Parametric and nonparametric analysis of interest rate exposures of Spanish banks.

Resumen

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Interest rates represent a major source of uncertainty for the value of companies because interest rate changes influence both the expected future cash flows and the discount rate employed to value them. The high interest rate volatility and the important level of financial leverage constitute additional factors contributed the increasing relevance of the corporate exposure.
The main contribution of this paper is to conduct an analysis of bank interest rate exposure using linear, non linear, asymmetric and non parametric models. Also, it investigates whether the introduction of the Euro as a common currency has affected banks’ interest rate sensitivity.
Keywords: interest rate risk, banking firms, stocks.

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Extracto

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Parametric and nonparametric analysis of interest rate exposures of Spanish banks.

1. Introduction

Interest rate risk (IRR, hereafter) is broadly acknowledged as one of the most important financial risks faced by companies. This is due to the fact that changes in interest rates affect both the firm’s expected future cash flows and the discount rates used to value these cash flows. Moreover, the high volatility in interest rates and financial market conditions in recent years along with the significant degree of financial leverage for most of the companies have also contributed to the growing importance of interest rate exposure.

The bulk of the research on corporate exposure to IRR has been concentrated on financial institutions because of the particularly interest rate sensitive nature of the banking business. Specifically, financial assets and liabilities represent a substantial portion of the total assets of financial firms and it is generally admitted that there exists a maturity mismatch between banks’ assets and liabilities. The most common approach consists of measuring interest rate exposure as the sensitivity of bank stock returns to movements in interest rates using traditional linear regression models (e.g., Flannery and James, 1984; Madura and Zarruk, 1995; Faff and Howard, 1999; Fraser et al., 2002; or Au Yong and Faff, 2008).

There are, however, several reasons to suspect that the relationship between interest rates and market value of banks may be of nonlinear nature. On the one hand, since bank stock prices depend on interest rates through the discount factor and through the impact of interest rate changes on expected cash flows, it seems reasonable to assume that the link between interest rates and bank equity values may not be strictly linear. On the other hand, the risk management policy followed by banks may also play a major role in explaining the presence of nonlinearity in interest rate exposure. In addition, the response of bank stock returns to interest rate shocks may depend upon the sign or the magnitude of the shock, thus generating an asymmetric exposure to IRR. Specifically, interest rate rises and falls may affect bank value differently (sign asymmetry). Similarly, larger interest rate fluctuations may have a differential effect on bank value than smaller interest rate changes (size or magnitude asymmetry). Lastly, it is also possible that the relationship between interest rates and stock prices does not follow a time invariant functional form. Obviously, should these cases exist the

conventional linear model would not be appropriate for estimating interest rate exposure of banks.

This study aims to provide a comprehensive analysis of the interest rate exposure of the Spanish banking industry both at the portfolio and firm level. To this end, the degree of interest rate exposure is assessed not only by employing the standard linear model used in most studies, but examining the possible existence of nonlinear exposure through alternative nonlinear parametric and nonparametric approaches as well. The primary contribution of the paper lies in the fact that it represents, to the best of our knowledge, the first attempt to estimate interest rate exposure using nonparametric regression methods. This new perspective helps to improve the understanding of the effect of IRR on banking fi...

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