The case against price-level targeting

As the Fed begins to wrestle with how to stimulate growth in the next economic downturn in an environment of low interest rates, a number of possible changes in its policy framework are being entertained. One in particular that has gained considerable support is price-level targeting, based on the view that this approach would tend to move inflation and nominal interest rates up late in the business cycle, yielding more room for rate cuts when the downturn ensues. We outline the inherent difficulties involved in controlling the level of inflation under the current inflation-targeting regime. We then argue that requiring the Fed to meet the more stringent objective of a price-level target could introduce significantly greater volatility into output growth—potentially worsening economic downturns—than is the case under the current policy framework. We also consider a preferred course of action that adds a bit more flexibility to the current framework, at least for the near to the medium term, and how the Fed might deal with the next recession.     

An empirical comparison of continuous time models of the short term interest rate

This article tests the performance of a wide variety of well-known continuous time models—with particular emphasis on the Black, Derman, and Toy (1990; henceforth BDT) term structure model—in capturing the stochastic behavior of the short term interest rate volatility. Many popular interest rate models are nested within a more flexible time-varying BDT framework that allows us to compare the models and find the proper specification of the dynamics of short rates. The empirical results indicate that the equilibrium models that do not allow the drift and diffusion parameters to vary over time and parameterize the volatility only as a function of interest rate levels overemphasize the sensitivity of volatility to the level of interest rate and fail to model adequately the serial correlation in conditional variances. On the other hand, the GARCH-based arbitrage-free models with time-dependent parameters in the drift and diffusion functions define the volatility only as a function of unexpected information shocks and fail to capture adequately the relationship between interest rate levels and volatility. This study shows that the most successful models in capturing the dynamics of short term interest rates are those that introduce time-dependent parameters to the short rate process and define the conditional volatility as a function of both the interest rate levels and the last period's unexpected news. © 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19: 777–797, 1999     

Sovereign default, interest rates and political uncertainty in emerging markets

A large body of the empirical literature shows that high turnover rates/length of tenure of policymakers and the degree of conflict within a country affects sovereign spreads, debt and default rates. We help to rationalize such claims by including these political features in a dynamic stochastic small open economy model of sovereign debt and default. In this way we offer a complementary approach to the econometric analyses in the literature. Consistent with the data, the quantitative analysis shows that politically unstable and more polarized economies experience higher default rates and larger level and volatility of sovereign interest rate spreads.     

通货膨胀幻觉对中国股市的影响分析

上海A股市价格波动无法用红利与无风险利率的变化来解释。通过实证分析发现,跟传统理论相反,中国股价跟通货膨胀呈现反向关系。其原因在于Fed模型的拥护者将E/P跟名义利率进行比较来判断股市估值是否合理。中国投资者中存在通货膨胀幻觉。通货膨胀幻觉假设在一定程度上能够解释上海A股市场价格变化,特别是该假设能解释1996-2001年的大牛市。     

Nonlinear asymmetric models of the short‐term interest rate

This study introduces a generalized discrete time framework to evaluate the empirical performance of a wide variety of well‐known models in capturing the dynamic behavior of short‐term interest rates. A new class of models that displays nonlinearity and asymmetry in the drift, and incorporates the level effect and stochastic volatility in the diffusion function is introduced in discrete time and tested against the popular diffusion, GARCH, and level‐GARCH models. Based on the statistical test results, the existing models are strongly rejected in favor of the newly proposed models because of the nonlinear asymmetric drift of the short rate, and the presence of nonlinearity, GARCH, and level effects in its volatility. The empirical results indicate that the nonlinear asymmetric models are better than the existing models in forecasting the future level and volatility of interest rate changes. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:869–894, 2006     

Pricing Stock Options in a Jump‐Diffusion Model with Stochastic Volatility and Interest Rates: Applications of Fourier Inversion Methods

Fast closed form solutions for prices on European stock options are developed in a jump‐diffusion model with stochastic volatility and stochastic interest rates. The probability functions in the solutions are computed by using the Fourier inversion formula for distribution functions. The model is calibrated for the S and P 500 and is used to analyze several effects on option prices, including interest rate variability, the negative correlation between stock returns and volatility, and the negative correlation between stock returns and interest rates.     

Accounting for stochastic interest rates,stochastic volatility and a general correlation structure in the valuation of forward starting options

A quantitative analysis on the pricing of forward starting options under stochastic volatility and stochastic interest rates is performed. The main finding is that forward starting options not only depend on future smiles, but also directly on the evolution of the interest rates as well as the dependency structures among the underlying asset, the interest rates, and the stochastic volatility: compared to vanilla options, dynamic structures such as forward starting options are much more sensitive to model specifications such as volatility, interest rate, and correlation movements. We conclude that it is of crucial importance to take all these factors explicitly into account for a proper valuation and risk management of these securities. The performed analysis is facilitated by deriving closed‐form formulas for the valuation of forward starting options, hereby taking the stochastic volatility, stochastic interest rates as well the dependency structure between all these processes explicitly into account. The valuation framework is derived using a probabilistic approach, enabling a fast and efficient evaluation of the option price by Fourier inverting the forward starting characteristic functions. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark 31:103–125, 2011     

Monetary policy and long‐term interest rates: Evidence from the U.S. economy

This paper addresses the ability of central banks to affect the structure of interest rates. We assess the causal relationship between the short‐term Effective Federal Funds Rate (FF) and long‐term interest rates associated with both public and private bonds and specifically, the 10‐Year Treasury Bond (GB10Y) and the Moody's Aaa Corporate Bond (AAA). To do this, we apply Structural Vector Autoregressive models to U.S. monthly data for the 1954–2018 period. Based on results derived from impulse response functions and forecast error variance decomposition, we find: a bidirectional relationship when GB10Y is considered as the long‐term rate and a unidirectional relationship that moves from short‐ to long‐term interest rates when AAA is considered. These conclusions show that monetary policy is able to permanently affect long‐term interest rates and the central bank has a certain degree of freedom in setting the levels of the short‐term policy rate.     

Reflections of a Professional Life-Long Fed Watcher

Policymaking at the Fed and Fed watching by the markets have changed dramatically over the past 30 years. In the 1970s, targets and instruments shifted constantly, and the prevalent belief in the Fed was that its deliberations should be as opaque as possible. Moreover, communications technology for those who would divine the Fed’s direction was limited to snail mail, faxes, and telephones. In the early 1980s, the Fed began to focus more directly on inflation and on increasing transparency. The future is likely to reveal continued restrictive Fed policy and an inverted yield curve due to eight factors that contribute to this “conundrum.” Diversification away from the dollar by foreign central banks is likely to put continued pressure on the value of the dollar and some modest upward pressure on inflation and interest rates, but a dollar meltdown is unlikely. Despite this relatively benign outlook, however, Fed watchers will continue to be busy and valued. JEL Classification E5, E58     

Monetary policy,exchange rate fluctuation,and herding behavior in the stock market

Interest rate and exchange rate are two important macroeconomic variables that exert considerable effects on the stock market. In this study, we investigate whether variations in interest and exchange rates induce herding behavior in the Chinese stock market. Empirical results indicate that interest rate increase and Chinese currency (CNY) depreciation will induce herding and this phenomenon is mainly manifested in down markets. Moreover, the herding level of the highest idiosyncratic volatility quintile portfolio is twice that of the lowest quintile portfolio which we consider evidence of intentional herding. This result is consistent with those of previous studies, which report that retail investors prefer and overweigh lottery-type stocks. Finally, we investigate the effects of monetary policy announcements and extreme exchange rate volatility on herding because these events elicit considerable public attention and may trigger collective behavior in the aggregate market.     

Short Rate Dynamics and Regime Shifts*

We characterize the dynamics of the US short‐term interest rate using a Markov regime‐switching model. Using a test developed by Garcia, we show that there are two regimes in the data: In one regime, the short rate behaves like a random walk with low volatility; in another regime, it exhibits strong mean reversion and high volatility. In our model, the sensitivity of interest rate volatility to the level of interest rate is much lower than what is commonly found in the literature. We also show that the findings of nonlinear drift in Aït‐Sahalia and Stanton, using nonparametric methods, are consistent with our regime‐switching model.     

Low‐Frequency Volatility of Yen Interest Rate Swap Market in Relation to Macroeconomic Risk*

Using ‘low‐frequency’ volatility extracted from aggregate volatility shocks in interest rate swap (hereafter, IRS) market, this paper investigates whether Japanese yen IRS volatility can be explained by macroeconomic risks. The analysis suggests that this low‐frequency yen IRS volatility has strong and positive association with most of the macroeconomic risk proxies (e.g., volatility of consumer price index, industrial production volatility, foreign exchange volatility, slope of the term structure and money supply) with the exception of the unemployment rate, which is negatively related to IRS volatility. This finding is fairly consistent with the argument that the greater the macroeconomic risk the greater is the use of derivative instruments to hedge or speculate. The relationship between the macroeconomic risks and IRS volatility varies slightly across the different swap maturities but is robust to alternative volatility specifications. This linkage between swap market and macroeconomy has practical implications since market makers and hedgers use the swap rate as benchmark for pricing long‐term interest rates, corporate bonds and various other securities.     

Approximation for convenience yield in commodity futures pricing

The pricing of commodity futures contracts is important both for professionals and academics. It is often argued that futures prices include a convenience yield, and this article uses a simple trading strategy to approximate the impact of convenience yields. The approximation requires only three variables—underlying asset price volatility, futures contract price volatility, and the futures contract time to maturity. The approximation is tested using spot and futures prices from the London Metals Exchange contracts for copper, lead, and zinc with quarterly observations drawn from a 25‐year period from 1975 to 2000. Matching Euro‐Market interest rates are used to estimate the risk‐free rate. The convenience yield approximation is both statistically and economically important in explaining variation between the futures price and the spot price after adjustment for interest rates. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:1005–1017, 2002     

Endogenous exchange rate pass-through when nominal prices are set in advance

This paper develops a model of endogenous exchange rate pass-through within an open economy macroeconomic framework, where both pass-through and the exchange rate are simultaneously determined, and interact with one another. Pass-through is endogenous because firms choose the currency in which they set their export prices. There is a unique equilibrium rate of pass-through under the condition that exchange rate volatility rises as the degree of pass-through falls. We show that the relationship between exchange rate volatility and economic structure may be substantially affected by the presence of endogenous pass-through. Our key results show that pass-through is related to the relative stability of monetary policy. Countries with relatively low volatility of money growth will have relatively low rates of exchange rate pass-through, while countries with relatively high volatility of money growth will have relatively high pass-through rates.     

Interest rate risk in long-dated commodity options positions: To hedge or not to hedge?

We empirically assess hedging interest rate risk beyond the conventional delta, gamma, and vega hedges in long-dated crude oil options positions. Using factor hedging in a model featuring stochastic interest rates and stochastic volatility, interest rate hedges consistently provide an improvement beyond delta, gamma, and vega hedges. Under high interest rate volatility and/or when a rolling hedge is used, combining interest rate and delta hedging improves performance by up to four percentage points over the common hedges of gamma and/or vega. Thus, contrary to common practice, hedging interest rate risk should have priority over these “second-order” hedges.     

Modeling the conditional mean and variance of the short rate using diffusion,GARCH, and moving average models

This article introduces a two‐factor‐discrete‐time‐stochastic‐volatility model that allows for departures from linearity in the conditional mean and incorporates serially correlated unexpected news, asymmetry, and level effects into the definition of conditional volatility of the short rate. The new class of econometric specifications nests many popular existing symmetric and asymmetric GARCH as well as diffusion models of the short‐term interest rate. This study attempts to determine the correct specification of conditional mean and variance of the short rate by developing a more general econometric framework that allows for nonlinear effects in the drift of the short rate, and that defines the conditional volatility as a nonlinear function of unexpected information shocks and interest rate levels. The existing and alternative models are compared in terms of their ability to capture the stochastic behavior of the short‐term riskless rate. The empirical results indicate that the relative performance of the two‐factor models in predicting the future level and variance of interest‐rate changes is superior to the nested models. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20:717–751, 2000     

Scheduled announcements and volatility patterns: The effects of monetary policy committee announcements on LIBOR and short sterling futures and options

Both the UK spot and futures markets in short‐term interest rates are found to react strongly to surprises in the scheduled announcements of the repo rate and RPI. Therefore, these announcements should also affect the market for options on short‐term interest rate futures. Because the repo rate and RPI announcements are scheduled, the options market can predict the days on which announcement shocks may hit, and build this information into its volatility expectations. It is argued that the volatility used in pricing options should alter over time in a predictable nonlinear manner that varies with contract maturity and the number of forthcoming announcements; but is independent of announcement content. The empirical results support this hypothesis. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:773–797, 2003     

Islamic financing and bank risks: The case of Malaysia

We examine whether Islamic financing can explain three important bank risks in a country with a dual banking system: credit risk, interest‐rate risk, and liquidity risk. Using Malaysian data, we find that commercial banks with Islamic financing have significantly lower credit and liquidity risks but significantly higher interest‐rate risk than banks without Islamic financing. There is also evidence that bank size is significantly related to credit risk; the proportion of loan sales to total liabilities and bank size are significant determinants of interest‐rate risk; and off‐balance‐sheet financing, the extent of securitization, loan volatility, bank capital, and bank size are statistically significantly related to liquidity risk. © 2005 Wiley Periodicals, Inc.     

Determinants of Japanese Yen interest rate swap spreads: Evidence from a smooth transition vector autoregressive model

This study investigates the determinants of variations in the yield spreads between Japanese yen interest rate swaps and Japan government bonds for a period from 1997 to 2005. A smooth transition vector autoregressive (STVAR) model and generalized impulse response functions are used to analyze the impact of various economic shocks on swap spreads. The volatility based on a GARCH (generalized autoregressive conditional heteroskedasticity) model of the government bond rate is identified as the transition variable that controls the smooth transition from a high volatility regime to a low volatility regime. The break point of the regime shift occurs around the end of the Japanese banking crisis. The impact of economic shocks on swap spreads varies across the maturity of swap spreads as well as regimes. Overall, swap spreads are more responsive to the economic shocks in the high volatility regime. Moreover, a volatility shock has profound effects on shorter maturity spreads, whereas the term structure shock plays an important role in impacting longer maturity spreads. Results of this study also show noticeable differences between the nonlinear and linear impulse response functions. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:82–107, 2008     

Debates and dissent inside the FOMC during WWII

Abstract

We demonstrate that even though during WWII the interest rate was close to zero supporting the financing of the military effort, dissent inside the FOMC occurred with a similar frequency to other policy episodes. Our analysis highlights that the debates which resulted in dissents turned around two broad issues: the size of the Fed’s balance sheet as well as the functioning of and communication with financial markets. Thus, we argue that the conventional view depicting the Fed as merely accommodating treasury needs should be revised. Our detailed investigation of dissents emphasises the modernity of the objections raised by Fed officials.