Interest Rate Uncertainty Research Articles

Practical Applications of Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think

In <b>Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think</b>, in the June 2020 Multi-Asset Special Issue of <b><i>The Journal of Portfolio Management</i>, Thomas J. O’Brien</b> of the <b>University of Connecticut</b> discusses the relative practicality and utility of various basic multiperiod allocation strategies. Applying a three-period binomial model, O’Brien calculates how much anticipated future wealth investors might forgo from following simpler portfolio-management strategies such as buy-and-hold or constant-mix, instead of a more complex optimal reallocation plan. He also determines which fixed-income vehicles would better suit which investors. By making assumptions about equities and interest rates in his analyses, O’Brien derives conclusions about the best allocation and fixed-income strategies for investors with differing risk thresholds. He finds that in an environment where equity mean-reversion and interest-rate uncertainty prevail, investors can pursue either buy-and-hold or constant-mix portfolio strategies without incurring much economic cost. Investors’ preferred allocation strategies and fixed-income approaches should be guided by their risk tolerance. The more risk averse would opt for a constant-mix allocation strategy paired with horizon-maturity fixed-income instruments. More-risk-accepting investors would apply a buy-and-hold allocation strategy coupled with a sequenced series of shorter-term bills. <b>TOPICS:</b>Portfolio management/multi-asset allocation, portfolio theory, portfolio construction

نااطمینانی نرخ سود تسهیلات و تأمین مالی بنگاههای کوچک و متوسط منتخب پذیرفتهشده در بورس اوراق بهادار

به بنگاه‌های کوچک و متوسط به‌‌دلیل نقش آنها در رشد و توسعۀ اقتصادی، هم در کشورهای توسعه‌‌یافته و هم در کشورهای درحال توسعه، بیش از پیش توجه شده است. پژوهش‌‌های متعدد دربارۀ این بنگاهها نشان می‌‌دهد مسئلۀ تأمین مالی برای آنها ازجمله موانع و چالش‌‌های مهم به شمار می‌‌رود. با توجه به سهم شایان توجه نظام بانکی در تأمین مالی بنگاه‌های، نااطمینانی نرخ سود تسهیلات بانکی تأثیر زیادی بر تأمین مالی و سرمایه‏گذاری آنها می‌‌گذارد. در این بین تعیین دستوری نرخ سود تسهیلات به همراه کامل‌‌نبودن اطلاعات بین بانک و متقاضیان تسهیلات موجب بروز نااطمینانی در این نرخ شده است؛ بنابراین پژوهش حاضر با توجه به تأثیر نااطمینانی بر شدت و نحوۀ اثرگذاری متغیرهای اقتصادی، به دنبال آن است تا به‌‌طور مشخص نقش نااطمینانی نرخ سود تسهیلات در تأمین مالی بنگاههای کوچک و متوسط که یکی از چالش‌‌های اصلی توسعۀ آنها است را با استفاده از الگوی داده‌‌های تابلویی بررسی کند. جامعۀ آماری مطالعه،70 شرکت کوچک و متوسط منتخب پذیرفته‌‌شده در بورس اوراق بهادار طی دورۀ زمانی 1390 تا 1396 است. به‌‌طور کلی، نتایج نشان‌‌دهندۀ اثر منفی و معنی‌‌دار نااطمینانی نرخ سود تسهیلات بر تأمین مالی بنگاههای کوچک و متوسط در ایران است. براساس نتایج تجربی پیشنهاد می‌‌شود برای بهبود تأمین مالی این بنگاهها در کشور، ازطریق کاهش دامنۀ نوسان‌‌های نرخ سود حقیقی تسهیلات، سیاست‌‌های مبتنی‌‌بر کاهش نااطمینانی نرخ سود تسهیلات در پیش گرفته شود.

Robust portfolios with commodities and stochastic interest rates

This paper addresses a gap in the literature concerning robust portfolio analysis for commodity markets in the presence of stochastic interest rates. For generality, we study an ambiguity-averse investor with a Cramér-Lundberg surplus to be allocated into a mean-reverting asset representing a commodity and a bond with a Vasicek interest rate model. Our framework allows for closed-form solutions for the optimal strategy, worst case measure, terminal wealth and value functions. We provide necessary conditions for a well-behaved solution. A full estimation is conducted on two commodity representatives: WTI oil prices and gold prices. We find strong evidence that optimal exposures to commodity risk and interest rate risk, as well as the performance of the portfolio, are significantly affected by the level of ambiguity aversion. Our analyses demonstrate that investors who ignore uncertainty incur drastic equivalent welfare losses, in particular ignoring commodity uncertainty is more costly than neglecting interest rate uncertainty. In a comparison between stocks and commodities, ignoring uncertainty on the latter is also more damaging. We also confirm the importance of working in a complete market (investing in Bonds) for commodity investors, otherwise welfare losses could easily reach 45%. In terms of parameter mis-specifications, we find that incorrect large correlation, smaller variance or simply the wrong market price of commodity risk, can lead to drastically large wealth-equivalent losses.

Robust portfolio choice under the interest rate uncertainty

ABSTRACT In this paper, we investigate a portfolio selection which is robust with respect to the interest rate uncertainty. For the portfolios with random assets, liabilities and interest rates, we bound from above Value-at-Risk of the change in the portfolio value, due to the interest rate model violation. Next, we find the robust portfolio applicable for a wide range of model perturbations. The robust optimization problem is treated in general and under additional restrictions, for example, on the expected duration of the portfolio. The results are based on the Hilbert space geometry methods applied to incomplete markets.

Monetary Policy Uncertainty and Economic Fluctuations at the Zero Lower Bound

We propose a TVP-VAR with stochastic volatility for the unemployment rate, core inflation and the federal funds rate augmented with survey-based interest rate expectations and uncertainty and a FAVAR with a wider set of observable variables and alternative monetary policy measures in order to explore U.S. monetary policy, accounting for the zero lower bound. We find that a rise in monetary policy uncertainty increases unemployment and lowers core inflation; the effects on unemployment in particular are robust (a gradual 0.4 percentage point increase), lasting more than two years after the initial shock. Interest rate uncertainty shocks explain a significant portion of macro fluctuations, particularly after the 2007-09 global financial crisis contributing to push the unemployment rate one percentage point higher during the early phase of the subsequent recovery. Furthermore, we find that higher interest rate uncertainty makes forward guidance shocks (but also federal funds rate shocks) less effective at moving unemployment and core inflation. We also posit a theoretical model to provide the structural backbone for our empirical results, via an “option value” channel. Theory yields sizeable real effects and a muted monetary policy transmission mechanism as firms choose to postpone investment decisions in response to heightened interest rate uncertainty.

Global Impacts of Us Monetary Policy Uncertainty Shocks

We build a new empirical model to estimate the global impact of an increase in the volatility of US monetary policy shocks. Specifically, we admit time-varying variances of local structural shocks from a stochastic volatility specification. By allowing for rich dynamic interaction between the endogenous variables and time-varying volatility in the global setting, we find that US interest rate uncertainty not only drives local output and inflation volatility, but also causes declines in output, inflation, and the interest rate. Moreover, we document strong global impacts, making the world move in a very synchronous way. Crucially, spillback effects are found to be significant even for the US economy. JEL Classification: C32, C54, E52, E58, F44

An economic model for offshore transmission asset planning under severe uncertainty

Abstract The inherent uncertainties associated with offshore wind are substantial, as are the investments. Therefore, investors are keen to identify and evaluate the risks. This paper presents a model to economically evaluate projects from an offshore transmission owner’s perspective by considering the revenue streams, capital costs, and operational expenditure. To allow a more realistic economic evaluation, data, regulatory information, and expert knowledge are collected, curated and, where necessary, combined with statistical techniques. A generic 1.2 GW project is used as a case study. This research contributes to a deeper understanding of the severe uncertainties involved in offshore transmission planning and their impact on a project’s expected profit. Understanding their impact, through a sensitivity analysis where individually one factor is varied within an interval, supports informed decision making with limited information. Uncertainty in interest rates, planned operational expenditure and, particularly, cable failure rates were found to be critical to an investor’s return. For the case study considered, comparing cable failure rates based on operational experience to inputs based on literature, resulted in a 64.2% lower net present value. In conclusion, further research into cable failures, and addressing the uncertainty in inputs used for economic evaluations could be beneficial to the industry.

Monetary policy uncertainty spillovers in time and frequency domains

We use the recently created monthly Interest Rate Uncertainty measure, to investigate monetary policy uncertainty across the US, Germany, France, Italy, Spain, UK, Japan, Canada, and Sweden in both the time and frequency domains. We find that the largest spillover indices are from innovations in the country itself; however, there are some instances where spillover indices between countries are large. These relationships change over time and we observe large variances in pairwise spillovers during the global financial crisis. We find that most of the volatility is confined to the crisis period. Policy makers should consider accounting for the spillovers from the US, Germany, France and Spain, as we found that they are the most consistent net transmitters of monetary policy uncertainty.

Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies Than You Think

Given mean-reverting equity and interest rate uncertainty, this article shows a relatively low economic cost of using a simple allocation strategy, buy-and-hold or constant-mix, instead of optimal reallocation. Moreover, given the decision to use one of the simple allocation strategies, the article identifies (1) which investors will be better off with buy-and-hold than with constant-mix, and vice versa, and (2) which investors will be better off with a horizon-maturity fixed-income position than with a sequence of short-maturity ones, and vice versa. The article uses illustrations in a three-period binomial model to bridge the academic/practitioner gap and provide useful insights to those interested in applied investment management. TOPICS:Portfolio management/multi-asset allocation, portfolio theory, portfolio construction Key Findings • Given mean-reverting equity and uncertain interest rates, investors sacrifice little in expected utility by replacing the optimal reallocation strategy with a simpler allocation strategy of either buy-and-hold or constant-mix. • Traditional investors, with positive allocations to both equity and fixed income, are better off with constant-mix than with buy-and-hold and with allocating to a horizon-maturity fixed-income instrument rather than a sequence of single-period fixed-income instruments. • More risk-tolerant investors with levered equity positions are better off with buy-and-hold than with constant-mix and with levering by a sequence of single-period fixed-income instruments instead of a horizon-maturity fixed-income instrument.

Investment under uncertainty with a zero lower bound on interest rates

This paper examines irreversible investment decisions when the interest rate is stochastic and constrained by a zero lower bound. In contrast to the commonly found negative relationship between investment and uncertainty, it is shown that the presence of a lower bound on interest rates induces an asymmetric effect of interest rate uncertainty on investment decision. When the interest rate is low an increase in interest rate volatility decreases the value of waiting and increases investment but when the interest rate is high an increase in interest rate volatility increases the value of waiting and decreases investment.

Interest Rate Uncertainty as a Policy Tool

Interest Rate Uncertainty as a Policy Tool

Unexpected Supply Effects of Quantitative Easing and Tightening

To analyze the evolution of quantitative easing’s (QE) and tightening’s (QT) effects across consecutive announcements, we focus on their unexpected component. Treasury yield sensitivities to QE and QT supply surprises do not fall monotonically over time, thus later announcements seemed to remain powerful; yield sensitivities to QT surprises are on average larger than sensitivities to QE surprises, implying supply effects did not diminish during periods of market calm amid economic expansion; finally, yield sensitivities are amplified by the amount of interest-rate uncertainty prevailing before the announcement, implying that turning points in the balance sheet policy tended to elicit larger reactions.

Buy-and-Hold and Constant-Mix May Be Better Allocation Strategies than You Think

Given mean-reverting equity and interest rate uncertainty, this study shows a relatively low economic cost of using a simple allocation strategy, buy-and-hold or constant-mix, instead of optimal reallocation. Moreover, given the decision to use one of the simple allocation strategies, the study identifies (1) which investors will be better off with buy-and-hold than constant-mix, and vice versa; and (2) which investors will be better off with a horizon-maturity fixed-income position than a sequence of short-maturity ones, and vice versa. The study uses illustrations in a three-period binomial model to “bridge the academic/practitioner gap” and provide useful insights to those interested in applied investment management.

Uncertainty aversion, carry trades and agent heterogeneity in the FX market

We examine the roles of heterogeneous agents in the foreign exchange (FX) market under the uncertainty framework. The empirical results show that uncertainty aversion is an important feature of heterogeneous agents’ behavior in the FX market, and inclusion of uncertainty-averse carry traders helps to improve the out-of-sample predictive performance. The carry traders’ activities are significantly affected by the interest rate differential and uncertainty aversion. They participated actively in the market before 2009 because of the large interest rate differential, and exited the market after the global financial crisis as the interest rate differential narrowed.

A survey-based estimation of the Swiss franc forward term premium

This paper sheds light on Swiss franc LIBOR futures, which are often used to derive interest rate expectations. We show that the differences between LIBOR futures and realized rates (excess returns) are, on average, positive over the last 25 years. Using interest rate surveys, we decompose excess returns into a (forward) term premium and forecast errors. The decomposition reveals that the bulk of excess returns arises from forecast errors, while the term premium is, on average, zero but time varying. We find that the term premium positively correlates with the business cycle, interest rate developments, and in absolute values increases with interest rate uncertainty.

Modeling the Effect of Interest Rate Uncertainty on Residents’ Consumption – Based on a DSGE Model Embedded Stochastic Volatility

Modeling the effect of uncertainty shock usually employs VAR method. The approach however often leads to the results unstable with different structural equations. Especially it is modeled without a microscopic basis which often implies wrong policy advice. A new method to model the effect of interest rate uncertainty is proposed in this paper that overcomes this limitation. A stochastic volatility model is embedded into a dynamic stochastic general equilibrium framework to study the influence of interest rate uncertainty on the residents’ consumption. Using the third-order perturbation method to identify the impact of interest rate uncertainty on consumption. It is found by simulation that with the interest rate uncertainty increased, the consumption of residents in the current period has obviously decreased due to the preventive saving mechanism. Variance analysis shows that interest rate uncertainty shocks can explain 8% share of consumption volatility. The empirical results are robust when changing the parameter values and the prior distribution of the parameters. The conclusion shows the government should strengthen to guide the public reasonable expectations, to avoid the negative impact of interest rate uncertainty.

Real Option Valuation in a Gollier/Weitzman World: The Effect of Long-Run Discount Rate Uncertainty

Large-scale investment projects face significant long-run uncertainty in interest rates. However, little is known about the effect of long-term discount rate uncertainty on capital investment real option values. This paper bridges the long-run discount rate uncertainty literature developed in climate change economics with the financial literature on interest rate models and real options. First, we derive an Ingersoll-Ross real option model under the assumption of a declining discount rate model (DDR) following Gollier and Weitzman, and show how optimal investment timing is affected. Second, we study the problem of an open oil field with an abandonment option. We find that, compared with DDR, standard models using constant or mean-reverting interest rates undervalue projects and their real options to wait or to abandon. Indeed, results under DDR are more consistent with recent evidence on corporate decision-making under incomplete preferences or ambiguity. The results have implictions for both energy investment under uncertainty and climate finance.

The Use of Derivatives to Hedge Market Risk in Corporate Financing

In this tutorial article, the strategies available to hedge market risks arising from different financing instruments are explained. Financial derivatives, whether futures or options have been widely applied in companies to mitigate or eliminate potential losses due to the uncertainty in interest or foreign exchange currency rates. However, the mathematical complexity of derivatives has sometimes been a barrier to non-highly specialised financial managers in understanding their foundations, advantages and ways to apply them in exposure reduction strategies. To address this issue, a practical approach to the use of derivatives is presented in this article. The swap valuation concepts and foundations of pricing are dealt with in the text, but their formal valuation techniques are described separately in the appendices. Explanations will be provided to calculate option premiums with the extensively used and free downloadable software of John Hull (Derivagem), but the mathematics involving the models used in option valuation will not be shown as they are outside the scope of this paper.

Currency Carry, Momentum, and US Monetary Policy Uncertainty

Returns to currency carry and momentum are compensations for the risk of global interest rate uncertainty (IRU), with risk exposures explaining 92% of cross-sectional return variations. Higher carry and momentum signal increase investor's expectations for future excess returns and stimulate more risk-taking, yet the global IRU adversely affects investor's risk-bearing capacity and triggers losses of carry and momentum strategies. Expected returns estimated from those risk exposures predict carry and momentum returns, with large economic and statistical significance. Consistently, I find the risk of global IRU predicts contemporaneous and subsequent worsening of intermediary's financial constraints, and it is also priced in momentum returns across other asset classes. The explanatory power is robust to using currency-level tests and is not driven by existing measures of uncertainty or risk aversion.

Do China or the US Macroeconomic Conditions Affect Asian Public Real Estate Markets?

In retrospect of China’s increasing significance and active role in the global economy alongside with prominence in Asian economic growth, this paper investigates the relative impact of China’s and US’s macroeconomic factors on Asian real estate excess return performance. Although past literature covered extensively the influence of macroeconomic variables on the domestic stock markets, little had been done in the research of foreign macroeconomic factors on domestic real estate markets. This paper attempts to contribute along this direction. Using a set of 10 Asia-Pacific (APAC) and the US real estate market monthly excess returns, as well as several macroeconomic factors and economic policy uncertainty indices from January 1988 to April 2017, we implement multiple regression analysis, linear and nonlinear causality analysis and generalized impulse response functions to reach a robust conclusion. We find that there are insignificant correlations between China macroeconomic variables and APAC, as well as between the U.S macroeconomic variables and APAC real estate market excess returns in both the full and sub-period analysis. The observations would agree with the conventional wisdom that foreign macroeconomic factors have weaker correlations with the real estate returns, as compared to its domestic counterparts. Nevertheless, the US macroeconomic factors show stronger causal relationship with the APAC real estate excess returns during the full period analysis, while China macroeconomic variables have witnessed a stronger causal relationship in shorter sub-period analysis. Key macroeconomic variables such as Industrial Production Output Index, Long Term Interest Rates and Economic Policy Uncertainty had observed significant fluctuated responses for both US and China. Overall, it can be concluded from the study that the US economy continues to have a dominant influence in Asian real estate markets. However, during economic crises, the impact of China’s economy conclusively outweighs that of U.S. The key macroeconomic factors that are the most impactful include industrial output growth, long-term interest rate and economic policy uncertainty. Finally, the results reported in this paper might have portfolio and policy implications.