Market, Interest Rate and Exchange Rate Risk Effects

Market, Interest Rate and Exchange Rate Risk Effects -...

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Quantitative and Qualitative Analysis in Social Sciences Volume 3, Issue 2, 2009, 44-68 ISSN: 1752-8925 Market, Interest Rate and Exchange Rate Risk E f ects on Financial Stock Returns: A GARCH-M Approach John Beirne a Guglielmo Maria Caporale b Nicola Spagnolo c European Central Bank Brunel University, London Brunel University, London Brunel University, London Abstract In this paper we examine the sensitivity of nancial sector stock returns to market, interest rate, and exchange rate risk in three nancial sectors (Banking, Financial Services and Insurance) in 16 countries, including various European economies, the US and Japan. We also test for the presence of causality-in-mean and volatility spillovers. The econometric framework is a four-variate GARCH-in- mean model, which incorporates long- and short-term interest rates in turn. We nd in most cases a signi cant positive e f ect of stock market returns on mean returns in each sector; by contrast, interest rates and exchange rates have a signi cant e f ect (negative and mixed, respectively) in a fewer number of cases. As for the three types of risk, these are found to play a role mainly in the nancial services sector, but with no clear sign pattern. Finally, most cases of volatility spillovers occur from market return to sectoral returns in the insurance and banking sector in European economies, though there are also some instances of interest rate and exchange rate spillovers, both in Europe and the US. JEL Classi cations : C32, G12. Keywords : Exchange rate, interest rate, multivariate GARCH, volatility. a Centre for Empirical Finance, Brunel University, London; European Central Bank, Kaiserstrasse 29, Frankfurt am Main, 60311, Germany; email: john.beirne@ecb.int b Corresponding author. Centre for Empirical Finance, Brunel University, Middlesex, UB8 3PH, UK; tel.: +44 (0) 1895 266713, email: guglielmo-maria.caporale@brunel.ac.uk c Centre for Empirical Finance, Brunel University, Uxbridge, Middlesex, UB8 3PH, UK; tel.: +44 (0) 1895 266536, email: nicola.spagnolo@brunel.ac.uk © qass.org.uk
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45 1 Introduction Our aim is to investigate the sensitivity of stock returns to both interest and exchange rate risk in a number of European countries (including both EMU and non-EMU economies), as well as in the US and Japan. Both types of risk in recent years have attracted the attention of financial managers, agents, and policy makers in addition to academics. The latter type has become more important over time, as a result of the advent of flexible exchange rates in the 1970s, and the much higher degree of integration of financial markets. Its relevance was first highlighted in an equilibrium asset pricing context by Solnik (1974), who also showed that hedging or a short position in foreign bonds could reduce it. In the case of the member countries of the European Monetary Union (EMU) exchange rate exposure has presumably decreased since the introduction of a common currency (the euro) in January 1999. We
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