Bank stock return sensitivity to changes in interest rate level and volatility

This paper examines how the level and volatility of interest rates affect the stock return of banks using a GARCH-M model. Data is collected for Swedish and Danish banks stock return and interest rates on monthly basis for the period January 2000 to April 2018. The effects of interest rates on banks stock return is tested by two hypotheses, if the volatility of interest rates affects the volatility of the stock returns and if the level of the interest rate affects the excess return. The excess returns are also tested for significance of its own conditional variance in form of the mean term in the GARCH-M model. The results show that the volatility of interest rates has a significant effect on the excess return of the bank stocks while the level of the interest rate does not have a significant effect, the mean term is not significant, implying that some of the risk is not priced by an increased risk premium. The paper also discusses how the quantitative easing activities that has been performed by central banks could affect the bank stocks sensitivity to interest rates changes.