Yield Curve Predictors of Foreign Exchange Returns

We present a pricing kernel that summarizes well the main features of the dynamics of interest rates and risk in postwar U.S. data and use it to uncover how the pricing kernel has moved with the short rate in this data. Our findings imply that standard monetary models miss an essential link between the central bank instrument and the economic activity that monetary policy is intended to affect, and thus we call for a new approach to monetary policy analysis. We sketch a new approach using an economic model based on our pricing kernel. The model incorporates the key relationships between policy and risk movements in an unconventional way: the central bank's policy changes are viewed as primarily intended to compensate for exogenous business cycle fluctuations in risk that threaten to push inflation off target. This model, while an improvement on standard models, is considered just a starting point for their revision. It leads to critical questions that researchers need to answer as they continue to revise their approach to monetary policy analysis. Copyright © 2009 by the National Bureau of Economic Research.

Interest Rate Risk: Critical Component of Risk in Commercial Banks

58 - Portfolio management II

The fact that long term interest rates have been higher on average than short rates in the twentieth century has often been interpreted in the term structure literature as evidence of the existence of positive or term premiums. The purpose of this paper is to point out that an average differential between long and short rates does not necessarily represent a differential between returns realized by holders of long versus short term bonds. In particular, it is shown that if short term rates are positively autocorrelated, interest rate differentials overstate differentials in realized rates of return. We conclude that liquidity or term premiums properly estimated from the Durand yield curve data are not consistent with the liquidity preference theory. LONG TERM INTEREST RATES have been higher on average than short term rates during the twentieth century. The average differential over the period 1900-1958 between long term interest rates and spot one year rates in the Durand yield curve data increases monotonically with term to about half a percentage point at forty years. The interpretation given to these differentials in the term structure literature is that they are the additional rate of return earned on average by capital invested in long term bonds. The purpose of this paper is to point out that an average differential between long and short term interest rates does not necessarily represent a differential between realized rates of return. This is because the realized increment to capital invested in a sequence of short term bonds depends on the ex post product of uncertain future spot rates. The expected value of this ex post product will in general differ from the product of expected future spot rates. We show that if short term rates are positively autocorrelated, the interest rate differentials overstate differentials in realized rates of return. We shall refer to differentials in realized rates of return as term premiums. The proper interpretation of interest rate differentials is important to the assessment of the evidence for various theories of the term structure. The liquidity preference theory of J. R. Hicks [4, pp. 144-147] predicts that a term premium will be earned by capital invested in long term bonds because their holders require compensation for risk of capital fluctuation. Forward interest rates will exceed one period spot rates on average by the amount of premium which rises monotonically with horizon. The positive and monotonic average differentials between forward and spot one year rates in the Durand data have been

Recent events have highlighted the potential importance of nonlinear efiects of flscal variables (notably debt and deflcits) on interest rates: While in times when government solvency is not a concern the standard crowding-out efiects are of moderate magnitude, in times when default risk becomes an issue the interest rate efiects can become very large. This paper provides new evidence on the magnitude of these efiects. For the case when default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic efiects of flscal policy shocks on interest rates along the entire maturity spectrum. For the case when default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on EMU government bond spread regressions on time-varying efiects of national flscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of flscal policy. JEL classiflcation: E6, H6.

3 - The dynamics of asset prices

Historical shocks (Lehman Brothers bankruptcy (15 September 2008), the FED?s tapering decision (18 December 2013), the CBRT?s interest rate decision (28 January 2013)) had significant impact on global and domestic financial markets, especially nonperforming loans (NPLs). In this context, main aim of this study is to analyze how volatility changes in exchange rates and interest rates triggered by these historical shocks affect consumer and industrial nonperforming loans in Turkish economy by using quantile regression techniques. The results showed that shocks that cause volatility changes in foreign exchange rates and interest rates have important effects on NPLs in the Turkish banking industry.

The question of how monetary policy translates across the yield curve is at the forefront of many recent policy debates. This debate takes on added intensity when the choice of policy regime is heterogeneous. Monetary policy targets the very short end of the yield curve, although real economic activity is largely influenced by medium- to long-term market interest rates. Given efficient market conditions, conventional wisdom asserts that changes to the monetary policy instrument (policy interest rate) lead to an immediate change in market interest rates and bond prices distributed over all maturities; yet evidence supporting this view remains elusive. Using the expectations hypothesis as a benchmark, an empirical analysis of daily yield rates for the Japanese money and government bond markets for the period 2000 to 2009 provides evidence for segmentation over the yield curve. The expectations hypothesis receives little support in either an interest rate targeting or quantitative targeting regime, but the policy impact is weaker in times of quantitative targeting; the observed concentration of impact suggests highly segmented market niches. The empirical findings invite attention of monetary policymakers to the financial system and its structural impediments, especially in an environment of economic uncertainty, low market confidence, and a binding interest rate floor.

Term Structure and the Sluggishness of Retail Bank Interest Rates in Euro Area Countries

Changes in interest rates may be attributed to changes in the supply schedule of funds, changes in the demand schedule, or changes in both schedules. Since interest rates link the financial and real sectors of the economy and thus transmit the major thrust of central bank actions to the ultimate targets of monetary policy, it is important to identify properly the causes underlying changes in rates. An increase in rates resulting from an upward shift in the demand fot funds has substantially different implications for the course of economic activity than an equal rise attributable to a downward shift in the supply of funds. This paper conducts tests to determine whether postwar changes in interest rates have resulted primarily from changes in the demand for funds or in the supply of funds. As a first approximation, interest rates can be assumed to be affected on the supply side primarily by the supply of money and on the demand side primarily by aggregate income or output. We can test the relative strengths of money and output on rates by including them both as explanatory variables in one equation1:

Chapter 23 - Market Risk, Interest Rates and Bank Intermediary Role in Developing Economies

Bond issuers frequently immunise/hedge their interest rate exposure by means of interest rate swaps (IRS). The receiving leg matches all bond cash flows, while the pay leg requires floating rate coupon payments of form LIBOR plus a spread. The goal of hedging against interest rate risk is only achieved in full if the present value of this spread is zero. Using market data it is shown that under a traditional IRS hedging strategy an investor could still experience significant cash flow losses given a 1 per cent shift in the underlying benchmark yield curve. Consideration is given to the instantaneous interest rate risk of a bond portfolio that allows for general changes in interest rates. Two contributions are made. The paper analyses the size of hedging imperfections arising from the widening of the floating rate spread in a traditional swap contract and subsequently proposes two new practical, effective and analytically tractable swap structures: Structure 1: an improved parallel hedge swap, hedges against parallel shifts of the yield curve; and Structure 2: an improved non-parallel hedge swap, hedges against any movement of the swap curve. Analytical representations of these swaps are provided such that spreadsheet implementations are easily attainable.

Purpose: The aim of the study was to assess the effect of interest rate changes on stock market volatility in Congo. Methodology: This study adopted a desk methodology. A desk study research design is commonly known as secondary data collection. This is basically collecting data from existing resources preferably because of its low cost advantage as compared to a field research. Our current study looked into already published studies and reports as the data was easily accessed through online journals and libraries. Findings: Changes in interest rates have a notable impact on stock market volatility. When central banks adjust interest rates, it influences investor sentiment and economic forecasts. Typically, an increase in interest rates makes borrowing more expensive, which can dampen corporate profits and economic growth, leading to higher market volatility as investors reassess the value of stocks. Conversely, a decrease in interest rates generally lowers borrowing costs, potentially boosting corporate earnings and economic expansion, which can initially reduce market volatility. However, the long-term effects might differ as lower rates can also lead to overvaluation concerns, eventually increasing volatility. Additionally, interest rate changes signal monetary policy shifts and broader economic conditions, further influencing investor behavior and stock market dynamics. Overall, interest rate fluctuations are a critical factor contributing to stock market volatility through their direct and indirect effects on economic activities and investor perceptions. Implications to Theory, Practice and Policy: Efficient market hypothesis, portfolio theory and behavioral finance theory may be used to anchor future studies on assessing the effect of interest rate changes on stock market volatility in Congo. For practical implications, investors and financial institutions should develop risk management strategies that account for the short-term volatility spikes following interest rate announcements. From a policy perspective, policymakers should consider the lagged effects of interest rate changes when formulating monetary policy to ensure smoother market transitions.

Interest Rate Risk Management by Indian Scheduled Commercial Banks: Evidence Using Linear Programming Problem and Panel Data Analysis

This study sets out to investigate the relationships that exist among key macroeconomic variables in Fiji. The purpose of the investigation is to ascertain whether, given the interrelationships that do exist among the key macroeconomic variables, the existing monetary policy setting is appropriate to this small semiopen economy in its endeavours to stabilise fluctuations in output and the price level. A semiopen economy is defined as one where restrictions exist on the capital account of the balance of payments. These restrictions imply that changes in domestic interest rates can differ in the short run from changes in international interest rates. Fiji maintains an anchor on its nominal effective exchange rate which is tied to a basket of currencies comprising the currencies of the major trading partners. These trading partners have credible anti-inflationary strategies. Apart from maintaining a nominal exchange rate anchor, authorities also pursue an active monetary policy and respond to inflationary pressures that arise from within the Fijian economy. As such, the Reserve Bank of Fiji is actively engaged in following simultaneously an exchange rate policy and monetary policy. The use of monetary policy necessitates activities by the Reserve Bank of Fiji to manage the level of liquidity in the financial sector. This thesis addresses a number of specific questions. Is the policy of setting an anchor on the nominal exchange rate appropriate for Fiji? Are there any arguments in favour of making the nominal exchange rate more flexible? Is the use of monetary policy appropriate? Should the Reserve Bank sterilise the monetary effects of the balance of payments? What factors determine the supply of and demand for money in Fiji? What is the role of interest rates in Fiji? To answer these questions, a general equilibrium macroeconomic model that captures the characteristics of the Fijian economy is formulated and then estimated. The model is basically a Mundell-Fleming type of model but includes the supply side and models policy response explicitly. It is assumed that prices and interest rates are sticky in the short run, foreign assets are imperfect substitutes for domestic assets, and capital is imperfectly mobile. The model is estimated using the Cowles Commission approach using 3SLS and FIML estimates. The time series modelling strategy has not been used. In recent times, it has been demonstrated that in the context of structural equation modelling, nonstationarity does not necessarily call for a modelling strategy different from the Cowles Commission approach. It has been demonstrated that prior information, both theoretical and empirical, are more important in a nonstationary framework than a stationary one for identification on the one hand and for ensuring that the parameters possess desirable statistical properties on the other. The estimates of the model for Fiji reveal that there is a divide between the real and monetary sectors: the rate of interest has no effects on real demand or supply. Real demand and supply are determined almost exclusively by foreign prices and the exchange rate anchor. This raises doubts about the effectiveness of monetary policy and about the rationale behind liquidity management. With regard to sterilisation policies aimed at managing liquidity, the estimates reveal that the monetary effect of the balance of payments does not conform to the traditional assumption that the monetary effects are realised only when there is intervention in the foreign exchange market. The estimates demonstrate that an inflow of foreign exchange sees the money multiplier work through the economy twice: once when the foreign currency initially enters the country and once when the Reserve Bank of Fiji intervenes. This has implications for the sterilisation policies.