An Alternative Strategy for Estimation of a Nonlinear Model of the Term Structure of Interest Rates
description- – This paper develops and tests a nonlinear general equilibrium model of the term structure of interest rates based on the framework of Cox, Ingersoll and Ross (CIR, 1985). The contributions of this paper to the literature are both theoretical and empirical. The theoretical advantages of the general equilibrium model developed in this paper over the CIR model are (a) the risk premium is endogenously derived as a nonlinear function of the instantaneous interest rate. (b) The nonlinear model shows that the term premium need not be strictly increasing in maturity as in CIR's model; it can be either increasing or humped, a result that is consistent with recent findings by Fama (1984) and McCulloch (1987). (c) Yields of different maturities are not perfectly correlated, but exhibit positive correlations. A partial differential equation for valuing the discount bond price is presented, and a closed-form expression is derived. The term structure of interest rates derived from this nonlinear model may be increasing, decreasing, humped or inverted, depending on parameter values.In an empirical application of the model, we develop a strategy for estimation which permits analysis of the model's temporal stability. Our model, like that of CIR, expresses the underlying stochastic process as a highly nonlinear function of two fundamental, time-invariant parameters. Many researchers have found that general equilibrium models such as CIR's provide quite poor explanations of the evolution of the term structure of interest rates. As an alternative strategy to that of fitting the fundamental parameters, we employ nonlinear system estimation of the unrestricted reduced-form parameters with a moving-window strategy in order to capture the term structure volatility caused by factors other than the instantaneous interest rate. We purposefully do not impose any law of motion on the estimated volatilities. This methodology is shown to have strong predictive power for the observed term structure of interest rates, both in-sample and out-of-sample.
- – WP275
- – 1994-10-01
- – application/pdf
An Empirical Investigation of Risk Premia in the Foreign Currency Futures Basis
description- – Significant time-varying risk premia exist in the foreign currency futures basis, and these risk premia are meaningfully correlated with common macroeconomic risk factors from equity and bond markets. The stock index dividend yield and the bond default and term spreads in the U.S. markets help forecast the risk premium component of the foreign currency futures basis. The specific source of risk matters, but the relationships are robust across currencies. The currency futures basis is positively associated with the dividend yield and negatively associated with the spread variables. These correlations cannot be attributed to the expected spot price change component of the currency futures basis, thus establishing the presence of a time-varying risk premium component in the currency futures basis.
- – WP281
- – 1996-01-01
- – application/pdf
Stochastic Long Memory in Traded Goods Prices
description- – Using spectral regression and exact maximum likelihood methods, we test for long memory dynamics in the traded goods prices for the G7 countries, as measured in their import and export price indices. Significant and robust evidence of fractional dynamics with long memory features is found in both import and export price inflation rates.
- – WP349
- – 1996-10-01
- – application/pdf
Fractional Differencing Modeling and Forecasting of Eurocurrency Deposit Rates
description- – We investigate the low frequency properties of three- and six-month rates for Eurocurrency deposits denominated in eight major currencies with specific emphasis on fractional dynamics. Using the fractional integration testing procedure suggested by Geweke and Porter-Hudak (1983), we find that several of the Eurocurrency deposit rates are fractionally integrated processes with long memory. These findings have important implications for econometric modeling, forecasting, and cointegration testing of Eurocurrency rates.
- – WP317
- – 1996-10-01
- – application/pdf
Fractional Cointegration Analysis of Long Term International Interest Rates
description- – DeGennaro, Kunkel, and Lee (1994) studied the long run dynamics of a system of long term interest rates of five industrialized countries by means of sophisticated cointegration methods. They found little evidence in support of the cointegration hypothesis, thus concluding that a separate set of fundamentals drives the dynamics of each of the individual long term interest rate series. In this study, we extend their analysis by exploring the possibility of very slow mean reverting dynamics (fractional cointegration) in the system of the five long term interest rates. We use the GPH test as our testing methodology for fractional integration and cointegration. Through rigorous investigation of the full system of the five long term interest rate series and its various subsystems, we provide evidence that the error correction term follows a fractionally integrated process with long memory, that is, it is mean reverting, though not covariance stationary. Despite significant persistence in the short run, a shock to the system of long term interest rates eventually dissipates so that an equilibrium relationship prevails in the long run.
- – WP315
- – 1996-10-01
- – application/pdf
Factor-GARCH Modeling of the Treasury Term Structure
description- – In this paper, we test the multivariate model of securities' excess returns formulated by Engle et al. (1990) on an expanded set of maturities. By applying their methodology to the entire Treasury term structure, we consider the applicability of a parsimonious common factor approach to the dynamics of short-, medium-, and long-term interest rates. We extend their methodology to incorporate asymmetric GARCH representations, in which the slope of the yield curve (and its sign) affects the evolution of the conditional variance of excess returns in fixed-income and equity markets. We find this approach quite successful in explaining the comovements of excess returns on the spectrum of Treasury issues for the 1962-1992 period.
- – WP288
- – 1996-06-01
- – application/pdf
Long Term Dependence in Stock Returns
description- – This paper investigates the presence of fractal dynamics in stock returns. We improve upon existing literature in two ways: i) instead of rescaled-range analysis, we use the more efficient semi-nonparametric procedure suggested by Geweke and Porter-Hudak (GPH, 1983), and ii) to ensure robustness, we apply the GPH test to a variety of aggregate and sectoral stock indices and individual companies' stock returns series at both daily and monthly frequencies. Our results indicate that fractal structure is not exhibited by stock indices, but it may characterize the behavior of some individual stock returns series.
- – WP314
- – 1996-04-01
- – application/pdf
Modelling Federal Reserve Discount Policy
description- – We employ threshold cointegration methodology to model the policy problem solved by the Federal Reserve System in their manipulation of the discount rate under a reserves target operating procedure utilized since October 1979. The infrequent and discrete adjustments that characterize movements in the discount rate instrument vis-a-vis the Federal Funds rate do not lend themselves to a linear cointegration framework. The inherently nonlinear relationship arising from the Fed's self-imposed constraints on discontinuously changing the discount rate is satisfactorily modelled as an instance of threshold cointegration between the discount rate and the Federal Funds rate.
- – WP335
- – 1996-03-01
- – application/pdf
Nearest-Neighbor Forecasts of U.S. Interest Rates
description- – We employ a nonlinear, nonparametric method to model the stochastic behavior of changes in several short and long term U.S. interest rates. We apply a nonlinear autoregression to the series using the locally weighted regression (LWR) estimation method, a nearest-neighbor method, and evaluate the forecasting performance with a measure of root mean square error. We compare the forecasting performance of the nonparametric fit to the performance of two benchmark linear models: an autoregressive model and a random-walk-with-drift model. The nonparametric model exhibits greater out-of-sample forecast accuracy than that of the linear predictors for most U.S. interest rate series. The improvements in forecasting accuracy are statistically significant and robust. This evidence establishes the presence of significant nonlinear mean predictability in U.S. interest rates, as well as the usefulness of the LWR method as a modeling strategy for these benchmark series.
- – WP313
- – 1996-02-01
- – application/pdf
Poison Pills, Optimal Contracting and the Market for Corporate Control: Evidence from Fortune 500 Firms
description- – The rationale for issuing poison pill securities remains unclear, despite the findings of a large body of prior research that these defenses adversely affect shareholder wealth. This paper investigates the hypothesis that the adoption of such defenses may reflect shareholders?desire to contract efficiently with their managers in an environment characterized by hostile takeovers and uncertainty about the managers?true performance. Unlike previous research, we focus on financial characteristics of firms as they relate to the motives for adopting such defenses. Our empirical research does not support the optimal contacting hypothesis. We interpret our results as supportive of the managerial entrenchment hypothesis.
- – WP393
- – 1997-11-01
- – application/pdf
Reexamining the Term Structure of Interest Rates and the Interwar Demand for Money
description- – This paper reexamines whether the term structure of interest rates, rather than merely a single interest rate, should be included in the demand for money of the interwar era. In contrast to earlier work, we use cointegration techniques to model the equilibrium/error correction process, and find that a sufficiently rich dynamic model using a single interest rate has considerable explanatory power. Nevertheless, we conclude that the inclusion of the term structure may help to explain the turbulent monetary dynamics of the Depression era.
- – WP384
- – 1997-09-01
- – application/pdf
The Ex Ante Predictive Accuracy of Alternative Models of the Term Structure of Interest Rates
description- – This paper compares six term structure estimation methods in terms of actual ex ante price and yield prediction accuracy. Specifically, we examine the models' ability to price Treasuries for one to five trading days ahead. The models' performance differs markedly between in- and out-of-sample predictions. Their relative success also depends on time, the forecast horizon, and whether price or yield errors are compared. We examine the degree of loss in accuracy the modeler incurs by not using the best method: in particular, we compare the more complex splining methods and the parsimonious Nelson-Siegel model.
- – WP372
- – 1997-08-19
- – application/pdf
Fractional Dynamics in Japanese Financial Time Series
description- – Using the spectral regression and Gaussian semiparametric methods of estimating the long-memory parameter, we test for fractional dynamic behavior in a number of important Japanese financial time series: spot exchange rates, forward exchange rates, stock prices, currency forward premia, Euroyen deposit rates, and the Euroyen term premium. Stochastic long memory is established as a feature of the currency forward premia, Euroyen deposit rates, and Euroyen term premium series. The martingale model cannot be rejected for the spot, forward, and stock price series.
- – WP334
- – 1997-07-01
- – application/pdf
Credible Disinflation Policy in a Dynamic Setting
description- – This paper builds upon the analysis of Orphanides and Wilcox (1996) to evaluate optimal anti-inflation policy under a broader set of circumstances than considered in their work. We consider a monetary authority with two instruments--the funds rate and the discount rate--with the distinction that only movements of the latter are 'credible' alterations of the Fed's policy stance, reflecting reputational effects. The public forms expectations of inflation given realized inflation and the expected progress toward lower inflation, as evidenced by credible policy moves. Optimal policy is formulated in a stochastic, dynamic setting of the Tinbergen-Theil framework. The presence of a"cost-of-change"penalty on the sequence of discount rate adjustments generates expected trajectories for targets and policy instruments which differ considerably from those lacking such a penalty.
- – WP375
- – 1997-06-27
- – application/pdf
A Nonparametric Investigation of the 90-Day T-Bill Rate
description- – We employ a nonlinear, nonparametric method to model the stochastic behavior of changes in the 90-day U.S. T-bill rate. The estimation technique is locally weighted regression (LWR), a nearest-neighbor method, and the forecasting criteria are the root mean square error (RMSE) and mean absolute deviation (MAD) measures. We compare the forecasting performance of the nonparametric fit to the performance of two benchmark linear models: an autoregressive model and a random-walk-with-drift model. The nonparametric fit results in significant improvements in forecasting accuracy as compared to benchmark linear models both in-sample and out-of-sample, thus establishing the presence of substantial nonlinear mean predictability of changes in the 90-day T-bill rate.
- – WP320
- – 1997-05-01
- – application/pdf
Long Memory and Forecasting in Euroyen Deposit Rates
description- – We test for long memory in 3- and 6-month daily returns series on Eurocurrency deposits denominated in Japanese yen (Euroyen). The fractional differencing parameter is estimated using the spectral regression method. The conflicting evidence obtained from the application of tests against a unit root as well as tests against stationarity provides the motivation for testing for fractional roots. Significant evidence of positive long-range dependence is found in the Euroyen returns series. The estimated fractional models result in dramatic out-of-sample forecasting improvements over longer horizons compared to benchmark linear models, thus providing strong evidence against the martingale model.
- – WP361
- – 1997-02-01
- – application/pdf
Long memory or structural breaks: Can either explain nonstationary real exchange rates under the current float?
description- – This paper considers two potential rationales for the apparent absence of mean reversion in real exchange rates in the post-Bretton Woods era. We allow for (i) fractional integration and (ii) a double mean shift in the real exchange rate process. These methods, applied to CPI-based rates for 17 countries and WPI-based rates for 12 countries, demonstrate that the unit-root hypothesis is robust against both fractional alternatives and structural breaks. This evidence suggests rejection of the doctrine of absolute long-run purchasing power parity during the post-Bretton Woods era.
- – WP380
- – 1999-01-01
- – application/pdf
Persistence in International Inflation Rates
description- – We test for fractional dynamics in CPI-based inflation rates for twenty-seven countries and WPI-based inflation rates for twenty-two countries. The fractional differencing parameter is estimated using semiparametric and approximate maximum likelihood methods. Significant evidence of fractional dynamics with long-memory features is found in both CPI- and WPI-based inflation rates for industrial as well as developing countries. Implications of the findings are considered and sources of long memory are hypothesized.
- – WP333
- – 1998-04-01
- – application/pdf
Waves and Persistence in Merger and Acquisition Activity
description- – Does merger and acquisition (M&A) activity occur in waves, that is, are there oscillations between low and high levels of M&A activity? The answer to this question is important in developing univariate as well as structural models of explaining and forecasting the stochastic behavior of M&A activity. There is evidence to suggest that aggregate U.S. time-series data on merger and acquisition (M&A) activity exhibit a"wave: behavior, which has been modeled by fitting either a two-state Markov switching-regime model or a sine-wave model to the data. This study provides an alternative characterization of the temporal patterns in M&A as a nonlinear process with strongly persistent or long-memory dynamics. The apparent level changes or partial cycles of differing magnitudes in aggregate M&A time series are consistent with an underlying data generating process exhibiting long memory. Time- and frequency-domain estimation methods are applied to a long M&A time series constructed by Town (1992), covering approximately a century of merger activity in the U.S. economy. We find significant evidence of long-term cyclical behavior, nonperiodic in nature, in the M&A time series, even after accounting for potential shifts in the mean level of the series. A shock to M&A activity exhibits significant persistence as it is damped at the very slow hyperbolic rate, but it eventually dissipates. We provide both theoretical and empirical rationales for the presence of fractional dynamics with long-memory features in M&A activity. Theoretically, long-term dependence may be due to persistent differences in firm valuation between stockholders and nonstockholders following an"economic disturbance,"as suggested by Gort (1969). Empirically, long-memory dynamics in M&A activity may reflect the statistical properties of fundamental factors underlying its behavior, as several of the proposed determinants of M&A activity have been shown to exhibit strong persistence.
- – WP396
- – 1999-12-01
- – application/pdf
Nonlinear Adjustment to Purchasing Power Parity in the post-Bretton Woods Era
description- – This paper models the dynamics of adjustment to long-run purchasing power parity (PPP) over the post-Bretton Woods period in a nonlinear framework consistent with the presence of frictions in international trade. We estimate exponential smooth transition autoregressive (ESTAR) models of deviations from PPP using both CPI- and WPI-based measures for a broad set of U.S. trading partners. We find clear evidence of a mean-reverting dynamic process for sizable deviations from PPP, with an equilibrium tendency varying nonlinearly with the magnitude of disequilibrium.
- – 1999-11-16
- – application/pdf
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