Accountability of the ECB and a Government's Incentives to Rebel against the Common Monetary Policy in EMU

This paper considers how the "true" common monetary policy that is conducted by the ECB under various sources of uncertainty will differ from the policy that was agreed in the Maastricht Treaty, and how the uncertainties may induce a representative government to criticise the common monetary policy. Acquiring information about the transmission mechanism, and revealing that information as well as information about the ECB reaction function, is incentive compatible for the ECB both directly and indirectly. The direct effect means that the ECB's own welfare is decreasing in uncertainties. The indirect effect arises because less uncertainty reduces the risk of criticism from the individual governments' side. The risk of criticism is the larger, and consequently the indirect incentive to reduce uncertainty is the higher, the larger are the leftward shifts in national political preferences from those that prevailed when the Maastricht Treaty was signed. The model also provides an explanation for the ECB's choice of monetary policy strategy that incorporates elements of both monetary targeting and inflation targeting.monetary uncertainty; monetary strategy; EMU

Foreign exchange option and returns based correlation forecasts: evaluation and two applications

We compare option-implied correlation forecasts from a dataset consisting of over 10 years of daily data on over-the-counter (OTC) currency option prices to a set of return-based correlation measures and assess the relative quality of the correlation forecasts. We find that while the predictive power of implied correlation is not always superior to that of returns based correlations measures, it tends to provide the most consistent results across currencies. Predictions that use both implied and returns-based correlations generate the highest adjusted R2s, explaining up to 42 per cent of the realised correlations. We then apply the correlation forecasts to two policyrelevant topics, to produce scenario analyses for the euro effective exchange rate index, and to analyse the impact on cross-currency co-movement of interventions on the JPY/USD exchange rate. JEL Classification: F31, F37, G15Correlation forecasts, currency options data, effective exchange rate

Capital market development, corporate governance and the credibility of exchange rate pegs

Focusing on emerging market currency arrangements, we build a model of an exchange rate peg with escape clauses and output persistence. We first show how output persistence works as an additional 'fundamental' so that an exogenous increase in persistence can make the currency peg more vulnerable to speculative attacks. We then endogenise output persistence as arising from capital market frictions that are caused by weak corporate governance institutions. It turns out that in emerging market economies, often characterised by credit constraints, a partial reform of corporate governance institutions may enhance a financial accelerator mechanism, which increases output persistence and deteriorates the credibility of the exchange rate peg. A conservative policymaker partially counters this adverse effect, but only a complete reform of corporate governance institutions fully eliminates persistence and reduces the risk of currency crisis on all levels of policy preferences. JEL Classification: E58, F33, D84, G18, G38

Balance Sheet Interlinkages and Macro-Financial Risk Analysis in the Euro Area

The financial crisis has highlighted the need for models that can identify counterparty risk exposures and shock transmission processes at the systemic level. We use the euro area financial accounts (flow of funds) data to construct a sector-level network of bilateral balance sheet exposures and show how local shocks can propagate throughout the network and affect the balance sheets in other, even seemingly remote, parts of the financial system. We then use the contingent claims approach to extend this accounting-based network of interlinked exposures to risk-based balance sheets which are sensitive to changes in leverage and asset volatility. We conclude that the bilateral cross-sector exposures in the euro area financial system constitute important channels through which local risk exposures and balance sheet dislocations can be transmitted, with the financial intermediaries playing a key role in the processes. High financial leverage and high asset volatility are found to increase a sector’s vulnerability to shocks and contagion. JEL Classification: C22, E01, E21, E44, F36, G01, G12, G14Balance sheet contagion, contingent claims analysis, financial accounts, macro-prudential analysis, network models, systemic risk

Do financial market variables show (symmetric) indicator properties relative to exchange rate returns?

This paper assesses the contemporaneous, leading and lagging indicator properties of financial market variables relative to movements in six major developed country currency pairs. As indicator variables changes in various relative asset prices, short-term portfolio flows and currency options data are used. We find that changes in equity index differentials, short-term speculative flows and risk reversals on currency options prices exhibit consistent contemporaneous indicator properties and leading indicator properties for several currency pairs. Since 1999, changes in short-term interest rate differentials have gained importance as indicators. The best indicator variables explain over 50% of monthly returns of the USD/EUR and GBP/USD exchange rates and over 60% of the appreciation and depreciation episodes of the USD/EUR and JPY/EUR currency pairs. JEL Classification: F31, F32, G15asset prices, Capital flows, Exchange Rates, GMM, leading and lagging indicators, logit estimation, market microstructure

Do options-implied RND functions on G3 currencies move around the times of interventions on the JPY/USD exchange rate?

This paper focuses on changes in the currency options market’s assessment of likely future exchange rate developments around the times of official interventions in the JPY/USD exchange rate. We estimate the options-implied risk-neutral density functions (RNDs) using daily OTC quotes for options prices with fixed moneyness that avoids the biases that typically characterise the exchange traded price quotes. We find that the episodes of interventions on the JPY/USD exchange rate coincide with systematic changes in all moments of the estimated RNDs on the JPY/USD currency pair, and in several of the moments of the estimated RNDs on the JPY/EUR and USD/EUR currency pairs. In particular, the operations where Japanese yen is sold coincide with a movement in the mean of the RND towards a weaker yen both against the US dollar and the euro, as well as with an increase in implied standard deviations. Prior to the interventions, the RNDs tend to move into opposite direction suggesting, on the average, increasingly unfavourable market conditions and leaning-against-the wind by the Japanese authorities. JEL Classification: E58, F31, F33Foreign exchange market intervention, GARCH, option-implied distributions

Capital flows and the US ‘New Economy’: consumption smoothing and risk exposure

In an analytically tractable model of the global economy, we calculate the Pareto improvement where a country experiencing a favourable supply side shock consumes more against expected future output and spreads the risk by selling shares. With capital inflows to finance the ‘New Economy’ significantly exceeding the current account deficit, however, we show that selling shares globally at inflated prices – due to ‘irrational exuberance’ and distorted corporate incentives – can generate significant international transfers when the asset bubble bursts. The analysis complements recent econometric studies which appeal to financial factors to explain why the European economy was so strongly affected by the recent US downturn. JEL Classification: F41, F32, G15Capital flows, international transmission of shocks, Moral Hazard

Assessing portfolio credit risk changes in a sample of EU large and complex banking groups in reaction to macroeconomic shocks

In terms of regulatory and economic capital, credit risk is the most significant risk faced by banks. We implement a credit risk model - based on publicly available information - with the aim of developing a tool to monitor credit risk in a sample of large and complex banking groups (LCBGs) in the EU. The results indicate varying credit risk profiles across these LCBGs and over time. Furthermore, the results show that large negative shocks to real GDP have the largest impact on the credit risk profiles of banks in the sample. Notwithstanding some caveats, the results demonstrate the potential value of this approach for monitoring financial stability. JEL Classification: C02, C19, C52, C61, E32macroeconomic shock measurement, Portfolio credit risk measurement, stress testing

What drives EU banks’ stock returns? Bank-level evidence using the dynamic dividend-discount model

We combine the dynamic dividend-discount model with an accounting-based vector autoregression framework that allows for a decomposition of EU banks' stock returns to cash-flow and expected return news components. The main findings are that while the bulk of the variability of EU banks' stock returns is due to cash flow shocks, the expected return shocks are relatively more important for larger than for smaller banks. Moroever, variables used in the literature as cash-flow proxies explain a higher share of the cash-flow component of the total excess returns for smaller than for larger EU banks. This suggests that large banks could be more prone to market wide news and events - that in the literature are associated with the expected return news component - as opposed to the bank-specific news, typically assumed to be incorporated in the cash-flow component. JEL Classification: C33, G12, G21Bank stock return predictability, cash flow news, panel VAR estimation, return decomposition

What drives investors’ behaviour in different FX market segments? A VAR-based return decomposition analysis

We apply the Campbell-Shiller return decomposition to exchange rate returns and fundamentals in a stationary panel vector autoregression framework. The return decomposition is then used to analyse how different investor segments react to news as captured by the different return components. The results suggest that intrinsic value news are dominating for equity investors and speculative money market investors while investors in currency option markets react strongly to expected return news. The equity and speculative money market investors seem able to distinguish between transitory and permanent FX movements while options investors mainly focus on transitory movements. We also find evidence that offsetting impact on the various return components can blur the effect of macroeconomic data releases on aggregate FX excess returns. JEL Classification: C23, F31, F32, G15FX return prediction, investor flows, news surprises, panel estimation, stationary VAR