Measuring market and inflation risk premia in France and in Germany

This paper studies the role of inflation in the determination of financial asset prices. We estimate an Intertemporal Capital Asset Pricing Model à la Merton (1973), with inflation as an independent source of risk, for France and Germany. Our study also allows us to evaluate how the different nature of the French and German monetary policies before 1999 as well as the convergence process towards the single currency might have affected the role of inflation in the pricing of financial assets. We find that inflation is a significant explanatory factor for the pricing of stocks and government bonds in the two countries. Moreover, while there seems to be no clear structural break in the impact of inflation on asset prices after Stage Three of Economic and Monetary Union, such an impact has been increasingly similar in the two countries after 1999. JEL Classification: C32, C61, E44, G12business cycles, GARCH-in-Mean, Intertemporal CAPM

The sustainability of China's exchange rate policy and capital account liberalisation.

This paper deals with two related issues: the sustainability of China’s exchange rate regime and the opening up of its capital account. The exchange rate discussion deliberately passes over the issue of the “equilibrium” value of the renminbi and its alleged undervaluation – typically at the heart of the current policy debate – and focuses instead on the domestic costs of the current regime and the potential risks to domestic financial stability in the long run. The paper argues that the renminbi exchange rate should be increasingly determined by market forces and that administrative controls should be progressively relinquished. The exchange rate is obviously linked to well-functioning and efficient capital markets, which require no barriers to capital flows. Thus, exchange rate reform has to be correctly sequenced with reform of the capital account to avoid disruptive capital flows. The paper discusses China’s twin surpluses of the current and capital accounts and attempts to identify the drivers of this “anomalous” external position. The pragmatic strategy pursued by the Chinese authorities in the aftermath of the Asian crisis encouraged FDI inflows and favoured the accumulation of a large stock of foreign exchange reserves. Combined with a relatively weak institutional setting, these factors have been important determinants of the pattern and composition of the country’s capital flows and international investment position. Finally, the paper speculates on the outlook for Chinese capital flows should barriers to capital movements be lifted. It argues that whether China continues to supply capital to the rest of the world or eventually becomes a net borrower in international capital markets – as was the case for most of its recent history – will depend on the evolution of its institutions. JEL Classification: F10, F21, F31, F32, P48.China, exchange rate policy, international investment position, capital account liberalisation, institutions.

Uncovered interest parity at distant horizons: evidence on emerging economies & nonlinearities

This paper tests for uncovered interest parity (UIP) at distant horizons for the US and its main trading partners, including both mature and emerging market economies, also exploring the existence of nonlinearities. At long and medium horizons, it finds support in favour of the standard, linear, specification of UIP for dollar rates vis-à-vis major floating currencies, but not vis-à-vis emerging market currencies. Moreover, the paper finds evidence that, not only yield differentials widen, but that US bond yields do react in anticipation of exchange rate movements, notably when these take place vis-à-vis major floating currencies. Last, the paper detects signs of nonlinearities in UIP at the mediumterm horizon for dollar rates vis-à-vis some of the major floating currencies, albeit surrounded by some uncertainty. JEL Classification: E43, F31, F41distant horizon, emerging economies, Nonlinearities, Uncovered interest parity

Estimates of Foreign Exchange Risk Premia: A Pricing Kernel Approach

The goal of this study is to measure market prices of risk and the associated foreign exchange risk premia extending the approach proposed by Balduzzi and Robotti (2001) to an international framework. Estimations of minimum variance stochastic discount factors permits the determination of market prices of risk, which, in turn, in an international framework, allow to compute foreign exchange risk premia. Market prices of risk are time-varying and surge during financial turmoil. This may be interpreted as an increase of the investors' coefficient of risk aversion during turbulent financial markets. Foreign exchange risk premia are also time-varying and they exhibit most variation from the early '70s onwards, when the Bretton Wood exchange rate system collapsed.Foreign exchange, Risk premia, Pricing kernel

International CAPM with Regime Switching GARCH Parameters

This paper tests a conditional version of Adler and Dumas'(1983) International CAPM with regime switching GARCH parameters. As benchmark the same model is estimated without state dependent parameters. The switching representation is found to react faster than the benchmark to shocks in stock market returns. This suggests that the non-switching model suffers from spuriously high persistence. In particular, when a financial crisis occurs, the conditional risk exposures appear to be underestimated, while overestimated in the aftermath. The introduction of a regime switching model should hence improve forecasting power. We also find that in periods of financial turmoil, weight is shifting from the GARCH, towards the ARCH termes of the conditional covariance generating process. During such events investors, when formin their (co)variance expectations, seem to put more emphasis on current shocks, at the expense of the current second moments.International CAPM; Multivariate GARCH-in-Mean; Regime Switching

The uncovered return parity condition

This paper proposes an equilibrium relationship between expected exchange rate changes and differentials in expected returns on risky assets. We show that when expected returns on a risky asset in a certain economy are higher than the returns that are expected from investing in a risky asset in another economy, then the currency corresponding to the economy whose asset offers higher returns is expected to depreciate. Due to its similarity with Uncovered Interest Parity (UIP), we call this equilibrium condition “Uncovered Return Parity” (URP). However, in the URP condition returns’ differentials are not known ex ante, while in the UIP they are. The paper finds empirical support in favour of URP for certain markets over some sample periods. JEL Classification: F30, F31, G12, C32GMM, stochastic discount factor, Uncovered interest parity, Uncovered Return Parity

The Contagion Box: Measuring Co-Movements in Financial Markets by Regression Quantiles

We propose a semi-parametric approach to investigate whether co-dependence across markets increase in periods of extreme returns. Given that returns on one market fall in the extreme tail of their own distribution, we compute the conditional probability that returns on another market will also take on extreme values. An application to the “tequila†crisis is performedcontagion, conditional probabilities, CAViaR

Explaining exchange rate dynamics: the uncovered equity return parity condition

By employing Lucas’ (1982) model, this study proposes an arbitrage relationship – the Uncovered Equity Return Parity (URP) condition – to explain the dynamics of exchange rates. When expected equity returns in a country/region are lower than expected equity returns in another country/region, the currency associated with the market offering lower returns is expected to appreciate. First, we test the URP assuming that investors are risk neutral and next we relax this hypothesis. The resulting risk premia are proxied by economic variables, which are related to the business cycle. We employ differentials in corporate earnings’ growth rates, short-term interest rate changes, annual inflation rates, and net equity flows. The URP explains a large fraction of the variability of some European currencies vis-à-vis the US dollar. When confronted with the naïve random walk model, the URP for the EUR/USD performs better in terms of forecasts for a set of alternative statistics. JEL Classification: D82, G14, G15asset pricing, foreign exchange markets, GMM, random walk, UIP

Measuring comovements by regression quantiles

This paper develops a rigorous econometric framework to investigate the structure of codependence between random variables and to test whether it changes over time. Our approach is based on the computation - over both a test and a benchmark period - of the conditional probability that a random variable yt is lower than a given quantile, when the other random variable xt is also lower than its corresponding quantile, for any set of prespecified quantiles. Time-varying conditional quantiles are modeled via regression quantiles. The conditional probability is estimated through a simple OLS regression. We illustrate the methodology by investigating the impact of the crises of the 1990s on the major Latin American equity markets returns. Our results document significant increases in equity return co-movements during crises consistent with the presence of financial contagion. JEL Classification: C14, C22, G15codependence, conditional quantiles, semi-parametric

Do fixed income securities also show asymmetric effects in conditional second moments?

This paper estimates a trivariate two-factor conditional version of the Intertemporal CAPM of Merton (1973). The three considered assets are: US stocks, 6-month T-bills, and 10-year government bonds. As a second factor the growth rate of industrial production is chosen. Two multivariate GARCH processes able to capture the asymetric effects for both conditional variances and covariances are developed ans tested. News impact curves and surfaces as well as robust conditional second moments for equities as well as fixed income securities do respond asymmetrically to past positive and/or negative news. Finally, the prices of market and intertemporal risk, first held constant, are next allowed to vary over time according to the regime switching model of Hamilton (1988, 1989, 1990,1994). the two identified states might reflect a switch in investors' preferences whose degree of risk aversion increases in correspondence to or after financial turmoil.Intertemporal CAPM, business cycle, asymmetric multivariate GARCH-in-Mean, regime shifts.