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Does Interest Rate Exposure Explain the Low-Volatility Anomaly?

Last Updated on 10 February, 2024 by Rejaul Karim

Delving into the intricate dynamics of financial markets, Joost Driessen, Ivo Kuiper, Korhan Nazliben, and Robbert Beilo unravel the enigma in “Does Interest Rate Exposure Explain the Low-Volatility Anomaly?” Published in the Journal of Banking and Finance, this exploration, spanning the intricate landscape of the low-volatility anomaly, offers a compelling revelation.

The researchers navigate the realms where low-volatility stocks shine, unveiling a connection to interest rate exposure. In this financial interplay, low-volatility portfolios showcase a negative association with interest rates, while their more volatile counterparts exhibit a positive correlation.

The incorporation of an interest rate premium emerges as a key player in elucidating this anomaly, shedding light on the multifaceted forces shaping stock returns. The study not only uncovers these complex relationships but also unveils the nuanced variations in the interest rate risk premium, providing a profound perspective on equity and bond markets’ intricate dance.

Abstract Of Paper

We show that part of the outperformance of low-volatility stocks can be explained by a premium for interest rate exposure. Low-volatility stock portfolios have negative exposure to interest rates, whereas the more volatile stocks have positive exposure. Incorporating an interest rate premium explains part of the anomaly. We also find that the interest rate risk premium in equity markets exhibits time variation similar to bond markets, but that the level of the interest rate premium, as estimated from the cross-section of stocks, is much higher than the premium observed in the bond market.

Original paper – Download PDF

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Author

Joost Driessen
Tilburg University – Tilburg University School of Economics and Management; Tilburg University – Center for Economic Research (CentER)

Ivo Kuiper
Tilburg University – Center and Faculty of Economics and Business Administration; Kempen Capital Management

Korhan Nazliben
affiliation not provided to SSRN

Robbert Beilo
Tilburg University – Tilburg University School of Economics and Management

Conclusion

In conclusion, this study unravels a facet of the low-volatility anomaly, attributing a portion of the superior performance of low-volatility stocks to an interest rate exposure premium. Notably, portfolios of low-volatility stocks demonstrate a negative correlation with interest rates, while their more volatile counterparts exhibit a positive association.

The incorporation of an interest rate premium into the analysis provides a nuanced understanding of the anomaly, offering insights into its underlying dynamics. Furthermore, the research unveils a temporal variability in the interest rate risk premium within equity markets, mirroring patterns observed in bond markets.

Importantly, the estimated interest rate premium from the stock cross-section surpasses levels observed in the bond market, underscoring the unique characteristics of equity markets in relation to interest rate dynamics.

Related Reading:

Why the Low Volatility Anomaly Will Persist

Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly

FAQ

Q1: What is the primary focus of the research conducted by Joost Driessen, Ivo Kuiper, Korhan Nazliben, and Robbert Beilo?

A1: The research investigates the low-volatility anomaly in financial markets, specifically exploring the connection between low-volatility stocks and interest rate exposure. The authors aim to understand whether part of the outperformance of low-volatility stocks can be explained by an interest rate exposure premium.

Q2: What key findings does the study reveal regarding the relationship between low-volatility stocks and interest rates?

A2: The study uncovers that portfolios of low-volatility stocks have a negative exposure to interest rates, while more volatile stocks exhibit a positive correlation with interest rates. The incorporation of an interest rate premium into the analysis is shown to explain a portion of the low-volatility anomaly.

Q3: How does the research contribute to understanding the dynamics of the low-volatility anomaly?

A3: The research provides a nuanced perspective on the low-volatility anomaly by attributing part of the superior performance of low-volatility stocks to an interest rate exposure premium. Additionally, it highlights the temporal variability in the interest rate risk premium within equity markets, emphasizing unique characteristics in equity markets compared to bond markets in relation to interest rate dynamics.

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