Exploring the market risk profiles of US and European stock insurers

Market risks account for an integral part of insurers' risk profiles. We explore market risk sensitivities of insurers in the United States and Europe. Based on panel regression models and daily market data from 2012 to 2018, we find that sensitivities are particularly driven by insurers' product portfolio. The influence of interest rate movements on stock returns is 60% larger for US than for European life insurers. For the former, interest rate risk is a dominant market risk with an effect that is five times larger than through corporate credit risk. For European life insurers, the sensitivity to interest rate changes is only 44% larger than toward credit default swap of government bonds, underlining the relevance of sovereign credit risk.     

Bank risk and real estate: An asset pricing perspective

While a number of papers have investigated the time-series behavior ofex post bank stock returns and real estate returns, no study has comprehensively studied the relationship betweenex ante risk premiums on both assetsand the time-varying nature of such premiums in relationship to economic and real estate market conditions. In this study, we investigate how the changing nature of bank risk taking, especially in the real estate market, has affected theex ante pricing of risk in the market for bank stocks. We find that the time variation in bank risk premiums are partly determined by interest rate and real estate market conditions. We also discover that the real estate factor has been important for banks in the 1980s.     

Conditional risk premia in currency markets and other asset classes

The downside risk capital asset pricing model (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly rationalize the cross section of equity, equity index options, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specific asset class fail to jointly price other asset classes.     

EXPECTATIONS,INTEREST RATES,AND COMMERCIAL BANK STOCKS

This study examines the effect of current and expected interest rate changes on bank equity values and attempts to reconcile the conflicting findings of previous research regarding this issue. A multiple index market model of bank security returns is specified and estimated. The results confirm the existence of an interest rate effect on bank stocks that is not explained by returns on the market portfolio. In addition, bank stock returns appear to be sensitive to an interest rate forecast error.     

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.     

Interest rates and risk premia in the stock market and in the foreign exchange market

This paper documents common empirical regularities in the foreign exchange market and in the US stock market. We find that increases in interest rates are associated with predictable increases in the volatility of returns in both markets, and that expected returns both in the stock market and in the foreign exchange market are negatively correlated with nominal interest rates.We show that not taking into account the time variation of second moments may seriously affect tests of asset pricing models. Using a numerical example based on the static capital asset pricing model, we are able to produce fluctuations in risk premia similar to those observed empirically. Finally we show that the overidentifying restrictions of the latent variable capital asset pricing model are not rejected when beats are assumed to be correlated with nominal interest rates.     

Market Risk,Interest Rate Risk,and Interdependencies in Insurer Stock Returns: A System‐GARCH Model

We examine market risk, interest rate risk, and interdependencies in returns and return volatilities across three insurer segments within a System‐GARCH framework. Three main results are obtained: market risk is greatest for accident and health (A&H) insurers, followed by life (Life) and property and casualty (P&C) insurers; interest rate sensitivity is negative and greatest for Life insurers; and interdependencies in returns are significant with the magnitude being strongest between P&C and A&H insurers. The implication is that greatest diversification benefits arise between Life and the other segments of the insurance industry. Market risk and interest rate risk for diversified firms are smaller than those for nondiversified firms for both product and geographic diversification.     

Interest Rate Risk Rewards in Stock Returns of Financial Corporations: Evidence from Germany

The interest rate sensitivity of stock returns of financial and non-financial corporations is a well-known phenomenon. However, only little is known about the part of total stock returns that is attributable to the compensation an investor receives for being exposed to interest rate risk when investing in equity securities. We pursue here a benchmark portfolio approach, constructing benchmark portfolios having the same interest rate risk exposure as a particular stock. By studying the time series of returns of these asset-specific benchmarks, we find: i) Regardless of the industry considered, the interest rate risk benchmarks of German corporations have mostly earned a significantly positive reward. ii) Returns of interest rate risk benchmarks of financial institutions exceeded significantly those of non-financial corporations. iii) An investor willing to bear nothing but the average interest rate risk of German financial institutions would have earned a mean return of about or even exceeding 70% of the corresponding total stock returns. iv) Returns of the interest rate risk benchmarks of the German insurance sector were significantly higher than those of German banks, which seems to contradict conventional market wisdom that insurances hedge interest rate risks.     

INTEREST RATE SENSITIVITY OF BANK STOCK RETURNS: SPECIFICATION EFFECTS AND STRUCTURAL CHANGES

In this paper the interest rate sensitivity of bank stock returns under alternative econometric specifications and the changes in the sensitivity over time are studied. Results indicate that the sensitivity depends on the econometric specification and the period considered. Bank stock returns show a sensitivity to long-term government security returns and innovations, but not to short-term government security returns and innovations except under one specification. Since 1980, banks seem to have reduced their interest rate risk exposure. Finally, while long-term returns are positively associated with stock returns, short-term returns show a positive association only since 1980.     

Bear beta

We test whether bear market risk, time variation in the probability of future bear market states, is priced. We construct an Arrow–Debreu security that pays off in bear market states (AD Bear) from traded Standard & Poor’s (S&P) 500 index options and use its returns to measure bear market risk. We find that bear beta (exposure to bear market risk) has a strong relation with expected stock returns that is robust, persistent, and remains strong among liquid and large stocks. Historical bear beta also predicts future bear market risk exposure. We conclude that bear market risk is priced in the cross section of stock returns.     

The weekend effect on the distribution of stock prices: Implications for option pricing

Evidence of weekend effects on the distribution of security returns suggests that returns are generated by a process operating closer to trading time rather than calendar time. In contrast, accumulation of interest over the weekend follows a calendar-time process. Since both the variance of returns and the interest rate are important parameters of the Black-Scholes option pricing model, this paper suggests that the model be stated to account for this by utilizing a trading-time variance and a calendar-time interest rate. Empirical evidence indicates that this allows the model to better explain market option prices.     

What does futures market interest tell us about the macroeconomy and asset prices?

Economists have traditionally viewed futures prices as fully informative about future economic activity and asset prices. We argue that open interest could be more informative than futures prices in the presence of hedging demand and limited risk absorption capacity in futures markets. We find that movements in open interest are highly pro-cyclical, correlated with both macroeconomic activity and movements in asset prices. Movements in commodity market interest predict commodity returns, bond returns, and movements in the short rate even after controlling for other known predictors. To a lesser degree, movements in open interest predict returns in currency, bond, and stock markets.     

Time-varying market,interest rate,and exchange rate risk premia in the US commercial bank stock returns

This paper examines the role of market, interest rate, and exchange rate risks in pricing a sample of the US Commercial Bank stocks by developing and estimating a multi-factor model under both unconditional and conditional frameworks. Three different econometric methodologies are used to conduct the estimations and testing. Estimations based on nonlinear seemingly unrelated regression (NLSUR) via GMM approach indicate that interest rate risk is the only priced factor in the unconditional three-factor model. However, based on ‘pricing kernel’ approach by Dumas and Solnik [(1995). J. Finance 50, 445–479], strong evidence of exchange rate risk is found in both large bank and regional bank stocks in the conditional three-factor model with time-varying risk prices. Finally, estimations based on the multivariate GARCH in mean (MGARCH-M) approach where both conditional first and second moments of bank portfolio returns and risk factors are estimated simultaneously show strong evidence of time-varying interest rate and exchange rate risk premia and weak evidence of time-varying world market risk premium for all three bank portfolios, namely those of Money Center bank, Large bank, and Regional bank.     

The risk adjusted uncovered equity parity

This paper explores the risk adjusted uncovered equity parity model to investigate a degree of market integration for four Asian emerging markets relative to the U.S., Japan and the U.K. from January 1994 to July 2008. The uncovered equity parity is revised to take into account of market risk in a framework of a portfolio rebalancing model. Evidence was found to strongly support our hypotheses; Market risk is significant in international capital flows between the Asian emerging markets and the developed economies, and it can help explain the failure of a traditional uncovered equity (or interest) parity model. The relationship between returns and an appreciation of the exchange rate are divided between the Asian emerging markets and the developed economies, depending on the direction of capital flows.     

REIT Characteristics and the Sensitivity of REIT Returns

Previous research on the returns to real estate investment trusts (REITs) has considered whether REITs are systematically exposed to general stock-market risk and interest-rate risk. This study examines how the sensitivity of REIT returns to these factors may be influenced by various REIT characteristics. Using a sample of publicly traded REITs, we estimate the sensitivity of REIT returns to stock market and interest-rate changes. We then propose and implement a model for testing whether differences in asset structure, financial leverage, management strategy, and degree of specialization in the REIT portfolios are related to their sensitivity to interest rate and market risk. Our results permit us to offer some inferences about how REITs can alter their risk exposure by managing these characteristics.     

A note on the temporal variability of Canadian financial services stock returns

We show that Financial Services stock returns in Canada are covariance nonstationary with respect to any benchmark variable and vary negatively with interest rate levels. We find that the conditional correlation between financial services stock returns and the market returns varies directly and monotonically with market volatility. This result is robust to monetary regime shifts and other sources of high volatility. These findings, combined with those of Kane and Unal (1988) for the U.S., cast considerable doubt on the constant coefficient Two-Index model and its variants, to provide reliable estimates of usual risk measures.     

Interest Rate Risk of European Financial Corporations

We investigate the interest rate exposure of large European financial corporations' equity returns. For the period from January 1982 to March 1995 we estimate multifactor index models to examine the sensitivity of equity returns to market index returns and domestic as well as global interest rate movements. In addition, we specify an APT‐model to test whether an exposure to interest rate movements is rewarded in the cross‐section of expected returns. In the four European markets both domestic and global interest rate shifts constitute driving forces of stock returns beyond the influence of the domestic market indices. However, the exposure to interest rate movements does not seem to be rewarded in the same fashion among the markets.     

Costly arbitrage and idiosyncratic risk: Evidence from short sellers

Previous studies have shown that high short interest stocks have low subsequent returns. We test whether the persistence of this effect is due to costs limiting arbitrage. The arbitrage cost that we focus on is idiosyncratic risk which, regardless of the arbitrageur’s level of diversification, deters arbitrage activity. Consistent with costly arbitrage, we find that among high short interest stocks a one standard deviation increase in idiosyncratic risk predicts a more than 1% decline in monthly returns. Moreover, idiosyncratic risk does not predict returns across low short interest stocks, and short interest does not predict low returns across low idiosyncratic risk stocks. Our results are robust to commonly used proxies for both transaction costs and short sale constraints.     

Benchmarking Australian fixed interest fund performance: finding the optimal factors

In this paper, we analyse the performance of Australian fixed interest managed funds and assess multiple benchmarks through which such performance can be reliably measured. We examine the effectiveness of seven indices of bond performance, as well as factors impacting on fixed interest asset values and, hence, returns, including interest rate fluctuations, economic fundamentals, maturity risk, default risk and cross‐market influences. We test all combinations of factors in cross‐section and time series to find the optimum benchmark. The results, consistent across time, show that a correct combination of a fund‐based market variable, a mixture of interest rate factors and economic factors as well as a proxy for movements in the equity markets yield the optimal benchmark.     

An empirical analysis of the incentives to engage in costly information acquisition: The case of risk arbitrage

In order for security prices to be informationally efficient, incentives must exist for traders to engage in costly information acquisition. This paper provides empirical evidence on this proposition. We observe that risk arbitrageurs (i.e., market participants who trade in securities of firms that are involved in mergers, tender offers, and voluntary liquidations) are able to generate private information regarding the success or failure of corporate reorganizations. Moreover, risk arbitrageurs earn substantial returns on their trading activities. These results suggest that security prices are sufficiently noisy to create incentives for costly information acquisition.