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Series:Research Paper  Bank:Federal Reserve Bank of New York 

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Modeling volatility dynamics
Many economic and financial time series have been found to exhibit dynamics in variance; that is, the second moment of the time series innovations varies over time. Many possible model specifications are available to capture this phenomena, but to date, the class of models most widely used are autoregressive conditional heteroskedasticity (ARCH) models. ARCH models provide parsimonious approximations to volatility dynamics and have found wide use in macroeconomics and finance. The family of ARCH models is the subject of this paper. In section II, we sketch the rudiments of a rather general univariate time-series model, allowing for dynamics in both the conditional mean and variance. In section III, we provide motivation for the models. In section IV, we discuss the properties of the models in depth, and in section V, we discuss issues related to estimation and testing. In Section VI, we detail various important extensions and applications of the model. We conclude in section VII with speculations on productive directions for future research.
AUTHORS: Lopez, Jose A.; Diebold, Francis X.
DATE: 1995

Report
The short end of the forward convergence curve and asymmetric cat's tail convergence
How is the term structure able to predict future interest rates several months in the future and why is it so steep at the short end? Recent empirical work shows that rates of mean reversion are too slow to help predict short rates or to account for the curve's steepness. We propose that short term interest rates are predictable because Federal Reserve actions are predictable. In particular, our estimates suggest that the market anticipates the Fed's monetary stance twelve months in advance. Moreover, forward rates contain more information when the Fed is expected to tighten than when it is expected to ease. When the market anticipates a tightening, expectations about rising short rates drive movements in near term forward rates. When the market anticipates an easing, the term premia drives movements in forward curves. This asymmetry in the behavior of forward rates with regard to future monetary policy stance explains the forward curve's typically humped shape. We argue that a rapid convergence to a Fed target when a tightening is anticipated but not when an easing is anticipated generates an average forward curve that is steep at the short end.
AUTHORS: Remolona, Eli M.; Dziwura, Joseph; Pedraza, Irene
DATE: 1995

Report
Evaluating the predictive accuracy of volatility models
The volatility forecast evaluations most meaningful to forecast users are those conducted under economically relevant loss functions. Although several such loss functions are proposed in the literature, their implied economic costs are of interest only to specific types of volatility forecast users. A forecast evaluation framework that incorporates a more general class of economic loss functions is proposed. A user's loss function specifies the three key elements of the evaluation framework: the economic events to be forecast, the criterion with which to evaluate these forecasts, and the subsets of the forecasts of particular interest. Volatility forecasts are transformed into probability forecasts of the specified events, and the probability forecasts are evaluated using statistical criteria, such as probability scoring rules, tailored to the user's interests. An empirical example using exchange rates illustrates the procedure and confirms that the choice of loss function directly affects the forecast evaluation results.
AUTHORS: Lopez, Jose A.
DATE: 1995

Report
Forecast evaluation and combination
Forecasts are of great importance and widely used in economics and finance. Quite simply, good forecasts lead to good decisions. The importance of forecast evaluation and combination techniques follows immediatelyforecast users naturally have a keen interest in monitoring and improving forecast performance. Here we provide a five-part selective account of forecast evaluation and combination methods. In the first, we discuss evaluation of a single forecast, and in particular, evaluation of whether and how it may be improved. In the second, we discuss the evaluation and comparison of the accuracy of competing forecasts. In the third, we discuss whether and how a set of forecasts may be combined to produce a superior composite forecast. In the fourth, we describe a number of forecast evaluation topics of particular relevance in economics and finance, including methods for evaluating direction-of-change forecasts, probability forecasts and volatility forecasts. In the fifth, we conclude.
AUTHORS: Lopez, Jose A.; Diebold, Francis X.
DATE: 1995

Report
The term structure of interest rates and its role in monetary policy for the European Central Bank
This paper examines the relationship of the term structure of interest rates to monetary policy instruments and to subsequent real activity and inflation in both Europe and the United States. The results show that monetary policy is an important determinant of the term structure spread, but is unlikely to be the only determinant. In addition, there is significant predictive power for both real activity and inflation. The yield curve is thus a simple and accurate measure that should be viewed as one piece of useful information which, along with other information, can be used to help guide European monetary policy.
AUTHORS: Estrella, Arturo; Mishkin, Frederic S.
DATE: 1995

Report
Multiple ratings and credit standards: differences of opinion in the credit rating industry
This paper tests whether the tendency of third rating agencies to assign higher ratings than Moody's and Standard & Poor's results from more lenient standards or sample selection bias. More lenient standards might result from incentives to satisfy issuers who are, in fact, the purchasers of the ratings. Selection bias might be important because issuers that expect a low rating from a third agency are unlikely to request one. Our analysis of a broad sample of corporate bond ratings at year-end 1993 reveals that, although sample selection bias appears important, it explains less than half the observed difference in average ratings. The paper also investigates why bond issuers seek ratings in addition to those of Moody's and Standard & Poor's. Contrary to expectations, the probability of obtaining a third rating is not found to be related to levels of ex ante uncertainty over firm default probabilities. In particular, a firm's decision to obtain a third rating appears unrelated to its Moody's and Standard & Poor's ratings or the amount of disagreement between them. Instead, the most important determinants of the decision are a firm's age and size. The results should be of interest to investors and financial market regulators who generally use the ratings of different agencies as if they correspond to similar levels of default risk. In addition, our findings raise a number of questions about the certification role of rating agencies and about the strength of the rating agencies' incentives to maintain a reputation for high quality (accurate) ratings.
AUTHORS: Cantor, Richard; Packer, Frank
DATE: 1995

Report
Modelling U.S. services trade flows: a cointegration-ECM approach
The U.S. service surplus soared from near zero in 1985 to about $60 billion in 1992, offsetting about two thirds of the goods trade deficit. Could this merely reflect improvement in data collection? Or does this mean U.S. services industries are more competitive internationally than goods industries? Is the services surplus likely to continue to rise? This paper estimates a forecastable model of U.S. services trade to address the above questions. We find that data improvement actually had a negative net impact on the services surplus, since it affected imports more than exports. Instead, the surge in the services surplus was mainly due to strong foreign growth and, to a lesser extent, dollar depreciation. An increase in either outward or inward foreign direct investment asset (FDIA) has a significant and positive impact on both exports and imports of other private services, but has only a modest net effect on the U.S. services balance. Thus, the outlook for the U.S. services balance largely depends on the growth prospect of foreign economies.
AUTHORS: Viana, Sandra; Hung, Juann H.
DATE: 1995

Report
Regime-switching monetary policy and real business cycle fluctuations
This paper investigates the implications of a regime switching monetary policy on real business cycle fluctuations. In a Cash-in-Advance model, a regime switching monetary policy with the typical observed business cycle durations could cause sizable fluctuations in real variables such as consumption, and to a lesser extent, investment. The correlations of these real variables with output matched those in the data very well. It is also found that the expected durations of the monetary policy in each regime have a significant effect on the fluctuation of real variables such as consumption and investment. In the longer duration case, the agents would supply more hours and invest less (thus consume more) in the low inflation regime than in the high inflation regime. However, if the monetary policy has a very short expected duration in each regime and switches a lot between the states, the agents' decision rules in different regimes will be close, and contrary to the long duration case, hours are a little lower and investment a little higher in the lower money growth regime than in the higher growth regime. The findings are consistent with the agents' behavior with rational expectations. Adding monetary shock in real business cycle models helps to explain the fluctuations not only in monetary and price variables, but also in real variables. Compared to a non-monetary model, the variations in the model economy are closer to what we see in the data. The implication is that, if there are different policy regimes and people are uncertain about the timing of policy changes, then the expected duration of monetary policy could affect the size of business cycle fluctuations even in a world where agents are assumed to behave rationally and there are no "confusions" or "rigidities."
AUTHORS: Gong, Fangxiong
DATE: 1995

Report
New York merchandise exports
New York's merchandise export performance has lagged that of the U.S. economy over the first part of the 1990s. Such slippage could be due to slow growth in export markets, a concentration in slow-growth product lines, and/or declining competitiveness relative to the overall U.S. economy. We find that none of these factors fully explains the declining share of New York merchandise exports. New York's export markets are growing nearly as fast as the U.S. foreign market; New York exports are more concentrated in the industries with fastest export growth than the U.S. average; and New York's unit labor costs by and large compare favorably with overall U.S. unit labor costs. Rather, total New York manufacturing output has been slipping behind U.S. manufacturing in a way not explained by relative unit labor cost trends. The lagging performance of New York goods exports appears to be a symptom of broader problems within the New York manufacturing sector.
AUTHORS: Leary, Mark; Howe, Howard
DATE: 1995

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