Time-varying Interest Rate Research Articles

The term premium, time varying interest rate volatility and central bank policy reaction

The solution of the McCallum policy reaction model of the term structure of interest rates including a volatility-dependent term premium indicates that the performance of the expectations hypothesis of the term structure (EHTS) in simple regression and ARCH in mean framework is strongly affected by policy reaction. This finding is illustrated with US data for the 1973–1995 period.

Time-varying market, interest rate, and exchange rate risk premia in the US commercial bank stock returns

This paper examines the role of market, interest rate, and exchange rate risks in pricing a sample of the US Commercial Bank stocks by developing and estimating a multi-factor model under both unconditional and conditional frameworks. Three different econometric methodologies are used to conduct the estimations and testing. Estimations based on nonlinear seemingly unrelated regression (NLSUR) via GMM approach indicate that interest rate risk is the only priced factor in the unconditional three-factor model. However, based on ‘pricing kernel’ approach by Dumas and Solnik [(1995). J. Finance 50, 445–479], strong evidence of exchange rate risk is found in both large bank and regional bank stocks in the conditional three-factor model with time-varying risk prices. Finally, estimations based on the multivariate GARCH in mean (MGARCH-M) approach where both conditional first and second moments of bank portfolio returns and risk factors are estimated simultaneously show strong evidence of time-varying interest rate and exchange rate risk premia and weak evidence of time-varying world market risk premium for all three bank portfolios, namely those of Money Center bank, Large bank, and Regional bank.

Debt and Deficit Ceilings, and Sustainability of Fiscal Policies: an Intertemporal Analysis

In this paper, we examine the likely consequences for the sustainability of fiscal policy of pursuing goals that rely on restrictive ceilings on deficits and debt. We provide a formal theoretical framework for analyzing the sustainability of fiscal policy based on the government intertemporal budget constraint and derive conditions that determine whether a given fiscal stance is sustainable. This framework generalizes the existing literature in several important respects. We allow for time-varying interest rates, for the primary deficit to be endogenous, for a finite planning horizon suitable for medium-term policy making, for possible future policy shifts, we show how published forecasts can be used and we provide a measure of fiscal pressure. We then apply this analysis to the fiscal positions of the United States and the European Union countries since 1970 and to their planned positions over the next decade. We find that many countries do not have a sustainable policy. The evidence in favor of sustainability is strengthening for most countries when the data are extended to incorporate future fiscal consolidation plans, reflecting the general shift toward fiscal austerity in recent years. In contrast, with a finite horizon we show that the recent policy shift made the paths of future policies sustainable. However, imposing ceilings on debt or deficit-to-GDP ratio throws most economies onto an unsustainable path unless governments undertake a major tax or expenditure adjustment. High-debt countries can satisfy the 60 percent debt rule by 1999 only by raising (reducing) the average tax (spending) rate substantially for five years. A 3 percent plan 1999 or a zero-deficit plan by the year 2002, puts an increasingly high pressure on most economies, including the United States, requiring a gradual rise (decline) in the tax (spending) rate.

Permanent, Temporary, and Non-Fundamental Components of Stock Prices

This paper identifies various components of stock prices and examines the response of stock prices to different types of shocks: permanent and temporary changes in earnings and dividends, changes in discount factors, and non-fundamental factors. The analysis is conducted in a log-linear structural VAR framework. I find that about half of the yearly variation in prices is not related to either earnings or dividend changes. Time-varying interest rates do not help explain the remaining price movements. However, time-varying excess stock returns (i.e., risk premiums) account for much of the remaining variation in stock prices, in particular, in the postwar period. As a result, the deviation of stock prices from these fundamentals reduces to about 10% of stock price movements and tends to persist for a while before it declines eventually. This finding seems more compatible with a fad rather than a bubble interpretation.

How forecastable is consumption growth? New evidence on the Hall random walk hypothesis

I provide new evidence on the accuracy of the Hall random walk hypothesis that consumption growth is not predictable. Using 1971–94 US data, I find that consumption growth is substantially more predictable than previously believed. A regression of consumption growth on lagged nominal interest rate changes, lagged consumption growth and forecasts by Data Resources, Inc. yields an adjusted R-squared of 0.32. The empirical tests further suggest that excess sensitivity of consumption to current disposable income, rather than time-varying real interest rates or non-separable utility, is the most likely explanation for the predictability of consumption growth.

Fundamentals and bubbles in asset prices: Evidence from U.S. and Japanese asset prices

This paper investigates the existence and extent of non-fundamental bubbles in both U.S. and Japanese asset prices by employing a flexible empirical method which allows us to decompose asset prices into fundamental and non-fundamental bubble components. This study finds that a substantial fraction of U.S. and Japanese asset prices is accounted for by non-fundamental bubble components and that these asset prices overreact to non-fundamental bubble shocks. In addition, allowing for time-varying interest rates as another fundamental factor does not change any qualitative results about the role of non-fundamental bubble components. This suggests that the present value model fails to explain volatile asset price behavior even with time-varying interest rates.

Re-examination of interest rate sensitivity of commercial bank stock returns using a random coefficient model

This article develops and tests a random coefficient two-index model for commercial bank stock returns which controls for the time-varying interest rate sensitivity caused by a bank's changing maturity profile. Using a sample of 51 actively traded commercial banks, the seemingly unrelated regression results provide evidence that commercial bank stock returns are significantly interest rate sensitive. The effect of interest rate changes on bank stock returns is found to be positively related to the maturity mismatch between the bank's assets and liabilities, when the proxy for interest rate changes and the proxy for maturity mismatch are compatible to each other.

Transactions Demand for Money with a Stochastic, Time-Varying Interest Rate

This paper considers a stochastic, time-varying interest rate in a continuous-time inventory-theoretic model of the demand for money. The problem of minimizing expected, discounted cash-management costs is ascribed to an agent. An optimal cash-management policy exists and is of a familiar target-threshold form. Closed-form expressions for the forward-looking, time-varying targets and thresholds are derived in special cases and implications for the dynamics of the cash balance are described.