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ON THE ROMANIAN YIELD CURVE: THE EXPECTATIONS HYPOTHESIS AND CONNECTIONS TO THE REAL ECONOMY

ACADEMY OF ECONOMIC STUDIES DOCTORAL SCHOOL OF FINANCE AND BANKING – DOFIN DISSERTATION PAPER. ON THE ROMANIAN YIELD CURVE: THE EXPECTATIONS HYPOTHESIS AND CONNECTIONS TO THE REAL ECONOMY. M.Sc. Student: Alina ŞTEFAN Advisor : Prof. Mois ă ALTĂR Bucharest 2008. Motivation - questions.

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ON THE ROMANIAN YIELD CURVE: THE EXPECTATIONS HYPOTHESIS AND CONNECTIONS TO THE REAL ECONOMY

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  1. ACADEMY OF ECONOMIC STUDIES DOCTORAL SCHOOL OF FINANCE AND BANKING – DOFIN DISSERTATION PAPER ON THE ROMANIAN YIELD CURVE: THE EXPECTATIONS HYPOTHESIS AND CONNECTIONS TO THE REAL ECONOMY M.Sc. Student: Alina ŞTEFAN Advisor: Prof. Moisă ALTĂR Bucharest 2008

  2. Motivation - questions Romanian Yield Curve • Shape and movements • How does one analyze the yield curve • Predictive power • What can we learn from the yield curve? • Connections with the real economy • How is the yield curve influenced by inflation and real activity? • Caveat: data are scarce and volatile • Methodology: • All the tests are done in STATA • August 1999 – February 2008, monthly data

  3. Motivation – questions (2)

  4. Results • In the short run BUBOR is a good approximation for the Romanian T-bills yields • In the medium and long run the yield curve is flat or downward sloping • The expectation hypothesis does not hold, yet the market correctly anticipates the direction of yields • Parallel shifts in the yield curve represent the largest part of the movements in the yield curve • Yields on the primary market are higher than on the secondary market (related to the winner’s curse) • A backwards-looking Taylor rule performs well • Yields respond to shocks to inflation and real activity

  5. Short term • UK: Panel regression with Fixed Effects for GBP LIBOR on the T-bills yields •  = -0.01,  = 1.087, R2 = 0.99 • Cointegrated (using 3-Month data) • T-bills yields Granger cause LIBOR • The credit spread improves the model • Romania: Panel regression with Random Effects for 3M, 6M, 12M BUBOR on T-bills yields •  = 0.02,  = 1.035, R2 = 0.99 • The variables Granger cause each other • Romanian yields follow BUBOR closely

  6. Medium & long term • Construction of yield curve using cubic spline interpolation  Yi(t) = ai + bit + cit2 + dit3 • March 2007: • The shape of the yield curve reveals market expectations about future interest rates • Theory: term premium (liquidity premium) hypothesis / expectations hypothesis

  7. Expectation hypothesis • Explains the shape of the yield curve fj = E(YTMj)  YTMj= fj +  (1+YTMj)j = (1+YTMi)I (1+fi:j)j-i • Regress realized yields on forward rates (e.g. f2:5 compares with YTM3, 2 years from now) • Expectation hypothesis says  = 0,  = 1 • Alternative theory: term premium says  < 0,  = 1 • Fama & Bliss (1987) find that forward rates do not have predictive power at a short horizon

  8. Expectation hypothesis (2) • Realized yields on forward rates with Fixed Effects • No evidence for a term premium • The expectations hypothesis does not hold • Still, the market correctly anticipates the direction, but not the degree, of interest rate changes

  9. Movements of the yield curve • How to describe movements of the yield curve? • Group the yields into short term, medium term and long term and run a principal component analysis • Risk factors: slope, level, curvature • Scheinkman&Litterman (1991), Dai&Singleton (2000) • 68.22% of the movements of the yield curve are parallel shifts • For comparison, more than 99% of the movements in BUBOR are explained by parallel shifts (because of short maturities)

  10. Movements of the yield curve (2) • Principal component analysis • Alternative model: Evans & Marshall (1998)

  11. Primary vs. secondary markets • Two opposing theories: • Avoid winner’s curse yields on the primary market > yields on the secondary market – Neyt (1995) for Belgium • Liquidity hypothesis  yields on the primary market < yields on the secondary market – Krishnamurthy (2002) for the US • In Romania there is evidence of the former, although the data are scarce and volatile • Volatility on the primary market = 0.29, on the secondary = 0.58

  12. Taylor rules • Taylor rule (1993): rt = a0 + a'1ft0+ vt • Clarida et al (2000)  backwards-looking • rt = b0 + b'1Xt0+ vt, where Xt0= (ft0' ft0'-1, ..., ft0'-p-1 )' • I use 3-Month yields – logs, first difference; CPI and IP – deseasonalized, logs, first difference • For Romania: • In the original Taylor rule, R2 is very small (0.04) • In backwards-looking form, R2 is 0.67

  13. Taylor rules (2) • Taylor rule – backwards-looking

  14. Taylor rules (3) • Autocorrelations:

  15. Taylor rules (4) • Residuals from Taylor rules and the short rate:

  16. Taylor rules (5) • Also take into account: • Larger set of macroeconomic data • The Taylor rule is sensitive to the measures of inflation and real activity • The Taylor rule has a forward-looking component • Interest rate smoothing

  17. Vector autoregression • Analyze the interactions between yields and real economy • 2 models: • Short term yields, medium term yields, principal component for inflation (consumer price index, Brent price, production price index), industrial production • The commodity price also accounts for unexpected inflation • The inflation factor is closely correlated to the CPI (79.92%) and the PPI (82.62%) and less correlated with Brent (59.65%). • Short term yields, medium term yields, consumer price index, industrial production • The yields are in logs and first difference • The inflation and industrial production is seasonally adjusted, in logs and first difference

  18. Vector autoregression (2) • The first model: • VAR with 3 lags – economically significant • R2 is 80.11% for the short-term yields equation and 52.03% for the medium-term yields • Ang & Piazzesi(2003) find that 85% of the US short-term rate is explained by macroeconomic factors(they also identify latent factors)

  19. Vector autoregression (3) • The VAR is stable, the residuals are correlated at lag 2, errors are not normally distributed • Yields are Granger caused by inflation and real activity

  20. Vector autoregression (4) • Impulse response functions:

  21. Conclusions • In the short run BUBOR is a good approximation for the Romanian T-bills yields • In the medium and long run the yield curve is flat or downward sloping • The expectation hypothesis does not hold, yet the market correctly anticipates the direction of yields • Parallel shifts in the yield curve represent the largest part of the movements in the yield curve • Yields on the primary market are higher than on the secondary market (related to the winner’s curse) • A backwards-looking Taylor rule performs well • Yields respond to shocks to inflation and real activity

  22. References • "Stata: Time Series", Stata Press, 2007 • Acock, Alan C., 2006,"A Gentle Introduction to Stata",Stata Press • Ang A., Piazzesi M., 2003,"A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables", Journal of Monetary Economics 50, 745-787 • Ang, Andrew, Dong, Sen, Piazzesi, Monika, 2007,"No-Arbitrage Taylor Rules", NBER Working Papers 13448 • Baum, Christopher F., 2006, "An Introduction to Modern Econometrics Using Stata", Stata Press • Bodie, Zvi, Kane, Alex, Marcus, Alan J., 2008, "Investments, Eigth Edition", McGraw-Hill • Boţel, Cezar, 2002,"Cauzeleinflaţiei în România, iunie 1997-august 2001. Analiză bazată pe vectorul autoregresiv structural", BNR, Caiete de studii 11 • Chen, R. R., Scott, L., 1993, "Maximum likelihood estimation for a multi-factor equilibrium model of the term structure of interest rates", Journal of Fixed Income 3, 1993, 14-31 • Christiano, Lawrence J., Eichenbaum, Martin, Evans, Charles L., 1998,"Monetary Policy Shocks: What Have We Learned and to What End?", NBER Working Paper, 6400 • Christiano, Lawrence J., Eichenbaum, Martin, Evans, Charles L., 2001,"Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy", NBER Working Papers, 8403 • Clarida, R., Gali, J., Gertler, M., 2000,"Monetary policy rules and macroeconomic stability: evidence and some theory", Quarterly Journal of Economics 41, 277-300 • Clinebell, John M., Kahl, Douglas R., Stevens, Jerry L., 2000, "Integration of LIBOR and Treasury bill yields over different monetary regimes", Global Finance Journal, 17-30 • Dai, Q., Singleton, K., 2000, "Specification Analysis of affine term structure models", Journal of Finance 55, 1943-1978 • Duffie, D., Kan, R., 1996,"A yield-factor model of interest rates", Mathematical Finance 6, 379-406 • European Central Bank, 2003, "Bond Markets and Long-Term Interest Rates in European Union Accesion Countries" • Evans C.L., Marshall D., 1998,"Monetary policy and the term structure of nominal interest rates evidence and theory", Carnegie-Rochester Conference Series on Public Policy 49

  23. References (2) • Fama, Eugene F., Bliss, Robert R., 1987, "The information in Long-Maturity Forward Rates", The American Economic Review, 680-692 • Greene, William H., 2003,"Econometric Analysis, Fifth Edition", Prentice Hall • Hamilton, James D., 1994, "Time Series Analysis", Princeton University Press • Krishnamurthy, Arvind, 2002, "The Bond/Old Bond Spread", Forthcoming Journal of Financial Economics • Kuttner, Kenneth, N., Mosser, Patricia, P., 2002, "The Monetary Transmission Mechanism: Some Answers and Further Questions ", FRBNY Economic Policy Review/ May 2002 • Litterman, R., Scheinkman, J., 1991,"Common factors affecting bond returns", Journal of Fixed Income 1, 51-61 • Longstaff, F.A., Schwartz, E.S., 1992,"Interest rate volatility and the term structure: a two factor general equilibrium model", Journal of Finance 47, 1252-1282 • McCulloh, J. Huston, 1975,"An Estimate of the Liquidity Premium", The Journal of Political Economy, 95-120 • Mönch, Emanuel, 2005, "Forecasting the Yield Curve in a Data Rich Environment: A No-Arbitrage Factor Augmented VAR Approach", ECB Working Papers, 544 • Neyt, R., 1995, "Evidence on the Yield Differentials between the Primary and Secondary Market for Belgian Treasury Bills", Tijdschrift voor Economie en Management, Vol. XLI. I, 1996 • Rotemberg, Julio, Woodford, Michael, 1998, "Interest Rate Rules in an Estimated Sticky Price Model ", NBER Working Papers, 6618

  24. References (3) • Taylor, J.B., 1993,"Discretion versus policy rules in practice ", Carnegie-Rochester Conference Series on Public Policy 39, 195-214 • Varian, Hal R,., 2005"Intermediate Microeconomics: A Modern Approach, Seventh Edition", W. W. Norton • Veronesi, Pietro, 2007, "Recent Advances in Fixed Income Securities Modeling Techniques", presentation made at the Bank of Italy, July 2007 • Wooldridge, Jeffrey M., 2002,"Econometric Analysis of Cross Section and Panel Data", The MIT Press • Wu, T., 2003,"What makes the yield curve move?", FRBSF Economic Letter

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