Essays in empirical finance

Abstract

The aim of this thesis is to deepen our understanding of new empirical methods, results and implications in interest rate and foreign exchange markets. To this end, this thesis is organised in three chapters. The first chapter tests the validity of the Expectation Hypothesis (EH) of the term structure using daily data for US repo rates spanning the 1991-2005 sample period and ranging in maturity from overnight to three months. We revisit a recent study by Longstaff (2000a) by implementing statistical tests designed to increase test power in this context. Specifically, we apply the Lagrange Multiplier and Distance Metric statistics to test a set of,nonlinear cross-equation restrictions imposed by the EH on a vector autoregression model of the short- and long-term interest rates. We find that EH is rejected throughout the term structure examined on the basis of the statistical tests. In the second chapter, we extend the study carried out in the first chapter in a different direction and assess the economic value of departures from the EH based on criteria of profitability and economic significance. In the context of a mean-variance framework, we compare the performance of a dynamic portfolio strategy consistent with EH to a dynamic portfolio strategy that exploits the departures from the EH. The results of our economic analysis are favourable to the EH, suggesting that the statistical rejections of the EH in the repo market are economically insignificant. Finally, in the third chapter, we provide a comprehensive evaluation of the shorthorizon predictive ability of economic fundamentals and fonvard premia on monthly exchange rate returns in a framework that allows for volatility timing. We implement Bayesian methods for estimation and ranking of a set of empirical exchange rate models, and construct combined forecasts based on Deterministic and Bayesian Model Averaging. More importantly, we assess the economic value of the in-sample and out-of-sample forecasting power of the empirical models, and find two key results: (i) a risk averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on the random walk model to one which conditions on the forward premium with stochastic volatility innovations; and (ii) strategies based on combined forecasts yield large economic gains over the random walk benchmark. These two results are robust to reasonably high transaction costs