Essays on Monetary Economics and International Finance

This thesis consists of two chapters. In the first chapter, I study optimal monetary policy rules in a general equilibrium model with financial market imperfections and uncertain business cycles. Earlier consensus view --using models with financial amplification with disturbances that have no direct effect on credit market conditions-- suggests that financial variables should not be assigned an independent role in policy making. Introducing uncertainty, time-variation in cross-sectional dispersion of firms' productive performance, alters this policy prescription. The results show that (i) optimal policy is to dampen the strength of financial amplification by responding to uncertainty (at the expense of creating a mild degree of fluctuations in inflation). (ii) a higher uncertainty makes the planner more willing to relax `financial stress' on the economy. (iii) Credit spreads are a good proxy for uncertainty, and hence, within the class of simple monetary policy rules I consider, a non-negligible interest rate response to credit spreads (32 basis points in response to a 1% change in credit spreads) -together with a strong anti-inflationary stance- achieves the highest aggregate welfare possible. In the second chapter, I study global, regional and idiosyncratic factors in driving the sovereign credit risk premium (as measured by sovereign credit default swaps) for a set of 25 emerging market economies during the last decade. The results show that (i) On average, global and regional factors account for a substantial portion of the movements in sovereign risk premium (of 63% and 21%, respectively). (ii) there exists noticeable heterogeneity in the contribution of factors across the emerging markets. (iii) The (extracted) global factor is best reflected by the VIX (investors' risk sentiment) among the financial market indicators considered. (iv) There are regime changes in the relation between the global factor and the financial market indicators

Forecasting Stock Market Volatilities Using MIDAS Regressions: An Application to the Emerging Markets

We explore the relative weekly stock market volatility forecasting performance of the linear univariate MIDAS regression model based on squared daily returns vis-a-vis the benchmark model of GARCH(1,1) for a set of four developed and ten emerging market economies. We first estimate the two models for the 2002-2007 period and compare their in-sample properties. Next we estimate the two models using the data on 2002-2005 period and then compare their out-of-sample forecasting performance for the 2006-2007 period, based on the corresponding mean squared prediction errors following the testing procedure suggested by West (2006). Our findings show that the MIDAS squared daily return regression model outperforms the GARCH model significantly in four of the emerging markets. Moreover, the GARCH model fails to outperform the MIDAS regression model in any of the emerging markets significantly. The results are slightly less conclusive for the developed economies. These results may imply superior performance of MIDAS in relatively more volatile environments.Mixed Data Sampling regression model; Conditional volatility forecasting; Emerging Markets

The Economics of Uncovered Interest Parity Condition for Emerging Markets: A Survey

Financial account liberalizations since the second half of the 1980s paved way for the burgeoning literature that investigates foreign exchange market efficiency in emerging markets via testing for the uncovered interest parity (UIP) condition. This paper provides a broad and critical survey on this recent literature as well as a general understanding on the topic through reviewing the related literature on developed economies where recent methodological advances in time series econometrics have provided favorable results, questioning the previously documented UIP puzzle. The literature on emerging markets suggests that these countries deserve a special treatment by taking into account the existence of additional types of risk premia, high inflation episodes, financial contagion, peso problem, simultaneity problem, asymmetricity, and the determination of de facto structural breaks.Uncovered Interest Parity; Forward Premium Bias; Emerging Markets

Forecasting Stock Market Volatilities Using MIDAS Regressions: An Application to the Emerging Markets

We explore the relative weekly stock market volatility forecasting performance of the linear univariate MIDAS regression model based on squared daily returns vis-a-vis the benchmark model of GARCH(1,1) for a set of four developed and ten emerging market economies. We first estimate the two models for the 2002-2007 period and compare their in-sample properties. Next we estimate the two models using the data on 2002-2005 period and then compare their out-of-sample forecasting performance for the 2006-2007 period, based on the corresponding mean squared prediction errors following the testing procedure suggested by West (2006). Our findings show that the MIDAS squared daily return regression model outperforms the GARCH model significantly in four of the emerging markets. Moreover, the GARCH model fails to outperform the MIDAS regression model in any of the emerging markets significantly. The results are slightly less conclusive for the developed economies. These results may imply superior performance of MIDAS in relatively more volatile environments

Forecasting Stock Market Volatilities Using MIDAS Regressions: An Application to the Emerging Markets

We explore the relative weekly stock market volatility forecasting performance of the linear univariate MIDAS regression model based on squared daily returns vis-a-vis the benchmark model of GARCH(1,1) for a set of four developed and ten emerging market economies. We first estimate the two models for the 2002-2007 period and compare their in-sample properties. Next we estimate the two models using the data on 2002-2005 period and then compare their out-of-sample forecasting performance for the 2006-2007 period, based on the corresponding mean squared prediction errors following the testing procedure suggested by West (2006). Our findings show that the MIDAS squared daily return regression model outperforms the GARCH model significantly in four of the emerging markets. Moreover, the GARCH model fails to outperform the MIDAS regression model in any of the emerging markets significantly. The results are slightly less conclusive for the developed economies. These results may imply superior performance of MIDAS in relatively more volatile environments

Optimal Monetary Policy Rules, Financial Amplification, and Uncertain Business Cycles

This paper studies whether financial variables per se should matter for monetary policy. Earlier consensus view - using financial amplification models with disturbances that have no direct effect on credit market conditions- suggests that financial variables should not be assigned an independent role in policy making. Introducing uncertainty, time- variation in cross-sectional dispersion of firms’ productive performance, alters this policy prescription. The results show that (i) optimal policy is to dampen the strength of financial amplification by responding to uncertainty (at the expense of creating a mild degree of fluctuations in inflation). Moreover, a higher uncertainty makes the planner more willing to relax the financial constraints. (ii) Credit spreads are a good proxy for uncertainty, and hence, within the class of simple monetary policy rules I consider, a non-negligible response to credit spreads -together with a strong anti-inflationary stance- achieves the highest aggregate welfare possible.Optimal Monetary Policy, Financial Amplification, Uncertainty Shocks

THE ECONOMICS OF UNCOVERED INTEREST PARITY CONDITION FOR EMERGING MARKETS: A SURVEY

Financial account liberalizations since the second half of the 1980s paved way for the burgeoning literature that investigates foreign exchange market efficiency in emerg-ing markets via testing for the uncovered interest parity (UIP) condition. This paper provides a broad and critical survey on this recent literature as well as a general under-standing on the topic through reviewing the related literature on developed economies where recent methodological advances in time series econometrics have provided fa-vorable results, questioning the previously documented UIP puzzle. The literature on emerging markets suggests that these countries deserve a special treatment by taking into account the existence of additional types of risk premia, high inflation episodes, financial contagion, peso problem, simultaneity problem, asymmetricity, and the deter-mination of de facto structural breaks