Alternative Tests of the Expectations Hypothesis of the Term Structure of Interest Rates

Similar to the US Federal Reserve and the European Central Bank, most central banks use the day-to-day interest rate on the inter-bank money market as their operational target. Using modern monetary instruments central banks can control very short-term interest rates. However, the problem is that the real economy (e.g. investment and consumption) and inflation, will generally be affected by the long-term interest rate. Central banks are unable to control the long-term interest rate. Therefore in order to analyse how monetary policy will affect the real economy, we need to know the relationship between short-term interest rates and long-term interest rates, referred to as the term structure of interest rates. Given the importance of knowing how this mechanism works, it is not surprising that this topic has become a highly important area of research and this is likely to continue to be the case now that the exchange rate channel does not exist in the Euro area. What is required is a theory, which will link interest rates of different maturities. The expectations hypothesis (EH) of the term structure of interest rates states that long-term interest rates depend entirely on expected future short-term interest rates. Hence the interest rate on a long-term bond (a debt instrument) will equal the average of short-term interest rates that people expect to occur over the life of the bond. This is referred to as the pure expectations hypothesis (PEH) and assumes there is no added risk to holding a longer maturity bond as opposed to a series of shorter maturity bonds, in other words the risk (term) premium is zero. It is the main theory behind the analysis of the link between interest rates of different maturities and hence is of crucial importance in understanding the impact of monetary policy on the real economy, referred to as the transmission mechanism of monetary policy. Although the evidence using European data is very supportive of the EH, for interest rates at the short end of the maturity spectrum (i.e. less than 12 months), the central bank’s influence on interest rates declines as the maturities become longer. There are two possible reasons why the EH may be rejected. The first is the impact of a time varying risk premium. If agents perceive large (unpredictable) changes in short rates as a result of inflation or general uncertainty, then this will lead to rejections of the EH. The second possible reason is of a more statistical nature. The tests used may lead to false rejections of the EH because of their poor properties in finite samples. It is specifically these issues that are the main focus of this study, where we analyse the small sample properties using a number of Monte Carlo (MC) experiments. The experiments focus on the fact that the alternative single equation tests based on the regression of the change in the short-term rate on the lagged spread are prone to severe over-rejection of the EH, even when it is true. However tests of the spread on the first difference of the short-rate reject at the correct rate. We find using MC experiments that this is in fact the case and these findings are consistent with those using US data.

Volatility and Irish Exports

We analyse the impact of volatility per se on exports for a a small open economy concentrating on Irish trade with the UK and the US. An important element is that we take account of the time lag between the trade decision and the actual trade or payments taking place by using a flexible lag approach. Rather than adopt a single measure of risk we also adopt a spectrum of risk measures and detail varied size characteristics and statistical properties. We find that the ambiguous results found to date may well be due to not taking account of the timing effect which varies substantially depending on which volatility measure is used. However, the foreign exchange volatility effect is consistently positive, indicating the dominance of exporters expectations of possible profitable opportunities from future cash flows. The potential negative aspects of trade, the entry and exit costs, are accounted for by a negative influence of income volatility on trade.Exports, risk measurement, distributed lags

An Analysis of the EU Emission Trading Scheme

The European Union’s Emissions Trading Scheme (ETS) is the key policy instrument of the European Commission’s Climate Change Program aimed at reducing green- house gas emissions to eight percent below 1990 levels by 2012. A critically important element of the EU ETS is the establishment of a market determined price for EU allowances. This article examines the extent to which several theoretically founded factors including, energy price movements, economic growth, temperature and stock market activity determine the expected prices of the European Union CO2 allowances during the 2005 through to the 2009 period. The novel aspect of our study is that we examine the heavily traded futures instruments that have an expiry date in Phase 2 of the EU ETS. Our study adopts both static and recursive versions of the Johansen multivariate cointegration likelihood ratio test as well as a variation on this test with a view to controlling for time varying volatility effects. Our results are indicative of a new pricing regime emerging in Phase 2 of the market and point to a maturing market driven by the fundamentals. These results are valuable both for traders of EU allowances and for those policy makers seeking to improve the design of the European Union ETS.CO2 prices, EU ETS, Energy, Kyoto Protocol, Weather

The Expectations Hypothesis of the Term Structure - The Case of Ireland

Using a number of short-term maturities and monthly data, 1984-1997, we provide a number of tests of the expectations hypothesis (EH) of the term structure. The paper draws on cointegration techniques and the methodological approach of Campbell and Shiller (1987,1991). On balance our results lend support to the EH and are broadly consistent with recent findings for the UK, but are in sharp contrast to those for the US.

US Oil Price Exposure: The Industry Effects

This paper investigates the exposure of industry level portfolios to oil price shocks. Our paper utilizes the Campbell (1991) decomposition of stock returns based on a log-linear approximation to the discounted present value relation while allowing for time varying expected returns. The results from our baseline regressions indicate that there is little sensitivity in industry level portfolios to unexpected movements in oil prices, with the gold, oil & gas and retail industries being the only exception. In contrast, based in the Campbell (1991) decomposition, we identify extensive exposure to oil prices in industry level returns in particular channels. The extent of the exposure is particularly significant for a number of the industries, with positive (negative) permanent implications for gold, and the oil and gas industries (retail and meals, restaurants and hotels).Oil, Industry Stock Returns, Vector autoregression

Liquidity Effects and Precautionary Saving in The Czech Republic

Since the break up of the Czech-Slovak Federation on 31 December 1992, the Czech Republic has been at the forefront of the transition to a market economy. Key aims of the Czech Republic, and many other former centrally planned economies, are low inflation and a stable exchange rate, particularly for those who ultimately wish to enter the European Union (EU). The aggregate consumption function has been a key component of macro-models since Keynes and is especially important for growth in a transitional economy. Key economic variables will be used to explain the consumption function, e.g. real houshold income, interest rates on credit, inflation and real wealth. We expect a positive relationship between real consumption and the level of real income and wealth, with a negative relationship between the consumption and the rate of interest and inflation. The estimation approach we use is an error correction model. Given the nature of the Czech financial markets and institutions it is likely that consumption will not immediately reach the long-run equilibrium. Therefore the long-run relationship and short-run interactions which is the basis of the error correction model approach would appear to be the appropriate choice for an emerging economy. The data used in the study is monthly and runs from January 1993 to April 1995. All the required data are taken from the CNB, Financial Statistics Report. Given that the Czech Republic has been hit by a number of different shocks over the relatively short transition period, we will estimate the empirically based consumption functions starting from 1993. Due to the paucity of data we initially include only standard variables associated with the consumption function; real disposable income, interest rates and inflation. We do however test a number of variants, including using an alternative measure of income, namely real wage income. We also include the unemployment rate which would proxy liquidity constraints. Also if there is an increase in the probability of unemployment current liquidity, future liquidity or uncertainty - or all three - may lead to a reduction in current consumption. Although we are faced with a limited data set we do however find a number of interesting results. Of particular note for a transition economy, such as the Czech Republic, is the long-run relationship between real consumption and wage income, interest rates, inflation and the rate of unemployment. We take the change in unemployment to reflect changes in liquidity constraints and the level of unemployment to reflect precautionary saving. The results imply that these effects are present and statistically significant both in the short and long-run. Our results also indicate that the long-run income elasticity is affected by the inclusion of the unemployment term.

Investigating Sources of Unanticipated Exposure in Industry Stock Returns

This paper investigates the degree of both foreign exchange rate and interest rate exposure of industry level portfolios in the G7. Our paper draws on the efficient market hypothesis and examines the extent of unexpected foreign exchange (and interest rate) exposure rather than the standard approach of focusing purely on the change in foreign exchange (and interest rate) exposure. The results from our baseline regressions are consistent with those previously found in the literature that there is little evidence of exchange rate exposure in most markets — this is the exchange rate exposure puzzle. The second critical element of our analysis is that we investigate the sources of the exposure and examine the existence of indirect levels of both foreign exchange and interest rate exposure. The findings of exposure to foreign exchange rates and interest rates are extensive for industry sectors in the G7 economies when we take account of the possible channels of influence. Results indicate key differences between countries in terms of the relative importance of these cash flow and discount rate channels.Foreign exchange, exposure, interest rates, stock returns, international finance

Risk Premia and Long Rates in Ireland

Using a number of long-term maturities and monthly data, 1989-1997, we provide a number of tests of the expectations hypothesis (EH) of the term structure. The main insight in this paper is the use of the excess holding period return to provide a proxy for a possible time varying term premium. Nearly all previous studies using the VAR methodology have used only the spread and the change in (short) rates and they have ignored the excess holding period return. Our results are consistent with recent evidence for the UK (Cuthbertson and Nitzsche, 1998), in that we cannot reject the EH. However we do reject the presence of a time varying risk premia.

An Analysis of the Transmission Mechanism of Monetary Policy in Ireland

This paper examines the impact of monetary policy shocks on a number of key economic variables, including output, prices and the exchange rate. The paper draws on recent techniques used in the structural vector autoregression literature. Our results suggest that an exogenous temporary increase in the short-term interest rate leads to a decline in output and prices with the latter responding more sluggishly. In addition, a higher interest rate leads to an immediate appreciation of the domestic exchange rate and a subsequent depreciation of the currency. Hence, there is an absence of an exchange rate or forward bias puzzle, which are prevalent in other studies. Overall the response of macroeconomic variables to a change in the interest rate are very small in magnitude.

US Infl ation and infl ation uncertainty in a historical perspective: The impact of recessions

We use over two hundred years of US inflation data to examine the impact of inflation uncertainty on inflation. An analysis of the full period without allowing for various regimes shows no impact of uncertainty on inflation. However, once we distinguish between recessions and non recessions, we find that inflation uncertainty has a negative effect on inflation only in recession times, thus providing support to the Holland hypothesis.asymmetric GARCH, recession, inflation uncertainty