Skip to main content
SpringerLink
Log in

The relation between stock returns and short-term interest rates

  • Published:
Review of Quantitative Finance and Accounting Aims and scope Submit manuscript

Abstract

This study examines the relation between the expected returns on common stocks and short-term interest rates. Using a two-factor model of stock returns, we show that the expected returns on common stocks are systematically related to the market risk and the interest-rate risk, which are estimated as the sensitivity of common-stock excess returns to the excess return on the equally weighted market index and to the federal fund premium, respectively. We find that the interest-rate risk for small firms is a significant source of investors' portfolio risk, but is not properly reflected in the single-factor market risk. We also find that the interest-rate risk for large firms is “negative” in the sense that the market risk estimated from the single-factor model overstates the true risk of large firms. An application of the Fama-MacBeth methodology indicates that the interest-rate risk premium as well as the market's risk premium are significant, implying that both the market risk and the interest-rate risk are priced. We show that the interest-rate risk premium explains a significant portion of the difference in expected returns between the top quintile and the bottom quintile of the NYSE and AMEX firms. We also show that the turn-of-the-year seasonal is observed for the interest-rate risk premium; however, the risk premium for the rest of the year is still significant, although small in mangitude.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

References

  • Banz, R.W., “The Relationship Between Return and Market Value of Common Stocks,”Journal of Financial Economics, 9, 3–18 (1981).

    Article  Google Scholar 

  • Benston, G., and Hagerman, R., “Determinants of Bid-Ask Spreads in the Over-the-Counter Market,”Journal of Financial Economics, 1, 353–364 (1974).

    Article  Google Scholar 

  • Bhandari, L.C., “Debt/Equity Ratio and Expected Common Stock Returns: Empirical Evidence,”Journal of Finance, 43, 507–528 (1988).

    Google Scholar 

  • Blume, M.E., and Stambaugh, R.F., “Biases in Computed Returns: An Application to the Size Effect.”Journal of Financial Economics, 12, 387–404 (1983).

    Article  Google Scholar 

  • Chan, K.C., and Chen, N., “An Unconditional Asset-Pricing Test and the Role of Firm Size as an Instrumental Variable for Risk,”Journal of Finance, 43, 309–325 (1988).

    Google Scholar 

  • Chan, K.C., Chen, N., and Hsieh, D., “An Exploratory Investigation of the Firm Size Effect,”Journal of Financial Economics, 14, 451–471 (1985).

    Article  Google Scholar 

  • Chen, N., Roll, R., and Ross, S., “Economic Forces and the Stock Market,”Journal of Business, 59, 383–403 (1986).

    Article  Google Scholar 

  • Conrad, J., and Kaul, G., “Time Variation in Expected Returns,”Journal of Business, 61, 409–425 (1988).

    Article  Google Scholar 

  • deJong, D.V., and Collins, D.W., “Explanations for the Instability of Equity Beta: Risk-Free Rate Changes and Leverage Effects,”Journal of Financial and Quantitative Analysis, 20, 73–94 (1985).

    Article  Google Scholar 

  • Dothan, U.L., “On the Term Structure of Interest Rates,”Journal of Financial Economics, 6, 59–69 (1978).

    Article  Google Scholar 

  • Fama, E.F.,Foundations of Finance, New York. Basic Books (1976).

    Google Scholar 

  • Fama, E.F., and MacBeth, J.D., “Risk, Return and Equilibrium: Empirical Tests,”Journal of Political Economy, 71, 607–636 (1973).

    Google Scholar 

  • Fama, E.F., and Schwert, G.W., “Asset Returns and Inflation,”Journal of Financial Economics, 5, 115–146 (1977).

    Article  Google Scholar 

  • Ferson, W.E., Kandel, S., and Stambaugh, R.F., “Tests of Asset Pricing with Time-Varying Expected Risk Premiums and Market Betas,”Journal of Finance, 42, 201–220 (1987).

    Google Scholar 

  • Flannery, M.J., and James, C.M., “The Effect of Interest Rate Changes on the Common Stock Returns of Financial Institutions,”Journal of Finance, 39, 1141–1153 (1984).

    Google Scholar 

  • French, K.R., “Stock Returns and the Weekend Effect,”Journal of Financial Economics, 8, 55–69 (1980).

    Article  Google Scholar 

  • French, K.R., Schwert, G.W., and Stambaugh, R.F., “Expected Stock Returns and Volatility,”Journal of Financial Economics, 19, 3–29 (1987).

    Article  Google Scholar 

  • Gordon, D.A., Gordon, M.J., and Gould, L.I., “The Interest Rate Component of Systematic Risk,”Journal of Accounting, Auditing and Finance (forthcoming).

  • Harris, L., “A Transaction Data Study of Weekly and Intradaily Patterns in Stock Returns,”Journal of Financial Economics, 16, 99–118 (1986).

    Article  Google Scholar 

  • Ho, T.S.Y., and Saunders, A., “A Micro Model of the Federal Funds Market,”Journal of Finance, 40, 977–988 (1985).

    Google Scholar 

  • Huizinga, J., and Mishkin, F., “Inflation and Real Interest Rates on Assets with Different Risk Characteristics,”Journal of Finance, 34, 699–712 (1984).

    Google Scholar 

  • Keim, D.B., “Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence,”Journal of Financial Economics, 12, 13–32 (1983).

    Article  Google Scholar 

  • Keim, D.B., and Stambaugh, R.F., “Predicting Returns in the Stock and Bond Markets,”Journal of Financial Economics, 17, 357–390 (1986).

    Article  Google Scholar 

  • Lo, A.W., MacKinlay, A.C., “Stock Market Prices Do Not Follow Random Walks: Evidence from a Simple Specification Test,”Review of Financial Studies, 1, 47–66 (1988).

    Article  Google Scholar 

  • Merton, R., “An Intertemporal Capital Asset Pricing Model,”Econometrica, 44, 867–887 (1973).

    Google Scholar 

  • Ogden, J.P., “Turn-of-Month Evaluations of Liquid Profits and Stock Returns: A Common Explanation for the Monthly and January Effects,”Journal of Finance (forthcoming).

  • Reinganum, M.R., “Misspecification of Capital Asset Pricing: Empirical Anomalies Based on Earning Yields and Market Values,”Journal of Financial Economics, 9, 19–46 (1981).

    Article  Google Scholar 

  • Roll, R., “Vas ist das? The Turn of the Year Effect and the Return Premium of Small Firms,”Journal of Portfolio Management, 9, 18–28 (1983a).

    Article  Google Scholar 

  • Roll, R., “On Computing Mean Returns and the Small Firm Premium,”Journal of Financial Economics, 12, 371–386 (1983b).

    Article  Google Scholar 

  • Ross, S., “The Arbitrage Theory of Capital Asset Pricing,”Journal of Economic Theory, 13, 341–360 (1976).

    Article  Google Scholar 

  • Rozeff, M.S., and Kinney, W.R., “Capital Market Seasonality: The Case of Stock Returns,”Journal of Financial Economics, 3, 379–402 (1976).

    Article  Google Scholar 

  • Schwert, G.W., “Size and Stock Returns, and Other Empirical Regularities,”Journal of Financial Economics, 12, 3–12 (1983).

    Article  Google Scholar 

  • Shaken, J., “Multivariate Tests of the Zero-Beta CAPM,”Journal of Financial Economics, 14, 327–348 (1985).

    Article  Google Scholar 

  • Shaken, J., “Intertemporal Asset Pricing: An Empirical Investigation,” Working Paper, University of Rochester, Rochester, NY (1987).

    Google Scholar 

  • Simon, D.P., “Expectations and the Treasury Bill-Federal Funds Rate Spread over Recent Monetary Policy Regimes,”Journal of Finance, 45, 567–577 (1990).

    Google Scholar 

  • Stoll, H.R., “Dealer Inventory Behavior: An Empirical Investigation of NASDAQ Stocks,”Journal of Financial and Quantitative Analysis, 11, 359–380 (1976).

    Article  Google Scholar 

  • Stone, B.K., “Systematic Interest-Rate Risk in a Two-Index Model of Returns,”Journal of Financial and Quantitative Analysis, 9, 709–725 (1974).

    Article  Google Scholar 

  • Sweeny, R.J., and Warga, A.D., “The Pricing of Interest-Rate Risk: Evidence from the Stock Market,”Journal of Finance, 41, 393–410 (1986).

    Google Scholar 

  • Tinic, S.M., “The Economics of Liquidity Services,”Quarterly Journal of Economics, 86, 79 (1972).

    Article  Google Scholar 

  • Tinic, S.M., West, R.R., “Risk and Return: January vs. the Rest of the Year,”Journal of Financial Economics, 13, 561–574 (1984).

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. School of Management, State University of New York at Buffalo, 14260, Buffalo, New York

    Dosoung Choi & Frank C. Jen

Authors
  1. Dosoung Choi
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Frank C. Jen
    View author publications

    You can also search for this author in PubMed Google Scholar

Rights and permissions

Reprints and permissions

About this article

Cite this article

Choi, D., Jen, F.C. The relation between stock returns and short-term interest rates. Rev Quant Finan Acc 1, 75–89 (1991). https://doi.org/10.1007/BF02408407

Download citation

  • Issue Date:

  • DOI: https://doi.org/10.1007/BF02408407

Key words

Search

Navigation