nonlinear mean reversion in the short term interest rate using a new bayesian method for the analysis of diffusion processes this article finds that the nonlinear drift in interest rates found in a number of previous studies can be confirmed only under prior distributions that are best described as informative the assumption of stationarity which is common in the literature represents a nontrivial prior belief about the shape of the drift function this belief and the use of flat priors contribute strongly to the finding of nonlinear mean reversion implementation of an approximate jeffreys prior results in virtually no evidence for mean reversion in interest rates unless stationarity is assumed finally the article documents that nonlinear drift is primarily a feature of daily rather than monthly data and that these data contain a transitory element that is not reflected in the volatility of longermaturity yields the drift of the short term interest rate is an important determinant of a wide variety of asset prices both inside and outside the boundaries of what is often called fixed income while volatilities may be estimated relatively accurately using high frequency observations of the short rate the short rate s extreme persistence makes identifying the true shape of the drift function a particularly elusive goal if our goal is merely to fit prices then the difficulty in estimating a drift function can be avoided by backing out implied drifts using a no arbitrage approach such as hull and white 1990 or heath jarrow and morton 1992 these methods bypass the true distribution entirely focusing on solving for the risk neutral drift function that is consistent with the cross section of bond prices if our goal however is to learn from prices and to be able to assess theories such as the expectations hypothesis that link short and long rates then estimating the drift function under the true measure is unavoidable in several recent articles a variety of sophisticated econometric techniques have been brought to bear on the problem in particular

what macroeconomic risks are not shared by international investors adopting an asset market view of international risk sharing we identify various sources of macroeconomic risk faced by international investors using a structural vector autoregression model we find that most of the risks of exogenous financial market shocks are shared by international investors through the existing asset markets however other macroeconomic risks such as those associatedwith exogenousshocks to consumption growth inflationandmonetarypolicies arenot fullysharedacrosscountries this finding helps us understand the apparently contradicting perceptions of international risk sharing generated by the analysis of asset market returns versus that of aggregate consumption growth across countries jel codes e44 f31 g12

the stochastic volatility of short term interest rates some international evidence this paper estimates a stochastic volatility model of short term riskless interest rate dynamics estimated interest rate dynamics are broadly similar across a number of countries and reliable evidence of stochastic volatility is found throughout in contrast to stock returns interest rate volatility exhibits faster meanreverting behavior and innovations in interest rate volatility are negligibly correlated with innovations in interest rates the less persistent behavior of interest rate volatility reflects the fact that interest rate dynamics are impacted by transient economic shocks such as central bank announcements and other macroeconomic news the past decade has witnessed unprecedented growth in the market for fixedincome derivatives domestically as well as internationally in light of this growth recent research has attempted to empirically characterize the dynamics of short term riskless interest rates necessary for the valuation of many of these securities with few exceptions much of this evidence has been concerned with the behavior of u s interest rates the purpose of this paper is to investigate the dynamics of short term interest rates across a number of countries a particularly noteworthy feature at least of the u s evidence is that the volatility of short term interest rates is itself volatile the stochastic nature of volatility is an important property of interest rate dynamics which we wish to focus on in our comparison to do so practically this paper implements a computationally efficient and statistically reliable method for estimating stochastic volatility models in finance we apply this method to chan et al s 1992 specification of short term riskless interest rate dynamics augmented with stochastic volatility for a clean international comparison we use proxies for short term riskless interest rates drawn from the same market the london interbank market over the same sample period unlike nowman 1997 we find that the

an exploration of the forward premium puzzle in currency markets a standard empirical finding is that expected changes in exchange rates and interest rate differentials across countries are negatively related implying that uncovered interest rate parity is violated in the data this article provides new empirical evidence that suggests that violations of uncovered interest rate parity and its economic implications depend on the sign of the interest rate differentially a framework related to term structure models is developed to account for the puzzling relationship between expected changes in exchange rates and interest rate differentials estimation results suggest that a particular term structure model can account for the puzzling empirical evidence article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

out of sample density forecasts with affine jump diffusion models abstract we conduct out of sample density forecast evaluations of the affine jump diffusion models for the s p 500 stock index and its options contracts we also examine the time series consistency between the model implied spot volatilities using options returns and only returns in particular we focus on the role of the time varying jump risk premia particle filters are used to estimate the model implied spot volatilities we also propose the beta transformation approach for recursive parameter updating our empirical analysis shows that the inconsistencies between options returns and only returns are resolved by the introduction of the time varying jump risk premia for density forecasts the time varying jump risk premia models dominate the other models in terms of likelihood criteria we also find that for medium term horizons the beta transformation can weaken the systematic effect of misspecified ajd models using options returns

short term interest rates as subordinated diffusions in this article we cbaracterize and estimate the process for short term interest rates using federal funds interest rate data we presume that we are observing a discrete time sample of a stationary scalar diffusion we concentrate on a class of models in whicb the local volatility elasticity is constant and the drift has aflexible specufication to accommodate missing observations and to break the link between economic time and calendar time we model the sampling scheme as an increasing process that is not directly observed we propose and implement two new methods for estimation we find evidence for a volatility elasticity between one and onehalf and two when interest rates are high local mean reversion is smaul and the mechanism for inducing stationarity is the increased volatility of the diffusion process

common factors and local factors implications for term structures and exchange rates this paper studies a multi factor two country term structure and exchange rate model when a diversification effect for an international bond portfolio is expected it shows that the diversification gain calls upon certain restrictions on the process of the stochastic discount factor in a factor structured economy existence of local factors is shown to be a necessary condition for the gains from investing in foreign bonds further the exchange rate risk premia are shown to be a function of the differentials of the risk premia of the factors in bond returns empirical results reveal the tendency for investors to respond sensitively to rare shocks which is shown to be a potential solution to the forward premium puzzle

mcmc analysis of diffusion models with application to finance this article proposes a new method for estimation of parameters in diffusion processes from discrete observations the method is based on markov chain monte carlo methodology and applies to a wide class of models including systems with unobservable state variables and nonlinearities the method is applied to the estimation of parameters in one factor cev interest rate models and a two factor model with a latent stochastic volatility component sv the cev model is found to do a poor job in capturing the time varying volatility interest rate data the sv model provides vastly superior fit to that of the cev model the article also presents a simulation study that demonstrates that the method provides accurate parameter estimates of the sv model at moderate sample sizes

affine models of the joint dynamics of exchange rates and interest rates this paper extends the affine class of term structure models to describe the joint dynamics of exchange rates and interest rates in particular the issue of how to reconcile the low volatility of interest rates with the high volatility of exchange rates is addressed the in complete market approach of introducing exchange rate volatility that is orthogonal to both interest rates and the pricing kernels is shown to be infeasible in the affine setting models in which excess exchange rate volatility is orthogonal to interest rates but not orthogonal to the pricing kernels are proposed and validated via kalman filter estimation of maximal 5 factor models for 6 country pairs

optimal filtering of jump diffusions extracting latent states from asset prices this paper provides an optimal filtering methodology in discretely observed continuoustime jump diffusion models although the filtering problem has received little attention it is useful for estimating latent states forecasting volatility and returns computing model diagnostics such as likelihood ratios and parameter estimation our approach combines time discretization schemes with monte carlo methods it is quite general applying in nonlinear and multivariate jump diffusion models and models with nonanalytic observation equations we provide a detailed analysis of the filter s performance and analyze four applications disentangling jumps from stochastic volatility forecasting volatility comparing models via likelihood ratios and filtering using option prices and returns jel c11 c13 c15 c51 c52 g11 g12 g17 this paper develops a filtering approach for learning about unobserved shocks and states from discretely observed prices generated by continuous time jumpdiffusion models the optimal filtering problem which has received little attention is the natural companion to the parameter estimation problem as filters allow researchers to analyze and use their models for practical applications 1 despite its usefulness there is currently no general method for solving the filtering problem in continuous time models

gaussian estimation of single factor continuous time models of the term structure of interest rates this article presents the first application in finance of recently developed methods for the gaussian estimation of continuous time dynamic models a range of one factor continuous time models of the short term interest rate are estimated using a discrete time model and compared to a recent discrete approximation used by chan karolyi longstaff and sanders 1992a hereafter ckls whereas the volatility of short term rates is highly sensitive to the level of rates in the united states it is not in the united kingdom the econometric estimation of continuous time models of the short term interest rate has been a relatively recent development in empirical finance see for example brown and dybvig 1986 melino and turnbull 1986 barone cuoco and zautzik 1991 babbs 1992 abken 1993 chen and scott 1993 das 1993 gibbons and ramaswamy 1993 pearson and sun 1994 lund 1994 pfann schotman and tschernig 1995 ait sahalia 1995 and broze scaillet and zakoian 1995 1 in an important study chan karolyi longstaff and sanders 1992a hereafter ckls develop a general framework to estimate and compare a range of different single factor term structure models for the short term interest rate their major conclusion is that term structure models with volatilities more highly sensitive to the level of interest rates than more generally used models have a closer empirical fit to the data in addition the functional form of the drift with or without mean reversion is of secondary importance to the correct specification of the conditional heteroskedasticity in ckls the continuous time models of the term structure are estimated using a discrete approximation we present in this article an alternative

the covariation of risk premiums and expected future spot exchange rates abstract eugene fama 1984 analyzed the variability and the covariation of risk premiums and expected rates of depreciation we employ three statistical techniques that do not suffer from a potential bias in fama s analysis but we nevertheless conffirms his findings in contrast to his interpretation the results are not necessarily at variance with the predictions of a theoretical model of the risk premium increases in expected rates of depreciation of the dollar relative to five foreign currencies are positively correlated with increases in the expected profitability of purchasing these currencies in the forward market and risk premiums have larger variancies than expected rates of depreciation

interest rate volatility the yield curve and the macroeconomy abstract this paper provides theory and evidence that a low dimensional term structure model can simultaneously price bonds and related options it shows that a component of volatility risk largely unrelated to the shape of the yield curve is a determinant of expected excess returns for holding long maturity bonds it also finds evidence for this return relationship both in the model and directly in the data through regression analysis the paper also identifies a link between corporate earnings performance and interest rate volatility providing a channel driving interest rate volatility the structure of risk in the model that gives rise to these features of volatility is distinct from that inherent in recent models with unspanned stochastic volatility

tests of rational expectations and no risk premium in forward exchange markets abstract this paper tests the simple efficiency hypothesis i e that traders have rational expectations and charge no risk premium in the forward exchange market it uses a statistical procedure which is consistent under a large class of heteroscedasticity and a set of data which takes into account the institutional features of the forward exchange market the results show that this procedure leads to stronger rejections of the simple efficiency hypothesis than do procedures using the standard assumption of homoscedasticity

a test of the cox ingersoll and ross model of the term structure we test the theory of the term structure of indexed bond prices due to cox ingersoll and ross cir the econometric method uses hansen s generalized method of moments and exploits the probability distribution of the single state variable in cir s model thus avoiding the use of aggregate consumption data it enables us to estimate a continuous time model based on discretely sampled data the tests indicate that cir s model for index bonds performs reasonably well when confronted with short term treasury bill returns the estimates indicate that term premiums are positive and that yield curves can take several shapes however the fitted model does poorly in explaining the serial correlation in real treasury bill returns article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

exploiting the conditional density in estimating the term structure an application to the cox ingersoll and ross model we propose an empirical method that utilizes the conditional density of the state variables to estimate and test a term structure model with known price formulae using data on both discount and coupon bonds the method is applied to an extension of a two factor model due to cox ingersoll and ross 1985 cir our results show that estimates based on only bills imply unreasonably large price errors for longer maturities we reject the original cir model using a likelihood ratio test and conclude that the extended cir model also fails to provide a good description of the treasury market

interest rate risk and the forward premium anomaly in foreign exchange markets this paper shows that even adjusted for the time varying risk premiums implied by the yield curves across countries uncovered interest parity is still strongly rejected by the data moreover factors that predict the excess bond returns are found not significant at all in predicting the foreign exchange returns these results reject the joint restrictions on the exchange rate and interest rates imposed by dynamic term structure models suggesting that foreign exchange markets and bond markets may not be fully integrated and we have to look beyond interest rate risk in order to understand the exchange rate anomaly

on biases in the measurement of foreign exchange risk premiums abstract the hypothesis that the forward rate is an unbiased predictor of the future spot rate has been consistently rejected in recent empirical studies this paper examines several sources of measurement error and misspecification that might induce biases in such studies although previous inferences are shown to be robust to a failure to construct true returns and to omitted variable bias arising from conditional heteroskedasticity in spot rates we show that the parameters were not stable over the 1975 89 sample period estimation that allows for endogenous regime shifts in the parameters demonstrates that deviations from unbiasedness were more severe in the 1980s jel f31

unemployment benefits and unemployment rates revisited a general equilibrium job search model the impact of unemployment insurance systems on employment behaviour and its subsequent repercussions upon the unemployment rates is the subject of this paper generally unemployment can be viewed as the result of factors which are either external or internal to the labour market the external factors such as the level of aggregate product demand and its impact on the size of the labour market have been the chief concern of many studies of unemployment by contrast the possible impact of the internal structure of the labour market on its own size that is the employment impact of the labour turnover process has been a relatively neglected area of study here we concentrate mainly on the impact of the unemployment insurance system on search behaviour and its subsequent impact on the level of unemployment the type of unemployment we are concerned with is that affected by the duration of unemployed search and the expected duration of the resulting employment contracts rather than the unemployment generated by lack of product demand a common theoretical result in the literature is that higher unemployment insurance payments along with other factors affecting search behaviour may make unemployment less burdensome consequently reducing the incentive of the unemployed to take up employment an observable outcome of such phenomena can be that an increase in the average duration of unemployment spells follows a rise in the unemployment

implied exchange rate distributions evidence from otc option markets abstract this paper uses a rich new dataset of option prices on the dollar mark dollar yen and key ems cross rates to extract the entire risk neutral probability density function pdf over horizons of 1 and 3 months we compare three alternative smoothing methods cubic splines an implied binomial tree trimmed and untrimmed and a mixture of lognormals for transforming option data into the pdf despite their methodological differences the three approaches lead to a similar pdf clearly distinct from the lognormal benchmark and typically characterized by skewness and leptokurtosis we then document a striking positive correlation between skewness in these pdfs and the spot rate the stronger a currency the more expectations are skewed towards a further appreciation of that currency we interpret this finding as a rejection that innovations in these exchange rates are independent of the level or characteristic of a credible target zone explicit or implicit instead this positive correlation is consistent with target zones with endogenous realignment risk we discuss two interpretations of our results on skewness when a currency is stronger the actual probability of further large appreciation is higher or because of risk such states are valued more highly

modeling sovereign yield spreads a case study of russian debt we construct a model for pricing sovereign debt that accounts for the risks of both default and restructuring and allows for compensation for illiquidity using a new and relatively efficient method we estimate the model using russian dollar denominated bonds we consider the determinants of the russian yield spread the yield differential across different russian bonds and the implications for market integration relative liquidity relative expected recovery rates and implied expectations of different default scenarios this paper develops a model of the termstructure of credit spreads on sovereign bonds that accommodates i default or repudiation the sovereign announces that it will stop making payments on its debt ii restructuring or renegotiation the sovereign and the lenders agree to reduce or postpone the remaining payments and iii a regime switch such as a change of government or the default of another sovereign bond that changes the perceived risk of future defaults we build on the framework of duffie and singleton 1999 showing that cash flows promised by a sovereign bond can be discounted using a default adjusted short termdiscount rate that reflects the m ean arrival rate and associated losses in market value upon arrival of each of the aforementioned types of credit events since a sovereign credit event is often not a liquidation event the model allows for continued trading and pricing of a sovereign instrument through credit events possibly after writedowns in face value or cash distributions to creditors on credit event dates additionally we accommodate the possibility that bonds issued by the same sovereign of exactly the same type but possibly of different maturities may be priced in the market using different discount factors reasons for this may include i bond covenants may not include cross default clauses that would force upon the default of one bond the simultaneous default of other bonds of the same type but of a different maturity for various strategic reasons related to internal

international capital markets and foreign exchange risk author s brennan michael j xia yihong abstract the relation between the volatilities of pricing kernels associated with di erent currencies and the volatility of the exchange rate between the currencies is derived under the assumption of integrated capital markets and the volatilities of the pricing kernels are related to the foreign exchange risk premium time series of pricing kernel volatilities are estimated from panel data on bond yields for five major currencies using a parsimonious term structure model that allows for time varying pricing kernel volatilities the resulting estimates are used to test hypotheses about the relation between the volatilities of the pricing kernels in di erent currencies and the volatility of the exchange rate as predicted time variation in foreign exchange risk premia is found to be related to time variation in both the volatility of the pricing kernels and the volatility of exchange rates the estimated pricing kernel volatilities can account for the forward premium puzzle in an average sense across exchange rates

on the asset market view of exchange rates if the asset market is complete then the difference between foreign and domestic agents log intertemporal marginal rates of substitution imrss equals the log change in the real exchange rate this equation is frequently used to argue that changes in real exchange rates reflect differences between agents required compensation for exposure to asset return uncertainty we show that the relative returns on frictionlessly traded assets are only reflected in the common component of agents imrss not in differences instead when this equation does offer insights frictions in the goods market are the source of economic distinction between agents

a parametric nonlinear model of term structure dynamics recent nonparametric estimation studies pioneered by ait sahalia document that the diffusion of the short rate is similar to the parametric function r superscript 1 5 estimated by chan et al whereas the drift is substantially nonlinear in the short rate these empirical properties call into question the efficacy of the existing affine term structure models and beg for alternative models which admit the observed behavior this article presents such a model our model delivers closed form solutions for bond prices and a concave relationship between the interest rate and the yields we show that in empirical analyses our model outperforms the one factor affine models in both time series as well as cross sectional tests article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

do traditional chinese cultural values nourish a market for pirated cds on one hand chinese consumers are well known for conspicuous consumption and the adoption of luxury products and named brands on the other hand they also have a bad reputation for buying counterfeit products their simultaneous preferences for two contrasting types of product present a paradox that has not been addressed in the literature this study attempts to present an explanation of this paradox by examining the effects of traditional chinese cultural values and consumer values on consumers deontological judgment of pirated cds and the amount of social benefits they perceive they gain from them we interviewed 300 hong kong chinese consumers and found that face consciousness increased materialism and risk aversion thereby producing a favorable deontological judgment of pirated cds face consciousness also has a direct effect on the amount of social benefits perceived in pirated cds both favorable deontological judgment and perceived social benefits contributed to a strong intention to buy pirated cds the results are discussed in a cultural perspective

an international examination of affine term structure models and the expectations hypothesis we examine the yield curve behavior and the relative performance of affine term structure models atsms using government bond yield data from canada germany japan the u k and the u s we find strong predictability of forward rates for excess bond returns and reject the expectations hypothesis in all five countries a three factor model is sufficient to capture movements in the yield curve of canada japan the u k and the u s but may not be enough for germany an exhaustive comparison among atsms with no more than three factors reveals that the three factor essential affine model a 1 3 e with only one factor affecting the volatility of the short rate but with all three factors affecting the price of risk performs best in all five countries simulations provide inconclusive evidence on whether this best affine model can successfully generate the rich yield curve behavior observed in the data

the monetary approach to exchange rate in an efficient foreign exchange market tests based on volatility the variance bounds on exchange rate movements implied by the monetary approach to exchange rate in an efficient foreign exchange market is shown to be violated by sample data the paper also presents evidence showing that the forecast errors implied by the monetary model can be forecasted using historical data the results are interpreted to suggest either the incompatibility of the monetary approach with sample data or an inefficient foreign exchange market or both models of exchange rate determination based on the monetary approach to the balance of payments imply when coupled with an interest rate parity relation and the assumption of an efficient foreign exchange market that exchange rates are related to a long average of money stocks differentials 1 2 the long average is analogous to the difference across countries of the long average of expected future money stocks which was supposed to characterize the price level of a single country see e g sargent and wallace 20 since long averages are known to have certain smoothing properties it appears that the observed volatility of exchange rates may be inconsistent with these models thus alternative tests of the models may be produced which rely on those properties the aim of this paper is to determine if the observed volatility is consistent with those properties the paper is the first to use tests based on the volatility of the exchange rate in an efficient market model of the monetary approach the first set of tests is based on the property of implied variance bounds for exchange rate movements and the second set consists of the more familiar efficient market tests of forecastability the empirical results violate these two sets of tests of the model thus casting doubt on the model even though the claim that exchange rates are too volatile has been commonly made few direct attempts have been made in the past to determine the validity of the claim some studies have presented estimates of variances of spot and forward rates but lacking an objective criterion to determine what constitutes

simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets abstract we present an econometric method for estimating the parameters of a diffusion model from discretely sampled data the estimator is transparent adaptive and inherits the asymptotic properties of the generally unattainable maximum likelihood estimator we use this method to estimate a new continuous time model of the joint dynamics of interest rates in two countries and the exchange rate between the two currencies the model allows financial markets to be incomplete and specifies the degree of incompleteness as a stochastic process our empirical results offer several new insights into the dynamics of exchange rates

conditional variance and the risk premium in the foreign exchange market abstract we investigate the existence of a risk premium in the foreign exchange market based on the conditional variance of market forecast errors the forecast errors are assumed to follow the arch process introduced by engle 1982 estimation and diagnostic testing of the model are discussed and results are presented for the currencies of the united kingdom france germany japan and switzerland