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Arbitrage-free affine models of the forward price of foreign currency
Forward foreign exchange contracts embed not only expected depreciation but also a sizable premium, which complicates inferences about anticipated returns. This study derives arbitrage-free affine forward currency models (AFCMs) with closed-form expressions for both unobservable variables. Model calibration to forward term structures of eleven U.S.-dollar currency pairs from the mid-to-late 1990s through early 2014 fits the data closely and suggests that the premium is indeed nonzero and variable, but not to the degree implied by previous econometric studies.
Working Paper
The effect of monetary policy on monthly and quarterly stock market returns: cross-country evidence and sensitivity analyses
Several studies report an empirical link between changes in monetary policy and short- as well as long-run stock market performance in the United States. Such findings are germane both to the study of market anomalies and to monetary policy transmission mechanisms. Previous univariate time-series results on long-run data, which use the discount rate as the main policy indicator, seem robust to alternative specifications of stock price returns given data on 16 countries from 1956 through 2000. However, out-of-sample tests indicate that the relation has largely decreased over time. Also, panel ...
Working Paper
Foreign portfolio investment, foreign bank lending, and economic growth
In contrast to the empirical literature's focus on foreign direct investment (FDI), this study examines the effects of foreign portfolio investment (FPI) and "other" foreign investment (OFI) on economic growth using data on 88 countries from 1977 through 2000. Most measures suggest that FPI has no effect, and some results indicate that OFI has a negative impact on growth that is somewhat mitigated by initial financial and/or legal development. However, these results are questionable due to possible simultaneity bias. The empirical analyses also examine whether non-FDI foreign investment ...
Working Paper
Does monetary policy affect stock prices and Treasury yields? An error correction and simultaneous equation approach
This study pursues two addenda to the practitioner and academic on the effect of monetary policy on asset prices. First, this paper applies cointegration theory, and, second, relaxes the stringent assumption in the literature that changes in 10-year Treasury yields, stock returns, and changes in the stance of monetary policy are exogenous. Given quarterly data from 1978:Q4 to 2002:Q3, two-stage least squares (2SLS) regressions suggest that changes in the exogenous component of the federal funds rate affect changes in Treasury yields but not stock returns, ceteris paribus. However, this result ...
Working Paper
Sacrifice ratios and monetary policy credibility: do smaller budget deficits, inflation-indexed debt, and inflation targets lower disinflation costs?
A growing empirical literature addresses the determinants of the sacrifice ratio, an imperfect measure of the tradeoff between inflation and aggregate output. This study endeavors to advance previous studies in three ways. First, the literature does not satisfactorily examine key fiscal and monetary policy practices that arguably affect policymaking credibility. These include the stock (and flow) of government debt, the issuance of inflation-indexed bonds, and the existence of explicit inflation targets. Second, previous studies unfortunately exclude non-OECD countries. Third, the literature ...
Working Paper
An estimate of the inflation risk premium using a three-factor affine term structure model
This paper decomposes nominal Treasury yields into expected real rates, expected inflation rates, real risk premiums, and inflation risk premiums by separately calibrating a three-factor affine term structure model to the nominal Treasury and TIPS yield curves. Although this particular application seems to produce expected real short rates and inflation rates that are somewhat static, there are theoretical advantages to calibrating the model to nominal and real yields separately. Moreover, the estimates correlate positively with back-of-the-envelope measures of the inflation risk premium. ...
Report
Arbitrage-free models of stocks and bonds
A small but ambitious literature uses affine arbitrage-free models to estimate jointly U.S. Treasury term premiums and the term structure of equity risk premiums. Within this approach, this paper identifies the parameter restrictions that are consistent with a simple dividend discount model, extends the cross-section to Germany and France, averages across multiple observable-factor and market prices of risk specifications, and considers alternative samples for parameter estimation. The results produce intuitive trajectories for both sets of premiums given standard samples starting from July ...
Report
More on U.S. Treasury term premiums: spot and expected measures
Several studies that use affine term structure models (ATSMs) or survey data suggest that subdued nominal U.S. Treasury yields during the global financial crisis and its aftermath primarily reflected exceptionally low, if not negative, term premiums as distinct from depressed anticipated short rates. However, this literature pays little attention to the length of time market participants anticipated low term premiums to prevail, as captured by the ?forward? or ?expected? term premium over a given horizon, distinct from the ?spot? term premium. Besides the implications for investors at the ...
Working Paper
Jump-diffusion processes and affine term structure models: additional closed-form approximate solutions, distributional assumptions for jumps, and parameter estimates
Affine term structure models in which the short rate follows a jump-diffusion process are difficult to solve, and the parameters of such models are hard to estimate. Without analytical answers to the partial difference differential equation (PDDE) for bond prices implied by jump-diffusion processes, one must find a numerical solution to the PDDE or exactly solve an approximate PDDE. Although the literature focuses on a single linearization technique to estimate the PDDE, this paper outlines alternative methods that seem to improve accuracy. Also, closed-form solutions, numerical estimates, ...
Working Paper
The extreme bounds of the cross-section of expected stock returns
Several empirical studies report violations of the asset-pricing model of Sharpe (1964), Lintner (1965), and Black (1972). But, there is no consensus on specification in this literature, as such studies typically consider only a limited number of explanatory variables and do not satisfactorily control for previous findings. Extreme bound analysis (EBA), an imperfect but useful remedy for model uncertainty, suggests that comparatively few factors are robust. Given the cross-section of expected stock returns from July 1963 through December 2000, three of 23 variables - market size as well as ...