The depended variable in the research is the Return on Stock. The Returns on Stock may have an Impact because of various variables as; with risky debt instruments, one should approximate the market port folio not only by an equity index but by a combination of risky equity and debt return (Dinenis and Staikouras; 1998). Furthermore others said; The empirical relation between the interest rate sensitivity of common stock returns and the maturity composition of nominal contracts is examined for a set of actively traded commercial banks and stock savings and loan associations (Mark J. Flannery and Christopher M. James). While the evidence on the relationship between banks stock returns and an interest rate change is mixed (Stone 1974). This phenomenon is further tested and proved as empirical estimation of the expected rate of return on a portfolio of stocks (Peter Easton at el July 2000).
Now taking into consideration there are basically two major classification in the stock Market the financial and the non-Financial sectors both of them may have different effect on the returns the provide due to the asset and liability sensitivity to the Interest rates; Financial institutions' assets and liabilities are sensitive to interest rates and equilibrium returns for those institutions are based on certain expectations about interest rates (Dinenis and Staikouras; 1998). And the nominal returns of the stocks are the main area of affect; To examine the effect of interest rate changes on common stock returns, it is useful to consider the nominal return of a firm's common stock (Mark J. Flannery and Christopher M. James) But keeping in mind that the companies always have an alternative to buy back the equity; equities can be viewed as a call opt ion on the assets of the firm (Galai and Masulis, 1976) and consequently their stock returns should be affected by changes in interest rates (Dinenis and Staikouras; 1998).
To examine the effect of interest rate changes on common stock returns, it is useful to consider the nominal return of a firm's common stock as consisting of two components: (1) the return on nominal assets and (2) the return associated with real or physical assets (liabilities, excluding equity, can be viewed as negative assets) (Mark J. Flannery and Christopher M. James) The nominal contracting hypothesis postulates that a firm's holdings of nominal assets plays an important role in explaining the behavior of common stock returns through the redistributive effects of unanticipated inflation and unanticipated changes in expected inflation. (Mark J. Flannery and Christopher M. James)
Other researches propose the two-factor model as an extension of the capital asset pricing model. He suggests a model involving a "debt market factor" and an "equity market factor". He justifies the model by arguing that individual equity securities have different levels of interest rate sensitivities and it is a useful framework quantifying systematic interest rate risk (Stone 1974). Further justifications were given on individual equity securities have different levels of interest rate sensitivities and it is a useful framework quantifying systematic interest rate risk (Stone 1974). This also indicates that incorporating an index for the returns in a debt market might increase the explanatory power for the stock returns that exhibit considerably sensitivity to interest rate, such as the stock returns of banks, gold, public utilities, etc. (Stone 1974). The Multi-Index model was mostly regarded in testing the two variables on financial institutions; test the interest rate sensitivity of bank stock returns by estimating several multi- index models containing short- and long-term debt return indices (Lynge and Zumwalt 1980). And others use residual income valuation model to obtain an estimate of the expected rate of return for a portfolio of stocks where in the use of stock price and accounting data to simultaneously estimate the unique implied growth rate and internal rate of return (Peter Easton at el July 2000). Some also developed evidence of intertemporal capital asset pricing model (ICAPM) and proved with the positive the relationship between stock market risk and return and the extent to which stock market volatility moves stock prices (Hui Guo and Robert F. Whitelaw April 2005). Structural Models were also developed as to support the research's methodology; structural approach to stock market return, risk-free rate and Capital Asset Pricing Model (CAPM) developed a structural model, which shows interdependent relationship between risk free rate and stock market returns. It gives a new macroeconomics structural features which shape the price movement in stock exchange. In such a model instead using of exogenous values of stock market returns and risk free rate, one should use estimated values of these variable form reduced form equation of Capital Asset Pricing Model (CAPM). This was also tested and proved with the data of individual companies and found positively correlated (Tamal Datta Chaudhuri April 2008).
The companies also use such a technique to attain such favors through manipulating their assets and liabilities; there are a number of reasons why increased investment expenditures should be viewed favorably. First, higher investment expenditures are likely to be associated with greater investment opportunities. Second, higher investment expenditures may also indicate that the capital markets, which provide financing for the investments, have greater confidence in the firm and its management. (Ikenberry, Lakonishok, and Vermaelen, 1995).
Selection of the data may be done with respect to the time of return as well as the tenure in the Interest rates as; (Saunders and Yourougou;1990) using US data and on average a weak significant positive relation, and only for a sub period of their sample, Likewise the; Weekly stock returns for all institutions are used to create equally weighted portfolio returns for each group (Dinenis and Staikouras; 1998). To bring about the analysis of the two variables; Logarithmic returns are calculated by taking the prices at the last trading date of each week during the period examined (Dinenis and Staikouras; 1998). Development of Equally weighted portfolio to bring about an unbiased result is also adopted; To assess the effect of the market yields we have constructed equally weighted stock portfolios for the following sectors ; banks, insurance companies, investment trusts, finance firms, property investment companies and industrial and commercial Firms (Dinenis and Staikouras; 1998). While others suggested that this is a weakness due to the fact of small nature of available data, as an extremely large number of time-series observations are required to precisely estimate this relationship (Christian Lundblad February 2004)
The management of the Portfolio determines the overall returns on the Investment; if investors fail to appreciate managements' incentive to oversell their firms in these situations; stock returns subsequent to an increase in investment expenditures are likely to be negative. This effect is likely to be especially important for managers who are empire builders, and invest for their own benefits rather than the benefits of the firm's shareholders (Jensen 1986). The investment is also determined by the investment levels; Firms with different levels of investment expenditures are likely to be subject to different types of risk. One might expect that firms that invest the most are the riskiest, since a greater fraction of their value consists of growth options (Shumway 1996).
The Financial constrains and time series may also have an effect on the overall results; if we find no financial constraints factor, it would suggest that financial constraints do not expose firms to common shocks. If we do find a financial constraints factor, we can use the estimated time series of its returns to address questions in both finance and macroeconomics. In the area of finance, we test whether other factors in asset returns (such as the market factor, the book-to-market factor, and the size factor) subsume the constraints factor. (Lakonishok, and Vermaelen, 1995) These financial constrains effect the assets of the firm hence forth affecting the reputation of the firm in the stock market; A variety of financial constraints are important determinants of real activity and asset prices. (Lakonishok, and Vermaelen, 1995) but it has been empirically tested that; The results suggest that the constraints factor is not measuring aggregate changes in firm value due to changes in monetary policy, credit conditions, or macroeconomic shocks. (Lakonishok, and Vermaelen, 1995) where as in the case of bank; Their conclusion was that the addition of bond index only marginally improved the explanatory power of the model for the bank sample, but that the debt index was "more important than equity index". They then reasoned that a short term index would have been more appropriate as "Banks and their earnings should be more sensitive to short term rather than long term rates. (Morgan J. lynge, Jr. and J. Kenton Zumwalt) Furthermore in case of Banks researches found that the sensitivity of bank stock returns to changes in interest rates is significantly affected by four financial characteristics: equity to assets, non-interest income to total revenue, demand deposits to total deposits, and loans to assets (Madura and Weigand 2002). Whereas long run stock market returns participate higher in the real economy (Roger G. Ibbotson July 2002). And lastly some used residual-income valuation model simultaneously to estimate relationship between long term growth rate in abnormal earnings and cost of capital (Rong Huang at el May 2005).
Many of the researches determined that the Interest rates may have different effect on the nature of the company i.e. if it is a financial firm the sensitivity of the returns may differ to its counterparts; the sensitivity of individual financial groups was also statistically different from that of commercial companies (Dinenis and Staikouras; 1998). Besides the nature of the industry, the size of the Industry and the size of the financial firm may affect differently as well; average sensitivity of the financial institutions is almost twice as big as that of the commercial industry (Dinenis and Staikouras; 1998). So the conclusion of the present model may provide with an inverse relationship; there is an inverse relationship between changes in interest rates and common stock returns of financial institutions (Dinenis and Staikouras; 1998).
The reason for this unexpected negative relationship may be dependent on the Liabilities and the assets of that company or Industry; A common explanation for the significant negative relationship between unexpected changes in interest rates and common stock returns is the duration gap between their assets and liabilities that financial institutions apparently experienced over the sample period (Dinenis and Staikouras; 1998). Other made an assumption that it may also be the reason of Inflation which cycles around the assets and Liabilities of the firm having the same consequences; a firm's holdings of nominal assets plays an important role in explaining the behavior of common stock returns through the redistributive effects of unanticipated inflation and unanticipated changes in expected inflation. (Mark J. Flannery And Christopher M. James). Furthermore the; The higher the proportion of the net nominal assets and the longer the maturity of net nominal assets held, the more sensitive should be the firm's common stock returns to interest rate changes (Mark J. Flannery and Christopher M. James). The sensitivity on the asset in terms of Liquidity and efficiency ratios may also be a barrier to the results; Given that s tocks of non-financial firms are claims on real assets which are less sensitive compared to those which are claims on monetary assets, the sensitivity of commercial and industrial companies should b e lower or even insignificant (Dinenis and Staikouras; 1998).
The Assets are one part but the Liabilities may affect the returns of the company with the same perspective as the assets were affecting and the Liabilities have a direct related nature with the interest rate or the inter-bank rates; high levels of leverage combined with high customer credits, provided by nonfinancial firms, or inappropriate hedging of both their assets and liabilities could probably explain this significant negative relationship (Dinenis and Staikouras; 1998). Likewise; the variability of an institutions assets should also affect the value of the equity and should be considered as an additional factor (Dinenis and Staikouras; 1998). The relationship of the two variables are also explained by the nature of a debt Instrument; interest rates change, the common stock returns of a firm financed entirely by equity and holding only nominal assets should behave exactly like a bond with a maturity equal to the average maturity of the firm's assets (Mark J. Flannery and Christopher M. James). The further emphisis is on the net assets of the firm more than its liabilities; the effect of nominal interest rate changes on common stock prices is related to the maturity composition of a firm's net nominal asset holding (Mark J. Flannery and Christopher M. James).
The leverage of the firm may also determine the actual volatility in stock returns; Bhandari (1988), Chan and Chen (1991), Fama and French (1992), and Shumway (1996) all find that firms with high measures of leverage, financial distress, or probability of default tend to earn higher returns than other firms. In contrast, we find that financially constrained firms earn lower returns than other firms (Lakonishok, and Vermaelen, 1995)
Now further dividing the two major sectors into different industries may also have variations in the result as; bank's assets to be more interest rate sensitive than a commercial company's assets and therefore the effect of variability on bank assets to be higher (Dinenis and Staikouras; 1998). Like wise sugested by other researches regarding the intensity of the Bank's Stock returns was noted to be higher then other firms; For commercial bank and S&L stocks, changes in interest rates were found to be significantly related to stock price movements (Mark J. Flannery And Christopher M. James). Which further Indicated; the co- movement of bank stock returns with interest rate changes is found to be positively related to the size of the maturity difference between the bank's nominal assets and liabilities (Mark J. Flannery and Christopher M. James). Creating a portfolio and assessing both the sectors as a portfolio may show an increasing volatility; both financial and commercial companies are an increasing function of the volatility in the level of interest rates. The positive function is consistent with the view of equity claims on a firm's assets (Dinenis and Staikouras; 1998).
The Size may also affect the firms overall stock returns; Small firms have high returns, are more cyclical, have higher loadings on monetary policy, and tend to be more financial constrained than other firms. Unfortunately, the results in this article suggest that this explanation is wrong. (Vermaelen, 1995) to avoid such bias results; By forcing the long and short portfolios to equally represent small, medium, and large firms, the procedure ensures that one class of firms does not dominate the FC returns. Shumway (1996)
The stock returns can also be affected by the artificially created value of the stocks; However, if constrained firms are subject to common shocks, there will be common variation in the returns of firms with similar levels of financial constraint. Because stock returns reflect news (changes in expected future returns or changes in expected future cash flows), factor realizations reflect news that is common to many firms. (Shumway 1996)
Some research suggested that the payouts of Dividends may also encourage the growth of economic productivity in line with the growth of corporate productivity measured by earnings. The bulk of return comes from dividend payment and nominal earning including inflation and earnings growth (Roger G. Ibbotson July 2002).
The results of the (Dinenis and Staikouras; 1998) research determined; the effect of interest rate changes on financial institutions was much greater than on the industrial companies. The coefficient also determined close unity in both the factors; Comparisons of the volatility coefficients showed t-values very close to unity (Dinenis and Staikouras; 1998). While besides portfolio when specific industries were put to test there was a notable difference in the Financial and the non-Financial firms leading to a very diversifies results for both the sectors; when specific groups were examined the only notable difference was between the finance and industrial companies and the finance firms and investment trusts (Dinenis and Staikouras; 1998). Yet the effect of the Interest rates remain the same on the returns of both the sectors; The interest rate volatility proxied by the variance of the interest rates has also a statistically significant positive effect on both financial and non-financial companies returns (Dinenis and Staikouras; 1998). Hence forth, the research predicted that the; the value of financial institutions in the UK was seriously affected by the interest rates conditions and financial institutions apparently were not protected from interest rate risk (Dinenis and Staikouras; 1998). Whereas; find positive average returns for NYSE size-matched portfolios reflecting dividend payments and leverage. (Chan and Chen) and the negative returns were found (Ikenberry, Lakonishok, and Vermaelen, 1995). While in case of banks; most studies find that bank stock returns are negatively related to the changes in interest rate while others find no significant relationship between these two variables (Stone 1974). And the two components of expected return- the risk component and the component due to the desire to hedge changes in investment opportunities. This proved that the estimated coefficient of relative risk aversion positive, statistically significant (Hui Guo and Robert F. Whitelaw April 2005).