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Using the interest rate term spread as a means to predict stock market returns

Sandbakken, Sindre Vanebo; Skinlo, Jørgen
Master thesis
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1754415.pdf (7.590Mb)
Preliminary Master Thesis.pdf (1.255Mb)
Permanent lenke
http://hdl.handle.net/11250/2481159
Utgivelsesdato
2017
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Samlinger
  • Master of Science [1555]
Sammendrag
We research an investment strategy; the Asset Allocation Model, incorporating

the difference between long-term and short-term interest rate – the interest rate

term spread – as a leading indicator for asset class allocation. Intuitively, a

positive spread implies higher economic growth in the future, which should

eventually propagate to the stock markets. Using the term spread, we create a

categorical dummy variable which signals investment in the stock market in

positive spread periods and no exposure to stock (risk) in negative spread periods.

By the Efficient Market Hypothesis, all available information and expectations

about future economic growth should already be reflected in stock prices and

exploiting information from the debt markets should not yield any persistent

abnormal returns.

The model is tested in ten sample economies; the US, the UK, Japan, Norway,

Denmark, Sweden, Germany, Finland, Switzerland and China, using historical

data from 10-year government bonds, 3-month Interbank Offered Rates and the

major stock market indices from the respective markets.

We find evidence that the Asset Allocation Model has been able to outperform the

market index in every sample economy both in absolute cumulative returns and by

the risk-adjusted Sharpe ratio, with satisfactory statistical significance in seven out

of ten countries (excl. UK, China and Japan). We argue that the interest rate term

spread contains information that is not reflected in the stock market, with the

implication that the Efficient Market Hypothesis does not truly hold in its semistrong

form. We also emphasize that the good results are largely attributable to the

model’s ability to predict the heaviest stock market declines. Although the results

are very interesting and statistically significant, we advise caution on the

consistency of the results out of sample due to relatively short research periods,

and the nature of financial markets characterized by structural changes.
Beskrivelse
Masteroppgave(MSc) in Master of Science in Finance - Handelshøyskolen BI, 2017
Utgiver
BI Norwegian Business School

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