European Interest Rates Research Articles

Monetary Policy, the Composition of GDP and Crisis Duration in Europe

This paper analyzes the effects of changes in interest rates on the composition of production in 10 European countries during the boom period of the 2000s. We find that output elasticity differs across industries and across countries for similar industries. The paper suggests that in the run-up to the 2008 crisis, the European Central Bank's low interest rate policy affected the allocation of resources across industries. This may explain the sluggish overall recovery from the crisis in Europe.

Nonlinear adjustment between the Eonia and Euribor rates: a two-regime threshold cointegration analysis

This article examines the dynamic relationship between two key European short-term interest rates, the Eonia rate (EON) and the 3-month Euribor rate (ER3). Applying a threshold cointegration method developed by Hansen and Seo (2002) to monthly data over the period 1999 to 2011, we confirm that the null hypothesis of linear cointegaration is rejected in favour of a two-regime threshold cointegration model with regime-dependent short-run dynamics. Importantly, we show that an error correlation through a Euribor rate adjustment tends to occur only in an extreme regime, where ER3 increases relative to EON, such as was vigorously implemented immediately after the global financial crisis. In a typical regime, short-run responses are executed, instead, by an Eonia rate adjustment, which is not necessarily consistent with the conventional view that EON should anchor longer-term interest rates.

Testing for codependence of cointegrated variables

We analyse nonstationary time series that do not only trend together in the long run, but restore the equilibrium immediately in the period following a deviation. While this represents a common serial correlation feature, the framework is extended to codependence, allowing for delayed adjustment. We show which restrictions are implied for the Moving Average (MA) and Vector Error Correction Model (VECM) representations and put forward a Generalized Method of Moments (GMM) test. In addition, for cases where the constraints can be uniquely imposed on a VECM a likelihood ratio test is proposed. We apply the concept to US and European interest rate data, examining the capability of the Federal Reserve Bank (Fed) and European Central Bank (ECB) to control overnight money market rates.

Delta-Hedging of Interest Rate Risk in Longterm Contracts - An Application of the Cairns-Model

Long-term portfolios consisting of assets and liabilities often exhibit a significant sensitivity to changes in interest rates. For the management of the interest rate risk arising from such portfolios asset managers usually use duration based approaches like the PV01-method. In the meanwhile the model family proposed by Cairns (2004) proclaims to deliver arbitrage-free valuation of interest rate derivatives and an ideal framework for the management of long-term interest rate risks. In the following paper, we use the two-factor version of the Cairns-model in order to hedge interest rates of long-term portfolios and in order to test the hedge-effiectiveness of the commonly used PV01-approach. For this purpose we first derive interest rate sensitivity measures on the basis of the Cairns-model. Based on the extended Kalman-fillter approach, we calibrate the model and demonstrate the behavior of the sensitivity measures derived. We then use these measures in order to hedge interest rate risks of a pension-fund-like portfolio. The hedging-strategy we introduce for this purpose is based on plain vanilla interest rate swaps, it is rule-based and model independent. We then put the Cairns-model and PV01 approach to the test using one historical path (European interest rates, June 2000 - June 2010) as well as on the basis of a Monte Carlo simulation. Both analysis show that the strategy delivered is quite robust in eliminating interest rate risks. Interestingly, our analysis actually underlines the practicability and compatibility of the PV01-approach.

Structural changes, bid–ask spread composition and tick size in inter-bank futures trading

This paper studies a period containing three major structural changes, which constitute a natural experiment in the NYSE.Euronext-LIFFE European short-term interest rate (STIR) futures market. These changes comprise (1) a 50% reduction in minimum tick size for the most heavily traded contract, (2) European Monetary Union and (3) the transition from open outcry to electronic trading. We analyse a number of microstructure features of the four largest European interest rate futures contracts throughout this period. In particular, we focus on bid–ask spread composition using a recent model which is appropriate for this market structure. Our analysis identifies the tick size as the largest bid–ask spread component in almost every instance, which suggests that participants in this STIR future market might benefit from a reduction in minimum tick sizes.

Evolving Perceptions of Central Bank Credibility: The European Central Bank Experience

What are the preferences of a central bank over inflation and output-gap stabilization objectives, and what is its preferred long-run inflation rate? While statements of priorities and goals are important, the credibility of such statements and the market perception of the policy reaction function of a central bank play a key role in determining economic outcomes. This point, early on described as the “credibility” of central bank policies, is a standard theoretical result with recent interpretation in the New Keynesian paradigms. It is also received wisdom among practitioners. The importance of the market perception of the central bank’s acceptable trade-offs between inflation and output goals as well its specific targets naturally leads to the question of how the market acquires this perception and whether and how it evolves over time. One view is that establishing an appropriate institutional structure is the key element in insulating the monetary authority from political pressure and thereby convincing markets that a central bank has a strong and unvarying aversion to inflation. A second, more dynamic, view focuses on the role that actual policy conduct plays in building the reputation of a central bank. These two different views have distinct implications for the relative importance of the institutional structure of a central bank, as compared to its conduct, for attaining and maintaining its credibility. A survey of the heads of central banks and prominent monetary economists reflects a belief that the credibility of a central bank is based more on its past actions than on institutional structures that afford it independence by insulating it from political concerns, although there is also a consensus that structurematters (Blinder 2000). Empirical research has found that institutional features related to central bank independence are associated with economic performance in cross sections of

TALKING LESS AND MOVING THE MARKET MORE: EVIDENCE FROM THE ECB AND THE FED

ABSTRACTThis paper examines and compares the communication strategies of the Federal Reserve and the European Central Bank, and their effectiveness. First, we find that the surprise components of both monetary policy actions and statements have important but differing effects on asset prices, with unexpected communication having a much greater impact on longer‐term interest rates. Second, both the ECB and the Fed have proven to be equally successful in moving their domestic asset prices using either monetary policy or news shocks. However, the response of the American yield curve to the surprise component of Fed's statements is larger than the reaction of the European term structure to ECB's announcements. This result is intimately related to the amplitude of the policy rate cycle that is much larger in the US than in the euro area combined with the bounded support of the news shock. Third, we analyze the cross‐effects and show that the Fed has been more able to move the European interest rates of all maturities than the ECB to move American rates. This finding is tied to the predominance of dollar fixed income assets rather than to an attempt of the ECB to mimic the Fed.

Debt and Interest Rates: The U.S. and the Euro Area

We find that real interest rates paid on government debt depend significantly upon current and expected future levels of debt, in Europe as in the US. But this result only emerges when we condition on foreign interest rates, illustrating financial international integration. The previously strong effect of debt on US interest rates has been diluted by the addition of 2004-2006 data to the sample, perhaps reflecting the effect of massive purchases of US securities by foreign central banks. Another finding is that the asymmetry in the effect of US interest rates on European interest rates has not disappeared with the coming of European Economic and Monetary Union in 1999, as one might have thought. JEL: E43, E58, F41

Economic Integration Through Financial and Factor Mobility

Capital mobility impedes the ability of authorities to pursue independent policy goals. Market participants will drive the informal adoption of the most adaptive currency. The current paper is descriptive, predictive, and prescriptive. A Granger-Sims causality test shows the dependency of Japanese and European Union area interest rates on US interest rates. This econometrically illustrates the nature of the interdependency between monetary policies of studied countries. The potential gains from further integration, and further policy coordination, is a better allocation of the world’s savings and more effective risk-sharing among countries. Implicit in all of this is the need for further international arrangements on monetary and fiscal policies to avoid the trap of international policy competition where resources are allocated on the basis of privilege instead of efficiency. Real unity is dependent on policies that remove barriers to labor and factor mobility and fosters international cooperation.

Anmerkungen zur Zinspolitik des Euroraums. Some short remarks about the European interest rate policy

In modern monetary policy nearly every central bank has an output driven task to fulfil. This could be price stability or the attainment of a stable inflation rate. In order to establish whether the monetary policy has reached its goals, it is possible to use monetary rules ex post as a benchmark. For this we will use the Taylor rule and interest rate to describe the European interest rate policy from 1999 to 2009. The main result is that from 2000 till 2008 the Taylor interest rate is much higher than its benchmarks EONIA and EURIBOR. Only for the year 1999 a neutral interest rate emerges. Furthermore the paper shows that the European interest rate policy missed its Taylor interest rate benchmark every time except 1999. So it is possible to state that the European interest rate policy was too expansive.

External Macroeconomic Factors and the Link between Short‐ and Long‐Run European Interest Rates: A Note

This article analyzes the long‐run relationships linking long‐ and short‐run interest rates for the Euro‐wide aggregated variables. To this end, we extend the set of variables traditionally involved in the Campbell and Shiller (1987) framework for the term structure to add external macro variables (the exchange rate, U.S. inflation, and U.S. short‐run interest rates). Our results support the expectations hypothesis and also stress the importance of accounting for foreign economy influences on European monetary policy, namely, the real exchange rate of the American dollar as well as real interest rates.

Development and determinants of systemic risk in European banking – an empirical note

Compared with the broad supply of theoretical approaches towards systemic risk in (international) banking systems empirical contributions measuring its degree or potential triggering factors are rather scarce. Kwast and de Nicolo (2002) put systemic risk and (conditional) stock price correlations into a unique relation. Adopting this perspective, we provide a dynamic conditional correlation (DCC, Engle, 2002) analysis for the European banking sector. Our sample period covers establishment and advent of the Euro. Apart from time variation of correlation measures we investigate the content of exogenous factor variables to explain correlation patterns. Overall, we find a moderate and stable average level of systemic risk in European banking. The advent of the Euro came along with a 1-year period of short-run transition dynamics. Systemic risk is found to increase over states of high uncertainty in national stock markets and states of small-to-medium variation in European interest rates.

An optimal system and group-invariant solutions of the Cox-Ingersoll-Ross pricing equation

The valuation partial differential equation of standard European interest rate derivatives in the Cox-Ingersoll-Ross model is analysed. Its one-parameter Lie point symmetries and corresponding group of adjoint representations are obtained. An optimal system of one-dimensional subalgebras is derived and used to construct distinct families of special closed-form solutions of the equation.

Asymmetric Mean Reversion in European Interest Rates: A Two-factor Model

This paper tests for asymmetric mean reversion in European short-term interest rates using a combination of the interest rate models introduced by Longstaff and Schwartz (Longstaff, F.A., Schwarts, E.S. (1992) Interest rate volatility and the ferm structure: A two factor general equilibrium model, Journal of Finance, 48, pp. 1259–1282.) and Bali (Bali, T. (2000) Testing the empirical performance of stochastic volatility models of the short-term interest rates, Journal of Financial and Quantitative Analysis, 35, pp. 191–215.). Using weekly rates for France, Germany and the United Kingdom, it is found that short-term rates follow in all instances asymmetric mean reverting processes. Specifically, interest rates exhibit non-stationary behavior following rate increases, but they are strongly mean reverting following rate decreases. The mean reverting component is statistically and economically stronger thus offsetting non-stationarity. Volatility depends on past innovations past volatility and the level of interest rates. With respect to past innovations volatility is asymmetric rising more in response to positive innovations. This is exactly opposite to the asymmetry found in stock returns.

A numerical method to price European derivatives based on the one factor LIBOR Market Model of interest rates

We consider the problem of pricing European interest rate derivatives based on the LIBOR Market Model (LMM) with one driving factor. We derive a closed-form approximation of the transition probability density functions associated to the stochastic dynamical systems that describe the behaviour of the forward LIBOR interest rates in the LMM. These approximate formulae are based on a truncated power series expansion of the solutions of the Fokker–Planck equations associated to the LMM. The approximate probability density functions obtained are used to price European interest rate derivatives using the method of discounted expectations. The resulting integrals are low dimensional when the most commonly traded European interest rate derivatives are considered, and they can be computed efficiently using elementary numerical quadrature schemes (i.e. Simpson’s rule). The algorithm obtained is very well suited for parallel computing and is tested on the problem of pricing several derivatives including an European swaption and an interest rate spread option. In both cases, the method proposed in this paper appears to be accurate (i.e. relative error of order 10 −2, 10 −3, or even 10 −4) and approximately between 278 and 63 000 times faster than previous methods based on the Monte Carlo simulation of the LMM stochastic dynamical systems. The website http://www.econ.univpm.it/pacelli/ballestra/finance/w2 contains material that helps the understanding of this paper and makes available to the interested users the computer programs that implement the numerical method proposed.

Econometric issues in the analysis of contagion

This paper presents a canonical, econometric model of contagion and investigates the conditions under which contagion can be distinguished from interdependence. In a two-market set-up it is shown that for a range of fundamentals the solution is not unique, and for sufficiently large values of the contagion coefficients it has interesting bifurcation properties with bimodal density functions. The identification of contagion requires that the equations for the individual markets contain market specific regressors. This sheds doubt on the general validity of the correlation-based tests of contagion recently proposed in the literature which do not involve any market specific variables. Furthermore, we show that ignoring endogeneity and interdependence can introduce an upward bias in the estimate of the contagion coefficient, and using Monte Carlo experiments we further show that this bias could be substantial. Finally, we analyse data on European interest rate spreads during the ERM and find a clear asymmetry in the contagion effects of sharp rises and falls; with only the former having some statistically significant effects.

Structural Vector Autoregressions With Nonnormal Residuals

In structural vector autoregressive (SVAR) modeling, sometimes the identifying restrictions are insufficient for a unique specification of all shocks. In this paper it is pointed out that specific distributional assumptions can help in identifying the structural shocks. In particular, a mixture of normal distributions is considered as a possible model that can be used in this context. Our model setup enables us to test restrictions which are just-identifying in a standard SVAR framework. The results are illustrated using a U.S. macro data set and a system of U.S. and European interest rates.

Structural Vector Autoregressions with Nonnormal Residuals

In structural vector autoregressive (SVAR) models identifying restrictions for shocks and impulse responses are usually derived from economic theory or institutional constraints. Sometimes the restrictions are insufficient for identifying all shocks and impulse responses. In this paper it is pointed out that specific distributional assumptions can also help in identifying the structural shocks. In particular, a mixture of normal distributions is considered as a plausible model that can be used in this context. Our model setup makes it possible to test restrictions which are just-identifying in a standard SVAR framework. In particular, we can test for the number of transitory and permanent shocks in a cointegrated SVAR model. The results are illustrated using a data set from King, Plosser, Stock and Watson (1991) and a system of US and European interest rates.

Macroeconomic Fundamentals and Net Portfolio Investment Between Developed Regions*

Our paper investigates how macroeconomic fundamentals correlate with net capital inflows in the US. Understanding the factors associated with capital flows helps policy makers to predict future capital flows and analyse the international implications of domestic macroeconomic policy. Yet the theoretical relationship between net capital inflows and relative economic conditions is ambiguous. Using quarterly data from 1988 to 2003, we analyse the relation between a set of relative macroeconomic variables and net purchases of US stocks and bonds from Western Europe, Canada, Japan and Australia. We find that relative output growth is uncorrelated with net US investment for all regions. However, other macroeconomic factors matter; for example, an increase in US interest rates relative to European interest rates is associated with an increase in net portfolio investment from Europe. The linkages between macroeconomic factors and net foreign investment in the US are strongest for Western Europe, implying that information costs, home bias and other capital frictions are less relevant for US–Europe flows compared with capital flows between the US and the other three source regions. Lastly, stock purchases are more correlated with macroeconomic fundamentals than bonds, a striking finding suggesting that equity traders are more likely than bond traders to change their net asset holdings as a result of a macroeconomic event.

Euro Bonds: In Search of Financial Spillovers

The paper investigates the empirical relevance of the negative financial spillovers hypothesis according to which fiscal imbalances in one EMU member country bid up the interest rate faced by all other participants in the currency union. This idea questions the ability of financial markets to correctly price various types of risk now that the elimination of exchange rate fluctuations and the rapid integration of national government bond markets have made securities issued by different European governments closer substitutes. The paper takes an eclectic approach and tackles the issue from different angles, reviewing historical episodes, testing the Ricardian equivalence hypothesis in Europe as a whole and finally analyzing the impact of domestic and foreign fiscal variables on European bond yields. Despite the strong comovements displayed by European interest rates, empirical evidence does not support the idea that fiscal variables are a key determinant of these interrelations.