Different continuous-time models for interest rates coexist in the literature. We test parametric models by comparing their implied parametric density to the same density estimated nonparametrically. We do not replace the continuous-time model by discrete approximations, even though the data are recorded at discrete intervals. The principal source of rejection of existing models is the strong nonlinearity of the drift. Around its mean, where the drift is essentially zero, the spot rate behaves like a random walk. The drift then mean-reverts strongly when far away from the mean. The volatility is higher when away from the mean.

Testing Continuous-Time Models of the Spot Interest Rate

An important element of the macro-prudential analysis is the study of the link between business cycle fluctuations and banking sector profitability and how this link is affected by institutional and structural characteristics. This work estimates a set of equations for net interest income, non-interest income, operating costs, provisions, and profit before taxes, for banks in the main industrialized countries and evaluates the effects on banking profitability of shocks to both macroeconomic and financial factors. Distinguishing mainly the euro area from Anglo-Saxon countries, the analysis also identifies differences in the resilience of the respective banking systems and relates them to the characteristics of their financial structure.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID935026_code606534.pdf?abstractid=935026&rulid=5149012&mirid=4

Bank Profitability and the Business Cycle

We identify a ‘slope’ factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors – a country-specific factor and a global factor – can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1364313_code295977.pdf?abstractid=1364313&mirid=1

Common Risk Factors in Currency Markets

W e identify a “slope” factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts for most of the crosssectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors—a country-specific factor and a global factor—can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, U.S. investors load up on global risk. ( JEL G12, G15, F31) W e show that the large co-movement among exchange rates of different currencies supports a risk-based view of exchange rate determination. In order to do so, we start by identifying a slope factor in exchange rate changes: The exchange rates of high interest rate currencies load positively on this factor, while those of low interest rate currencies load negatively on it. The covariation with this slope factor accounts for most of the spread in average returns between baskets of high and low interest rate currencies—the returns on the currency carry trade. We show that a no-arbitrage model of interest rates and exchange rates with two state variables—country-specific and global risk factors—can match the data, provided there is sufficient heterogeneity in countries’ exposures to the global risk factor. To support this global risk interpretation, we provide evidence that the global risk factor is closely related to changes in volatility of equity markets around the world. We identify this common risk factor in the data by building monthly portfolios of currencies sorted by their forward discounts. The first portfolio contains

/pdf/common-risk-factors-in-currency-markets-7a6cyhfdsy.pdf

This paper examines how firm characteristics, legal rules and financial development affect corporate finance decisions. In contrast to the existing literature, I use data on unlisted companies to show that institutions play an important role in determining the extent of agency problems. In particular, I find that in countries with good creditor protection, it is easier for firms investing in intangible assets to obtain loans. The protection of creditor rights is also important for ensuring access to long-term debt for firms operating in sectors with highly volatile returns. Ceteris paribus, firms are more leveraged in countries where the stock market is less developed. Unlisted firms appear more indebted than listed companies even after controlling for firm characteristics such as profitability, size and the ability to provide collateral. Finally, institutions that favor creditor rights and ensure stricter enforcement are associated with higher leverage, but also with greater availability of long-term debt.

Do Better Institutions Mitigate Agency Problems? Evidence from Corporate Finance Choices

Carry trades - a popular strategy in the foreign exchange market - are long positions in high interest rate currencies financed by borrowing low interest rate currencies. Such positions are held as long as i) there remains a significant interest rate differential between the two currency groups and/or ii) exchange rate risk remains low. When either or both such conditions are violated positions are typically unwound, triggering rapid movements in the exchange rate level and its volatility and spillovers to other asset classes as well as to real activity. The recent global deleveraging has clearly evidenced the strength of this channel. From a financial standpoint, the mechanics of the carry trade has been recently examined in Brunnermeier et al. (2009). They showed that shocks to interest rate differentials lead to carry trade activity and to significant reactions in the bilateral exchange rates vis-a-vis the US dollar that they analyse. Starting from their paper, we take a more macroeconomic standpoint and aim to identify what kind of structural shock can generate the implications of their interest rate differential shock. To this aim we add two macroeconomic variables and two indicators of confidence to the 4-variable financial VAR of Brunnermeier et al. (2009) and use sign restrictions on the impulse responses of the resulting larger VAR to identify four macroeconomic shocks. We evidence that although all shocks may potentially have effects on developments in the interest rate differential and the exchange rate level that overall make carry trading profitable in the short run, demand shocks and confidence shocks only are associated with longer-term gains from carry trade activity, relative to supply and monetary policy shocks. This finding also supports the widely reported idea that sentiment boosts position taking. We also provide a measure of the potential gain/losses experienced by the actual positioning of market participants in the foreign exchange futures market, conditional on their ability to correctly anticipate the nature of the prevailing macroeconomic shock.

https://papers.ssrn.com/sol3/Delivery.cfm/j_1467-9396_2012_01034_x_wml.pdf?abstractid=2111749&mirid=1

Macroeconomic Determinants of Carry Trade Activity

The impact of news on the exchange rate of the lira and long-term interest rates

In this paper we attempt to evaluate the quantitative impact of financial shocks on key indicators of real activity and financial conditions. We focus on financial shocks as they have received wide attention in the recent literature and in the policy debate after the global financial crisis. We estimate a panel VAR for 21 advanced economies based on quarterly data between 1985 and 2011, where financial shocks are identified through sign restrictions. We find robust evidence that financial shocks can be separately identified from other shock types and that they exert a significant influence on key macroeconomic variables such as GDP and (particularly) investment, but it is unclear whether these shocks are demand or supply shocks from the standpoint of their macroeconomic impact. The financial development and structure of a given country is found not to matter much for the intensity of the propagation of financial shocks. Moreover, we generally find that these shocks play a role not only in crisis times, but also in normal conditions. Finally, we discuss the implications of our findings for monetary policy.

— Fabio Fornari and Livio Stracca

https://www.bis.org/events/bokbisimf2012/session2_what_does_a_financial_shock_do.pdf

What does a financial shock do? First international evidence

Low-yielding currencies (relative to dollar interest rate and based on annual data) represent a strong hedging tool for a US investor in the event of a slowdown of the US economy, as shown in Lustig and Verdelhan (2007) In this paper we show that such a conclusion is far more general, holding jointly for representative agents in a number of countries (Australia, Canada, France, United Kingdom and United States) and for quarterly holding period returns, which are closer to the frequency at which portfolios are re-balanced The prices of risk for nondurable and durable consumption growth explain the cross-sectional variation of average currency portfolio returns, as confirmed by high Rý coefficients However, statistical significance of the coefficients, checked both individually and joint, does not exceed 10% Overall, taking an economic standpoint, holding currencies that pay out low interest rates provides some means of insurance against economic slowdown in the domestic economy

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1140663_code495651.pdf?abstractid=1140663&mirid=2

Does Business Cycle Risk Account for Systematic Returns from Currency Positioning? The International Perspective

This paper analyzes the impact of news on several Italian financial variables, paying particular attention to the effect on the conditional volatility of these variables. The analysis spans a period of great financial and political turbulence in Italy, including the rapid succession of three governments. News releases (articles on political and economic events collected daily from both the Italian and international economic press) are classified as unscheduled (mostly political) and scheduled (i.e. economic and monetary statistics whose announcement is expected by market participants). The analysis is divided into two phases: first, we estimate the impact of each single political and economic news item on asset price changes and their conditional variance; second, those items that are identified as significant in the first stage are then aggregated into six dummies according to their nature and origin and employed as exogenous variables in a trivariate Garch scheme. Results show that i) news affects both the first and the second moment of the daily changes in the analyzed variables; ii) there is a significant regime shift of the unconditional variance of the analyzed variables across the three different governments; iii) the conditional variances display a significant i?½ albeit rather small i?½ seasonal dayweek pattern; iv) contrary to the conventional view, the impact of news on the conditional variance is more pronounced for exchange rates than for Italian long-term interest rates.

Fabio Fornari

Papers

Macroeconomic Determinants of Carry Trade Activity

The impact of news on the exchange rate of the lira and long-term interest rates

What does a financial shock do? First international evidence

Does Business Cycle Risk Account for Systematic Returns from Currency Positioning? The International Perspective

The Impact of News on the Exchange Rate of the Lira and Long-Term Interest Rates