Speculative dynamics in the term structure of interest rates

When long maturity bonds are traded frequently and traders have non-nestedinformation sets, speculative behavior in the sense of Harrison and Kreps (1978) arises.Using a term structure model displaying such speculative behavior, this paper proposesa conceptually and observationally distinct new mechanism generating time varying predictableexcess returns. It is demonstrated that (i) dispersion of expectations about futureshort rates is sufficient for individual traders to systematically predict excess returns and(ii) the new term structure dynamics driven by speculative trade is orthogonal to publicinformation in real time, but (iii) can nevertheless be quantified using only publicly availableyield data. The model is estimated using monthly data on US short to medium termTreasuries from 1964 to 2007 and it provides a good fit of the data. Speculative dynamicsare found to be quantitatively important, potentially accounting for a substantial fractionof the variation of bond yields and appears to be more important at long maturities.

Risk management under a two-factor model of the term structure of interest rates

This paper presents several applications to interest rate risk managementbased on a two-factor continuous-time model of the term structure of interestrates previously presented in Moreno (1996). This model assumes that defaultfree discount bond prices are determined by the time to maturity and twofactors, the long-term interest rate and the spread (difference between thelong-term rate and the short-term (instantaneous) riskless rate). Several newmeasures of ``generalized duration" are presented and applied in differentsituations in order to manage market risk and yield curve risk. By means ofthese measures, we are able to compute the hedging ratios that allows us toimmunize a bond portfolio by means of options on bonds. Focusing on thehedging problem, it is shown that these new measures allow us to immunize abond portfolio against changes (parallel and/or in the slope) in the yieldcurve. Finally, a proposal of solution of the limitations of conventionalduration by means of these new measures is presented and illustratednumerically.

A two-mean reverting-factor model of the term structure of interest rates

This paper presents a two--factor model of the term structure ofinterest rates. We assume that default free discount bond prices aredetermined by the time to maturity and two factors, the long--term interestrate and the spread (difference between the long--term rate and theshort--term (instantaneous) riskless rate). Assuming that both factorsfollow a joint Ornstein--Uhlenbeck process, a general bond pricing equationis derived. We obtain a closed--form expression for bond prices andexamine its implications for the term structure of interest rates. We alsoderive a closed--form solution for interest rate derivatives prices. Thisexpression is applied to price European options on discount bonds andmore complex types of options. Finally, empirical evidence of the model'sperformance is presented.

Term structure of interest rates. European financial integration

In this paper we estimate, analyze and compare the term structures of interest rates in six different countries over the period 1992-2004. We apply the Nelson-Siegel model to obtain the term structures of interest rates at weekly intervals. A total of 4,038 curves are estimated and analyzed. Four European Monetary Union countries¿Spain, France, Germany and Italy¿are included. The UK is also included as a European non-member of the Monetary Union. Finally the US completes the analysis. The goal is to determine the differences in the shapes of the term structure of interest rates among these countries. Likewise, we can determine the most usual term structure shapes that appear for each country.*****

Term structure of interest rates. European financial integration

In this paper we estimate, analyze and compare the term structures of interest rates in six different countries over the period 1992-2004. We apply the Nelson-Siegel model to obtain the term structures of interest rates at weekly intervals. A total of 4,038 curves are estimated and analyzed. Four European Monetary Union countries¿Spain, France, Germany and Italy¿are included. The UK is also included as a European non-member of the Monetary Union. Finally the US completes the analysis. The goal is to determine the differences in the shapes of the term structure of interest rates among these countries. Likewise, we can determine the most usual term structure shapes that appear for each country.*****

On the term structure of Interbank interest rates: Jump-diffusion processes and option pricing

In this paper we study the dynamic behavior of the term structureof Interbank interest rates and the pricing of options on interest ratesensitive securities. We posit a generalized single factor model withjumps to take into account external influences in the market. Daily datais used to test for jump effects. Qualitative examination of the linkagebetween Monetary Authorities' interventions and jumps are studied. Pricingresults suggests a systematic underpricing in bonds and call options ifthe jumps component is not included. However, the pricing of put optionson bonds presents indeterminacies.

The impact of interest-rate subsidies on long-term household debt: Evidence from a large program

The responsiveness of long-term household debt to the interest rate is acrucial parameter for assessing the effectiveness of public policies aimedat promoting specific types of saving. This paper estimates the effect ofa reform of Credito Bonificado, a large program in Portugal that subsidizedmortgage interest rates, on long-term household debt. The reform establisheda ceiling in the price of the house that could be financed through theprogram, and provides plausibly exogenous variation in incentives. Usinga unique dataset of matched household survey data and administrative recordsof debt, we document a large decrease in the probability of signing a newloan after the removal of the subsidy.

Fiscal policy and interest rates: the role of financial and economic integration

It is commonly believed that a fiscal expansion raises interest rates. However, these crowding out effects of deficits have been found to be small or non-existent. One explanation is that financial integration offsets interest rate differentials on globalised bond markets. This paper measures the degree of integration of government bond markets, using spatial modelling techniques to take this spillover on financial markets into account. Our main finding is that the crowding out effect on domestic interest rates is significant, but is reduced by spillover across borders. This spillover is important in major crises or in periods of coordinated policy actions. This result is generally robust to various measures of cross-country linkages. We find spillover to be much stronger among EU countries.

In Search of a theory of debt management

A growing literature integrates theories of debt management into models of optimal fiscal policy. One promising theory argues that the composition of government debt should be chosen so that fluctuations in the market value of debt offset changes in expected future deficits. This complete market approach to debt management is valid even when the government only issues non-contingent bonds. A number of authors conclude from this approach that governments should issue long term debt and invest in short term assets. We argue that the conclusions of this approach are too fragile to serve as a basis for policy recommendations. This is because bonds at different maturities have highly correlated returns, causing the determination of the optimal portfolio to be ill-conditioned. To make this point concrete we examine the implications of this approach to debt management in various models, both analytically and using numerical methods calibrated to the US economy. We find the complete market approach recommends asset positions which are huge multiples of GDP. Introducing persistent shocks or capital accumulation only worsens this problem. Increasing the volatility of interest rates through habits partly reduces the size of these simulations we find no presumption that governments should issue long term debt ? policy recommendations can be easily reversed through small perturbations in the specification of shocks or small variations in the maturity of bonds issued. We further extend the literature by removing the assumption that governments every period costlessly repurchase all outstanding debt. This exacerbates the size of the required positions, worsens their volatility and in some cases produces instability in debt holdings. We conclude that it is very difficult to insulate fiscal policy from shocks by using the complete markets approach to debt management. Given the limited variability of the yield curve using maturities is a poor way to substitute for state contingent debt. The result is the positions recommended by this approach conflict with a number of features that we believe are important in making bond markets incomplete e.g allowing for transaction costs, liquidity effects, etc.. Until these features are all fully incorporated we remain in search of a theory of debt management capable of providing robust policy insights.

Solving non-linear stochastic models by parameterizing expectations: An application to asset pricing with production

A new algorithm called the parameterized expectations approach(PEA) for solving dynamic stochastic models under rational expectationsis developed and its advantages and disadvantages are discussed. Thisalgorithm can, in principle, approximate the true equilibrium arbitrarilywell. Also, this algorithm works from the Euler equations, so that theequilibrium does not have to be cast in the form of a planner's problem.Monte--Carlo integration and the absence of grids on the state variables,cause the computation costs not to go up exponentially when the numberof state variables or the exogenous shocks in the economy increase. \\As an application we analyze an asset pricing model with endogenousproduction. We analyze its implications for time dependence of volatilityof stock returns and the term structure of interest rates. We argue thatthis model can generate hump--shaped term structures.

On the sources of business cycles in the G-7

This paper examines sources of cyclical movements in output, inflation and the term structure of interest rates. It employs a novel identification approach which uses the sign of the cross correlation function in response to shocks to catalog orthogonal disturbances. We find that demand shocks are the dominant source output, inflation and term structure fluctuations in six of the G-7 countries. Within the class of demand disturbances, nominal shocks are dominant, but their importance declined after 1982. Furthermore, there are no significant differences in the proportion of term structure variability explained by different structural sources at different horizons.

On the relevance of modeling volatility for pricing purposes

This paper presents a two-factor (Vasicek-CIR) model of the term structure of interest rates and develops its pricing and empirical properties. We assume that default free discount bond prices are determined by the time to maturity and two factors, the long-term interest rate and the spread. Assuming a certain process for both factors, a general bond pricing equation is derived and a closed-form expression for bond prices is obtained. Empirical evidence of the model's performance in comparisson with a double Vasicek model is presented. The main conclusion is that the modeling of the volatility in the long-term rate process can help (in a large amount) to fit the observed data can improve - in a reasonable quantity - the prediction of the future movements in the medium- and long-term interest rates. However, for shorter maturities, it is shown that the pricing errors are, basically, negligible and it is not so clear which is the best model to be used.

Do expectations matter? The Great Moderation revisited

We examine the role of expectations in the Great Moderation episode. We derive theoretical restrictions in a New-Keynesian model and test them using measures of expectations obtained from survey data, the Greenbook and bond markets. Expectations explain the dynamics of inflation and of interest rates but their importance is roughly unchanged over time. Systems with and without expectations display similar reduced form characteristics. Including or excluding expectations hardly changes the economic explanation of the Great Moderation. Results are robust to changes in the structure of the empirical model.

An analysis of inflation rates in the European Union using wavelets : strong evidence against unit roots

In this paper we assume inflation rates in European Union countries may in fact be fractionally integrated. Given this assumption, we obtain estimations of the order of integration by means a method based on wavelets coefficients. Finally, results obtained allow reject the unit root hypothesis on inflation rates. It means that a random shock on the rate of inflation in these countries has transitory effects that gradually diminish with the passage of time, that this, said shock hasn¿t a permanent effect on future values of inflation rates

An analysis of inflation rates in the European Union using wavelets : strong evidence against unit roots

In this paper we assume inflation rates in European Union countries may in fact be fractionally integrated. Given this assumption, we obtain estimations of the order of integration by means a method based on wavelets coefficients. Finally, results obtained allow reject the unit root hypothesis on inflation rates. It means that a random shock on the rate of inflation in these countries has transitory effects that gradually diminish with the passage of time, that this, said shock hasn¿t a permanent effect on future values of inflation rates