Koen van Ederen: Equity in times of increasing interest

15 maart 2022

By Koen van Ederen, Quant Consultant at Probability & Partners
 
After years of consistently declining interest rates, the tide has changed. There is an ongoing discussion about whether the ECB is going to increase its rates. As of recently, the question is not ‘if’ but ‘when’. This got us thinking about the effect this interest rate increase will have on (the prices of) equities.

Theoretical

In general, according theoretical equity-pricing models such as the Discount Dividend Model, we find decreasing equity prices when the interest rates increase due to heavier discounting of the future expected earnings (for instance: dividends).

This is the same as with bonds: increasing interest rates decrease the price of a bond. With fixed income securities, like with bonds, it is possible to calculate how much the price will change given an interest rate change, namely via the so-called Duration (for a small, local change). However, for equities, a closed-form pricing formula does not exist, so we are left to use empirical methods.

Empirical duration

Empirical duration (ED) can be estimated for a stock or index using a simple linear regression. The estimate for the ED tells us what the sensitivity of that particular equity is with respect to (local) interest rate fluctuations. The general consensus in the current academic literature is that in the long run (>30 years), the interest rate changes do not influence the price of equity.

We have performed in-house research on empirical duration using data ranging from 1998 to 2021. In this study, we found that for the medium-to-long term (between 5 and 20 years), the empirical duration can be statistically significantly different from zero. This indicates that when investing for the long run, the effect of changing interest rates is not as relevant as it is when investing for the medium-to-long run.

For all equity investigated, the only significant empirical durations found were positive. This means that the effect of increasing interest rate causes either a decrease in price or no change in price, but never an increase in price. This corresponds to what we find in the simple DDM model (albeit with a different order of magnitude) and the fixed income securities such as bonds.

What to do?

In the current economic situation, with high inflation and a lot of uncertainty (due to the aftermath of the COVID-19 crisis and the ongoing war in Ukraine), the interest rate can be used as an instrument of the ECB to slow the economy down, by way of increasing this rate. The question remains if or when the ECB is going to use this instrument, since currently, the stock market is already taking (large) hits and economies are quite unstable as it is.

Nevertheless, given our results, we would advise to look at your current portfolio and question if the interest rate risk of your equity is sufficiently monitored and hedged if needed. When monitoring the empirical duration, make sure you distinguish between different sectors, as it is likely that other sectors respond differently to increasing interest rates. Also, when evaluating duration of your portfolio, it might be that a qualitative correction for the market circumstances and especially the inflation is needed.

Probability & Partners is a Risk Advisory Firm offering integrated Risk Management and Quantitative Modelling Solutions to the financial sector and data-driven companies.