Abstract
Although there are many different interest rates in the economy, in theoretical and applied model building these distinctions are usually ignored by assuming that there is only one, “true” interest rate. Hence, the aim of this article is twofold. First, we empirically examine whether such assumption is plausible for the Euro area yield curve data. Second, using different time spans we try to assess the impact of the financial crisis on the validity of this assumption. For both purposes, the principal component analysis technique will be employed.
Highlights
Interest rates are the fundamental elements of financial and economic activities, and their movements are the major risk factors driving the global capital flows
The conclusion to be drawn is that we can find a relatively strong justification for the homogeneous interest rates assumption only for fairly tranquil periods, such as period (B) before the beginning of the financial meltdown, during which the first principal component alone explains more than 91% of the variation
The adopted verification method is empirical and relies on the principal component analysis, which is applied to different time periods
Summary
Interest rates are the fundamental elements of financial and economic activities, and their movements are the major risk factors driving the global capital flows. They are a vital tool of monetary policy, an important variable in many macroeconomic models and the building block of financial mathematics. In theoretical and applied model building, these distinctions are usually ignored. This is because the various interest rates tend to move up and down together, revealing the significant amount of joint behaviour, which can be abstracted and summarized by the notion of single interest rate. The abovementioned concept will be defined and referred to as the homogeneous interest rates assumption
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