Risk Premium Shocks Research Articles

Should Developed Economies Manage International Capital Flows? An Empirical and Welfare Analysis*

The literature on the effects of country risk premium shocks has largely focused on emerging market economies. We empirically show that in developed economies, risk premium shocks explain a non‐trivial share of aggregate fluctuations and are key drivers of real activity during crises. Our empirical results and results from a two‐country New Keynesian model indicate that an increase in the risk premium leads to a reduction in aggregate output under monetary union, but not so in countries with flexible exchange rates and independent monetary policy. Model simulations suggest that managing international capital flows enhances welfare in countries under monetary union.

Capital Control Taxes in an Emerging Market Economy

Historically, Emerging Markets (EMs) that own foreign debt and exhibit a high degree of dollarization have demonstrated vulnerability to a range of both real and financial shocks. Governments often use a range of capital control measures, particularly in nations burdened with external debt, with the aim of mitigating sudden swings in both inflows and outflows of capital. These policies are implemented to lessen exchange rate volatility and prevent dollarization. This study employs second moments analysis, impulse response functions and the welfare analysis to investigate the impact of a tax policy that restricts international capital flows on several macroeconomic variables in an emerging economy. A dynamic stochastic general equilibrium (DSGE) model is employed to examine the impact of the tax imposed on foreign borrowing on the economy, including both real shocks such as technology and growth, as well as financial shocks such as country risk premium. The findings of the study indicate that capital control taxes have a diminishing effect on the variability of significant macroeconomic variables, such as investment and consumption, when imposed at lower levels. Conversely, these taxes exhibit a stabilizing impact on the volatility of the trade balance-to-output ratio when implemented at higher levels. Moreover, quantitative evidence reveals that country risk premium shocks exert a substantial influence on variations in both the trade balance-to-output ratio and the level of investment, accounting for around 25% and 50% of the fluctuations, respectively. Finally, the existence of such a taxation enhances the intertemporal utility function at the steady state and reduces its volatility in the case of technology and growth shocks.

News and Asset Pricing: A High-Frequency Anatomy of the SDF

Abstract Utilizing real-time newswire data, together with a robustly estimated intraday stochastic discount factor (SDF), we identify and quantify the economic news that is priced. News related to monetary policy and finance on average accounts for most of the variation in the SDF, followed by news about international affairs and macroeconomic data. We also document nontrivial temporal variation in the relative importance of the news, along with marked differences in the estimated news risk premiums in the “factor zoo.” To further highlight the economic mechanisms at work, we associate the different news effects with interest rate, growth, and risk premium shocks. (JEL C58, G12, G14)

A structural approach to combining external and DSGE model forecasts

This note shows that combining external forecasts such as the Survey of Professional Forecasters can significantly increase DSGE forecast accuracy while preserving the interpretability in terms of structural shocks. Applied to pseudo real-time from 1997q2 onward, the canonical Smets and Wouters (2007) model has significantly smaller forecast errors when giving a high weight to the SPF forecasts. Incorporating the SPF forecast gives a larger role to risk premium shocks during the global financial crisis. A model with financial frictions favors a larger weight on the DSGE model forecast.

Risk premium in a real business cycle framework

A real business cycle framework with financial and informational frictions is developed for a small open economy in order to analyze the implications of risk premium shocks for aggregate fluctuations. The frictions in the dynamic, stochastic, general equilibrium model necessitate financial intermediation and the uncertainty in the production process requires collateralized borrowing in the economy. Sovereign risk exists in the model due to a government that borrows domestically with a partial default risk. The associated risk premium that the government is subject to is captured both endogenously and exogenously, which constitutes one of the major contributions of this study to the literature. It is shown that a positive, temporary risk premium shock leads to an increase in government borrowing and a decrease in government spending due to the rise in the cost of borrowing for the government. The model also predicts a fall in output, labor supply and loans as well as a rise in the default probability of the government. The results confirm the findings of the literature with respect to the expected effects of a positive risk premium shock on a small open economy in a novel framework, where financial and informational frictions as well as sovereign risk as key features of emerging economies are captured and analyzed.

A simulation of the macroeconomic effects of the Russia–Ukraine War on the Moroccan economy using the DSGE model

AbstractRussia's invasion of Ukraine has had significant global economic implications, disrupting trade flows and leading to a rise in oil prices that has affected world economies, including Morocco. The aim of this study is to assess the impact of these external shocks on the Moroccan economy using a dynamic stochastic general equilibrium (DSGE) model, which enables detailed analysis of the interactions between various macroeconomic variables such as inflation, exchange rates and trade balances. The results of the study highlight the importance of taking risk premium shocks into account in economic policy‐making, as they can lead to higher inflation and a real depreciation of the Moroccan currency. The DSGE model provides a sound analytical framework for policy‐makers to assess and manage the impact of these external shocks on the Moroccan economy and thus promote economic stability and growth in the context of global economic uncertainty.

High Discounts and Low Fundamental Surplus: An Equivalence Result for Unemployment Fluctuations

We establish an observational equivalence between unemployment fluctuations of the Diamond-Mortensen-Pissarides search economy augmented with time varying risk premia and an otherwise identical economy without risk premia but with a time varying value of leisure. This equivalence holds for general risk premia processes and allows us to view the effects of different models of risk premia as operating through a single channel—one that alters the value of leisure. We derive simple expressions for semielasticities of labor market tightness with respect to productivity and risk premium shocks. We show wages can be used to detect misspecification in the discount rate process used in hiring decisions. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2022.03712 .

DYNAMICS OF OPTIMUM MONETARY POLICY IN A SMALL OPEN-ECONOMY: A NEW-KEYNESIAN DSGE MODEL FOR TURKISH ECONOMY

The purpose of this paper is to investigate the sources of business cycle fluctuations in a small open economy (SOE) using dynamic stochastic general equilibrium (DSGE) models and to assess the path of optimal policy decisions taken by the Central Bank of the Republic of Turkey (CBRT). To that purpose, the SOE-DSGE model is estimated using the Bayesian technique with Turkish data spanning the quarters 2003Q2–2020Q1. Based on the estimated model, the study finds that the explanatory power of the SOE-DSGE model for household, firm and central bank behavior decreases when consumer habit formation, price indexation and exchange rate sensitivity are included. Furthermore, technology, preferences, and risk premium shocks all have a significant impact on the Turkish economy. The CBRT, on the other hand, was principally concerned with price stabilization, interest rate smoothing, output and output growth stabilization, and nominal exchange rate stabilization, respectively. More importantly, the optimal monetary policy function implies that output growth should be better stabilized if exchange rate sensitivity target is ignored.

Banks, nonbanks, and business cycles

European macroeconomic and financial aggregates move in lockstep over the business cycle. We develop a model in which a single risk premium shock triggers these comovements. The key feature is a financial sector where traditional banks transfer part of their risky loan portfolio to nonbank institutions. We fit the model to euro area data and find that risk premium shocks are the main driver of business and financial cycles over the past two decades.

US structural drivers of international portfolio returns

This paper examines the dynamic relationships between the global six Fama–French and momentum factors and three types of shocks from the US: growth, monetary policy, and risk premium shocks. Cross-sectional tests suggest that the US shocks capture a significant portion of the six factors’ explanatory power. Investigating the dynamic relationships, we find that although the market portfolio and small-minus-big style appreciate in value in response to positive growth shocks, the remaining factors—high-minus-low, conservative-minus-aggressive, robust-minus-weak, and winning-minus-losing—are not responsive or respond positively to the negative shocks. Internationally, the factors can respond heterogeneously to the same shock. By mapping risks to returns, our work paves the way for a detailed exploration of the structural drivers of excess equity returns.

The Impact of COVID-19 Shocks on Business and GDP of Global Economy

This study examines the relationship between COVID-19 shocks and GDP loss of different countries worldwide based on the seven scenarios of the epidemiological DSGE/CGE model of [McKibbin, W., & Fernando, R. (2020). The Global Macroeconomic Impacts of COVID-19: Seven Scenarios. Asian Economic Papers, 20(2): 1-30, MIT Press]. We implemented a panel data approach for 24 cross-sectional units with three periods and a general regression neural network. The economic and financial shocks consist of labor supply, equity risk premium, consumption demand, and government expenditure. The findings show that the consumption demand and equity risk premium shocks on GDP are more influential than the other shocks. Moreover, the results reveal that the most significant GDP loss is associated with Japan, Germany, and the US, respectively, which are industrialized countries with the most prominent automobile manufacturers. The lowest GDP loss is linked to Saudi Arabia, one of the world's biggest oil producer countries.

Emerging Markets Currency Factors and US High-Frequency Macroeconomic Shocks

Relying on the structural vector autoregression developed by Cieslak and Pang, the authors identify four shocks to the US economy based on the US Treasury yield curve and the stock market: two fundamental news shocks (growth and money) and two risk-premium shocks (common and hedging). They find that these shocks explain over 40% of the time-series variation of emerging markets currency (EMFX) returns. Additionally, EMFX returns increase significantly with positive growth shocks and decrease with monetary tightening and risk-premium shocks. The authors show that growth and common shocks are priced in the cross section of EMFX, with a positive and negative risk premiums, respectively. They then build long–short currency portfolios based on several academically researched style factors and test their performance and relative exposure to the macroeconomic shocks affecting the US economy. They find that only carry and macro momentum long–short portfolios generate positive and significant alphas and excess returns over their sample. However, all single-factor portfolios have sizable exposure to the four shocks. The authors show that a simple multifactor approach to investing in EMFXs eliminates the exposure of excess returns to all macroeconomic shocks.

The term structure of uncovered interest parity in emerging markets

ABSTRACT This note examines uncovered interest parity (UIP) at both short and longer horizons in emerging markets. In part due to currency market intervention, the duration of risk premium shocks, and more easily verified medium term trends, the UIP term structure in these economies may differ from that in advanced economies. Analysing ten major emerging markets between 2000 and 2020, the evidence indicates that the validity of UIP increases with the investment horizon, corroborating a similar finding for advanced economies.

The Real Response to Uncertainty Shocks: The Risk Premium Channel

Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty increases risk and elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant equity risk premia in bad times, which in turn, exacerbate the decline of macroeconomic aggregates and equity prices. Moreover, in the cross-section of equity returns, investors demand a risk premium for stocks that perform poorly in times of high uncertainty and elevated risk aversion. In a model with endogenously time-varying RA, uncertainty shocks lead to large falls in investment and equity prices that closely match state-dependent data responses. This paper was accepted by Tomasz Piskorski, finance. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2022.4335 .

A Medium-Scale Bayesian DSGE Model for Kazakhstan with Incomplete Exchange Rate Pass-Through

This paper analyzes the sources of business cycle fluctuations in Kazakhstan and the relevance of various frictions in the economy using a medium-scale DSGE model with imperfect exchange rate pass-through. We estimate the model via Bayesian methods and present estimates of structural parameters of the model and highlight the role of various shocks in explaining the actual dynamics of observed variables. In the absence of quality and deseasonalized data, we show that the DSGE model with time-varying markups possesses a reasonable level of accuracy as the one-sided Kalman filter predictions match the dynamics of the observable variables. Posterior estimates of the model show that the long-run growth rate of output is 4.5% per annum and the exchange rate pass-through to domestic prices is between 21% and 35% within a quarter. We also find that risk premium shocks have played an important role in determining the inflation rate, the interest rate and the real exchange rate in the economy since 2015.

The Effects of Trade War Risk on U.S. Financial Markets

Existing studies usually investigate the effects of Trump’s war on U.S. financial markets by the event-study method. We take an alternative approach by integrating war-related news into one single trade war shock based on a structural vector autoregression model identified via event day heteroscedasticity and then exploring its effect on various financial variables. We find that the identified war shocks consist of both growth news shocks and risk premium shocks. The former reflects shocks to investors’ cash-flow expectations, and the latter arises from shifts in the risk appetite or changes in the cash-flow uncertainty, both of which not only generates significant impacts on financial variables such as stock prices, treasury yields, and BAA corporate bond spreads but also explains a sizable fraction of their fluctuations. Additional analyses that employ stock prices in the S&P 500 index to explore the role of firms’ global value chain exposure during the war show that firms with high output exposure to China’s market suffer significantly more from the war, while input exposure does not cause a persistent significant difference.

Risk-premium shocks and the prudent exchange rate policy

Using a medium-size New Keynesian open economy model, we examine the issue of a prudent exchange rate policy when the economy encounters an adverse risk-premium shock. We show that the shock leads to terms of trade (ToT) deterioration and an increase in both the aggregate output and inflation. While examining the choice of an appropriate exchange rate policy to deal with the effects of the shock, analytical results of our baseline model show that neither a fully flexible nor a fully pegged exchange rate policy can yield the desired outcome. In the absence of the supply-side effects of ToT and a cost channel of monetary policy, a managed exchange rate policy can stabilize both domestic inflation and aggregate output. However, in the presence of either a cost channel of monetary policy or supply-side effects of the ToT or both, the central bank faces a trade-off between aggregate output and domestic inflation stabilization. We find that the presence of a cost channel of monetary policy gives rise to a pro-cyclical exchange rate policy. Simulation of a more general model suggests that, instead of using the conventional Taylor rule, the central bank should follow a ToT-augmented Taylor rule, which involves further monetary tightening as the ToT deteriorates. We find that the need for monetary tightening is linked to both the nominal and real rigidities in economy, which gives rise to increased exchange rate volatility. We also briefly consider the case of a productivity shock.

Emerging Markets Currency Factors and U.S. High Frequency Economic Shocks

Relying on the structural vector autoregression developed by Cieslak and Pang (2021), we identify four shocks to the U.S. economy based on the U.S. Treasury yield curve and the stock market: two fundamental news shocks (growth and monetary policy) and two risk-premium shocks (common and hedging). We find that these shocks explain over 40% of the time-series variation of emerging markets currency (EMFX) returns. Additionally, EMFX returns increase significantly with positive U.S. growth shocks and decrease with monetary tightening and risk-premium shocks. We then build long-short currency portfolios based on several academically researched style factors and test their relative exposure to U.S. macroeconomic shocks. We find that only Carry and Macro Momentum long-short portfolios generate positive and significant alphas and excess returns over our sample. However, all single factor portfolios have sizable exposure to U.S. high-frequency shocks. We show that a simple multifactor approach to investing in EMFXs eliminates the exposure of excess returns to U.S. macroeconomic shocks.

Common shocks in stocks and bonds

We propose an approach to identify economic shocks (monetary, growth, and risk premium news) from stock returns and Treasury yield changes, which allows us to study the drivers of asset prices at a daily frequency since the early 1980s. We apply the identification to examine investors’ responses to news from the Fed and key macro announcements. We uncover two risk premium shocks—time-varying compensation for discount rate and cash flow news—which have distinct effects on stocks and bonds. Since the mid-1990s, the Fed-induced reductions in both risk premium sources have generated high average stock returns but an ambiguous response in bonds on FOMC days.

External debt management as macroprudential policy in a small open economy

This paper examines the role of macroprudential policy and foreign exchange rate intervention in stabilizing the economy facing foreign shocks. To this end, we build a small open economy dynamic stochastic general equilibrium (DSGE) model with a banking sector. We add foreign loans by entrepreneurs regulated by a macroprudential policy via a foreign to domestic loan ratio requirement. The exchange rate intervention is undertaken via a modified Taylor rule. From the analysis, two important results emerge. First, the responses of aggregate output, consumption, investment, and inflation vary widely for different types of foreign shock and policy combinations. Second, the stabilization gain seems to depend on the type of foreign shock hitting the economy. When the economy is hit by a foreign interest rate shock, tightening the macroprudential measure reduces the volatility of output, consumption, and investment-more than if the stabilization effort is carried out through an exchange rate intervention. However, under a risk premium shock, this gain diminishes substantially.