Money market interest rate and bank shares: A case study of Australia

Abstract

There is a large literature on the relationship between changes in interest rate and stock return of commercial banks but the empirical evidence is conflicting and mixed. This paper sets out to explain the apparent differences in the relationship in terms of regime switching. Markov switching model is used for this because it allows for some parameters to change according to economic shocks. This paper examines the relationship by measuring the direction and magnitude in which stock return of commercial banks responds to changes in money market interest rate in Australia. The study covers the period from October 1993 to May 2008. The analysis shows that the noticeable differences in the relationship between changes in money market interest rate and commercial banks' stock return are caused by regime switching. Hence, it is arguable that the apparent different responses could be better explained in terms of regime switching.