Interest rate risk of German financial institutions: The impact of level, slope, and curvature of the term structure

We investigate here the sensitivity of the stock returns of German financial institutions to changes in the shape of the term structure of interest rates. The standard approach has been to measure the interest rate sensitivity of stock returns by focussing solely on changes in a single interest rate factor. We extend this approach to capture the sensitivity to changes in level, slope, and curvature of the term structure. More specifically, we use the parameters of the model by Nelson and Siegel (1987) to fit the term structure, which can be interpreted as the term structure's level, slope, and curvature. Applying multi-factor models, we find the level factor to be the single most important interest rate factor explaining stock returns. Nevertheless, neglecting the curvature factor would lead to a significant underestimation of the interest rate risk of financial institutions. The slope factor, on the other hand, has only minor importance for financial institutions. Moreover, we document both time-varying and industry-specific exposure to changes in the shape of the term structure. Finally, in an APT context, we test whether changes in level, slope, and curvature of the term structure are priced factors in the German equity market. We find the level and the curvature factor to be rewarded in the cross-section of expected returns in the German equity market, suggesting that both represent systematic risk factors.