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

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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

• M.Sc. Student Alina STEFAN
• Advisor Prof. Moisa ALTAR
• 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 winners
  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

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Expectation hypothesis

• Explains the shape of the yield curve
• fj E(YTMj) ? YTMj fj ?
• (1YTMj)j (1YTMi)I? (1fij)j-i
• Regress realized yields on forward rates (e.g.
  f25 compares with YTM3, 2 years from now)
• Expectation hypothesis says ? 0, ? 1
• Alternative theory term premium says ? lt 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

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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
• ScheinkmanLitterman (1991), DaiSingleton (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)

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Primary vs. secondary markets

• Two opposing theories
• Avoid winners curse ? yields on the primary
  market gt yields on the secondary market Neyt
  (1995) for Belgium
• Liquidity hypothesis ? yields on the primary
  market lt 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

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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

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Taylor rules (2)

• Taylor rule backwards-looking

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Taylor rules (3)

• Autocorrelations

15
Taylor rules (4)

• Residuals from Taylor rules and the short rate

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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

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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)

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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

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Vector autoregression (4)

• Impulse response functions

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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 winners
  curse)
• A backwards-looking Taylor rule performs well
• Yields respond to shocks to inflation and real
  activity

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References

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