply about a monetary tightening. To explain these facts, we build a model in which Fed announcements affect beliefs not only about monetary policy but also about other economic fundamentals. Our model implies that these information effects play an important role in the overall causal effect of monetary policy shocks on output.

Do Interest Rates Affect the Exchange Rate Under Capital controls? An event study of Iceland’s experience with capital controls

We study Iceland’s experience with capital controls, in particular whether changes in the central bank’s policy rate affected the exchange rate under the capital control regime from 2009 to 2015.We find that both actual changes and unexpected changes in interest rates may have affected the exchange rate when the year 2009 is included in a sample that ends in August of 2015, but not when it is excluded. This early period was characterized by lax capital controls until November of 2009. It follows that, based on the experience of the moderate changes of interest rates observed in the data, changes in interest rates may affect the exchange rate when capital controls are not effectively enforced but will have a small, if any, effect when they are enforced. It should be noted that the results are based on the experience of moderate interest rate changes during this time period. Moreover, interest rates affect other variables, such as aggregate demand and the rate of wage inflation.

Interest and Inflation Risk: Investor Behavior.

We examine investor behavior under interest and inflation risk in different scenarios. To that end, we analyze the relation between stock returns and unexpected changes in nominal and real interest rates and inflation for the US stock market. This relation is examined in detail by breaking the results down from the US stock market level to sector, sub-sector, and to individual industries as the ability of different industries to absorb unexpected changes in interest rates and inflation can vary by industry and by contraction and expansion sub-periods. While most significant relations are conventionally negative, some are consistently positive. This suggests some relevant implications on investor behavior. Thus, investments in industries with this positive relation can form a safe haven from unexpected changes in real and nominal interest rates. Gold has an insignificant beta during recessionary conditions hinting that Gold can be a safe haven during recessions. However, Gold also has a consistent negative relation to unexpected changes in inflation thereby damaging the claim that Gold is a hedge against inflation.

Can US Stocks Provide a Safe Haven from Interest and Inflation Risk? A Sector Level Examination of the Response to Unanticipated Nominal, Real Interest and Inflation Rate Shocks

This paper examines the relation between stock returns and unexpected changes in nominal and real interest rates and inflation for the US stock market. With the exception of Sweeney and Warga (1986), we are the first to examine this relation in detail by breaking the results down from the US stock market level to sector, sub-sector and to individual industries as the ability of different industries to absorb unexpected changes in interest rates and inflation can vary by industry and by time period. Unlike Sweeney and Warga (1986), we also look for stability in the relations by examining them by sector during contraction and expansion sub-periods throughout a long time period, from September 1989 to February 2014. While most significant relations are conventionally negative, some are consistently positive. Specifically, we find that Integrated Oil and Gas, Commercial Services and Supplies and Diversified Metals and Mining have a consistent significant positive relation between stock returns and unexpected changes in real interest rates while Diversified Metals and Mining has a significant consistently positive relation between stock returns and unexpected changes in nominal interest rates. This suggests that investments in these industries can form a safe haven from unexpected changes in real and nominal interest rates respectively. Interestingly, we find that Gold has an insignificant beta during recessionary conditions hinting that investments in the Gold industry can indeed be a safe haven during recessions. However, Gold also has a consistent negative relation to unexpected changes in inflation thereby damaging the claim that an investment in Gold is a hedge against inflation.

Interest rate sensitivity of US property/liability insurer stock returns

PurposeThe purpose of this study is to investigate interest rate sensitivity of the US property/liability (P/L) insurers stock returns using various return generating process models incorporating different interest rate changes such as actual interest rate changes, unexpected interest rate changes and orthogonalized market returns.Design/methodology/approachThe study follows the 1974 two‐index model by Stone. In the two‐index model, three different interest rate indices are tested one at a time to examine if interest rate sensitivity of the insurers stock returns, if any, is vulnerable to an interest rate index used.FindingsIt is found that the US P/L insurers' stock returns are sensitivity to interest rate changes. The impact of actual interest rate changes on the stock returns is little different from that of unexpected interest rate changes, which is consistent with findings in the banking literature. When orthogonalized market returns are used in the models in lieu of actual market returns, the statistical significance on the estimated interest rate sensitivity of the returns improves. Consistent with extant studies of financial institution's interest rate sensitivity, the paper also reports that the interest rate sensitivity of insurer stock returns is time varying.Research limitations/implicationsDue to the data availability, the period studied is between 1992 and 2001. However, the sample period does not weaken the findings of the study. In addition, future research could incorporate the insurers' balance sheet items to investigate which balance sheet items (i.e. investment in bonds, stocks and other items on asset side and reserves and other items on liability side) explain most interest rate sensitivity.Practical implicationsInvestors can adopt the findings of this study in creating or adjusting their portfolio with the US P/L insurers in it. The insurers stock returns are more sensitive to changes in long‐term interest rate when the underwriting profit increases and the stock returns are more sensitive to changes in short‐term interest rate when the underwriting profit decreases.Social implicationsAlthough generalization is difficult and the conclusion is not as convincing as it could be because only one underwriting cycle is sampled, it is still noteworthy to recognize that the insurers' interest rate sensitivity is closely related to the insurance industry's underwriting cycle or performance.Originality/valueThis is the first study reporting the association between the interest rate sensitivity of the US stock returns and the underwriting performance.

Monetary policy shocks and stock returns: evidence from the British market

This paper examines the impact of anticipated and unanticipated interest rate changes on aggregate and sectoral stock returns in the United Kingdom. The monetary policy shock is generated from the change in the 3-month sterling LIBOR futures contract. Results from time-series and panel analysis indicate an important structural break in the relationship between stock returns and monetary policy shifts. Specifically, whereas before the credit crunch, the stock market response to both expected and unexpected interest rate changes is negative and significant; the relationship becomes positive during the credit crisis. The latter finding highlights the inability, so far, of monetary policymakers to reverse, via interest rate cuts, the negative trend observed in stock prices since the onset of the credit crisis.

The Power of the Euro–Sterling Rates in Explaining Asset Market Rates: A High‐frequency Analysis

This article makes use of high‐frequency asset market data to explain unexpected changes in interest rates using the methodology proposed by Cochrane and Piazzesi (2002). This work departs from the existing literature because it uses UK market expectations to capture unexpected movements in the base rate, and explores its effect on a large number of asset market variables. Results indicate that the relation between asset market data and unexpected base rate changes is stronger and more consistent than the relation between asset market data and raw base rate changes. Results appear to be robust to extreme value changes.

Stock Market Sensitivity to U.K. Firms' Pension Discounting Assumptions

AbstractNew U.K. pension accounting regulations significantly increase the exposure of the balance sheets of U.K. firms to volatilities in pension fund valuations. We examine whether the abnormal returns of firms that voluntarily used market‐based pension discount rates are significantly different from the abnormal returns of industry‐matched pair samples of firms that retained traditional cost‐based valuation assumptions during the period surrounding the release of the related exposure draft. We also examine the interest rate sensitivity of stock price returns over the 4‐year period before and after the announcement date. Consistent with our hypotheses, U.K. stock price returns incorporate the effect of unexpected interest rate changes on sources of pension earnings for firms that voluntarily switched to market‐based assumptions but do not incorporate these effects for firms that did not switch. These results suggest that unexpected changes in interest rates have a differential effect on a firm's sources of pension, financial, and core earnings.

Equity returns of financial institutions and the pricing of interest rate risk

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 a...

Do Emerging Financial Markets React to Monetary Policy Announcements? The Case of Poland

This paper provides evidence on the short-run reactions of an emerging financial market to monetary policy announcements. We employ an instrumental variable estimation approach based on the identification through heteroscedasticity technique to estimate the impact of nominal and unexpected official interest rate changes on asset prices in Poland. The new methodology controls for possible feedback relations between financial variables and the official interest rate changes. The measures of unexpected interest rate changes are extracted from the implied forward interest rates on the money market. In the analysis, the short-term interest rates respond significantly to the official interest changes, but neither the long-term interest rates, stock indices, nor foreign exchange rates react to monetary announcements in the expected direction. The unexpected monetary policy changes have stronger influence on the money market than the nominal changes in the official interest rate on the days of the monetary policy announcements.

Reporting Fair Value Interest and Value Changes on Financial Instruments

AAA Financial Accounting Standards Committee INTRODUCTION The Joint Working Group of Standard Setters' (JWG 2000) Recommendations on Accounting for Financial Instruments and Similar Items (hereafter the Proposal) requires that all changes in the fair value of financial instruments be reported in the income statement, except those associated with certain foreign exchange transactions. The Proposal also requires that the interest and the gain or loss components of these changes in fair value be separately classified on the income statement, and it provides some guidance for calculating these components. Specifically, firms must record interest on a yield to maturity basis, with interest revenue (expense) on a financial asset (liability) being calculated as the current interest rate times the fair value of the instrument during the period. This approach differs from the current amortized cost accounting for interest. Assuming that the total changes in the fair value of financial instruments during the period are recognized in some fashion on the income statem ent, this difference in interest results in exactly the opposite difference in unrealized gains and losses. This commentary summarizes the position of the Financial Accounting Standards Committee of the American Accounting Association (hereafter the Committee) on the Proposal's fair value interest approach. (1) In particular, we compare the relative merits of the fair value and amortized cost approaches to interest. Our discussion assumes that the total changes in the fair value of financial instruments are recognized in some fashion on the income statement each period, so that the only issue is the classification of the components of those changes in fair value. The Committee is not aware of any empirical research that relates specifically to the relative desirability of the fair value and amortized cost approaches to measuring interest. However, empirical evidence supports the importance of reporting items separately with different sustainability and different certainty. By sustainability, we mean that an item persists over time, on average. A sustainable item could be uncertain, however, in that ex post its persistence may be higher or lower than expected. This evidence suggests that the preferred income statement reporting of the total periodic return to a financial instrument is to aggregate income components with similar sustainability and certainty. (2) Conceptually, the periodic returns to financial instruments can be separated into three components with distinct sustainability or certainty. The first two components- amortized cost interest and the difference between fair value interest and amortized cost interest--sum to fair value interest. It is useful to distinguish these two components of fair value interest because amortized cost interest is both sustainable and certain, whereas the difference between fair value interest and amortized cost interest is sustainable but uncertain. The difference between fair value interest and amortized cost interest is sustainable because unexpected changes in interest rates and the resulting unexpected changes in fair values affect fair value interest calculations throughout the remaining lives of financial instruments. For example, an unexpected gain on a financial asset due to a decrease in interest rates in the current period reduces expected fair value interest revenue on the asset throughout its remaining life. T he third component of the periodic returns to financial instruments is the unexpected change in their fair values during the period. Unexpected changes in the fair values of financial instruments are both unsustainable and uncertain. (3) The amortized cost interest method separately reports the first component--amortized cost interest--but combines the second and third components-the difference between fair value interest and amortized cost interest and the unexpected gain or loss. …

MONEY SUPPLY ANNOUNCEMENTS AND INTEREST SENSITIVE STOCKS

Much of the money announcement literature provides evidence that there is a significant response of nominal interest rates to unexpected changes in the money stock, especially in the October 1979‐October 1982 period. These money announcements provide a proxy for unexpected interest rate changes which can be used in a novel test for the interest sensitivity of stocks. Using the response of disaggregated stock price data to money announcements, we reach two major conclusions. First, that the interest rate response observed in the money announcement literature was predominantly a change in real rates. Second, an unusual group of stocks are excessively sensitive to these real rate changes and many groups of stocks that might logically have been expected to be sensitive are not.

Measuring Risk in Fixed Payment Securities: An Empirical Test of the Structured Full Rank Covariance Matrix

The appropriate set of parameters determining the volatility of the value of a portfolio of fixed cash flows of arbitrary maturities is the covariance matrix of unexpected interest rate changes over the term. Equilibrium models of the term structure limit the rank of the covariance matrix and implicitly impose restrictions on covariance estimation. The “full information” approach to risk measurement imposes only time stationarity assumptions on covariance matrix estimators and can result in sample matrices of full rank. Hilliard and Jordan (1989) develop a structured full rank covariance matrix that depends on only two parameters. This paper tests the Hilliard-Jordan model using likelihood ratios and criteria of forecast accuracy.

Dedicated stock portfolios

T he Markowitz portfolio model introduced in 1952 expressed the optimal relationship between portfolio volatility and expected return. While tlie procedure was quite capable of providing perfectly accurate answers to questions such as, “Given a population of securities, what single combination would have had the lowest volatility in monthly return over the preceding period?”, the computing power of the times limited its application. A decade later, Sharpe introduced the singleindex model [1963]. In essence, Sharpe’s model replaced the exact, but cumbersome, Markowitz formula for portfolio volatility with a simplified approximation that assumed all the interrelationships among security returns could be attributed to the fact that they all respond differentially to the pull of the single index. Sharpe represented his single index by the returns to the market itself, but others (King [1966], for example) soon provided evidence that other common forces were pulling security returns as well. King at the time noted industry-related factors, but since then attention has shifted from aggregate stock marketor industry-related portfolios to more generalized economic factors. In some models the factors are real (economic variables such as unexpected changes in inflation, industrial production, and term and default premiums in bond yields see Chen, Roll, and Ross [1986]), while in others they are portfolios, derived from factor analysis (Chen [1983]). The factor analytic portfolios allegedly mimic the behavior of the underlying economic variables actually responsible for the correlations between security returns. Index models that initially were regarded as routes to a simplified expression for portfolio volatility eventually became widely accepted as ways to track targets such as the S&P 500. But times have changed since 1952. There have been significant advances in computing hardware and in the algorithms to compute portfolio volatility (Von Holhenbalken (19751). Analysts are now fully capable of obtaining Markowitz solutions for several hundred securities at a time, which makes the relative computational simplicity of index models less valuable. The latest advances in hardware and software now make it possible to construct dedicated stock portfolios based on all the information in the full covariance matrix of security returns. These portfolios are dedicated to a mission of risk management such as hedging against inflation or against unexpected changes in interest rates that may dramatically increase the present value of the liabilities of pension funds. Just as the Markowitz model provides the reactively accurate answer to the minimum volatility question posed above, it also provides the more accurate answer to the question, “Which combination of securities would have achieved the greatest degree of tracking power in the past?” While the relative predictive power of the Markowitz and index models remains an open question (and one that obviously

Underpricing of Newly Issued Bonds: Evidence from the Swiss Capital Market

ABSTRACTThe pricing of newly issued bonds on the Swiss capital market is investigated over the years 1980–1982. The results reveal a slight underpricing of new bonds at the issue date that is roughly equal to the difference in transactions costs between the markets for new and seasoned bonds. Underpricing is no longer observed when the new bonds start to be traded on the stock exchange, that is, after about two days. Tests of several hypotheses show that unexpected changes in interest rates over the offering period explain part of the underpricing.

INTEREST RATE RISK AND EQUITY VALUES OF HEDGED AND UNHEDGED FINANCIAL INTERMEDIARIES

AbstractThis paper uses an approach developed by Flannery and James to show that interest rate changes have different effects on equity values of hedged and unhedged financial institutions. Equity values of (generally unhedged) savings and loans are significantly more sensitive to unexpected interest rate changes than equities of (generally hedged) commercial banks. The interest rate sensitivity of (generally hedged) life insurance equities is similar to that of bank equities. Overall, the equity values of unhedged financial institutions are more sensitive to interest rate changes than the equity values of financial institutions that more closely balance the maturities of their assets and liabilities.

The effects of a shift in monetary policy regime on the profitability and risk of commercial banks

This paper examines the effects of the Fed's October 6th, 1979 change in monetary policy regime on the profitability and risk of commercial banks. Using capital market data and an event study methodology it was found that bank stocks exhibited significant abnormal returns during the announcement week of the policy change. When these abnormal returns were decomposed into a part related to unexpected interest rate changes and a part (assumed) to reflect increased rate variability, the results were consistent with a negative relationship between bank returns and interest rate surprises as well as between bank returns and rate variability.

A Dynamic Global Portfolio Immunization Strategy in the World of Multiple Interest Rate Changes: A Dynamic Immunization and Minimax Theorem

man [5], and Khang [9] demonstrate that it is possible to immunize a portfolio of default-free assets against unexpected interest rate changes so that at the end of the planning period the investor will realize at least the returns expected at pur? chase. However, this immunization strategy is applicable for the case in which the change in unexpected interest rate occurs only once at the instant after the purchase of the asset. Obviously, the case depicted above is not likely to resemble the real world situation in at least two respects. First, the interest rate change is likely to occur at any time and, second, the interest rate change is likely to occur many times during the investor's planning period. Bierwag [4] deals with the case in which the interest rate change may occur many times during the planning period, each occurring at the instant after the beginning of each time period, and shows that, provided the interest rate changes are small, the investor can, at the end of the planning period, realize the returns expected at purchase by constructing the portfolio whose duration at the begin? ning of each period is equal to the length of the remaining planning period. Thus, Bierwag's [4] immunization theorem is a local theorem. Bierwag makes a conjecture that the theorem is not likely to hold true globally. This paper shows that the strategy of keeping the portfolio duration, calcu? lated on the basis of the term structure observed at each moment of time, equal to the length of the remaining planning period during the entire planning period, guarantees at least the returns expected (or promised) at purchase, regardless of when and how many times interest rate changes occur during the planning period and regardless of sizes of change in the interest rate structure. Thus, the theorem proven in the paper is a global theorem in a very general setting as opposed to Bierwag's [4] local theorem. A corollary is that Bierwag's unconditional im? munization policy does not immunize unless all changes in the term structure are * University of Oregon. The author expresses thanks to an anonymous referee whose careful reading of the paper resulted in an improvement.

Bond Immunization When Short-Term Interest Rates Fluctuate More than Long-Term Rates

In an important article in 1971, Fisher and Weil [4] demonstrated that it is possible to immunize a portfolio of default-free coupon bonds against unexpected interest rate changes so that at the end of the planning period the investor will realize at least the return expected at purchase. Immunization may be achieved by constructing a portfolio whose average duration is equal to the length of the investor's planning period. The computation of duration that produces immunization is dependent on the nature of the assumed stochastic interest rate shocks. Fisher and Weil derive the duration that will produce immunization for additive shifts in the yield curve under instantaneous compounding, e.g., g(t) + λ where g(t) is the instantaneous interest rate at time t and λ is a random shift parameter.