Discrete time models of the term structure of interest rates and interest rate contingent claims

In this study, discrete time one-factor models of the term structure of interest rates and their application to the pricing of interest rate contingent claims are examined theoretically and empirically. The first chapter provides a discussion of the issues involved in the pricing of interest rate contingent claims and a description of the Ho and Lee (1986), Maloney and Byrne (1989), and Black, Derman, and Toy (1990) discrete time models. In the second chapter, a general discrete time model of the term structure from which the Ho and Lee, Maloney and Byrne, and Black, Derman, and Toy models can all be obtained is presented. The general model also provides for the specification of an additional model, the ExtendedMB model. The third chapter illustrates the application of the discrete time models to the pricing of a variety of interest rate contingent claims. In the final chapter, the performance of the Ho and Lee, Black, Derman, and Toy, and ExtendedMB models in the pricing of Eurodollar futures options is investigated empirically. The results indicate that the Black, Derman, and Toy and ExtendedMB models outperform the Ho and Lee model. Little difference in the performance of the Black, Derman, and Toy and ExtendedMB models is detected. ^

Determinants of local government pension funding: Empirical evidence from Florida

The financial community is well aware that continued underfunding of state and local government pension plans poses many public policy and fiduciary management concerns. However, a well-defined theoretical rationale has not been developed to explain why and how public sector pension plans underfund. This study uses three methods: a survey of national pension experts, an incomplete covariance panel method, and field interviews.^ A survey of national public sector pension experts was conducted to provide a conceptual framework by which underfunding could be evaluated. Experts suggest that plan design, fiscal stress, and political culture factors impact underfunding. However, experts do not agree with previous research findings that unions actively pursue underfunding to secure current wage increases.^ Within the conceptual framework and determinants identified by experts, several empirical regularities are documented for the first time. Analysis of 173 local government pension plans, observed from 1987 to 1992, was conducted. Findings indicate that underfunding occurs in plans that have lower retirement ages, increased costs due to benefit enhancements, when the sponsor faces current year operating deficits, or when a local government relies heavily on inelastic revenue sources. Results also suggest that elected officials artificially inflate interest rate assumptions to reduce current pension costs, consequently shifting these costs to future generations. In concurrence with some experts there is no data to support the assumption that highly unionized employees secure more funding than less unionized employees.^ Empirical results provide satisfactory but not overwhelming statistical power, and only minor predictive capacity. To further explore why underfunding occurs, field interviews were carried out with 62 local government officials. Practitioners indicated that perceived fiscal stress, the willingness of policymakers to advance funding, bargaining strategies used by union officials, apathy by employees and retirees, pension board composition, and the level of influence by internal pension experts has an impact on funding outcomes.^ A pension funding process model was posited by triangulating the expert survey, empirical findings, and field survey results. The funding process model should help shape and refine our theoretical knowledge of state and local government pension underfunding in the future. ^

Principal component and second generation wavelet analysis of Treasury yield curve evolution

Prices of U.S. Treasury securities vary over time and across maturities. When the market in Treasurys is sufficiently complete and frictionless, these prices may be modeled by a function time and maturity. A cross-section of this function for time held fixed is called the yield curve; the aggregate of these sections is the evolution of the yield curve. This dissertation studies aspects of this evolution. ^ There are two complementary approaches to the study of yield curve evolution here. The first is principal components analysis; the second is wavelet analysis. In both approaches both the time and maturity variables are discretized. In principal components analysis the vectors of yield curve shifts are viewed as observations of a multivariate normal distribution. The resulting covariance matrix is diagonalized; the resulting eigenvalues and eigenvectors (the principal components) are used to draw inferences about the yield curve evolution. ^ In wavelet analysis, the vectors of shifts are resolved into hierarchies of localized fundamental shifts (wavelets) that leave specified global properties invariant (average change and duration change). The hierarchies relate to the degree of localization with movements restricted to a single maturity at the base and general movements at the apex. Second generation wavelet techniques allow better adaptation of the model to economic observables. Statistically, the wavelet approach is inherently nonparametric while the wavelets themselves are better adapted to describing a complete market. ^ Principal components analysis provides information on the dimension of the yield curve process. While there is no clear demarkation between operative factors and noise, the top six principal components pick up 99% of total interest rate variation 95% of the time. An economically justified basis of this process is hard to find; for example a simple linear model will not suffice for the first principal component and the shape of this component is nonstationary. ^ Wavelet analysis works more directly with yield curve observations than principal components analysis. In fact the complete process from bond data to multiresolution is presented, including the dedicated Perl programs and the details of the portfolio metrics and specially adapted wavelet construction. The result is more robust statistics which provide balance to the more fragile principal components analysis. ^

Essays in open economy macroeconomics

Research macroeconomists have witnessed remarkable methodological developments in mathematical, statistical, and computational tools during the last two decades. The three essays in this dissertation took advantage of these advances to analyze important macroeconomic issues. ^ The first essay, “ Habit Formation, Adjustments Costs, and International Business Cycle Puzzles” analyzes the extent to which incorporating habit formation and adjustment costs in investment in a one-good two-country general equilibrium model would help overcome some of the international business cycle puzzles. Unlike standard results in the literature, the model generates persistent, cyclical adjustment paths in response to shocks. It also yields positive cross-country correlations in consumption, employment, investment, and output. Cross-country correlations in output are higher than the ones in consumption. This is qualitatively consistent with the stylized facts. These results are particularly striking given the predicted negative correlations in investment, employment, and output that are typically found in the literature. ^ The second essay, “Comparison Utility, Endogenous Time Preference, and Economic Growth,” uses World War II as a natural experiment to analyze the degree to which a model where consumers' preferences exhibit comparison-based utility and endogenous discounting is able to improve upon existing models in mimicking the transitional dynamics of an economy after a shock that destroys part of its capital stock. The model outperforms existing ones in replicating the behavior of the saving rate (both on impact and along the transient paths) after this historical event. This result brings additional support to the endogenous rate of time preference being a crucial element in growth models. ^ The last essay, “Monetary Policy under Fear of Floating: Modeling the Dominican Economy,” presents a small scale macroeconomic model for a country (Dominican Republic) characterized by a strong presence of fear of floating (reluctance to have a flexible exchange rate regime) in the conduct of monetary policy. The dynamic responses of this economy to external shocks that are of interest for monetary policy purposes are analyzed under two alternative interest rate policy rules: One being the standard Taylor rule and another that responds explicitly to deviations of the exchange rate with respect to its long-term trend. ^

Variables affecting government debt: A comparison of certificates of participation, tax -exempt revenue bonds and tax -exempt general obligation bonds

This dissertation analyzed and compared variables affecting interest rate and yield of certificates of participation, tax-exempt revenue bonds and tax-exempt general obligation bonds. The study employed qualitative and quantitative analysis methods. ^ Qualitative research methods included surveys, interviews and focus groups. The survey solicited debt load information from 67 Florida school districts (21 responded) and addressed the question which districts used certificates of participation and why. Eight individuals with experience dealing with all three debt instruments were interviewed. A follow-up focus group of six school district financial officers gathered additional data. Results from the qualitative methods revealed school districts used certificates of participation based on millage authority amount available relative to overall tax base. Also identified was the belief of a significant difference in certificates of participation costs and the other two debt instrument types. ^ The study's quantitative methods analyzed 1998 and 1999 initial issues of Moody's AAA rated certificates of participation, tax-exempt revenue bonds and tax-exempt general obligation bonds. Through an analysis of covariance (ANCOVA), the study examined interest rates and yields while controlling for the covariates of credit enhancement, issue size, and maturity date. The analysis identified no significant difference between interest rates of certificates of participation and tax-exempt general obligation bonds (p < 0.05). There was a significant difference between interest rates of tax-exempt revenue bonds and tax-exempt general obligation bonds. This study discerned no significant difference between yield on certificates of participation and tax-exempt general obligation bonds. It identified a difference in yield between both certificates of participation and tax-exempt general obligation bonds compared with tax-exempt revenue bonds. ^ The study found COPs to have lesser overall costs than RV bonds. COPs also have a quicker entry into the market resulting in construction cost savings. The study found policy implications such as investment portfolio limitations and public choice issues about using COPs as a mechanism to grow government. ^

Essays in Open Economy Macroeconomics

Research macroeconomists have witnessed remarkable methodological developments in mathematical, statistical, and computational tools during the last two decades. The three essays in this dissertation took advantage of these advances to analyze important macroeconomic issues. The first essay, “ Habit Formation, Adjustments Costs, and International Business Cycle Puzzles” analyzes the extent to which incorporating habit formation and adjustment costs in investment in a one-good two-country general equilibrium model would help overcome some of the international business cycle puzzles. Unlike standard results in the literature, the model generates persistent, cyclical adjustment paths in response to shocks. It also yields positive cross-country correlations in consumption, employment, investment, and output. Cross-country correlations in output are higher than the ones in consumption. This is qualitatively consistent with the stylized facts. These results are particularly striking given the predicted negative correlations in investment, employment, and output that are typically found in the literature. The second essay, “Comparison Utility, Endogenous Time Preference, and Economic Growth,” uses World War II as a natural experiment to analyze the degree to which a model where consumers' preferences exhibit comparison-based utility and endogenous discounting is able to improve upon existing models in mimicking the transitional dynamics of an economy after a shock that destroys part of its capital stock. The model outperforms existing ones in replicating the behavior of the saving rate (both on impact and along the transient paths) after this historical event. This result brings additional support to the endogenous rate of time preference being a crucial element in growth models. The last essay, “Monetary Policy under Fear of Floating: Modeling the Dominican Economy,” presents a small scale macroeconomic model for a country (Dominican Republic) characterized by a strong presence of fear of floating (reluctance to have a flexible exchange rate regime) in the conduct of monetary policy. The dynamic responses of this economy to external shocks that are of interest for monetary policy purposes are analyzed under two alternative interest rate policy rules: One being the standard Taylor rule and another that responds explicitly to deviations of the exchange rate with respect to its long-term trend.

Essays on exchange rate economics

Exchange rate economics has achieved substantial development in the past few decades. Despite extensive research, a large number of unresolved problems remain in the exchange rate debate. This dissertation studied three puzzling issues aiming to improve our understanding of exchange rate behavior. Chapter Two used advanced econometric techniques to model and forecast exchange rate dynamics. Chapter Three and Chapter Four studied issues related to exchange rates using the theory of New Open Economy Macroeconomics. ^ Chapter Two empirically examined the short-run forecastability of nominal exchange rates. It analyzed important empirical regularities in daily exchange rates. Through a series of hypothesis tests, a best-fitting fractionally integrated GARCH model with skewed student-t error distribution was identified. The forecasting performance of the model was compared with that of a random walk model. Results supported the contention that nominal exchange rates seem to be unpredictable over the short run in the sense that the best-fitting model cannot beat the random walk model in forecasting exchange rate movements. ^ Chapter Three assessed the ability of dynamic general-equilibrium sticky-price monetary models to generate volatile foreign exchange risk premia. It developed a tractable two-country model where agents face a cash-in-advance constraint and set prices to the local market; the exogenous money supply process exhibits time-varying volatility. The model yielded approximate closed form solutions for risk premia and real exchange rates. Numerical results provided quantitative evidence that volatile risk premia can endogenously arise in a new open economy macroeconomic model. Thus, the model had potential to rationalize the Uncovered Interest Parity Puzzle. ^ Chapter Four sought to resolve the consumption-real exchange rate anomaly, which refers to the inability of most international macro models to generate negative cross-correlations between real exchange rates and relative consumption across two countries as observed in the data. While maintaining the assumption of complete asset markets, this chapter introduced endogenously segmented asset markets into a dynamic sticky-price monetary model. Simulation results showed that such a model could replicate the stylized fact that real exchange rates tend to move in an opposite direction with respect to relative consumption. ^

Essays on Exchange Rate Economics

Exchange rate economics has achieved substantial development in the past few decades. Despite extensive research, a large number of unresolved problems remain in the exchange rate debate. This dissertation studied three puzzling issues aiming to improve our understanding of exchange rate behavior. Chapter Two used advanced econometric techniques to model and forecast exchange rate dynamics. Chapter Three and Chapter Four studied issues related to exchange rates using the theory of New Open Economy Macroeconomics. Chapter Two empirically examined the short-run forecastability of nominal exchange rates. It analyzed important empirical regularities in daily exchange rates. Through a series of hypothesis tests, a best-fitting fractionally integrated GARCH model with skewed student-t error distribution was identified. The forecasting performance of the model was compared with that of a random walk model. Results supported the contention that nominal exchange rates seem to be unpredictable over the short run in the sense that the best-fitting model cannot beat the random walk model in forecasting exchange rate movements. Chapter Three assessed the ability of dynamic general-equilibrium sticky-price monetary models to generate volatile foreign exchange risk premia. It developed a tractable two-country model where agents face a cash-in-advance constraint and set prices to the local market; the exogenous money supply process exhibits time-varying volatility. The model yielded approximate closed form solutions for risk premia and real exchange rates. Numerical results provided quantitative evidence that volatile risk premia can endogenously arise in a new open economy macroeconomic model. Thus, the model had potential to rationalize the Uncovered Interest Parity Puzzle. Chapter Four sought to resolve the consumption-real exchange rate anomaly, which refers to the inability of most international macro models to generate negative cross-correlations between real exchange rates and relative consumption across two countries as observed in the data. While maintaining the assumption of complete asset markets, this chapter introduced endogenously segmented asset markets into a dynamic sticky-price monetary model. Simulation results showed that such a model could replicate the stylized fact that real exchange rates tend to move in an opposite direction with respect to relative consumption.