The Interest Rate Component of Systematic Risk

Abstract

Changes in the long-term interest rate would seem to be an important source of systematic risk for common shares, but the empirical results to date have been very disappointing. For the most part these results have been obtained with a model where an interest rate variable, say the holding period return (HPR) on a long bond, is added to the market model. This paper examines two alternative models in which the independent variables are different linear combinations of the HPRs on the market and a long bond. The alternative models are found to be superior theoretically and empirically. In tests on a large number of utility and industrial shares over a number of periods, the most attractive model theoretically produces interest rate betas that are highly significant for all utility shares and a very large fraction of the industrial shares.