A Two-Factor Arch Model for Deposit-Institution Stock Returns

Abstract

The economic environment facing both banks and savings and loan associations (S&Ls) changed dramatically during the later 1970s and into the decade of the 1980s. A drastic change in the Federal Reserve Bank's monetary policy regime, coupled with the deregulation of banking, seemed to expose banks and S&Ls to more risks. This paper applied a two- factor model for a sample of banks and S&Ls in order to identify their changing market risks and interest rate risks. The two factors considered are the market return and the interest rate. This two factor model is specified by the Autoregressive Conditional Heteroskedacity (ARCH) modelling strategy and is estimated by the Generalized Method of Moments (GMM). The market and interest rate risks are measured by their time-varying betas. The results suggest that the market risks were volatile over the sample period, 1977-87, and that they increased and became especially volatile after 1982. The interest rate risks, on the other hand, were more stable and did not respond to the changes in the Federal Reserve Bank's monetary policy regime in either 1979 or 1982. Specification tests suggest the usefulness of my two-factor ARCH model in the study of deposit-institution stock returns.

JEL Classification: G1