Increased Interest Rate Volatility Research Articles

Tax Rate Changes, Interest Rate Volatility, And The Decline In Velocity, 1981-1983

One of the most puzzling economic events in the U.S. during this decade has been the dramatic decline in the growth rate of the income velocity of money. From the fourth quarter of 1981 to the second quarter of 1983, the velocity growth rate fell by nearly 4% as opposed to its 3% trend growth rate. Traditional models have been unable to fully capture this unusual behavior of velocity, over predicting its rate of growth. The present study is concerned with this over prediction problem and attempts to more accurately explain the decline in the velocity growth rate in the 1981-1983 period. It examines the extent to which increased interest rate volatility in the early 1980s and the Reagan tax cuts may be contributed to the decline of the velocity growth rate from 1981 to 1983.

Structural Change in the Mortgage Market and the Propensity to Refinance

We hypothesize that the intrinsic benefit required to trigger a refinancing has become smaller due to a combination of technological, regulatory, and structural changes that have made mortgage origination more competitive and more efficient. To test this hypothesis, we estimate an empirical hazard model of loan survival for two subperiods, using a database that allows us to carefully control for homeowners' credit ratings, equity, loan size, and measurable transaction costs. Our findings strongly confirm that credit ratings and home equity have significant effects on the refinancing probability. In addition, we provide evidence that homeowners postpone refinancing in the face of increased interest rate volatility, consistent with option value theory. Finally, our results clearly support the hypothesis that structural change in the mortgage market has increased homeowners' propensity to refinance.

On Forest Rotation under Interest Rate Variability

The current literature on optimal forest rotation makes the unrealistic assumption of a constant interest rate although harvesting decisions of forest stands are typically subject to relatively long time horizons. We apply the single rotation framework to extend the existing studies to cover the unexplored case of variable interest rate. We show that even in the deterministic case if the current interest rate deviates from its long-run steady state, interest rate variability may change the rotation age significantly when compared with the constant discounting case. Further, and importantly, allowing for interest rate uncertainty as a mean reverting process and forest value as a geometric Brownian motion, we can provide an explicit solution for the two dimensional path-dependent optimal stopping problem. Increased interest rate volatility is shown to lengthen the optimal rotation period. Numerical calculations show that interest rate volatility has a large quantitative importance.

On the Tree-Cutting Problem Under Interest Rate and Forest Value Uncertainty

The current literature on optimal forest rotation makes the unrealistic assumption of constant interest rate though harvesting decisions of forest stands are typically subject to long time horizons. We apply the Wicksellian single rotation framework to cover the unexplored case of variable and stochastic interest rate. By modelling the stochastic interest rate according to the Cox-Ingersoll-Ross model and the forest value as a geometric Brownian motion we provide an explicit solution for the Wicksellian single rotation problem and show that increased interest rate volatility increases the optimal exercise threshold of the irreversible harvesting opportunity and thereby prolongs the optimal rotation period. Numerical illustration indicates that the optimal threshold becomes higher at an increasing rate.

Mortgage Terminations: The Role of Conditional Volatility

This article is the winner of the Real Estate Finance manuscript prize (sponsored by Fannie Mae Foundation) presented at the 2001 American Real Estate Society Annual Meeting.Studies of mortgage termination decisions typically rely on a competing risks framework comparing defaults and prepayments. While useful tools have been developed to approximate the values of these competing default and prepayment options, the available metrics do not adequately account for the role of the conditional volatility of interest rates and housing prices in option valuation. Using a sample of 1,428 mortgage loan payment histories, this study finds that exponential GARCH estimates of the conditional volatility of housing prices and interest rates influence mortgage termination decisions in a predictable manner. Specifically, increased housing price volatility is shown to enhance default option values, while increased interest rate volatility is shown to enhance prepayment option values. Therefore, it would appear that conditional volatility represents a more refined input into the competing risks option framework.

Structural Change in the Mortgage Market and the Propensity to Refinance

We hypothesize that the intrinsic benefit required to trigger a refinancing has become smaller, due to a combination of technological, regulatory, and structural changes that have made mortgage origination more competitive and more efficient and have raised financial awareness of homeowners. To test this hypothesis, we estimate an empirical hazard model of loan survival for two subperiods, using a database that allows us to carefully control for homeowners' credit ratings, equity, loan size, and measurable transaction costs. Our findings strongly confirm that credit ratings and home equity have significant effects on the refinancing probability. In addition, we provide evidence that homeowners postpone refinancing in the face of increased interest rate volatility, consistent with option value theory. Finally, our results support the hypothesis that structural change in the mortgage market has increased homeowners' propensity to refinance.

Wicksellian Theory of Forest Rotation Under Interest Rate Variability

The current literature on optimal forest rotation makes the assumption of constant interest rate. However, the irreversible harvesting decisions of forest stands are typically subject to relatively long time horizons over which interest rates do fluctuate considerably. In this paper we apply the Wicksellian single rotation framework to extend the existing studies to cover the unexplored case of variable interest rate. Given the technical generality of the considered valuation problem, we provide a thorough mathematical characterization of the optimal timing problem and develop new results. We show that even in the deterministic case if the current interest rate deviates from its long-run steady state, interest rate variability changes the rotation age significantly when compared with the constant discounting case. Further, and importantly, allowing for interest rate uncertainty is shown to increase the optimal rotation period when the value of the optimal policy is a convex function of the current interest rate. In line with this finding, we also establish that increased interest rate volatility has a positive impact on the optimal rotation period.

Non-Segmented Equilibria Under Differential Taxation: Evidence from the Canadian Government Bond Market

Tax-clientele effects induce segmented equilibria and these affect the estimation of the term structure of interest rates. The identification of these effects depends on the deviations of bond prices from the value of their discounted cash flows. However, bond prices contain noise that makes it difficult to determine whether the deviations are the result of statistical error or of clientele effects. Evidence from a deterministic test capable of detecting the feasibility of a non-segmented equilibrium is used to form hypotheses concerning the frequency and timing of tax effects in the Canadian bond market during the period 1964 through 1986. Tax reforms introducing capital gains taxation in Canada in 1972 generate additional hypotheses regarding the timing of tax effects. The empirical results from regression tests confirm that non-segmented equilibria occur in those months that the feasibility test indicated they were feasible. Further, the sample period is divided into an early period with virtually no evidence of tax effects and a later period characterized by tax effects. This division is roughly linked to the introduction of capital gains tax in 1972 and the increased interest rate volatility in the later period.

The Stabilizing Effect of the ERM on Exchange Rates and Interest Rates: Some Nonparametric Tests

This paper uses nonparametric procedures to test for a shift in the volatility of nominal and real exchange rates for members and nonmembers of the ERM. The results imply a reduction in volatility for ERM members, especially during the latter half of its operation. We also demonstrate that this enhanced stability was not bought at the expense of increased interest rate volatility. The issue of interest rate volatility during the British pound's participation in the ERM is also examined.

The Stabilizing Effect of the ERMon Exchange Rates and Interest Rates: An Empirical Investigation

This paper applies nonparametric test procedures to test for a shift in the volatility of nominal and real exchange rates for ERM members and nonmembers. The results imply a reduction in volatility for the ERM members, especially during the second half of the period of operation of the ERM. We also demonstrate that this enhanced stability was not bought at the expense of increased interest rate volatility. The issue of interest rate volatility during sterling’s participation in the ERM is also examined.

The Stabilizing Effect of the Erm on Exchange Rates and Interest Rates: An Empirical Investigation

This paper applies nonparametric test procedures to test for a shift in the volatility of nominal and real exchange rates for ERM members and nonmembers. The results imply a reduction in volatility for the ERM members, especially during the second half of the period of operation of the ERM. We also demonstrate that this enhanced stability was not bought at the expense of increased interest rate volatility. The issue of interest rate volatility during sterling`s participation in the ERM is also examined.

Pension Funds and Financial Innovation

Pension funds have played a critical role in the evolution of the markets for debt and equity securities and their derivatives in the U.S. over the last 15 years. The new securities and markets can largely be explained as responses to the investment demands of pension funds in an environment of increased interest rate volatility and tighter regulation. Defined benefit pension plans offer annuities that have a guaranteed floor specified by the benefit formula. In order to minimize the cost to the sponsor of providing this guarantee, there is a strong incentive to invest an amount equal to the present value of the accumulated benefit obligation in fixed- income securities with a matching duration. The pursuit of duration matching and related immunization strategies by pension funds has contributed to the emergence and rapid growth of markets for zero coupon bonds, GIC's, CMO's, options, and financial futures contracts. Recent changes in accounting rules (FAS 87) and tax law (OBRA) are likely to reinforce the use of immunization strategies.

Interest Rate Risk at Commercial Banks: An Empirical Investigation

AbstractThis paper develops and estimates models to measure banks' exposure to interest rate risk. The models are estimated for the 1976–1983 period to determine whether banks' exposure to interest rate risk increased as a result of increased interest rate volatility and financial deregulation. The major findings are that banks changed their risk management strategies after 1979 and that total exposure to interest rate risk remained quite small.

Elements of mortgage securitization

In this paper we review the forms of mortgage securitization, analyze the demand for securitization, and demonstrate how securitization meets these demands by reducing intermediation costs. We argue that the increased use of securitization is a response to increased interest rate volatility and represents a contractual innovation that facilitates an efficient allocation of risk-bearing among households and intermediaries.

Is interest rate volatility necessarily harmful?

It is frequently argued that increased interest rate volatility increases risk and thus, disrupts the saving-investment process. Using a mean-variance portfolio framework, this paper shows that increased interest rate volatility does not necessarily increase risk or reduce investor utility. The factors that determine whether heightened interest rate volatility increases or decreases investor risk and utility are derived and analyzed. Finally, evidence using variances, covariances and levels of asset returns is presented to provide insight into recent changes in interest rate volatility and associated changes in the risk borne and returns earned by investors.

The Effects on Output of Money Growth and Interest Rate Volatility in the United States

In October 1979, the Federal Reserve began a policy of disinflation and also stopped stabilizing interest rates. Subsequently, interest rates became much more volatile. Using a methodology advanced by Barro, this paper estimates what this change in policy did to output in the United States. The paper finds that the stagnation of the U.S. economy since 1979 stemmed almost as much from increased interest rate volatility as from reduced money growth. The paper also assesses the extent to which increased volatility of money growth has contributed to stagnation. It finds no evidence of any appreciable contribution. The paper concludes that stabilizing interest rates is probably sensible monetary policy.