Expected inflation and inflation risk premium in the euro area and in the United States

This paper uses the celebrated no-arbitrage affine Gaussian term structure model applied to index-linked and standard government bonds to derive expected inflation rates and inflation risk premia, in the euro area and in the US. Maximum likelihood estimates show that the model describes the evolution of the nominal and real term structures by using three latent factors which can be interpreted as two real factors and one inflation factor. These provide important information on expected inflation and inflation risk premia. The results highlight some striking differences between the euro area and the US. In the US, forward inflation risk premia become sizable around the start of the late-2000s financial crisis and considerably increase just before the adoption of the first unconventional monetary policy measures in March 2009. By contrast, in the euro area forward inflation risk premia remain unchanged even after the adoption of the unconventional monetary policy measures following the most acute phases of the financial crisis, in October 2008 and in May 2010. However, long-term inflation expectations have been well anchored over the past years.real and nominal term structure, inflation risk premium, affine term structure, Kalman filter

A Primer on Financial Contagion

This paper presents a unified framework to highlight possible channels for the international transmission of financial shocks. We first review the different definitions and measures of contagion used in the literature. We then use a simple multi-country asset pricing model to cast the main elements of the current debate on contagion and provide a stylized account of how a crisis in one country can spread to the world economy. In particular, the model shows how crises can be transmitted across countries, without assuming market imperfections or DG KRF portfolio management rules. Finally, tracking our classification, we survey the results obtained in the empirical literature on contagion.contagion, financial crisis, contagion

Canonical term-structure models with observable factors and the dynamics of bond risk premiums

We study the dynamics of risk premiums on the German bond market, employing no-arbitrage term-structure models with both observable and unobservable state variables, recently popularized by Ang and Piazzesi (2003). We conduct a specification analisys based on a new canonical representation for this class of models. We find that risk premiums display a considerable variability over time, are strongly counter-cyclical and bear no significant relation to inflation.term structure models, yield curve, risk premium

A specification analysis of discrete-time no-arbitrage term structure models with observable and unobservable factors

We derive a canonical representation for the no-arbitrage discrete-time term structure models with both observable and unobservable state variables, popularized by Ang and Piazzesi (2003). We conduct a specification analysis based on this canonical representation. We show that some of the restrictions commonly imposed in the literature, most notably that of independence between observable and unobservable variables, are not necessary for identification and are rejected by formal statistical tests. Furthermore, we show that there are important differences between the estimated risk premia, impulse response functions and variance decomposition of unrestricted models, parametrized according to our canonical representation, and those of models with overidentifying restrictions.Term structure; canonical models

Bond risk premia, macroeconomic fundamentals and the exchange rate

We introduce a two-country no-arbitrage term-structure model to analyse the joint dynamics of bond yields, macroeconomic variables, and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries, and how the exchange rate is influenced by the interactions between macroeconomic variables and time-varying bond risk premia. Estimating the model with US and German data, we obtain an excellent fit of the yield curves and we are able to account for up to 75 per cent of the variability of the exchange rate. We find that time-varying risk premia play a non-negligible role in exchange rate fluctuations due to the fact that a currency tends to appreciate when risk premia on long-term bonds denominated in that currency rise. A number of other novel empirical findings emerge.exchange rate, term structure, UIP

Stock Values and Fundamentals; Link or Irrationality?

In this paper, econometric techniques are employed to analyze the continuous and remarkable growth which has characterized international stock markets since 1995. The Campbell and Shiller dividend discount model, a dynamic version of Gordon's formula commonly employed by financial analysts to rate individual firms, is the main tool of the paper. Given the information set available at any time, the future values of the real interest rate and the expected growth of dividends are evaluated and employed as explanatory variables for the current dividend yield. The results of the econometric analysis demonstrate that current dividend yields are not in line with the expected trend in the underlying variables, for all the countries considered. A decline in the real interest rate or an increase in the expected growth of dividends, or a combination of the two, could reconcile fundamentals and current dividend yields. The assessment of whether or not such divergences are rational cannot be made safely on the basis of expectations of the fundamentals derived from the econometric scheme. These, in fact, rest on the hypothesis of rational expectations for agents utilizing the full information set of past information; of course, information related to a larger set, including survey data, or the effects of shifts in economic regimes are excluded in this setup.asset pricing, dividend yield, dividend discount model

Can option smiles forecast changes in interest rates? An application to the US, the UK and the euro area

This paper evaluates the use of risk-neutral probability density functions implied in 3-month interest-rate futures options to assess market perceptions regarding future monetary policy moves options allow the information content implied in simpler derivatives to be extended by providing indicators for asymmetry and extreme values. First, a cubic spline is implemented to evaluate the densities. Second, the methodology is applied to quotes on deposits denominated in US dollars, euros and sterling from January 1999 toMay 2004 results show that markets correctly forecast the monetary easing of 2001 in the United States in the course of the second half of 2000, but not in the euro area and the United Kingdom. The evidence for the tightening cycle of 1999 is mixed: markets expected an increase in euro area policy rates at the beginning of 1999 expectations were less clear for the United StatesÂ’ interest-rate increases. In the case of the United Kingdom the increase was not foreseen.risk-neutral density, cubic spline, monetary policy, interest-rate futures options

Correlation Analysis of Financial Contagion: What One Should Know Before Running a Test

This paper builds a general test of contagion in financial markets based on bivariate correlation analysis - a test that can be interpreted as an extension of the normal correlation theorem. Contagion is defined as a structural break in the data generating process of rates of return. Using a factor model of returns as theoretical framework, we nest leading contributions in the literature as special cases of our test. We show that, while the literature on correlation analysis of contagion is successful in controlling for a potential bias induced by changes in the variance of global shocks, current tests are conditional on a specific yet arbitrary assumption about the variance of country specific shocks. Our results suggest that, for a number of pairs of country stock markets, the hypothesis of 'no contagion' can be rejected only if the variance of country specific shocks is set to levels that are not consistent with the evidence.

Correlation Analysis of Financial Contagion: What One Should Know before Running a Test

This paper presents a general test of contagion in financial markets based on bivariate correlation analysis – a test that can be interpreted as an extension of the normal correlation theorem. Contagion is defined as a structural break in the data generating process of rates of return. Using a factor model of returns, our theoretical framework nests leading contributions in the literature as special cases. We show that the tests proposed in the literature are conditional on a specific yet arbitrary assumption about the variance of country specific shocks. Using the Hong Kong stock market crisis in October 1997 as a representative case study, our results suggest that, for a number of pairs of country stock markets, the hypothesis of 'no contagion' can be rejected only if the variance of country specific shocks is set to levels that are not consistent with the evidence.contagion, financial crisis, factor model, correlation analysis

The Impact of News on the Exchange Rate of the Lira and Long-Term Interest Rates

This paper analyzes the impact of news on several Italian financial variables, paying particular attention to the effect on the conditional volatility of these variables. The analysis spans a period of great financial and political turbulence in Italy, including the rapid succession of three governments. News releases (articles on political and economic events collected daily from both the Italian and international economic press) are classified as unscheduled (mostly political) and scheduled (i.e. economic and monetary statistics whose announcement is expected by market participants). The analysis is divided into two phases: first, we estimate the impact of each single political and economic news item on asset price changes and their conditional variance; second, those items that are identified as significant in the first stage are then aggregated into six dummies according to their nature and origin and employed as exogenous variables in a trivariate Garch scheme. Results show that i) news affects both the first and the second moment of the daily changes in the analyzed variables; ii) there is a significant regime shift of the unconditional variance of the analyzed variables across the three different governments; iii) the conditional variances display a significant — albeit rather small — seasonal dayweek pattern; iv) contrary to the conventional view, the impact of news on the conditional variance is more pronounced for exchange rates than for Italian long-term interest rates.News; Asset pricing; Conditional volatility