Regime-switching stochastic volatility and short-term interest rates

In this paper, we introduce regime switching in a two-factor stochastic volatility (SV) model to explain the behavior of short-term interest rates. We model the volatility of short-term interest rates as a stochastic volatility process whose mean is subject to shifts in regime. We estimate the regime-switching stochastic volatility (RSV) model using a Gibbs Sampling-based Markov Chain Monte Carlo algorithm. In-sample results strongly favor the RSV model in comparison to the single-state SV model and Generalized Autoregressive Conditional Heteroscedasticity (GARCH) family of models. Out-of-sample results are mixed and, overall, provide weak support for the RSV model.     

Changing patterns in the cycles in short-term interest rates

Short-term interest rates in the United States from 1950 to 1974 moved through seven cycles to successively higher peaks. This paper examines the events before and after each peak in the context of four types of structural changes that developed during this period: (1) the changes in the private financial structure that Minsky has described as a trend toward systematic fragility; (2) the growing inelasticity of the liquidity preference function; (3) the development of liability management techniques by commercial banks; (4) the deterioration of the linkage between the monetary base and the money supply.     

Modelling conditional heteroscedasticity and jumps in Australian short-term interest rates

The present paper explores a class of jump–diffusion models for the Australian short‐term interest rate. The proposed general model incorporates linear mean‐reverting drift, time‐varying volatility in the form of LEVELS (sensitivity of the volatility to the levels of the short‐rates) and generalized autoregressive conditional heteroscedasticity (GARCH), as well as jumps, to match the salient features of the short‐rate dynamics. Maximum likelihood estimation reveals that pure diffusion models that ignore the jump factor are mis‐specified in the sense that they imply a spuriously high speed of mean‐reversion in the level of short‐rate changes as well as a spuriously high degree of persistence in volatility. Once the jump factor is incorporated, the jump models that can also capture the GARCH‐induced volatility produce reasonable estimates of the speed of mean reversion. The introduction of the jump factor also yields reasonable estimates of the GARCH parameters. Overall, the LEVELS–GARCH–JUMP model fits the data best.     

The relation between stock returns and short-term interest rates

This study examines the relation between the expected returns on common stocks and short-term interest rates. Using a two-factor model of stock returns, we show that the expected returns on common stocks are systematically related to the market risk and the interest-rate risk, which are estimated as the sensitivity of common-stock excess returns to the excess return on the equally weighted market index and to the federal fund premium, respectively. We find that the interest-rate risk for small firms is a significant source of investors' portfolio risk, but is not properly reflected in the single-factor market risk. We also find that the interest-rate risk for large firms is “negative” in the sense that the market risk estimated from the single-factor model overstates the true risk of large firms. An application of the Fama-MacBeth methodology indicates that the interest-rate risk premium as well as the market's risk premium are significant, implying that both the market risk and the interest-rate risk are priced. We show that the interest-rate risk premium explains a significant portion of the difference in expected returns between the top quintile and the bottom quintile of the NYSE and AMEX firms. We also show that the turn-of-the-year seasonal is observed for the interest-rate risk premium; however, the risk premium for the rest of the year is still significant, although small in mangitude.     

Preferred habitat for liquidity in international short-term interest rates

Risk-shifting window dressing and a preferred habitat for liquidity have been offered as possible explanations as to why US money market rates are higher before the year-end than afterwards. The two hypotheses differ in the timing of the rate decline at the year-end and the evidence on the timing of the decline supports the preferred habitat hypothesis in US money markets. This paper extends this line of research to the behavior of international short-term interest rates at year-ends and quarter-ends using London interbank offer rates (LIBOR) for 11 different currencies. The results suggest that the behavior of LIBOR for five currencies: the US Dollar, Euro, Japanese Yen, Swiss Franc, and German Mark is consistent with year-end or quarter-end preferred habitats for liquidity. Other currencies do not demonstrate consistently distinct patterns in turn-of-the-year and turn-of-the-quarter yields. None of the results provides any support for risk-shifting window dressing.     

OPEC in world financial markets: Oil prices and interest rates

This article examines the relationship between the real rate of interest in world financial markets and the price of oil. If OPEC cannot be viewed as a ‘small’ participant in world financial markets, and should its savings and portfolio behavior differ from that of the rest of the world, then wealth shifts to or from OPEC would affect world interest rates. Subsequently, this paper examines the magnitude of oil price changes required to elicit a significant interest rate change. Our empirical results shed light on OPEC's behavior, which at times may differ from a pure profit maximizing cartel. The short-run price elasticity of the world demand for oil is -0.04 and the long-run elasticity is -0.10. OPEC itself, as expected, faces higher elasticities of -0.08 and -0.36, respectively. The demand elasticity of oil with respect to ‘world’ GNP is 0.8. A major objective of this paper has been to determine the effect of changes in oil prices on world interest rates, and vice versa. Our results imply that only very large oil price increases will have a significant impact on world interest rates. However, oil prices show a non-negligible sensitivity to changes in world interest rates.     

Regime switching in the relationship between equity returns and short-term interest rates in the UK

This paper examines the relationship between UK equity returns and short-term interest rates using a two regime Markov-Switching EGARCH model. The results suggest one high-return, low variance regime within which the conditional variance of equity returns responds persistently but symmetrically to equity return innovations. In the other, low-mean, high variance, regime equity volatility responds asymmetrically and without persistence to shocks to equity returns. There is evidence of a regime dependent relationship between shorter maturity interest rate differentials and equity return volatility. Furthermore, there is evidence that events in the money markets influence the probability of transition across regimes.     

Sterilization of short-term capital inflows—through lower interest rates?

Reductions in international interest rates are a major cause of capital flows to emerging economies. Increases in domestic interest rates are a frequent policy response to the resulting price increases. This is often unsuccessful. The paper suggests a theoretical explanation based on distinctive features of emerging financial markets, including imperfect asset substitutability and imperfect capital mobility for some sectors of the economy. It concludes that the appropriate policy response to capital inflows may be lower interest rates.     

Sterilization and interest rates

In this note, the effect of a rise in the foreign interest rate on the home rate is considered in a small economy model with a fixed exchange rate. The cases of sterilization annd non-sterilization are considered. The effect of the degree of substitutability beteen domestic and foreign bonds is outlined.     

Nominal interest rates and stationarity

This paper investigates the (break) stationarity null hypothesis using data for 25 interest rates with different maturities and risk characteristics in Canada and the US. In contrast to a large part of the literature, this paper reports strong empirical evidence in favour of the null hypothesis of stationarity for the interest rate series.     

Economic news,exchange rates and interest rates

The paper examines the post-October 1979 response of exchange rates and interest rates to the new information contained in the first announcement of fifteen US macroeconomic series. Markets respond primarily to monetary news, but also to news about the trade deficit, domestic inflation, and variables that reflect the state of the business cycle. For all fifteen macroeconomic variables, an increase (decrease) in interest rates is accompanied by an appreciation (depreciation) of the dollar, which is consistent with models that stress price rigidity and absence of purchasing power parity.     

Is there a world real interest rate?

This study uses panel data techniques to estimate a common component to the ex post real interest rates of nine countries with liberal capital markets over the past 16 years. We show that the residuals from such a regression have almost no serial correlation, and that each country's real interest rate is highly correlated with the estimated world real interest rate. The primary exception to these findings is the behavior of the US real interest rate, which exhibits large and persistent deviations from the estimated world real interest rate, although it is still highly correlated with the world real interest rate.     

Interest rates and currency prices in a two-country world

This paper is a theoretical study of the determination of prices, interest rates and currency exchange rates, set in an infinitely-lived two-country world which is subject both to stochastic endowment shocks and to monetary instability. Formulas are obtained for pricing all equity claims, nominally-denominated bonds, and currencies, and these formulas are related to earlier, closely related results in the theories of money, finance international trade.     

Negative real interest rates

Standard textbook general equilibrium term structure models such as that developed by Cox, Ingersoll, and Ross [1985b. “A Theory of the Term Structure of Interest Rates.” Econometrica 53 (2): 385–407], do not accommodate negative real interest rates. Given this, the Cox, Ingersoll, and Ross [1985b. “A Theory of the Term Structure of Interest Rates.” Econometrica 53 (2): 385–407] ‘technological uncertainty variable’ is formulated in terms of the Pearson Type IV probability density. The Pearson Type IV encompasses mean-reverting sample paths, time-varying volatility and also allows for negative real interest rates. The Fokker–Planck (i.e. the Chapman–Kolmogorov) equation is then used to determine the conditional moments of the instantaneous real rate of interest. These enable one to determine the mean and variance of the accumulated (i.e. integrated) real rate of interest on a bank (or loan) account when interest accumulates at the instantaneous real rate of interest defined by the Pearson Type IV probability density. A pricing formula for pure discount bonds is also developed. Our empirical analysis of short-dated Treasury bills shows that real interest rates in the UK and the USA are strongly compatible with a general equilibrium term structure model based on the Pearson Type IV probability density.     

Defaults and interest rates in international lending

Since lenders cannot observe the riskiness of the projects that borrowers could choose, interest rates alone cannot be used as an instrument to discipline borrowers. A credible threat to exclude borrowers who default more than a certain number of times from participating in the capital markets makes international debt contracts incentive compatible. Since larger borrowers get fewer chances to default, they choose safer projects and are therefore charged lower interest rates. Also, borrowers, after each successive default, switch to safer and safer projects, which may result in lower and lower interest rates. This paper provides empirical evidence supporting these two predictions.     

Exchange rates, interest rates, and money-stock announcements: a theoretical exposition

When the Federal Reserve announce a larger than anticipated weekly level of the US money stock (M1) the dollar appreciates and short-term interest rates increase because of an expected liquidity effect, but long-term interest rates and particularly long-run forward interest rates increase because of an expected inflation effect. The two effects are not mutually exclusive but coexist when market participants are not completely sure of the Fed's policy rule, and thus react in a weighted average manner with weights that reflect subjective probabilities about different Federal Reserve money growth policies.     

On interest rates,inflationary expectations and tax rates

This paper provides new evidence on the relationship between inflation and the rate of interest for the United States during the 1953–1984 period. The results indicate that contrary to most previous studies, the Fisher hypothesis is inverted, which means that it is the real rate of interest rather than the nominal rate that moves inversely to the rate of inflation. However, this is the case only during periods of relatively stable inflation rates and moderate regulatory change. Over longer periods when factors are more volatile the inverted Fisher hypothesis is rejected.     

On the correlation of exchange rates and interest rates

This note shows that a negative correlation between the price of foreign currency and nominal interest rates in not necessarily an indication of movements in the real rate of interests. Such a correlation could be consistent with a monetarist model in which the real rate is constant.     

The stability of short-term interest rates pass-through in the euro area during the financial market and sovereign debt crises

We analyse the dynamics of the pass-through of banks’ marginal cost to bank lending rates over the 2008 crisis and the euro area sovereign debt crisis in France, Germany, Greece, Italy, Portugal and Spain. We measure banks’ marginal cost by their rate on new deposits, contrary to the literature that focuses on money market rates. This allows us to account for banks’ risks. We focus on the interest rate on new short-term loans granted to non-financial corporations in these countries. Our analysis is based on an error-correction approach that we extend to handle the time-varying long-run relationship between banks’ lending rates and banks’ marginal cost, as well as stochastic volatility. Our application is based on a harmonised monthly database from January 2003 to October 2014. We estimate the model within a Bayesian framework, using Markov Chain Monte Carlo methods (MCMC).We reject the view that the transmission mechanism is permanent over time. The long-run relationship moved with the sovereign debt crises to a new one, with a slower pass-through and higher bank lending rates. Its developments are heterogeneous from one country to the other. Impediments to the transmission of monetary rates depend on the heterogeneity in banks marginal costs and therefore, its risks. We also find that rates to small firms increase compared to large firms in a few countries. Using a VAR model, we show that overall, the effect of a shock on the rate of new deposits on the unexpected variances of new loans has been less important since 2010. These results confirm the slowdown in the transmission mechanism.