Interest rate dynamics and the term structure: A note

The Brennan and Schwartz two-factor model of the term structure is re-examined using constant-duration long-term yields in place of the fluctuating-duration consol yields, and additional stability is achieved in the empirical estimations. The model is then reformulated to examine more closely the relationship between changes in long and short rates of interest. It is found that movements in the short rate of interest are related to movements in the long rate, the spread between the long and short rates, and the prior movement in the long rate. The model is then tested for its out-of-sample predictive ability and found to possess a modest amount of predictive power.     

Beyond the purchasing power parity: testing for cointegration and causality between exchange rates, prices, and interest rates

This paper reexamines the causality between the dollar and the yen in a multivariate framework with the aid of cointegration and error-correcting modeling for the 1951–94 period. The Phillips-Perron tests and Johansen's tests are performed. While causality from interest rates to exchange rates is found in the short run, no causality between prices and exchange rates is found in the short run. However, causality is found running from relative prices to exchange rates along with interest rates between the U.S. and Japan in the long run, which supports the long-run PPP hypothesis.     

National price levels, purchasing power parity, and cointegration: a test of four high inflation economies

The time series properties of exchange rates and wholesale prices from four high inflation countries show some evidence in support of purchasing power parity. Tests for stationarity of real exchange rates and cointegration among price and exchange rate variables are presented for Argentina, Brazil, Chile, and Israel during the 1970s and 1980s. Error correction models describe the mechanism of adjustment to long-run equilibrium.     

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 equity values of a large sample of German financial institutions to movements in the term structure of interest rates. While similar approaches rely on a single interest rate factor only, we quantify the exposure to changes in level, slope, and curvature, which are the driving factors of term structure changes. Our main findings are: (i) banks and insurances are exposed to level and curvature changes but only marginally to slope movements; (ii) the interest rate risk exposure depends on the banking sector investigated; (iii) level and curvature changes are priced in the cross-section of stock returns.

Materiality in an integrated reporting setting: Insights using an institutional logics framework

Using institutional logics as a theoretical framework and interviews with 20 preparers from 14 large organisations listed on the Johannesburg Stock Exchange (JSE), this paper focuses on examining differences in integrated reporting practices. The results reveal how a finance-centric market and professional logic interact with a stakeholder logic, leading to differences in the materiality determination process. Market-dominated firms have an internally focused approach to setting materiality which emphasises value-relevance for financial capital providers. Where logics are contested, materiality becomes an amalgamation of the factors which are important for shareholders and other stakeholders and essential for demonstrating compliance with codes of best practice. Organisations with market, professional and stakeholder logics aligned have the most sophisticated materiality determination processes. The emphasis shifts from lengthy reporting and compliance to providing a comprehensive account of the value creation process and how the business ensures long-term sustainability. In this way, how logics are instantiated may explain the considerable variation being observed in integrated reports. There are also implications for the propensity of firms either to view integrated reporting as a hegemonic challenge or to internalise it as part of a process of positive organisational change.     

Interest rate parity tests: Switzerland and some major western countries

This article reviews briefly the interest rate parity (IP) theory and possible divergences between covered interest rates on two assets denominated in different currencies. From direct IP tests involving pairs of assets denominated in Sfr., $, £ and DM, using monthly data on 3-month Treasury Bills and on 3-month Euro-deposits, it appears that the theory holds better for Euro-currency pairs of assets than for domestic pairs. Further investigation uncovers significant occurence of autocorrelation for domestic pairs, possibly indicating left-out explanatory factors in the standard IP formulation, and points to the non-normality of the distrbution of arbitrage margins, thus casting doubts on most statistical results in such tests.     

Interest parity,fractional differencing,and the strength of attraction: a reexamination of the cost-of-carry futures pricing model

This article discusses the strength of attraction in the cointegration of foreign exchange futures prices and their own cash prices under a cost-of-carry futures pricing model. The memories of the residuals in cointegration regression are analyzed by using the fractional cointegration of Cheung and Lai (1993) and the data-tapered method of Hurvich and Ray (1995) with fractional-difference time-series models. The investigation includes the foreign exchange futures and cash prices of the Swiss franc, the Japanese yen, the Deutsche mark, and the British pound. Although the empirical results indicate the existence of cointegration for the foreign exchange futures and cash prices, the strength of attraction is relatively weak.     

WEBS,SPDRs, and country funds: an analysis of international cointegration

Prior empirical studies analyzing linkages between international equity markets have suffered because suitable real-world financial instruments representing national equity markets were not available for trading. In March 1996, World Equity Benchmark Shares (WEBS) began trading on the American Stock Exchange. WEBS are open-end index funds that trade like closed-end index funds; they are designed to closely track the international indices developed by Morgan Stanley Capital International. This study utilizes WEBS along with Standard & Poor’s Depository Receipts (SPDRs) to avoid the previously encountered problems associated with nonsynchronous trading, fluctuating foreign exchange rates, non-liquidity, trading restrictions, and index replication. Results indicate that substantial pairwise cointegration exists among the 18 market indices as well as between individual closed-end country funds and their own-country WEBS. In addition, Granger causality tests indicate the existence of short-term causal relationships, suggesting market inefficiencies and the possibility of short-run arbitrage opportunities.     

Purchasing power parity, unit roots, and dynamic structure

Recent studies of purchasing power parity (PPP) account for the possible presence of unit roots in nominal exchange rates and relative price indices by applying standard unit-root tests to real exchange rates, which are ratios of nominal exchange rates and relative price indices. These studies occasionally find evidence of PPP, but as a whole, the evidence is not definitive. Standard unit-root tests impose a restrictive dynamic structure between nominal exchange rates and relative price indices. I specify and estimate a generalized dynamic structure. I reject the dynamic restrictions implicit in standard unit-root tests of PPP, and find stronger evidence of PPP than do most other recent studies.     

Testing the expectations hypothesis of the term structure with permanent-transitory component models

This study proposes a new application of Permanent-Transitory Component Models (PTCMs) to test the Expectation Hypothesis of the Term Structure (EHTS). Unlike previous approaches, tests based on PTCMs can simultaneously detect departures from rational expectations and time varying term premia. We set out analytically and empirically the links across previous tests and PTCMs. We also show that PTCMs identify an additional restriction for rational expectations, on top of the one-to-one relationship between forward and spot rates, that must be imposed in estimations of term premia. Data for the short-end of the US term structure suggest that both factors contribute to the rejection of the EHTS. Moreover, the empirical estimates of term premia are persistent and exhibit sign fluctuations. Their stochastic properties depend crucially on whether the additional restriction for rational expectations is imposed in estimation.     

Three aspects of the Swiss term structure: an empirical survey

The term structure is an important transmitter of, and indicator for, monetary policy. This paper studies the Swiss term structure using monthly data from 1989 to 2005. We study the impact of the new monetary policy strategy that the Swiss National Bank (SNB) adopted at the beginning of 2000 on three aspects of the term structure. First, we test the expectations hypothesis and find it confirmed at the short end of the yield curve. At the long end, time-varying term premia seem present. Second, we ask whether the yield curve contains information regarding future inflation and economic activity. We find that a steepening of the yield curve predicted an increase in economic activity in the short term before the change in policy strategy, but not thereafter. Third, we study the contemporaneous reaction of the term structure to macroeconomic conditions and conclude that the SNB’s commitment to stabilizing inflation may have become more credible after the change in the monetary policy strategy.      

Optimization,cointegration and diversification gains from international portfolios: an out-of-sample analysis

This study investigates comparative performance of iShares and their underlying market indices in a portfolio context from the perspective of U.S. investors. Two aspects are important. First, portfolios based on standard optimization procedures and a portfolio based on cointegration procedures are created and out-of-sample performance is compared. The portfolio utilizing cointegration inputs shows superior out-of-sample performance. Second, portfolio performance measurement is extended to different holding periods. The findings do not differ.     

Decomposing and Testing Long‐term Returns: an Application on Danish IPOs

An improved method for measuring and testing long‐run returns is proposed. The method adjusts for the right‐skewed distribution of long‐run buy‐and‐hold by decomposing average cross‐sectional buy‐and‐hold returns into mean components and volatility components. The method is applied to initial public offerings in Denmark. The mean‐component under performance of initial public offering stocks compared to the market is 30% and significant after 5 years. Compared to matching firms the under performance of IPO stocks is 13% after 5 years but insignificant.     

Interest rate co-movements, global factors and the long end of the term spread

The decoupling of US short and long interest rates has been a distinctive feature of the 2000s. We employ recent advances in panel econometrics to document this disconnect for industrial countries and link it to a global latent factor in long term rates. We investigate whether international forces, such as global inflation, global output, or the global savings glut may be behind this global latent factor. The savings glut is the most likely contender, suggesting that reserve accumulation and a search for yield from emerging markets has lowered long rates internationally, driving a wedge between domestic short and long rates.     

Nonlinear term structure dependence: Copula functions,empirics, and risk implications

This paper documents nonlinear cross-sectional dependence in the term structure of US-Treasury yields and points out risk management implications. The analysis is based on a Kalman filter estimation of a two-factor affine model which specifies the yield curve dynamics. We then apply a broad class of copula functions for modeling dependence in factors spanning the yield curve. Our sample of monthly yields in the 1982–2001 period provides evidence of upper tail dependence in yield innovations; i.e., large positive interest rate shocks tend to occur under increased dependence. In contrast, the best-fitting copula model coincides with zero lower tail dependence. This asymmetry has substantial risk management implications. We give an example in estimating bond portfolio loss quantiles and report the biases which result from an application of the normal dependence model.     

The information in the term structure

This paper presents a regression approach to measuring the information in forward interest rates about time varying premiums and future spot interest rates. Like earlier work, the regressions identify variation in the expected premiums on longer-maturity Treasury bills. The more novel evidence concerns the forecasts of future spot rates in forward rates. The regressions provide evidence that the one-month forward rate has power to predict the spot rate one month ahead. During periods preceding 1974, forward rates have reliable forecast power for one-month spot rates up to five months in the future.     

Fiscal policy and the term structure

This paper investigates the empirical association between deficits in interest rates. It extends the results in Plosser (1982) to include the more recent experience. The association between a measure of ex ante real rates and deficits is also considered. The results largely corroborate the previous results. First, little or no association between real or nominal interest rates and deficits is found. Second, output and, to a lesser extent, military spending are found to have a significant association with interest rates.     

Stock returns and the term structure

In monthly U.S. data for 1959–1979 and 1979–1983, the state of the term structure of interest rates predicts excess stock returns, as well as excess returns on bills and bonds. This paper documents this fact and uses it to examine some simple asset pricing models. In 1959–1979, the data strongly reject a single-latent-variable specification of predictable excess returns. There is considerable evidence that conditional variances of excess returns change through time, but the relationship between conditional mean and conditional variance is reliably positive only at the short end of the term structure.     

Taylor rules and the term structure

The expectations model of the term structure has been subjected to numerous empirical tests and almost invariably rejected, with the failure generally attributed to systematic expectations errors or to shifts in risk premia. Rules for monetary policy designed along the lines of Taylor [1993. Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195-214] specify that the central bank adjusts short-term yields in response to deviations of inflation and output gaps from target level. Such rules give a good empirical account of the behavior of the short-term interest rate. Combining the Taylor rule and expectations theory, it is possible to generate—along lines pioneered by Campbell and Shiller [1987. Cointegration and tests of present value models. Journal of Political Economy 95, 1062-1088]—a series of theoretical long-term interest rates. When such theoretical rates are calculated for the US over 1980-2004, considerable support for the expectations theory emerges.