A comparison of test of non-linear cointegration with an application to the predictability of US interest rates using the term structure

We evaluate the forecasting performance of a number of systems models of US shortand long-term interest rates. Non-linearities, induding asymmetries in the adjustment to equilibrium, are shown to result in more accurate short horizon forecasts. We find that both long and short rates respond to disequilibria in the spread in certain circumstances, which would not be evident from linear representations or from single-equation analyses of the short-term interest rate.

Price risk management in the copper market using commodity derivatives and options strategies

Metals price risk management is a key issue related to financial risk in metal markets because of uncertainty of commodity price fluctuation, exchange rate, interest rate changes and huge price risk either to metals’ producers or consumers. Thus, it has been taken into account by all participants in metal markets including metals’ producers, consumers, merchants, banks, investment funds, speculators, traders and so on. Managing price risk provides stable income for both metals’ producers and consumers, so it increases the chance that a firm will invest in attractive projects. The purpose of this research is to evaluate risk management strategies in the copper market. The main tools and strategies of price risk management are hedging and other derivatives such as futures contracts, swaps and options contracts. Hedging is a transaction designed to reduce or eliminate price risk. Derivatives are financial instruments, whose returns are derived from other financial instruments and they are commonly used for managing financial risks. Although derivatives have been around in some form for centuries, their growth has accelerated rapidly during the last 20 years. Nowadays, they are widely used by financial institutions, corporations, professional investors, and individuals. This project is focused on the over-the-counter (OTC) market and its products such as exotic options, particularly Asian options. The first part of the project is a description of basic derivatives and risk management strategies. In addition, this part discusses basic concepts of spot and futures (forward) markets, benefits and costs of risk management and risks and rewards of positions in the derivative markets. The second part considers valuations of commodity derivatives. In this part, the options pricing model DerivaGem is applied to Asian call and put options on London Metal Exchange (LME) copper because it is important to understand how Asian options are valued and to compare theoretical values of the options with their market observed values. Predicting future trends of copper prices is important and would be essential to manage market price risk successfully. Therefore, the third part is a discussion about econometric commodity models. Based on this literature review, the fourth part of the project reports the construction and testing of an econometric model designed to forecast the monthly average price of copper on the LME. More specifically, this part aims at showing how LME copper prices can be explained by means of a simultaneous equation structural model (two-stage least squares regression) connecting supply and demand variables. A simultaneous econometric model for the copper industry is built: {█(Q_t^D=e^((-5.0485))∙P_((t-1))^((-0.1868) )∙〖GDP〗_t^((1.7151) )∙e^((0.0158)∙〖IP〗_t ) @Q_t^S=e^((-3.0785))∙P_((t-1))^((0.5960))∙T_t^((0.1408))∙P_(OIL(t))^((-0.1559))∙〖USDI〗_t^((1.2432))∙〖LIBOR〗_((t-6))^((-0.0561))@Q_t^D=Q_t^S )┤ P_((t-1))^CU=e^((-2.5165))∙〖GDP〗_t^((2.1910))∙e^((0.0202)∙〖IP〗_t )∙T_t^((-0.1799))∙P_(OIL(t))^((0.1991))∙〖USDI〗_t^((-1.5881))∙〖LIBOR〗_((t-6))^((0.0717) Where, Q_t^D and Q_t^Sare world demand for and supply of copper at time t respectively. P(t-1) is the lagged price of copper, which is the focus of the analysis in this part. GDPt is world gross domestic product at time t, which represents aggregate economic activity. In addition, industrial production should be considered here, so the global industrial production growth that is noted as IPt is included in the model. Tt is the time variable, which is a useful proxy for technological change. A proxy variable for the cost of energy in producing copper is the price of oil at time t, which is noted as POIL(t ) . USDIt is the U.S. dollar index variable at time t, which is an important variable for explaining the copper supply and copper prices. At last, LIBOR(t-6) is the 6-month lagged 1-year London Inter bank offering rate of interest. Although, the model can be applicable for different base metals' industries, the omitted exogenous variables such as the price of substitute or a combined variable related to the price of substitutes have not been considered in this study. Based on this econometric model and using a Monte-Carlo simulation analysis, the probabilities that the monthly average copper prices in 2006 and 2007 will be greater than specific strike price of an option are defined. The final part evaluates risk management strategies including options strategies, metal swaps and simple options in relation to the simulation results. The basic options strategies such as bull spreads, bear spreads and butterfly spreads, which are created by using both call and put options in 2006 and 2007 are evaluated. Consequently, each risk management strategy in 2006 and 2007 is analyzed based on the day of data and the price prediction model. As a result, applications stemming from this project include valuing Asian options, developing a copper price prediction model, forecasting and planning, and decision making for price risk management in the copper market.

The Real Exchange Rate in Small Open Developed Economies: Evidence from Cointegration Analysis

We examine the effects of the terms of trade and the expected real interest rate differential on the real exchange rate in a sample of small open developed economies. We employ cointegration analysis to search for possible long-term linkages. We find that while both the terms of trade and the expected real interest rate differentials affect the real exchange rate in the long run, the role of the terms of trade generally proves more consistent across countries. The speed of adjustment for the expected real interest rate differential in the error-correction model, however, is quantitatively larger than it is for the terms of trade.

Essays on Monetary Policy in Small Open Economies

Thesis (Ph.D.)--University of Washington, 2016-06

On the estimation and comparison of short-rate models using the generalised method of moments

Subsequent to the influential paper of [Chan, K.C., Karolyi, G.A., Longstaff, F.A., Sanders, A.B., 1992. An empirical comparison of alternative models of the short-term interest rate. Journal of Finance 47, 1209-1227], the generalised method of moments (GMM) has been a popular technique for estimation and inference relating to continuous-time models of the short-term interest rate. GMM has been widely employed to estimate model parameters and to assess the goodness-of-fit of competing short-rate specifications. The current paper conducts a series of simulation experiments to document the bias and precision of GMM estimates of short-rate parameters, as well as the size and power of [Hansen, L.P., 1982. Large sample properties of generalised method of moments estimators. Econometrica 50, 1029-1054], J-test of over-identifying restrictions. While the J-test appears to have appropriate size and good power in sample sizes commonly encountered in the short-rate literature, GMM estimates of the speed of mean reversion are shown to be severely biased. Consequently, it is dangerous to draw strong conclusions about the strength of mean reversion using GMM. In contrast, the parameter capturing the levels effect, which is important in differentiating between competing short-rate specifications, is estimated with little bias. (c) 2006 Elsevier B.V. All rights reserved.

Are there non-linearities in short-term interest rates?

The present paper investigates the characteristics of short-term interest rates in several countries. We examine the importance of nonlinearities in the mean reversion and volatility of short-term interest rates. We examine various models that allow the conditional mean (drift) and conditional variance (diffusion) to be functions of the current short rate.We find that different markets require different models. In particular, we find evidence of nonlinear mean reversion in some of the countries that we examine, linear mean reversion in others and no mean reversion in some countries. For all countries we examine, there is strong evidence of the need for the volatility of interest rate changes to be highly sensitive to the level of the short-term interest rate. Out-of-sample forecasting performance of one-factor short rate models is poor, stemming from the inability of the models to accommodate jumps and discontinuities in the time series data.

Az egyensúlyi ráták unicitása és a bérráta pozitivitása a Neumann-modell általánosításaiban (Uniqueness of equilibrium rates and the positive value of the wage rate in generalizations from the Neumann model)

Cikkünk arról a paradox jelenségről szól, hogy a fogyasztást explicit módon megjelenítő Neumann-modell egyensúlyi megoldásaiban a munkabért meghatározó létszükségleti termékek ára esetenként nulla lehet, és emiatt a reálbér egyensúlyi értéke is nulla lesz. Ez a jelenség mindig bekövetkezik az olyan dekomponálható gazdaságok esetén, amelyekben eltérő növekedési és profitrátájú, alternatív egyensúlyi megoldások léteznek. A jelenség sokkal áttekinthetőbb formában tárgyalható a modell Leontief-eljárásra épülő egyszerűbb változatában is, amit ki is használunk. Megmutatjuk, hogy a legnagyobbnál alacsonyabb szintű növekedési tényezőjű megoldások közgazdasági szempontból értelmetlenek, és így érdektelenek. Ezzel voltaképpen egyrészt azt mutatjuk meg, hogy Neumann kiváló intuíciója jól működött, amikor ragaszkodott modellje egyértelmű megoldásához, másrészt pedig azt is, hogy ehhez nincs szükség a gazdaság dekomponálhatóságának feltételezésére. A vizsgált téma szorosan kapcsolódik az általános profitráta meghatározásának - Sraffa által modern formába öntött - Ricardo-féle elemzéséhez, illetve a neoklasszikus növekedéselmélet nevezetes bér-profit, illetve felhalmozás-fogyasztás átváltási határgörbéihez, ami jelzi a téma elméleti és elmélettörténeti érdekességét is. / === / In the Marx-Neumann version of the Neumann model introduced by Morishima, the use of commodities is split between production and consumption, and wages are determined as the cost of necessary consumption. In such a version it may occur that the equilibrium prices of all goods necessary for consumption are zero, so that the equilibrium wage rate becomes zero too. In fact such a paradoxical case will always arise when the economy is decomposable and the equilibrium not unique in terms of growth and interest rate. It can be shown that a zero equilibrium wage rate will appear in all equilibrium solutions where growth and interest rate are less than maximal. This is another proof of Neumann's genius and intuition, for he arrived at the uniqueness of equilibrium via an assumption that implied that the economy was indecomposable, a condition relaxed later by Kemeny, Morgenstern and Thompson. This situation occurs also in similar models based on Leontief technology and such versions of the Marx-Neumann model make the roots of the problem more apparent. Analysis of them also yields an interesting corollary to Ricardo's corn rate of profit: the real cause of the awkwardness is bad specification of the model: luxury commodities are introduced without there being a final demand for them, and production of them becomes a waste of resources. Bad model specification shows up as a consumption coefficient incompatible with the given technology in the more general model with joint production and technological choice. For the paradoxical situation implies the level of consumption could be raised and/or the intensity of labour diminished without lowering the equilibrium rate of the growth and interest. This entails wasteful use of resources and indicates again that the equilibrium conditions are improperly specified. It is shown that the conditions for equilibrium can and should be redefined for the Marx-Neumann model without assuming an indecomposable economy, in a way that ensures the existence of an equilibrium unique in terms of the growth and interest rate coupled with a positive value for the wage rate, so confirming Neumann's intuition. The proposed solution relates closely to findings of Bromek in a paper correcting Morishima's generalization of wage/profit and consumption/investment frontiers.

Kamatlábak és árszint kis, nyitott gazdaságban = Interest rates and price levels in a small open economy

A tanulmány azt vizsgálja, hogy a különböző kamatlábaknak milyen hatásai vannak az árszintre, illetve a nominális árakra egy nyitott elsősorban kis, nyitott gazdaságban szabad tőkeáramlás mellett. Míg a zárt gazdaságban csupán a nominális és reálkamatláb megkülönböztetése a lényeges, nyitott gazdaságban a kamatlábak vizsgálatakor meg kell fontolnunk a kamatlábparitás kérdését is. Tisztáznunk kell a reálkamatláb összetevőit, amelyben fontos szerepet kap mind az árfolyam-begyűrűzés (pass-through), mind pedig a kockázati prémium mértéke. A kamatlábhatások vizsgálatakor először azt a mechanizmust elemezzük, amely által a kamatláb befolyásolja a tartós jószágok költségét (explicit vagy implicit bérleti díját). Másodszor az exportszektor termelési döntése és a hazai kamatláb viszonyára vonatkozó mechanizmust vizsgáljuk. Belátjuk, hogy az exportáló szektor döntései függetlenek lehetnek a belföldi kamatlábaktól. Harmadszor bizonyos árazási viselkedéseket tanulmányozunk. Bebizonyítjuk, hogy a kamatláb olyan növelése, ami nem változtat a jelenlegi árfolyamon, árszintnövelő az importőr ország számára. Megfogalmazható az a nézet, hogy ha van is a kamatlábaknak keresleti hatása a zárt gazdaságban, a kis, nyitott gazdaságban ez vélhetőleg sokkal gyengébb. _____ The study examines what effects various interest rates have on the price level and nomi-nal prices in an open (primarily small) economy with free flows of capital. A closed economy calls for a distinction only between nominal and real rates of interest, but in an open economy, questions of interest-rate parity have to be considered as well. It is nec-essary to clarify the factors behind the real interest rate important for price-level pass-through and for the scale of risk premium. Analysis of interest-rate effects begins with the mechanism whereby the interest rate influences the cost of fixed assets (explicit or implicit rents). Secondly, the mechanism behind the relation of export-sector production decisions and domestic interest rates is examined. It emerges that decisions of the export sector are independent of domestic interest rates. Thirdly, certain types of pricing behav-iour are studied. It is shown that a rise in the interest rate that does not alter the present exchange rate is a price-raising factor for the importing country. It can be assumed that if the interest rate has a demand effect in a closed economy, this will presumably be much weaker in a small open economy.

Credit risk & forward price models

Doutoramento em Gestão

Diversification and value-at-risk

A pervasive and puzzling feature of banks’ Value-at-Risk (VaR) is its abnormally high level, which leads to excessive regulatory capital. A possible explanation for the tendency of commercial banks to overstate their VaR is that they incompletely account for the diversification effect among broad risk categories (e.g., equity, interest rate, commodity, credit spread, and foreign exchange). By underestimating the diversification effect, bank’s proprietary VaR models produce overly prudent market risk assessments. In this paper, we examine empirically the validity of this hypothesis using actual VaR data from major US commercial banks. In contrast to the VaR diversification hypothesis, we find that US banks show no sign of systematic underestimation of the diversification effect. In particular, diversification effects used by banks is very close to (and quite often larger than) our empirical diversification estimates. A direct implication of this finding is that individual VaRs for each broad risk category, just like aggregate VaRs, are biased risk assessments.

Financialization, crisis and commodity correlation dynamics

Stronger investor interest in commodities may create closer integration with conventional asset markets. We estimate sudden and gradual changes in correlation between stocks, bonds and commodity futures returns driven by observable financial variables and time, using double smooth transition conditional correlation (DSTCC–GARCH) models. Most correlations begin the 1990s near zero but closer integration emerges around the early 2000s and reaches peaks during the recent crisis. Diversification benefits to investors across equity, bond and stock markets were significantly reduced. Increases in VIX and financial traders’ short open interest raise futures returns volatility for many commodities. Higher VIX also increases commodity returns correlation with equity returns for about half the pairs, indicating closer integration.

Form prevailing over substance?

The decision of the Court of Appeal in Kellas-Sharpe v PSAL Ltd [2012] QCA 371 considered a not unusual provision in a loan agreement, being a provision whereby a lender agrees to accept a lower or concessional rate of interest in circumstances of prompt payment by the borrower. The loan agreement in question provided for the borrower to pay a standard rate of interest of 7.5% per month. However, if the borrower was not in default, the lender agreed to accept interest at a concessional rate of interest of 4% per month. The issue for determination by the Court of Appeal (McMurdo P, Gotterson JA and Fryberg J) was whether the clause was subject to the equitable jurisdiction to relieve against penalties, and, if so, if the interest rate provision should be treated as a penalty making the interest rate provision void. In mounting this argument, the borrower was seeking to overturn a long line of authority which has repeatedly upheld the semantic distinction between an increase in the rate of interest (which attracts the doctrine concerning penalties) and an incentive to the borrower by way of a reduction in the interest rate for prompt payment (which does not attract the doctrine)...

Financial Markets, Institutions and Money [3rd ed.]

"The financial system is a key influencer of the health and efficiency of an economy. The role of the financial system is to gather money from people and businesses that currently have more money than they need and transfer it to those that can use it for either business or consumer expenditures. This flow of funds through financial markets and institutions in the Australian economy is huge (in the billions of dollars), affecting business profits, the rate of inflation, interest rates and the production of goods and services. In general, the larger the flow of funds and the more efficient the financial system, the greater the economic output and welfare in the economy. It is not possible to have a modern, complex economy such as that in Australia, without an efficient and sound financial system. The global financial crisis (GFC) of late 2007–09 (and the ensuing European debt crisis), where the global financial market was on the brink of collapse with only significant government intervention stopping a catastrophic global failure of the market, illustrated the importance of the financial system. Financial Markets, Institutions and Money 3rd edition introduces students to the financial system, its operations, and participants. The text offers a fresh, succinct analysis of the financial markets and discusses how the many participants in the financial system interrelate. This includes coverage of regulators, regulations and the role of the Reserve Bank of Australia, that ensure the system’s smooth running, which is essential to a modern economy. The text has been significantly revised to take into account changes in the financial world."---publisher website Table of Contents 1. The financial system - an overview 2. The Monetary Authorities 3. The Reserve Bank of Australia and interest rates 4. The level of interest rates 5. Mathematics of finance 6. Bond Prices and interest rate risk 7. The Structure of Interest Rates 8. Money Markets 9. Bond Markets 10. Equity Markets

Climate change and financial regulation : challenges for the financial sector post the Global Financial Crisis

Regulation has played a significant role in shaping the financial services sector in Australia over the past few decades. Regulatory changes have included the establishment of the Australian Prudential Regulation Authority (APRA), floating the Australian dollar, allowing foreign financial institutions to operate domestically, the introduction of the superannuation guarantee charge, and the removal of interest rate controls. As the economy emerges from the worst financial crisis since the great depression, a new force of change that is recognised as one of the most significant sources of risk and opportunity facing the business community in the foreseeable future is that of climate change. Climate change is expected to be a significant change agent in the financial services sector as extreme weather patterns, sea level rises, and atmospheric changes impact on asset values (both investment and lending), project finance, and risk products. The financial services industry will be particularly affected by these developments, both as a provider of financial products (capital, credit, investment, advice, and insurance), and also through its powerful influence on the economy in terms of capital allocation. In addition, industry constituents will be heavily impacted by government regulation in this area (reporting, emissions trading and environmental policies), with respect to their own business practices and also those of their clients. This study reports the results of interviews conducted with senior members of the finance sector working in the sustainability area to gauge their perceptions of the challenges facing the sector with respect to climate change. Our results confirm that that regulatory intervention will be critical to climate change response gaining traction and momentum. In particular, regulatory certainty will promote engagement, particularly in relation to the Carbon Pollution Reduction Scheme (CPRS), with other developments needed in terms of information disclosure, performance and remuneration, and incentive programs. Accordingly, the significant potential risks and opportunities that climate change presents to the sector, and the broader economy, will in part be managed/realised only if a swift and significant regulatory response is achieved.

A Tradable Permit System in an Intertemporal Economy

It is known that in an intertemporal competitive economy, a tradable permit system may not achieve efficiency without setting appropriate permit interest rates (i.e., rewards for holding permits). To find the rates, however, we need to know in advance the path of efficient permit prices, which is difficult to obtain. This study intends to solve this problem in two ways. First, we analyze a special case in which the permit interest rates are given by a simple rule. For example, if the marginal abatement cost of pollution emission is constant, then the appropriate rate is to equal the monetary interest rate. As is the case for global warming, if the damage is caused in the future far beyond the planning period of the environmental program, the appropriate rate coincides with the marginal self-recovery of environmental stock under certain conditions. As a second approach, we propose a tradable permit system with a permit bank, as a mechanism by which the permit interest rates are generated endogenously without governmental intervention other than the issuance of permits. However, we also show that this approach raises the problem of indeterminacy of the equilibrium. © 2013 Springer Science+Business Media Dordrecht.