Relationship between Interest Rate and Bank Common Stock Return: Evidence from the Top 10 United States Banks and Financial Sector Index

This research paper investigates the effect of changes in long-term interest rates on the returns of the top 10 US banks included in the Financial Sector Index. There are three main parts of this paper. The first part uses the Augmented Dickey-Fuller (ADF) test to test the “Random Walk” of banks’ common stock returns. Based on the test’s results, returns of banks’ common stock do not solely follow the “Random Walk”. In the second part, the Two-Factor Arbitrage Pricing Theory is employed to test the effect of changes in long-term interest rate on the return of banks’ common stocks. The findings provide strong and consistent evidences that volatility of bank common stock returns is very sensitive to the long-term interest rate movement. The third part explores the effect of long-term interest rates on returns of banks’ common stocks before and after the financial crisis (September 12th, 2008). The same testing methods are used as those in part 1 and 2. The findings suggest that, after the crisis, changes in long-term interest rates exhibit an even more significant impact on banks’ common stock returns than that before the financial crisis