Forecasting the term structure when short-term rates are near zero

This paper compares the experience of forecasting the UK government bond yield curve before and after the dramatic lowering of short-term interest rates from October 2008. Out-of-sample forecasts for 1, 6 and 12 months are generated from each of a dynamic Nelson-Siegel model, autoregressive models for both yields and the principal components extracted from those yields, a slope regression and a random walk model. At short forecasting horizons, there is little difference in the performance of the models both prior to and after 2008. However, for medium- to longer-term horizons, the slope regression provided the best forecasts prior to 2008, while the recent experience of near-zero short interest rates coincides with a period of forecasting superiority for the autoregressive and dynamic Nelson-Siegel models. © 2014 John Wiley & Sons, Ltd.

Do external funds yield lower returns? Recent evidence from East Asian economies

One of the central explanations of the recent Asian Crisis has been the problem of moral hazard as the source of over-investment and excessive external borrowing. There is however rather limited firm-level empirical evidence to characterise inefficient use of internal and external finances. Using a large firm-level panel data-set from four badly affected Asian countries, this paper compares the rates of return to various internal and external funds among firms with low and high debt financing (relative to equity) among financially constrained and other firms. Selectivity-corrected estimates obtained from random effects panel data model do suggest evidence of significantly lower rates of return to long-term debt, even among firms relying more on debt relative to equity in our sample. There is also evidence that average effective interest rates often significantly exceeded the average returns to long-term debt in the sample countries in the pre-crisis period. © 2006 Elsevier Inc. All rights reserved.

Capital markets and the market structure of foreign investments

Contrary to the long-received theory of FDI, interest rates or rates of return can motivate foreign direct investment (FDI) in concert with the benefits of direct ownership. Thus, access to investor capital and capital markets is a vital component of the multinational’s competitive market structure. Moreover, multinationals can use their superior financial capacity as a competitive advantage in exploiting FDI opportunities in dynamic markets. They can also mitigate higher levels of foreign business risks under dynamic conditions by shifting more financial risk to creditors in the host economy. Furthermore, the investor’s expectation of foreign business risk necessarily commands a risk premium for exposing their equity to foreign market risk. Multinationals can modify the profit maximization strategy of their foreign subsidiaries to maximize growth or profits to generate this risk premium. In this context, we investigate how foreign subsidiaries manage their capital funding, business risk, and profit strategies with a diverse sample of 8,000 matched parents and foreign subsidiary accounts from multiple industries in 38 countries.We find that interest rates, asset prices, and expectations in capital markets have a significant effect on the capital movements of foreign subsidiaries. We also find that foreign subsidiaries mitigate their exposure to foreign business risk by modifying their capital structure and debt maturity. Further, we show how the operating strategy of foreign subsidiaries affects their preference for growth or profit maximization. We further show that superior shareholder value, which is a vital link for access to capital for funding foreign expansion in open market economies, is achieved through maintaining stability in the rate of growth and good asset utilization.

A two-factor model of the U.K. yield curve

I model the forward premium in the U.K. gilt-edged market over the period 1982–96 using a two-factor general equilibrium model of the term structure of interest rates. The model permits the decomposition of the forward premium into separate components representing interest rate expectations, the risk premia associated with each of the underlying factors, and terms capturing the direct impact of the variances of the factors on the shape of the forward curve.

Econometrics of yield spreads in the money market:a note

The literature on bond markets and interest rates has focused largely on the term structure of interest rates, specifically, on the so-called expectations hypothesis. At the same time, little is known about the nature of the spread of the interest rates in the money market beyond the fact that such spreads are generally unstable. However, with the evolution of complex financial instruments, it has become imperative to identify the time series process that can help one accurately forecast such spreads into the future. This article explores the nature of the time series process underlying the spread between three-month and one-year US rates, and concludes that the movements in this spread over time is best captured by a GARCH(1,1) process. It also suggests the use of a relatively long term measure of interest rate volatility as an explanatory variable. This exercise has gained added importance in view of the revelation that GARCH based estimates of option prices consistently outperform the corresponding estimates based on the stylized Black-Scholes algorithm.

Editorial

The year so far has been a slow start for many businesses, but at least we have not seen the collapse of as many businesses that we were seeing around two years ago. We are, however, still well and truly in the midst of a global recession. Interest rates are still at an all time low, UK house prices seem to be showing little signs of increase (except in London where everyone still seems to want to live!) and for the ardent shopper there are bargains to be had everywhere. It seems strange that prices on the high street do not seem to have increased in over ten years. Mobile phones, DVD players even furniture seems to be cheaper than they used to be. Whist much of this is down to cheaper manufacturing and the rest could probably be explained by competition within the market place. Does this mean that quality suffered too? Now that we live in a world when if a television is not working it is thrown away and replaced. There was a time when you would take it to some odd looking man that your father would know who could fix it for you. (I remember our local television fix-it man, with his thick rimmed bifocal spectacles and a poor comb-over; he had cardboard boxes full of resistors and electrical wires on the floor of his front room that smelt of soldering irons!) Is this consumerism at an extreme or has this move to disposability made us a better society? Before you think these are just ramblings there is a point to this. According to latest global figures of contact lens sales the vast majority of contact lenses fitted around the world are daily, fortnightly or monthly disposable hydrogel lenses. Certainly in the UK over 90% of lenses are disposable (with daily disposables being the most popular, having a market share of over 50%). This begs the question – is this a good thing? Maybe more importantly, do our patients benefit? I think it is worth reminding ourselves why we went down the disposability route with contact lenses in the first place, and unlike electrical goods it was not just so we did not have to take them for repair! There are the obvious advantages of overcoming problems of breakage and tearing of lenses and the lens deterioration with age. The lenses are less likely to be contaminated and the disinfection is either easier or not required at all (in the case of daily disposable lenses). Probably the landmark paper in the field was the work more commonly known as the ‘Gothenburg Study’. The paper, entitled ‘Strategies for minimizing the Ocular Effects of Extended Contact Lens Wear’ published in the American Journal of Optometry in 1987 (volume 64, pages 781-789) by Holden, B.A., Swarbrick, H.A., Sweeney, D.F., Ho, A., Efron, N., Vannas, A., Nilsson, K.T. They suggested that contact lens induced ocular effects were minimised by: •More frequently removed contact lenses •More regularly replaced contact lenses •A lens that was more mobile on the eye (to allow better removal of debris) •Better flow of oxygen through the lens All of these issues seem to be solved with disposability, except the oxygen issue which has been solved with the advent of silicone hydrogel materials. Newer issues have arisen and most can be solved in practice by the eye care practitioner. The emphasis now seems to be on making lenses more comfortable. The problems of contact lens related dry eyes symptoms seem to be ever present and maybe this would explain why in the UK we have a pretty constant contact lens wearing population of just over three million but every year we have over a million dropouts! That means we must be attracting a million new wearers every year (well done to the marketing departments!) but we are also losing a million wearers every year. We certainly are not losing them all to the refractive surgery clinics. We know that almost anyone can now wear a contact lens and we know that some lenses will solve problems of sharper vision, some will aid comfort, and some will be useful for patients with dry eyes. So if we still have so many dropouts then we must be doing something wrong! I think the take home message has to be ‘must try harder’! I must end with an apology for two errors in my editorial of issue 1 earlier this year. Firstly there was a typo in the first sentence; I meant to state that it was 40 years not 30 years since the first commercial soft lens was available in the UK. The second error was one that I was unaware of until colleagues Geoff Wilson (Birmingham, UK) and Tim Bowden (London, UK) wrote to me to explain that soft lenses were actually available in the UK before 1971 (please see their ‘Letters to the Editor’ in this issue). I am grateful to both of them for correcting the mistake.

Do R&D strategies in high-tech sectors differ from those in low-tech sectors? An alternative approach to testing the pooling assumption

Most studies investigating the determinants of R&D investment consider pooled estimates. However, if the parameters are heterogeneous, pooled coefficients may not provide reliable estimates of individual industry effects. Hence pooled parameters may conceal valuable information that may help target government tools more efficiently across heterogeneous industries. There is little evidence to date on the decomposition of the determinants of R&D investment by industry. Moreover, the existing work does not distinguish between those R&D determinants for which pooling may be valid and those for which it is not. In this paper, we test the pooling assumption for a panel of manufacturing industries and find that pooling is valid only for output fluctuations, adjustment costs and interest rates. Implementing the test results into our model, we find government funding is significant only for low-tech R&D. Foreign R&D and skilled labour matter only in high-tech sectors. These results suggest important implications for R&D policy.