nep-fmk New Economics Papers
on Financial Markets
Issue of 2005‒10‒04
113 papers chosen by
Carolina Valiente
London South Bank University

  1. Interest Rate Setting and the Colombian Monetary Transmission Mechanism By Carlos Andrés Amaya
  2. Costs of Taxation and the Benefits of Public Goods: The Role of Income Effects By Will Martin; James E. Anderson
  3. Market Concentration, Macroeconomic Uncertainty and Monetary Policy. By Juan de Dios Tena; Francesco Giovannoni
  4. The Impact of FX Central Bank Intervention in a Noise Trading Framework By Michel Beine; Paul De Grauwe; Marianna Grimaldi
  5. Firm Heterogeneity and Credit Risk Diversification By Samuel Hanson; M. Hashem Pesaran; Til Schuermann
  6. Global Business Cycles and Credit Risk By M. Hashem Pesaran; Til Schuermann; Björn-Jakob Treutler
  7. Target Zones in Theory and History: Credibility, Efficiency, and Policy Autonomy By Flandreau, Marc; Komlos, John
  8. Satisficing in Financial Decision Making A Theoretical and Experimental Attempt to Explore Bounded Rationality By Gerlinde Fellner; Werner Güth; Boris Maciejovsky
  9. On the social dimension of time and risk preferences: An experimental study By M. Vittoria Levati; Werner Güth; Matteo Ploner
  10. The Impact of Financial Services Trade Liberalization on China By Li-Gang Liu
  11. Why and when do spot prices of crude oil revert to futures price levels? By Mark W. French
  12. An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates By Don H. Kim; Jonathan H. Wright
  13. Open market operations and the federal funds rate By Daniel L. Thornton
  14. How and why do small firms manage interest rate risk? Evidence from commercial loans By James Vickery
  15. Prepaid cards: how do they function? how are they regulated? By Mark Furletti
  16. The laws, regulations, and industry practices that protect consumers who use electronic payment systems: credit and debit cards By Mark Furletti; Stephen Smith
  17. Will online bill payment spell the demise of paper checks? By James C. McGrath
  18. ART versus reinsurance: the disciplining effect of information insensitivity By Christian Laux; Silke Brandts
  19. An Essay on the Interactions between the Bank of England's Forecasts, The MPC's Policy Adjustments, and the Eventual Outcome By Charles Goodhart
  20. Do Dollar Forecasters Believe too Much in PPP? By Menkhoff, Lukas; Rebitzky, Rafael; Schröder, Michael
  21. Adopting the Euro in Central Europe: Challenges of the Next Step in European Integration By Schadler, Susan; Drummond, Paulo Flavio Nacif; Kuijs, Louis; Murgasova, Zuzana; van Elkan, Rachel
  22. Financial Liberalization and Inflationary Dynamics in the Context of a Small Open Economy By Rangan Gupta
  23. How Ownership Structure Affects Capital Structure and Firm Performance? Recent Evidence from East Asia By Nigel Driffield; Vidya Mahambare; Sarmistha Pal
  24. Collusion and Commitment in Bank Bailout By Yanhua ZHANG
  25. Australia's Cash Economy: Are the estimates credible? By Trevor Breusch
  26. Value-at-Risk: The Delta-normal Approach By Marc Henrard
  27. Strategic interactions between monetary and fiscal authorities in a monetary union By Valeria De Bonis; Pompeo Della Posta
  28. Investigating the Early Signals of Banking Sector Vulnerabilities in Central and East European Emerging Markets By Kadri Männasoo; David G Mayes
  29. The Effect of Financial Depth on Monetary Transmission By Danny Pitzel; Lenno Uusküla
  30. On PPP, Unit Roots and Panels By Wagner, Martin
  31. The credibility of the monetary policy ‘free lunch’ By James Yetman
  32. Monetary and fiscal interactions in open economies By Giovanni Lombardo; Alan Sutherland
  33. Bank mergers, competition and liquidity By Elena Carletti; Philipp Hartmann; Giancarlo Spagnolo
  34. Does the yield spread predict recessions in the euro area? By Fabio Moneta
  35. Optimal allotment policy in the eurosystem’s main refinancing operations? By Christian Ewerhart; Nuno Cassola; Steen Ejerskov; Natacha Valla
  36. Monetary policy analysis in a small open economy using bayesian cointegrated structural VARs? By Mattias Villani; Anders Warne
  37. Measurement of contagion in banks’ equity prices By Reint Gropp; Gerard Moerman
  38. The lender of last resort - a 21st century approach By Xavier Freixas; Bruno M. Parigi; Jean-Charles Rochet
  39. Developing statistical indicators of the integration of the euro area banking system By Michele Manna
  40. Deposit insurance, moral hazard and market monitoring By Reint Gropp; Jukka Vesala
  41. Fiscal policy events and interest rate swap spreads - evidence from the EU By António Afonso; Rolf Strauch
  42. International risk-sharing and the transmission of productivity shocks By Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
  43. Monetary policy shocks in the euro area and global liquidity spillovers By João Sousa; Andrea Zaghini
  44. The high-yield segment of the corporate bond market: a diffusion modelling approach for the United States, the United Kingdom and the euro area By Gabe de Bondt; David Marqués
  45. Exchange rate risks and asset prices in a small open economy By Alexis Derviz
  46. Option-implied asymmetries in bond market expectations around monetary policy actions of the ECB By Sami Vähämaa
  47. Cooperation in international banking supervision By Cornelia Holthausen; Thomas Rønde
  48. Diversification in euro area stock markets: country versus industry By Gerard A. Moerman
  49. Non-fundamental exchange rate volatility and welfare By Roland Straub; Ivan Tchakarov
  50. On the determinants of euro area FDI to the United States: the knowledge- capital- Tobin's Q framework By Roberto A. De Santis; Robert Anderton
  51. The demand for euro area currencies By Björn Fischer; Petra Köhler; Franz Seitz
  52. The decline of activist stabilization policy: Natural rate misperceptions, learning and expectations. By Athanasios Orphanides; John C. Williams
  53. The optimal degree of discretion in monetary policy. By Susan Athey; Andrew Atkeson; Patrick J. Kehoe
  54. Understanding the effects of government spending on consumption. By Jordi Galí; J. David López-Salido; Javier Vallés
  55. Equal size, equal role? Interest rate interdependence between the euro area and the United States. By Michael Ehrmann; Marcel Fratzscher
  56. Financial openness and growth: Short-run gain, long-run pain? By Marcel Fratzscher; Matthieu Bussiere
  57. Exchange-rate policy and the zero bound on nominal interest rates By Günter Coenen; Volker Wieland
  58. Taking stock: monetary policy transmission to equity markets By Michael Ehrmann; Marcel Fratzscher
  59. Excess reserves and the implementation of monetary policy of the ECB By Ulrich Bindseil; Gonzalo Camba-Mendez; Astrid Hirsch; Benedict Weller
  60. Communication and exchange rate policy By Marcel Fratzscher
  61. Asset price booms and monetary policy By Carsten Detken; Frank Smets
  62. Exchange rates and fundamentals - new evidence from real-time data By Michael Ehrmann; Marcel Fratzscher
  63. The information content of over-the-counter currency options By Peter Christoffersen; Stefano Mazzotta
  64. Sovereign risk premia in the European government bond market By Kerstin Bernoth; Jürgen von Hagen; Ludger Schuknecht
  65. Guess what: it's the settlements! By Thorsten V. Koeppl; Cyril Monnet
  66. Raising rival's costs in the securities settlement industry By Cornelia Holthausen; Jens Tapking
  67. Liquidity, information, and the overnight rate By Christian Ewerhart; Nuno Cassola; Steen Ejerskov; Natacha Valla
  68. Do financial market variables show (symmetric) indicator properties relative to exchange rate returns? By Olli Castrén
  69. Optimal monetary policy under discretion with a zero bound on nominal interest rates By Klaus Adam; Roberto M. Billi
  70. Euro area sovereign yield dynamics - the role of order imbalance By Albert J. Menkveld; Yiu C. Cheung; Frank de Jong
  71. Horizontal and vertical integration and securities trading and settlement By Jens Tapking; Jing Yang
  72. Financial markets’ behavior around episodes of large changes in the fiscal stance By Silvia Ardagna
  73. The role of central bank capital revisited By Ulrich Bindseil; Andres Manzanares; Benedict Weller
  74. The determinants of the overnight interest rate in the euro area By Julius Moschitz
  75. Liquidity, money creation and destruction, and the returns to banking By Ricardo de O. Cavalcanti; Andrés Erosa; Tod Temzelides
  76. Determinants of euro term structure of credit spreads By Astrid Van Landschoot
  77. Mergers and acquisitions and bank performance in Europe: the role of strategic similarities By Yener Altunbas; David Marqués Ibáñez
  78. Sporadic manipulation in money markets with central bank standing facilities By Christian Ewerhart; Nuno Cassola; Steen Ejerskov; Natacha Valla
  79. Cross-country differences in monetary policy transmission By Robert-Paul Berben; Alberto Locarno; Julian Morgan; Javier Valles
  80. Financial market integration and loan competition: when is entry deregulation socially beneficial? By Leo Kaas
  81. An analysis of systemic risk in alternative securities settlement architectures By Giulia Iori
  82. Currency mismatch, uncertainty and debt maturity structure By Matthieu Bussière; Marcel Fratzscher; Winfried Koeniger
  83. An empirical study of liquidity and information effects of order flow on exchange rates By Francis Breedon; Paolo Vitale
  84. Security fungibility and the cost of capital - evidence from global bonds By Darius P. Miller; John J. Puthenpurackal
  85. Interlinking securities settlement systems - a strategic commitment? By Karlo Kauko
  86. Who benefits from IPO underpricing? Evidence form hybrid bookbuilding offerings By Vicente Pons-Sanz
  87. Cross-border diversification in bank asset portfolios By Claudia M. Buch; John C. Driscoll; Charlotte Ostergaard
  88. Public policy and the creation of active venture capital markets By Marco Da Rin; Giovanna Nicodano; Alessandro Sembenelli
  89. Regulation of multinational banks - a theoretical inquiry By Giacomo Calzolari; Gyöngyi Lóránth
  90. Trading European sovereign bonds - the microstructure of the MTS trading platforms By Yiu Chung Cheung; Frank de Jong; Barbara Rindi
  91. What drives international bank flows? Politics, institutions and other determinants By Elias Papaioannou
  92. A look at intraday frictions in the euro area overnight deposit market By Vincent Brousseau; Andrés Manzanares
  93. Estimating and analysing currency options implied risk-neutral density functions for the largest new EU member states By Olli Castrén
  94. Why do financial systems differ? History matters By Cyril Monnet; Erwan Quintin
  95. Foreign exchange option and returns based correlation forecasts - evaluation and two applications By Olli Castrén; Stefano Mazzotta
  96. Stocks, bonds, money markets and exchange rates - measuring international financial transmission By Michael Ehrmann; Marcel Fratzscher; Roberto Rigobon
  97. Central bank transparency and private information in a dynamic macroeconomic model By Joseph G. Pearlman
  98. Transparency, disclosure and the Federal Reserve By Michael Ehrmann; Marcel Fratzscher
  99. Capital flows and the US ‘New Economy’ - consumption smoothing and risk exposure By Marcus Miller; Olli Castrén; Lei Zhang
  100. Yield curve prediction for the strategic investor By Carlos Bernadell; Joachim Coche; Ken Nyholm
  101. Communication and decision-making by central bank committees - different strategies, same effectiveness? By Michael Ehrmann; Marcel Fratzscher
  102. Optimal research in financial markets with heterogeneous private information a rational expectations model By Katrin Tinn
  103. Financial integration and entrepreneurial activity - evidence from foreign bank entry in emerging markets By Mariassunta Giannetti; Steven Ongena
  104. Fleshing out the monetary transmission mechanism - output composition and the role of financial frictions By André Meier; Gernot J. Müller
  105. Fiscal and monetary rules for a currency union By Andrea Ferrero
  106. Productivity shocks, budget deficits and the current account By Matthieu Bussière; Marcel Fratzscher; Gernot J. Müller
  107. Gains from international monetary policy coordination - does it pay to be different? By Zheng Liu; Evi Pappa
  108. An international analysis of earnings, stock prices and bond yields By Alain Durré; Pierre Giot
  109. Credit ratings and the standardised approach to credit risk in Basel II By Patrick Van Roy
  110. Term structure and the sluggishness of retail bank interest rates in euro area countries By Gabe de Bondt; Benoit Mojon; Natacha Valla
  111. International equity flows and returns: A quantitative equilibrium approach By Rui Albuquerque; Gregory H. Bauer; Martin Schneider
  112. The longer term refinancing operations of the ECB By Ulrich Bindseil; Tobias Linzert; Dieter Nautz
  113. Systemic risk in alternative payment system designs By Peter Galos; Kimmo Soramäki

  1. By: Carlos Andrés Amaya
    Abstract: This paper is concerned with interest rate setting by commercial banks and how the transmission of monetary policy is re°ected in these rates. For this purpose we study the case of the Colombian banking industry for the period 1996-2004. Using microdata, the Certi¯cate of Deposit(CD) market and the credit market are studied for a balanced panel of 21 and 16 banks, respectively. The paper motivates the discussion with a theoretical model that explains how banks set their interest rates and how these are a®ected by the policy rate. Overcoming some of the empirical di±culties presented in other studies, this paper deals with them by performing panel unit root tests and panel cointegration tests. The results suggest that the transmission of the policy rate to the CD rate and the credit rate is on average high and quick. Additionally, rates react strongly to in°ation shocks, specially credit rates. Finally, the evidence presented shows the importance of banks' characteristics and in°ation as long-run drivers of interest rates.
    Keywords: Banks, Monetary Policy, Interest Rates, Panel Data
    JEL: C33 E43 E52 E58
  2. By: Will Martin (World Bank); James E. Anderson (Boston College)
    Abstract: The fact that raising taxes can increase taxed labor supply through income effects is frequently used to justify very much lower measures of the marginal welfare cost of taxes and greater public good provision than indicated by traditional, compensated analyses. We confirm that this difference remains substantial with newer elasticity estimates, but show that either compensated or uncompensated measures of the marginal cost of funds can be used to evaluate the costs of taxation– and will provide the same result– as long as the income effects of both taxes and public good provision are incorporated in a consistent manner.
    Keywords: fiscal policy; second best; public goods; distortions; costs of taxation, marginal cost of funds; marginal excess burden, thought experiment.
    JEL: D61 F11 H21 H43
    Date: 2005–09–08
  3. By: Juan de Dios Tena; Francesco Giovannoni
    Abstract: This paper studies the effect of market structure and macroeconomic uncertainty on the transmission of monetary policy. We motivate our analysis with a simple model which predicts that: 1) investment and production in more concentrated sectors are more affected by demand changes and 2) high uncertainty makes investment and production more sensitive to demand changes. The empirical analysis estimates the effect of monetary shocks on sectoral output for different sectors in the US using different structural vector autoregressive VAR approaches. The results are largely consistent with the proposed theory.
    Keywords: Market concentration, macroeconomic uncertainty, monetary policy transmission, vector autoregressive models.
    JEL: E22 E32 E52 D43
    Date: 2005–08
  4. By: Michel Beine; Paul De Grauwe; Marianna Grimaldi
    Abstract: In this paper we investigate the effects of central bank interventions (CBI) in a noise trading model with chartists and fundamentalists. We first estimate a model in which chartists extrapolate past returns and fundamentalists forecast a mean reverting dynamics of the exchange rate towards a fundamental value. Then, we investigate the role of central bank interventions in explaining the switching properties between the two types of agents. We find evidence that in the medium run, interventions increase the proportion of fundamentalists and therefore exert some stabilizing influence on the exchange rate.
    JEL: F31 F33
    Date: 2005
  5. By: Samuel Hanson; M. Hashem Pesaran; Til Schuermann
    Abstract: This paper considers a simple model of credit risk and derives the limit distribution of losses under different assumptions regarding the structure of systematic and idiosyncratic risks and the nature of firm heterogeneity. The theoretical results obtained indicate that if firm-specific risk exposures (including their default thresholds) are heterogeneous but come from a common parameter distribution, for sufficiently large portfolios there is no scope for further risk reduction through active credit portfolio management. However, if the firm risk exposures are draws from different parameter distributions, say for different sectors or countries, then further risk reduction is possible, even asymptotically, by changing the portfolio weights. In either case, neglecting parameter heterogeneity can lead to underestimation of expected losses. But, once expected losses are controlled for, neglecting parameter heterogeneity can lead to overestimation of risk, whether measured by unexpected loss or value-at-risk. The theoretical results are confirmed empirically using returns and credit ratings for firms in the U.S. and Japan across seven sectors. Ignoring parameter heterogeneity results in far riskier credit portfolios.
    Keywords: risk management, correlated defaults, heterogeneity, diversification, portfolio choice
    JEL: C33 G13 G21
    Date: 2005
  6. By: M. Hashem Pesaran; Til Schuermann; Björn-Jakob Treutler
    Abstract: The potential for portfolio diversification is driven broadly by two characteristics: the degree to which systematic risk factors are correlated with each other and the degree of dependence individual firms have to the different types of risk factors. Using a global vector autoregressive macroeconometric model accounting for about 80% of world output, we propose a model for exploring credit risk diversification across industry sectors and across different countries or regions. We find that full firm-level parameter heterogeneity along with credit rating information matters a great deal for capturing differences in simulated credit loss distributions. Imposing homogeneity results in overly skewed and fat-tailed loss distributions. These differences become more pronounced in the presence of systematic risk factor shocks: increased parameter heterogeneity reduces shock sensitivity. Allowing for regional parameter heterogeneity seems to better approximate the loss distributions generated by the fully heterogeneous model than allowing just for industry heterogeneity. The regional model also exhibits less shock sensitivity.
    Keywords: risk management, default dependence, economic interlinkages, portfolio choice
    JEL: C32 E17 G20
    Date: 2005
  7. By: Flandreau, Marc; Komlos, John
    Abstract: A natural experiment with an exchange-rate band in Austria-Hungary in the early 20th century provides a rare opportunity to discuss critical aspects of the theory of target zones. Providing a new derivation of the target zone model as a set of nested hypotheses, the inference is drawn that policy credibility and market efficiency were paramount in the success of the Austro-Hungarian experience.
    Keywords: Austria-Hungary; covered interest parity; credibility; market efficiency hypothesis; monetary model; monetary policy; target zone
    JEL: F31 N32
    Date: 2005–08
  8. By: Gerlinde Fellner; Werner Güth; Boris Maciejovsky
    Abstract: In this paper, we apply the bounded rationality approach to an investment situation. In a simple setting where an investor decides between a riskless bond and a risky asset, we distinguish three aspiration levels: a lowest threshold which one wants to guarantee, the aspiration level given by investing all risk-free, and an even higher return level representing a real success. The ranges for such aspirations are naturally determined by the parameters. These three aspirations allow us to classify investors as actual or only potential satisficers, as well as risk shy or more open to risk. In the experiment, participants are first asked for their lowest and highest aspiration before investing. Thus, we can test whether they behave as predicted by their aspiration type. By presupposing specific cardinal utility functions, we also compare the bounded rationality approach to the rational choice-approach.
    Date: 2005–08
  9. By: M. Vittoria Levati; Werner Güth; Matteo Ploner
    Abstract: We report on an experiment designed to explore the interrelation of other-regarding concerns with attitudes towards risk and delay when the latter have a social dimension, i.e., pertain to one's own and another person's payoffs. For this sake, we compare evaluations of several prospects, each of which allocates either certain or risky and either immediate or delayed payoffs to the actor and to another participant. We find that individuals are mainly self-oriented as to social allocation of risk and delay, although they are other-regarding with respect to expected payoff levels.
    Keywords: Willingness to accept, Risk attitudes, Time preferences, Other-regarding concerns
    JEL: C91 D63 D81
    Date: 2005–09
  10. By: Li-Gang Liu
    Abstract: This paper shows that financial services trade liberalization in China has set impetus for accelerated domestic financial liberalization. Foreign banks, though still relatively small in size, have already exerted considerable influence on China's capital flows. Empirical findings from a gravity model analysis indicate that financial services trade liberalization under the WTO promotes bank loans to developing economies strongly though not evenly conditional on country characteristics.
    Date: 2005–09
  11. By: Mark W. French
    Abstract: Recent studies of crude oil price formation emphasize the role of interest rates and convenience yield (the adjusted spot-futures spread), confirming that spot prices mean-revert and normally exceed discounted futures. However, these studies don't explain why such "backwardation" is normal. Also, models derived in these studies typically explain only about 1 percent of daily returns, suggesting other factors are important, too. In this paper, I specify a structural oil-market model that links returns to convenience yield, inventory news, and revisions of expected production cost (growth of which is related to backwardation). Although its predictive power is only a marginal improvement, the model fits the data far better. In addition, I find reversion of spot to futures prices only when backwardation is severe. Convenience yield behaves nonlinearly, but price response to convenience yield is also nonlinear. Equivalently, futures are informative about future spot prices only when spot prices substantially exceed futures.
    Date: 2005
  12. By: Don H. Kim; Jonathan H. Wright
    Abstract: This paper reviews a simple three-factor arbitrage-free term structure model estimated by Federal Reserve Board staff and reports results obtained from fitting this model to U.S. Treasury yields since 1990. The model ascribes a large portion of the decline in long-term yields and distant-horizon forward rates since the middle of 2004 to a fall in term premiums. A variant of the model that incorporates inflation data indicates that about two-thirds of the decline in nominal term premiums owes to a fall in real term premiums, but estimated compensation for inflation risk has diminished as well.
    Date: 2005
  13. By: Daniel L. Thornton
    Abstract: The Fed's ability to control the federal funds rate stems from its ability to alter the supply of liquidity in the overnight market through open market operations. This paper uses daily data compiled by the author from the records of the Trading Desk of the Federal Reserve Bank of New York over the period March 1, 1984, through December 31, 1996, to analyze the Desk's use of its operating procedure in implementing monetary policy, and the extent to which open market operations affect the federal funds rate-the liquidity effect. I find that operating procedure was used to guide daily open market operations; however, there is little evidence of a liquidity effect at the daily frequency and even less evidence at lower frequencies. Consistent with the absence of a liquidity effect, open market operations appear to be a relatively unimportant source of liquidity to the federal funds market.
    Keywords: Federal funds rate ; Open market operations
    Date: 2005
  14. By: James Vickery
    Abstract: Although small firms are most sensitive to interest rate and other shocks, empirical work on corporate risk management has focused instead on large public companies. This paper studies fixed-rate and adjustable-rate loans to see how small firms manage their exposure to interest rate risk. The cross-sectional findings are as follows: credit-constrained firms consistently favor fixed-rate loans, minimizing their exposure to rising interest rates; firms adjust their exposure depending on how interest rate shocks covary with industry output; and "fixed versus adjustable" outcomes are correlated with lender characteristics. In a twenty-eight-year time series, the aggregate share of fixed-rate bank loans moves with interest rates in a manner consistent with recent evidence on debt market timing. I conclude that the "fixed versus adjustable" dimension of financial contracting helps small U.S. firms ameliorate interest rate risk, and discuss the implications for risk management theories and the credit channel of monetary policy.
    Keywords: Interest rates ; Risk management ; Commercial loans
    Date: 2005
  15. By: Mark Furletti
    Abstract: This conference, sponsored by the Payment Cards Center, brought together prepaid card industry leaders and regulators to discuss how various prepaid-card systems work and the ways in which different state and federal laws can affect them. The conference featured sessions on bank- and merchant-issued gift cards, payroll cards, and flexible spending account cards. It also featured presentations by experts on Regulation E, the Federal Deposit Insurance Act, state money transmitter laws, and state abandoned property laws.
    Keywords: Regulation E: Electronic Fund Transfers ; Stored-value cards
    Date: 2004
  16. By: Mark Furletti; Stephen Smith
    Abstract: Summary: This is the first in a series of three papers that examines the protections available to users of various electronic payment vehicles who fall victim to fraud, discover an error on their statement, or have a dispute with a merchant after making a purchase. Specifically, it examines in detail the federal and state laws that protect consumers in the three situations described above as well as the relevant association, network, and bank policies that may apply. The protection information included in this paper is derived from a wide range of public and non-public sources, including federal and state statutes, consumer-issuer contracts, and interviews with scores of payments industry experts. This first paper focuses on the two most widely used electronic payment methods: credit cards and debit cards. The second paper in the series will examine two newer electronic payment vehicles: ACH debits and prepaid cards. The third paper will discuss the broader industry and policy implications of the authors’ findings.
    Keywords: Regulation E: Electronic Fund Transfers ; Regulation Z: Truth in Lending ; Consumer protection ; Fraud
    Date: 2005
  17. By: James C. McGrath
    Abstract: Over the past several years, the emergence and adoption of electronic payment instruments have acutely affected check usage. This transition has been especially evident at the point of sale as debit and credit cards have become pervasive. Today, the rapid growth of online bill payment looks to threaten checks’ last redoubt. However, bill payment technology is still in its adolescence; the interplay of many stakeholders in the industry, including technology firms, banks, billers, payment cards, and customers, has led to rapid, unscripted innovation in just a few years. This paper quantifies some of the trends in the industry while addressing the interests and impact of the market’s prime movers in an effort to determine to what extent the displacement of checks will continue.
    Keywords: Electronic funds transfers ; Checks ; Internet banking
    Date: 2005
  18. By: Christian Laux; Silke Brandts
    Abstract: We provide a novel benefit of ¶Alternative Risk Transfer¶ (ART) products with parametric or index triggers. When a reinsurer has private information about his client’s risk, outside reinsurers will price their reinsurance offer less aggressively.  Outsiders are subject to adverse selection as only a high-risk insurer might find it optimal to change reinsurers. This creates a hold-up problem that allows the incumbent to extract an information rent. An information insensitive ART product with a parametric or index trigger is not subject to adverse selection. It can therefore be used to compete against an informed reinsurer, thereby reducing the premium that a low-risk insurer has to pay for the indemnity contract. However, ART products exhibit an interesting fate in our model as they are useful, but not used in equilibrium because of basis-risk.
    Date: 2005–10
  19. By: Charles Goodhart
    Abstract: No abstract available.
    Date: 2005–10
  20. By: Menkhoff, Lukas; Rebitzky, Rafael; Schröder, Michael
    Abstract: This paper extends earlier studies on exchange rate expectations' formation by using new data and adding information about forecasters' reliance on fundamental analysis for the first time. We replicate the conventional result of non rational expectations. Moreover, biases in expectations are identified as professionals significantly belief too much in mean reversion, mean being represented by PPP. When respondents are grouped on their reliance to fundamental analysis, fundamentalists reveal an even stronger bias. Those, who rely the least on fundamentals preferring technical analysis instead , show a significantly smaller bias towards PPP in lieu of expecting too much trend extrapolation. Biased beliefs will grow stronger when the US Dollar is further away from PPP. Finally, the accuracy of the expectations is poor for both groups however we find directional forecasting ability.
    Keywords: Exchange rate expectations, forecasting, fundamental analysis, technical analysis, purchasing power parity
    JEL: F31 G14
    Date: 2005–09
  21. By: Schadler, Susan; Drummond, Paulo Flavio Nacif; Kuijs, Louis; Murgasova, Zuzana; van Elkan, Rachel
    Abstract: Upon entry into the European Union (EU), countries become members of the Economic and Monetary Union (EMU), with a derogation from adopting the euro as their currency (that is, each country joining the EU commits to replace its national currency with the euro, but can choose when to request permission to do so). For most of these countries, adopting the euro will entail major economic change. This paper examines likely economic developments and policy challenges for the five former transition countries in central Europe--the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia--that joined the EU in May 2004 and operate independent monetary policies but have not yet achieved policy convergence with the rest of the euro area.
    Date: 2005
  22. By: Rangan Gupta (University of Connecticut and University of Pretoria)
    Abstract: The paper develops a short-run model of a small open financially repressed economy characterized by unorganized money markets, capital good imports, capital mobility, wage indexation, and flexible exchange rates. The analysis shows that financial liberalization, in the form of an increased rate of interest on deposits and tight monetary policy, unambiguously and unconditionally causes deflation. Moreover, the results do not depend on the degree of capital mobility and structure of wage setting. The paper recommends that a small open developing economy should deregulate interest rates and tighten monetary policy if reducing inflation is a priority. The pre-requisite for such a policy, however, requires the establishment of a flexible exchange rate regime.
    Keywords: Financial Liberalization; Inflation; Small open economy.
    JEL: E31 E44 E52 F41
    Date: 2005–07
  23. By: Nigel Driffield (Aston Business School); Vidya Mahambare (Cardiff Business School); Sarmistha Pal (Department of Economics & Finance, Brunel University)
    Abstract: Despite the seminal work of Claessens et al. (2002), role of ownership structure on capital structure and firm performance in East Asian corporattions remains much unexplored. Within the framework of Bajaj et al. (1998), the present paper empirically examines the effects of a controlling manager and degree of monitoring (a measure of moral hazard) on capital structure and firm performance among a sample of Korean and Indonesian firms. In doing so, we not only allow for simultaneity between capital structure and firm performance (a la Berger and di Patti, 2003), but also the non-linearity in these relationships. Our empirical results in essence depend on whether a firm is run by a family and also whether there is a manager who is also a controlling owner. There is evidence that family ownership could mitigate the problem of moral hazard though it could exacerbate the problem of over-lending in our samples. Also the effects of ownership structure on firm performance cannot be delineated from its effects on leverage. As such, the results presented here confirm and extend the essential findings of Claessens et al. (2002) and Bajaj et al. (1998).
    Keywords: Asian Crisis, Corporate Governance, Capital structure, Firm performance, Expropriation of minority shareholders, 3SLS estimates, Simultaneity bias, Non-linearity.
    JEL: G32
    Date: 2005–09–27
  24. By: Yanhua ZHANG (GREMAQ, University of Toulouse)
    Abstract: Collusion and soft budget constraint are two conspicuous phenomena in transition economies¡¯ banking system. Literature has separately investigated those two phenomena from theoretical point of views. However, the cross-point of both phenomena has been neglected in the research of banking regulation. The present paper addresses this issue in a simple model of two-period contract with termination at the end of the first period. By comparing the two hierarchies -- ¡°bank-firm¡± and ¡°government-bank-firm¡±, we show that the government¡¯s non-commitment and banking bailout cause inefficiency in the contact relationship. Moreover, after introducing collusion possibility, non-commitment of the government increases the stakes, or bribes, which the collusive bank can extract, and makes it more costly for the government to implement this contract. However, taking into account the fact that the bank is collusive, the government who aims to prevent collusion will switch to the other equilibrium where she sticks to her commitment and excludes collusion from the contract relationship. Here, collusion plays a role as a hardening budget constraint device. Some policy implications are suggested at the end.
    Keywords: soft budget constraint, collusion, moral hazard, commitment, transition, centralized economy.
    JEL: C72 D23 D82 G14 H72 L23 P31
    Date: 2005–09–27
  25. By: Trevor Breusch (Australian National University)
    Abstract: The method of "excess sensitivity" of Bajada (1999, 2001, 2002) indicates a large underground economy in Australia, with estimates of unrecorded income around 15 per cent of official GDP. These estimates concern policymakers, especially those agencies responsible for national accounts, tax collection, economic stabilization and law enforcement. We show that the method exhibits a severe form of non-robustness, in which the results change markedly with a simple change in the units of measurement of the variables. There is a separate problem in which a key parameter is set to an unrealistic value that makes the estimates many times too high.
    Keywords: underground economy, currency demand, tax evasion, econometric models
    JEL: C51 E42 E62 H26
    Date: 2005–09–23
  26. By: Marc Henrard (Bank for International Settlements)
    Abstract: This book presents a simple model (the simplest?) for the computation of the value-at-risk: the delta-normal approach. It doesn't explain the shortcomings and advantages of the method nor compares it with other models. Even on this single topic, by no way it pretends to be complete or in the forefront.
    Keywords: value-at-risk; delta normal approach
    Date: 2005–09–29
  27. By: Valeria De Bonis (Dipartimento di Scienze Economiche, University of Pisa); Pompeo Della Posta (Dipartimento di Scienze economiche, University of Pisa)
    Abstract: In this paper we extend Nordhaus’ (1994) results to an environment which may represent the current European situation, characterised by a single monetary authority and several fiscal bodies. We show that: a) co-operation among national fiscal authorities is welfare improving only if they also co-operate with the central bank; b) when this condition is not satisfied, fiscal rules, as those envisaged in the Maastricht Treaty and in the Stability and Growth Pact, may work as co-ordination devices that improve welfare; c) the relationship between several treasuries and a single central bank makes the fiscal leadership solution collapse to the Nash one, so that, contrary to Nordhaus (1994) and Dixit and Luisa Lambertini (2001), when moving from the Nash to the Stackelberg solution, fiscal discipline no longer obtains. Also in this case we thus argue in favour of fiscal rules in a monetary union.
    Keywords: Fiscal and monetary policy co-ordination; monetary union;international fiscal issues
    JEL: E61 F42 H87
    Date: 2005–09
  28. By: Kadri Männasoo; David G Mayes
    Abstract: This paper considers the joint role of macro-economic and bankspecific factors in explaining the occurrence of banking problems in the twenty-one Central and East European emerging markets over the recent decade. Using data at the individual bank level we show, using a logit model, that the macroeconomic factors play a central role in determining banking sector instability in the early stages of difficulty, while the bankspecific factors are more important in the later stages and gain more weight as the banking sector develops and the institutional framework becomes mature.
    Keywords: banking sector vulnerability, banking crises, early warning indicators, Central and Eastern Europe
    JEL: E44 G21
  29. By: Danny Pitzel; Lenno Uusküla
    Abstract: Several papers have looked at the relationship between country-specific factors and the strength of monetary transmission. Cecchetti (1999) concentrated on legal aspects, De Grauwe and Storti (2004) more on the financial structure of the economy. The objective of this paper is to measure how financial development variables influence the strength of monetary transmission in European countries. This paper employs a meta-analysis technique that has gained much popularity in recent years. According to the results, monetary transmission in Europe is strongly influenced by financial depth and structure.
    Keywords: monetary transmission, financial depth, meta-analysis
    JEL: E3 E4 E5 E6
  30. By: Wagner, Martin (Department of Economics and Finance, Institute for Advanced Studies, Vienna, Austria)
    Abstract: This paper re-assesses the panel (unit root test) evidence for PPP on four monthly data sets. We discuss and illustrate that commonly-used first generation panel unit root tests are inappropriate for PPP analysis since they are constructed for cross-sectionally uncorrelated panels. Given that real exchange rate panel data sets are – almost by construction – highly cross-sectionally correlated, so called second generation panel unit root methods that allow for and model cross-sectional dependence should be applied. Using inappropriate first generation tests, quite strong evidence for PPP is found. However, this evidence vanishes entirely when resorting to an appropriate method (e.g. the one developed in Bai and Ng, 2004a) for nonstationary cross-sectionally correlated panels. We strongly believe that our findings are relevant beyond the data sets investigated here for illustration.
    Keywords: PPP, Real exchange rate index, Unit root, Panel, Cross-sectional dependence, Factor model
    JEL: C23 F30 F31
    Date: 2005–09
  31. By: James Yetman (School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong.)
    Abstract: Price level targeting has been proposed as an alternative to inflation targeting that may confer benefits if a central bank sets policy under discretion, even if society’s loss function is specified in terms of inflation (instead of price level) volatility. This paper demonstrates the sensitivity of this argument. If even a small portion of agents use a rule-of-thumb to form inflation expectations, or does not fully understand the nature of the target, price level targeting may in fact impose costs on society rather than benefits. While rational expectations and perfect credibility are generally beneficial with either a price level or an inflation target, an inflation target is more robust to alternative assumptions. These results suggest that caution should be exercised in considering a price level target as the basis for monetary policy, unless society has preferences specified in terms of price level, rather than inflation, volatility.
    Keywords: Price Level Targeting; Inflation Targeting; Credibility; Free Lunch; Discretion.
    JEL: E52
    Date: 2003–11
  32. By: Giovanni Lombardo (Deutsche Bundesbank, Postfach 100602, D-60006 Frankfurt am Main, Germany.); Alan Sutherland (Department of Economics, University of St Andrews, St Andrews, Fife, KY16 9AL, UK.)
    Abstract: A two-country sticky-price model is used to analyse the interactions between fiscal and monetary policy. The role of an ‘activist’ fiscal policy as a stabilisation tool is considered and a measure of the welfare gains from international fiscal policy cooperation is derived. It is found that welfare gains from fiscal cooperation do exist provided monetary policy is set cooperatively. There are also welfare gains from fiscal policy cooperation in a monetary union. However, it is found that a ‘non-activist’ fiscal policy can be better than non-cooperative fiscal policy when the international correlation of shocks is strongly negative. And non-cooperative fiscal policy can be better than cooperative fiscal policy if monetary policy is not set cooperatively.
    Keywords: Fiscal and monetary policy; policy coordination.
    JEL: E52 E58 F42
    Date: 2003–11
  33. By: Elena Carletti (University of Mannheim, Department of Economics, 68131 Mannheim, Germany.); Philipp Hartmann (European Central Bank, DG Research, Kaiserstrasse 27, 60311 Frankfurt, Germany, and CEPR.); Giancarlo Spagnolo (Stockholm School of Economics, Handelshogskolan, BOX 6501, SE-11383 Stockholm, Consip SpA and CEPR.)
    Abstract: We model the impact of bank mergers on loan competition, banks' reserve holdings and aggregate liquidity. Banks compete in a differentiated loan market, hold reserves against liquidity shocks, and refinance in the interbank market. A merger creates an internal money market that induces financial cost advantages and may increase reserve holdings. We assess changes in liquidity risk and expected liquidity needs for each bank and for the banking system. Large mergers tend to increase expected aggregate liquidity needs, and thus the liquidity provision by the central bank. Comparative statics suggest that a more competitive environment moderates this effect.
    Keywords: Credit market competition; bank reserves; internal money market; banking system liquidity.
    JEL: D43 G21 G28 L13
    Date: 2003–11
  34. By: Fabio Moneta (Finance Department, Carroll School of Management, Boston College, 140 Commonwealth Avenue, Chestnut Hill, MA 02467-3808.)
    Abstract: This paper studies the informational content of the slope of the yield curve as a predictor of recessions in the euro area. In particular, the historical predictive power of ten yield spreads, for different segments of the yield curve, is tested using a probit model. The yield spread between the ten-year government bond rate and the threemonth interbank rate outperforms all the other spreads in predicting recessions in the euro area. The result is confirmed when the autoregressive series of the state of the economy is added in the same model. The forecast accuracy of the spread between 10-year and 3-month interest rates is explored in an exercise of out-of-sample forecasting. This yield spread appears to contain information which goes beyond the information already available in the history of output, providing further evidence of the potential usefulness of this indicator for monetary policy purposes.
    Keywords: Probit model; forecasting; recessions; yield curve.
    JEL: E44 E52 C53
    Date: 2003–12
  35. By: Christian Ewerhart (Institute for Empirical Research in Economics (IEW), University of Zurich, Bluemlisalpstrasse 10, CH-8006 Zurich, Switzerland.); Nuno Cassola (European Central Bank, Postfach 160319, 60311 Frankfurt am Main, Germany); Steen Ejerskov (European Central Bank, Postfach 160319, 60311 Frankfurt am Main, Germany); Natacha Valla (Banque de France, Paris, France)
    Abstract: On several occasions during the period 2001-2003, the European Central Bank (ECB) decided to deviate from its “neutral” benchmark allotment rule, with the effect of not alleviating a temporary liquidity shortage in the banking system. This is remarkable because it implied the possibility of short-term interest rates raising significantly above the main policy rate. In the present paper, we show that when the monetary authority cares for both liquidity and interest rate conditions, the optimal allotment policy may entail a discontinuous reaction to initial conditions. More precisely, we prove that there is a threshold level for the accumulated aggregate liquidity position in the banking system prior to the last operation in a given maintenance period, so that the benchmark allotment is optimal whenever liquidity conditions are above the threshold, and a tight allotment is optimal whenever liquidity conditions are below the threshold.
    Keywords: euro; monetary policy instruments; operational framework; refinancing operations.
    JEL: E43 E52
    Date: 2003–12
  36. By: Mattias Villani (Sveriges Riksbank, Research Department, SE-103 37 Stockholm, Sweden, and Department of Statistics, Stockholm University.); Anders Warne (European Central Bank, Postfach 160319, 60311 Frankfurt am Main, Germany)
    Abstract: Structural VARs have been extensively used in empirical macroeconomics during the last two decades, particularly in analyses of monetary policy. Existing Bayesian procedures for structural VARs are at best confined to a severly limited handling of cointegration restrictions. This paper extends the Bayesian analysis of structural VARs to cover cointegrated processes with an arbitrary number of cointegrating relations and general linear restrictions on the cointegration space. A reference prior distribution with an optional small open economy effect is proposed and a Gibbs sampler is derived for a straightforward evaluation of the posterior distribution. The methods are used to analyze the effects of monetary policy in Sweden.
    Keywords: Structural; Vector autoregression; Monetary policy; Impulse responses; Counterfactual experiments.
    JEL: C11 C32 E52
    Date: 2003–12
  37. By: Reint Gropp (European Central Bank, Kaiserstrasse 28, 60311 Frankfurt am Main, Germany.); Gerard Moerman (Erasmus University Rotterdam, The Netherlands)
    Abstract: This paper uses the co-incidence of extreme shocks to banks’ risk to examine within country and across country contagion among large EU banks. Banks’ risk is measured by the first difference of weekly distances to default and abnormal returns. Using Monte Carlo simulations, the paper examines whether the observed frequency of large shocks experienced by two or more banks simultaneously is consistent with the assumption of a multivariate normal or a student t distribution. Further, the paper proposes a simple metric, which is used to identify contagion from one bank to another and identify “systemically important” banks in the EU.
    Keywords: Banking; Contagion; Monte Carlo Simulations.
    JEL: G21 F36 G15
    Date: 2003–12
  38. By: Xavier Freixas (Universitat Pompeu Fabra, Barcelona, Spain); Bruno M. Parigi (University of Padova, Italy); Jean-Charles Rochet (University of Toulouse, IDEI, France)
    Abstract: The classical Bagehot’s conception of a Lender of Last Resort (LOLR) that lends to illiquid banks has been criticized on two grounds: on the one hand, the distinction between insolvency and illiquidity is not clear cut; on the other a fully collateralized repo market allows Central Banks to provide the adequate aggregated amount of liquidity and leave the responsibility of lending uncollateralized to the banks. The object of this paper is to analyze rigorously these issues by providing a framework where liquidity shocks cannot be distinguished from solvency ones and ask whether there is a need for a LOLR and how should it operate. Determining the optimal LOLR policy requires a careful modeling of the structure of the interbank market and of the closure policy. In our set up, the results depend upon the existence of moral hazard. If the main source of moral hazard is the banks’ lack of incentives to screen loans, then the LOLR may have to intervene to improve the efficiency of an unsecured interbank market; if instead, the main source of moral hazard is loans monitoring, then the interbank market should be secured and the LOLR should never intervene.
    Keywords: Lender of Last Resort; Interbank Market; Liquidity.
    JEL: E58 G28
    Date: 2003–12
  39. By: Michele Manna (Banca d’Italia)
    Abstract: This paper discusses a wide range of indicators of the degree of integration of the euro area banking system. It is concerned with volume data, a less developed field of research compared with studies on prices/rates. We first set out a methodological framework, a mixture of elementary and more sophisticated statistics which can also be used in other contexts and datasets. We then apply this framework to unconsolidated balance sheet data of banks, aggregated at the national level. The paper offers three main empirical conclusions. First, within the euro area the gap between the cross-border banking activity in wholesale and retail markets is widening. Second, at the same time, with the exception of the home bias, even in retail markets there is increasing neutrality towards the location of the counterparty. Third, following a moderate decline in the wake of EMU, London is once again gaining market shares.
    Keywords: banking system, balance sheet, integration, euro area.
    JEL: C43 D40 G21 L11
    Date: 2004–01
  40. By: Reint Gropp (European Central Bank, Directorate General Research); Jukka Vesala (Finnish Financial Supervision Authority, Prudential Supervision)
    Abstract: The paper analyses the relationship between deposit insurance, debt-holder monitoring, and risk taking. In a stylised banking model we show that deposit insurance may reduce moral hazard, if deposit insurance credibly leaves out non-deposit creditors. Testing the model using EU bank level data yields evidence consistent with the model, suggesting that explicit deposit insurance may serve as a commitment device to limit the safety net and permit monitoring by uninsured subordinated debt holders. We further find that credible limits to the safety net reduce risk taking of smaller banks with low charter values and sizeable subordinated debt shares only. However, we also find that the introduction of explicit deposit insurance tends to increase the share of insured deposits in banks’ liabilities.
    Keywords: Banking, Moral Hazard, Market Monitoring, Deposit Insurance.
    JEL: G21 G28
    Date: 2004–02
  41. By: António Afonso (European Central Bank, Directorate General Economics); Rolf Strauch (European Central Bank, Directorate General Economics)
    Abstract: In this paper we assess the importance given in capital markets to the credibility of the European fiscal framework. We evaluate to which extent relevant fiscal policy events taking place in the course of 2002 produced a reaction in the long-term bond segment of the capital markets. Firstly, we identify the fiscal policy events and qualitatively assess the views of capital market participants. Secondly, we estimate the impact of these fiscal events on the interest rate swap spreads, which is our measure for the risk premium. According to our results the reaction of swap spreads, where it turned out to be significant, has been mostly around five basis points or less.
    Keywords: fiscal policy events; Stability and Growth Pact; interest rate swap spreads
    JEL: C22 G15 H30
    Date: 2004–02
  42. By: Giancarlo Corsetti (European University Institute, Via dei Roccettini 9, I-San Domenico di Fiesole 50016, Italy); Luca Dedola (European Central Bank, Kaiserstr. 29, D-Frankfurt am Main, Germany); Sylvain Leduc (Federal Reserve Bank of Philadelphia,Ten Independence Mall, Philadelphia, PA 19106-1574;)
    Abstract: A central puzzle in international finance is that real exchange rates are volatile and, in stark contradiction to efficient risk-sharing, negatively correlated with cross-country consumption ratios. This paper shows that incomplete asset markets and a low price elasticity of tradables can account quantitatively for these properties of real exchange rates. The low price elasticity stems from distribution services, intensive in local inputs, which drive a wedge between producer and consumer prices and lower the impact of terms-of-trade changes on optimal agents’ decisions. Two very different patterns of the international transmission of productivity improvements generate the observed degree of risk-sharing: one associated with a strengthening, the other with a deterioration of the terms of trade and real exchange rate. Evidence on the effect of technology shocks to U.S. manufacturing, identified through long-run restrictions, is found in support of the first transmission pattern, questioning the presumption that terms-of-trade movements foster international risk-pooling.
    Keywords: Incomplete asset markets; Distribution margin; Consumption-real exchange rate. F32, F33, F41
    JEL: F32 F33 F41
    Date: 2004–02
  43. By: João Sousa (Banco de Portugal,Av. Almirante Reis 71, P-1150-012 Lisbon, Portugal.); Andrea Zaghini (European Central Bank, Directorate Monetary Policy, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: This paper analyses the international transmission of monetary shocks with a special focus on the effects of foreign money ("global liquidity") on the euro area. We estimate structural VAR models for the euro area and the global economy including a global liquidity aggregate. The impulse responses obtained show that a positive shock to extra-euro area liquidity leads to permanent increases in the euro area M3 aggregate and the price level, a temporary rise in real output and a temporary appreciation of the real effective exchange rate of the euro. Moreover, we find that innovations in global liquidity play an important role in explaining price and output fluctuations in the euro area and in the global economy.
    Keywords: Monetary policy; Structural VAR; International spillovers.
    JEL: E52 F01
    Date: 2004–02
  44. By: Gabe de Bondt (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); David Marqués (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany)
    Abstract: This study empirically examines the development of the high-yield segment of the corporate bond market in the United States, as a pioneer country, and the United Kingdom and the euro area, as later adopting countries. Estimated diffusion models show for the United States a significant pioneer influence factor and autonomous speed of diffusion. The latter is found to be higher in Europe than in the United States as also macroeconomic factors are considered. The high-yield bond diffusion pattern is significantly affected by financing need variables, e.g. leverage buy-outs, mergers and acquisitions, and industrial production growth, and return or financing cost variables, e.g. stock market return and the spread between the yield on speculative-grade and BBB-rated investment-grade bonds. These findings suggest that the diffusion of new financial products depends on the macroeconomic environment and can be quickly in case of the diffusion from a pioneer country to later adopting countries.
    Keywords: High-yield bond market; Financial innovation; Diffusion models
    JEL: G32 E44
    Date: 2004–02
  45. By: Alexis Derviz (Czech National Bank, Na P?íkop? 28, CZ-115 03 Praha 1, Czech Republic)
    Abstract: The paper proposes a multi-factor international asset pricing model in which the exchange rate is allowed to be co-determined by a risk factor imperfectly correlated to other priced risks in the economy. The significance of this factor can be established as long as one is able to observe a proxy for the foreign cash order flow. Then, the asset pricing model is decomposed into the standard ICCAPM no-arbitrage setup characterized by a pricing kernel, in which, however, the “autarky” exchange rate is unobserved, and an additional equation that links this autarchic currency price with the FX order flow. The model is put in the state space form. The unobserved variables span the macroeconomic risk factors with an impact on the asset markets and determine the dynamics of the pricing kernel, the autarchic exchange rate and the FX order flow. A comparison of models allowing for an independent OF risk factor with a restricted one, where the forex order flow plays no role, should disclose the existence of a “nonfundamental” source of a systematic divergence of the observed and the autarchic (i.e. fundamental) FX returns. The model is calibrated and tested on the Czech koruna/euro exchange rate in a setting with seven Czech and euro area asset returns.
    Keywords: Exchange rate; Pricing kernel; Order flow; Latent risk; State space.
    JEL: F31 F41 G12 G15
    Date: 2004–03
  46. By: Sami Vähämaa (University of Vaasa, Department of Accounting and Finance, P.O. Box 700, FIN-65101 Vaasa, Finland;)
    Abstract: This paper uses data on German government bond futures options to examine the behaviour of market expectations around monetary policy actions of the European Central Bank (ECB). In particular, this paper focuses on the asymmetries in bond market expectations, as measured by the skewness of option-implied probability distributions of future bond yields. The results show that market expectations are systematically asymmetric around monetary policy actions of the ECB. Around monetary policy tightening, option-implied yield distributions are positively skewed, indicating that market participants attach higher probabilities for sharp yield increases than for sharp decreases. Correspondingly, around loosening of the policy, implied yield distributions are negatively skewed, suggesting that markets assign higher probabilities for sharp yield decreases than for increases. Furthermore, the results indicate that market expectations are significantly altered around monetary policy actions, as asymmetries in market expectations tend to increase before changes in the monetary policy stance, and to decrease afterwards.
    Keywords: Market expectations; Asymmetries; Implied skewness; Monetary policy.
    JEL: E44 E52 G10 G13
    Date: 2004–03
  47. By: Cornelia Holthausen (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Thomas Rønde (University of Copenhagen,Institute of Economics, Studiestraede 6, DK-1455 Copenhagen K, Denmark.)
    Abstract: This paper analyzes cooperation between sovereign national authorities in the supervision and regulation of a multinational bank. We take a political economy approach to regulation and assume that supervisors maximize the welfare of their own country. The communication between the supervisors is modeled as a ?cheap talk? game. We show that: (1) unless the interests of the countries are perfectly aligned, Þrst best closure regulation cannot be implemented; (2) the more aligned the interests are, the higher is welfare; (3) the bank can allocate its investments strategically across countries to escape closure.
    Keywords: Multinational banks; Supervision; Closure; Cheap talk.
    JEL: F36 G21 G28 L51
    Date: 2004–03
  48. By: Gerard A. Moerman (Erasmus University Rotterdam, Department Financial Management, Burgemeester Oudlaan 50, 3000 DR Rotterdam, The Netherlands)
    Abstract: The harmonisation of fiscal and economic policy within the European Monetary Union (EMU) has had a considerable impact on the economies of member countries in the past decade. In particular, several studies indicate that the proceeding economic integration among euro area countries has important consequences for the factors driving asset returns in financial markets. This study concentrates on the implications of the changing structure of security returns for asset management. Using recent euro area stock markets data, we find clear evidence that diversification over industries yields more efficient portfolios than diversification over countries. We show that this result is robust with respect to the information technology-hype and different volatility regimes. This contrasts with e.g. Rouwenhorst (1999), who finds, based on a different methodology and a different sample period, that country diversification strategies are superior. We regard this paper as a robustness check challenging the existing strand of literature and show that Rouwenhorst’s (1999) conclusions seem to be outdated.
    Keywords: EMU; Euro area stock markets; Portfolio diversification; Industry factors; Country factors
    JEL: G11 G15
    Date: 2004–03
  49. By: Roland Straub (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Ivan Tchakarov (International Monetary Fund, 700 19th Street, N.W. Washington, D.C. 20431, USA)
    Abstract: We lay out an empirical and a theoretical model to analyze the effects of non-fundamental exchange rate volatility on economic activity and welfare. In the first part of the paper, the GARCH-SVARmodel is applied to measure empirically the effect of the conditional exogenous exchange rate volatility on the conditional mean of the endogenous variables in our open economy VAR. Our results for Canada, Germany and UK indicate that the effects of exchange rate uncertainty are small empirically. In the second part, we investigate the effect of non-fundamental exchange rate volatility in a stochastic open economy model. The second order approximation method of Sims [2003] is applied to the model equilibrium conditions. We show that in a model with habit persistence, even non-fundamental exchange rate volatility that generate only small variation in the unconditional mean of the variables might induce economically significant welfare changes.
    Keywords: GARCH-SVAR; Exchange rate volatility; Second-order approximation; Welfare;
    JEL: C32 F31 F41
    Date: 2004–04
  50. By: Roberto A. De Santis (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Robert Anderton (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany)
    Abstract: The long-run determinants of euro area FDI to the United States during the period 1980-2001 are explained by employing the Tobin's Q-model of investment. By using the fixed effects panel estimator, stock market developments in the euro area countries including a measure adjusted for economic developments common to both the United States and the euro area - are found to influence euro area FDI to the United States. Moreover, the inclusion of the Tobin's Q enhances the traditional knowledge-capital framework specification. Overall, the empirical findings suggest that euro area patents (ownership advantage), various variables related to productivity in the United States (location advantage), the volume of bilateral telephone traffic to the United States relative to euro area GDP (ownership advantage), euro area stock market developments (Tobin's Q), and the real exchange rate are statistically significant determinants of euro area FDI to the United States.
    Keywords: Euro area; Foreign Direct Investment; Multinational firms; Tobin's Q.
    JEL: F21 F23
    Date: 2004–04
  51. By: Björn Fischer (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Petra Köhler (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Franz Seitz (Fachhochscule Amberg-Weiden)
    Abstract: The present paper analyses currency in circulation in the euro area since the beginning of the 1980s. After a comprehensive literature review on this topic we present some stylised facts on currency holdings in the euro area countries as well as at an aggregate euro area level. The next chapter develops a theoretical model, which extends traditional money demand models to also incorporate arguments for the informal economy and foreign demand for specific currencies. In the empirical sections we first estimate the demand for euro legacy currencies in total and for small and large denominations within a cointegration framework. We find significant differences between the determinants of holdings of small and large denominations as well as overall currency demand. While small-value banknotes are mainly driven by domestic transactions, the demand for large-value banknotes depends on a short-term interest rate, the exchange rate of the euro as a proxy for foreign demand and inflation variability. Large-value banknotes seem to be therefore used to an important extent as a store of value domestically and abroad. As monetary policy is mainly interested in getting information on the demand for currency used for domestic transactions we also try several approaches in this direction. All the methods applied result in rather low levels of transaction balances used within the euro area of around 25% to 35% of total currency. After this we deal with possibly changing cost-benefit-considerations of the use of cash due to the introduction of euro notes and coins. Overall, there seems no evidence so far of a substantial decline of the demand for currency in the euro area. The analysis of currency in circulation and in particular estimates on the share of currency which is likely to be used for domestic transactions therefore help to explain monetary developments and are informative for monetary policy.
    Keywords: currency in circulation; Cointegration; Purposes of holding currency
    JEL: E41 E52 E58
    Date: 2004–04
  52. By: Athanasios Orphanides (Board of Governors of the Federal Reserve System, Federal Reserve Board,Washington, D.C. 20551,USA.); John C. Williams (Federal Reserve Bank of San Francisco, 101 Market Street, San Francisco, CA 94105,USA.)
    Abstract: We develop an estimated model of the U.S. economy in which agents form expectations by continually updating their beliefs regarding the behavior of the economy and monetary policy. We explore the effects of policymakers' misperceptions of the natural rate of unemployment during the late 1960s and 1970s on the formation of expectations and macroeconomic outcomes. We find that the combination of monetary policy directed at tight stabilization of unemployment near its perceived natural rate and large real-time errors in estimates of the natural rate uprooted heretofore quiescent inflation expectations and destabilized the economy. Had policy reacted less aggressively to perceived unemployment gaps, inflation expectations would have remained anchored and the stagflation of the 1970s would have been avoided. Learning from the experience of the 1970s, policymakers eschewed activist policies in favor of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance.
    Keywords: Monetary policy; stagflation; rational expectations; learning.
    JEL: E52
    Date: 2004–04
  53. By: Susan Athey (Stanford University and National Bureau of Economic Research,Stanford University, Stanford, CA 94305-6072, USA.); Andrew Atkeson (University of California, Los Angeles,CA, USA. Federal Reserve Bank of Minneapolis, and National Bureau of Economic Research.); Patrick J. Kehoe (Federal Reserve Bank of Minneapolis, University of Minnesota, and National Bureau of Economic Research)
    Abstract: How much discretion should the monetary authority have in setting its policy? This question is analyzed in an economy with an agreed-upon social welfare function that depends on the randomly fluctuating state of the economy. The monetary authority has private information about that state. In the model, well-designed rules trade off society’s desire to give the monetary authority discretion to react to its private information against society’s need to guard against the time inconsistency problem arising from the temptation to stimulate the economy with unexpected inflation. Although this dynamic mechanism design problem seems complex, society can implement the optimal policy simply by legislating an inflation cap that specifies the highest allowable inflation rate. The more severe the time inconsistency problem, the more tightly the cap constrains policy and the smaller is the degree of discretion. As this problem becomes sufficiently severe, the optimal degree of discretion is none.
    Keywords: Rules vs. discretion; time inconsistency; optimal monetary policy; inflation targets; inflation caps.
    JEL: E5 E6 E52 E58 E61
    Date: 2004–04
  54. By: Jordi Galí (CREI and Universitat Pompeu Fabra, Spain.); J. David López-Salido (Banco de España, Alcala 50, E-28014 Madrid, Spain.); Javier Vallés (Banco de España, Alcala 50, E-28014 Madrid, Spain.)
    Abstract: Recent evidence on the effect of government spending shocks on consumption cannot be easily reconciled with existing optimizing business cycle models. We extend the standard New Keynesian model to allow for the presence of rule-of-thumb (non-Ricardian) consumers. We show how the interaction of the latter with sticky prices and deficit financing can account for the existing evidence on the effects of government spending.
    Keywords: rule-of-thumb consumers; fiscal multiplier; government spending; Taylor rules.
    JEL: E32 E62
    Date: 2004–04
  55. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper investigates whether the degree of interdependence between the United States and the euro area economies has changed with the advent of EMU. It addresses this issue from the perspective of financial markets by analysing the effects of monetary policy and macroeconomic news on daily interest rates. First, the paper finds that the interdependence of money markets has increased strongly around EMU. Although spillover effects from the United States to the euro area remain stronger than in the opposite direction, US markets have started reacting to euro area developments since the onset of EMU. Second, certain US macroeconomic news affect euro area money markets, especially in recent years. Finally, we show that US macroeconomic news have become good leading indicators for economic developments in the euro area, indicating that the higher money market interdependence is at least partly explained by the increased real integration of the two economies.
    Keywords: interdependence; announcements; news; money markets; real-time data; United States; euro area.
    JEL: E43 E52 F42
    Date: 2004–04
  56. By: Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany.); Matthieu Bussiere (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany.)
    Abstract: No empirical evidence has yet emerged for the existence of a robust positive relationship between financial openness and economic growth. This paper argues that a key reason for the elusive evidence is the presence of a time-varying relationship between openness and growth over time: countries tend to gain in the short-term, immediately following capital account liberalisation, but may not grow faster or even experience temporary growth reversals in the medium- to long-term. The paper finds substantial empirical evidence for the existence of such an intertemporal trade-off for 45 industrialised and emerging market economies. The acceleration of growth immediately after liberalisation is found to be often driven by an investment boom and a surge in portfolio and debt inflows. By contrast, the quality of domestic institutions, the size of FDI inflows and the sequencing of the liberalisation process are found to be important driving forces for growth in the medium to longer term.
    Keywords: liberalisation; capital account; economic growth; intertemporal trade-off;quality of institutions; composition of capital flows; sequencing.
    JEL: F33 F34 F36 F43
    Date: 2004–04
  57. By: Günter Coenen (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany.); Volker Wieland (Professur für Geldtheorie und -politik, Johann-Wolfgang-Goethe Universität, Mertonstrasse 17, D-60325 Frankfurt am Main, Germany.)
    Abstract: In this paper, we study the effectiveness of monetary policy in a severe recession and deflation when nominal interest rates are bounded at zero. We compare two alternative proposals for ameliorating the effect of the zero bound: an exchange-rate peg and price-level targeting. We conduct this quantitative comparison in an empirical macroeconometric model of Japan, the United States and the euro area. Furthermore, we use a stylized micro-founded two-country model to check our qualitative findings. We find that both proposals succeed in generating inflationary expectations and work almost equally well under full credibility of monetary policy. However, price-level targeting may be less effective under imperfect credibility, because the announced price-level target path is not directly observable.
    Keywords: monetary policy rules; zero-interest-rate bound; liquidity trap; nominal rigidities; exchange rates.
    JEL: E31 E52 E58 E61
    Date: 2004–04
  58. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany;); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany;)
    Abstract: This paper analyses the effects of US monetary policy on stock markets. We find that, on average, a tightening of 50 basis points reduces returns by about 3%. Moreover, returns react more strongly when no change had been expected, when there is a directional change in the monetary policy stance and during periods of high market uncertainty. We show that individual stocks react in a highly heterogeneous fashion and relate this heterogeneity to financial constraints and Tobin's q. First, we show that there are strong industry-specific effects of US monetary policy. Second, we find that for the individual stocks comprising the S&P500 those with low cashflows, small size, poor credit ratings, low debt to capital ratios, high price-earnings ratios or high Tobin's q are affected significantly more. The use of propensity score matching allows us to distinguish between firmand industry-specific effects, and confirms that both play an important role.
    Keywords: monetary policy; stock market; credit channel; Tobin’s q; financial constraints; S&P500; propensity score matching.
    JEL: G14 E44 E52
    Date: 2004–05
  59. By: Ulrich Bindseil (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Gonzalo Camba-Mendez (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Astrid Hirsch (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Benedict Weller (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper explains to what extent excess reserves are and should be relevant today in the implementation of monetary policy, focusing on the specific case of the operational framework of the Eurosystem. In particular, this paper studies the impact that changes to the operational framework for monetary policy implementation have on the level and volatility of excess reserves. A ‘transaction costs’ model that replicates the rather specific intra-reserve maintenance period pattern of excess reserves in the euro area is developed. Simulation results presented not only show that excess reserves may increase considerably under some changes to the operational framework, but also that their volatility and hence unpredictability could.
    Keywords: excess reserves; monetary policy implementation; liquidity management.
    JEL: E52 E58
    Date: 2004–05
  60. By: Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper deals with the very short-term influence of "oral interventions" on the exchange rate of major currencies. The paper finds that official communication, as reported by wire services, are effective in influencing the US dollar-euro and yen-US dollar exchange rates in the desired direction on intervention days. Oral interventions are found to be substantially more effective if they deviate from the prevalent policy "mantra". They also tend to reduce market volatility whereas actual interventions raise volatility. A key result of the paper is that oral interventions are effective independently from the stance and direction of monetary policy as well as the occurrence of actual interventions. This suggests that oral interventions might constitute, on a short-term basis, an effective and largely autonomous policy tool.
    Keywords: communication; exchange rate; intervention; policy; United States; euro area; Japan.
    JEL: E61 E58 F31
    Date: 2004–05
  61. By: Carsten Detken (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Frank Smets (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: The paper aims at deriving some stylised facts for financial, real, and monetary policy developments during asset price booms. We observe various macroeconomic variables in a pre-boom, boom and post-boom phase. Not all booms lead to large output losses. We analyse the differences between highcost and low-cost booms. High-cost booms are clearly those in which real estate prices and investment crash in the post-boom periods. In general it is difficult to distinguish a high-cost from a low-cost boom at an early stage. However, high-cost booms seem to follow very rapid growth in the real money and real credit stocks just before the boom and at the early stages of a boom. There is also evidence that high-cost booms are associated with significantly looser monetary policy conditions over the boom period, especially towards the late stage of a boom. We finally discuss the results with regard to the theoretical literature.
    Keywords: asset price booms; asset price bubbles; optimal monetary policy; over-investment; real estate prices.
    JEL: E44 E52 E58
    Date: 2004–05
  62. By: Michael Ehrmann (European Central Bank); Marcel Fratzscher (European Central Bank)
    Abstract: This paper analyses the link between economic fundamentals and exchange rates by investigating the importance of real-time data. We find that such economic news in the United States, Germany and the euro area have indeed been a driving force behind daily US dollar – euro/DEM exchange rate developments in the period 1993-2003. The larger importance of US macroeconomic news is at least partly explained by their earlier release time compared to corresponding German and euro area news. The exchange rate is also shown to respond more strongly to news in periods of large market uncertainty and when negative or large shocks occur. Overall, the model based on real-time data is capable of explaining about 75% of the monthly directional changes of the US dollar-euro exchange rate, although it does not explain well the magnitude of the exchange rate changes.
    Keywords: exchange rates; fundamentals; announcements; news; real-time data; United States; euro area; interdependence; US dollar euro; EMU.
    JEL: F31 F42 E52
    Date: 2004–05
  63. By: Peter Christoffersen (Faculty of Management, McGill University); Stefano Mazzotta (Department of Economics & Finance, Coles College of Business, Kennesaw State University)
    Abstract: Financial decision makers often consider the information in currency option valuations when making assessments about future exchange rates. The purpose of this paper is to systematically assess the quality of option based volatility, interval and density forecasts. We use a unique dataset consisting of over 10 years of daily data on over-the-counter currency option prices. We find that the OTC implied volatilities explain a much larger share of the variation in realized volatility than previously found using market-traded options. Finally, we find that wide-range interval and density forecasts are often misspecified whereas narrow-range interval forecasts are well specified.
    Keywords: FX, Volatility, Interval, Density, Forecasting.
    JEL: G13 G14 C22 C53
    Date: 2004–06
  64. By: Kerstin Bernoth (Research Division, De Nederlandsche Bank); Jürgen von Hagen (Center for European Integration Studies); Ludger Schuknecht (DG Economics, European Central Bank)
    Abstract: This paper provides a study of bond yield differentials among EU eurobonds issued between 1991 and 2002. Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premia which increase with the debt, deficit and debt-service ratio and depend positively on the issuer’s relative bond market size. Global investors’ attitude towards credit risk, measured as the yield spread between low grade US corporate bonds and government bonds, also affects bond yield spreads between EU countries and Germany/USA. The start of the European Monetary Union had significant effects on the bond pricing of the member states.
    Keywords: asset pricing, determination of interest rates, fiscal policy, government debt.
    JEL: G12 E43 E62 H63
    Date: 2004–06
  65. By: Thorsten V. Koeppl (Department of Economics, Queen's University); Cyril Monnet (European Central Bank, DG Research)
    Abstract: Exchanges and other trading platforms are often vertically integrated to carry out trading, clearing and settlement as one operation. We show that such vertical silos can prevent efficiency gains from horizontal consolidation of trading and settlement platforms to be realized. Independent of the gains from such consolidation, when costs of settlement are private information, there is no mechanism that achieves the merger of the vertical silos in a way that trading and settlement are produced efficiently after the merger. Furthermore, we show that such an ex-post efficient merger can always be implemented by delegating the operation of settlement platforms to agents.
    Keywords: Clearing and Settlement; Mechanism Design; Horizontal and Vertical Integration
    JEL: C73 G20 G34 L22
    Date: 2004–07
  66. By: Cornelia Holthausen (European Central Bank, DG Research); Jens Tapking (European Central Bank, DG Payment Systems and Market Infrastructure)
    Abstract: The competition between a central securities depository (CSD) and a custodian bank is analysed in a Stackelberg model. The CSD sets its prices first, the custodian bank follows. There are many investor banks each of which has to decide whether to use the service of the CSD or of the custodian bank. This decision depends on the prices and the investor bank's preferences for the inhomogeneous services of the two service providers. Since the custodian bank uses services provided by the CSD as input, the CSD can raise its rival's costs. However, due to network externalities, the CSD's equilibrium market share is not necessarily higher than socially optimal. This result has important policy implications that are related to a discussion currently taking place in the securities settlement industry.
    Keywords: Securities settlement, network competition, raising rival's cost.
    JEL: G10 G20 L14
    Date: 2004–07
  67. By: Christian Ewerhart (Institute for Empirical Research in Economics (IEW)); Nuno Cassola (European Central Bank, DG Market Operations); Steen Ejerskov (Danmarks Nationalbank, Economics); Natacha Valla (Banque de France (Bank of France))
    Abstract: We model the interbank market for overnight credit with heterogeneous banks and asymmetric information. An unsophisticated bank just trades to compensate its liquidity imbalance, while a sophisticated bank will exploit its private information about the liquidity situation in the market. It is shown that with positive probability, the liquidity effect (Hamilton, 1997) is reversed, i.e., a liquidity drainage from the banking system may generate an overall decrease in the market rate. The phenomenon does not disappear when the number of banks increases. We also show that private information mitigates the effect of an unexpected liquidity shock on the market rate, suggesting a conservative information policy from a central bank perspective.
    Keywords: Liquidity effect, asymmetric information, monetary policy implementation.
    JEL: G14 G21 E52
    Date: 2004–07
  68. By: Olli Castrén (European Central Bank, DG Economics)
    Abstract: This paper assesses the contemporaneous, leading and lagging indicator properties of financial market variables relative to movements in six major developed country currency pairs. As indicator variables changes in various relative asset prices, short-term portfolio flows and currency options data are used. We find that changes in equity index differentials, short-term speculative flows and risk reversals on currency options prices exhibit consistent contemporaneous indicator properties and leading indicator properties for several currency pairs. Since 1999, changes in short-term interest rate differentials have gained importance as indicators. The best indicator variables explain over 50% of monthly returns of the USD/EUR and GBP/USD exchange rates and over 60% of the appreciation and depreciation episodes of the USD/EUR and JPY/EUR currency pairs.
    Keywords: Exchange rates, asset prices, capital flows, leading and lagging indicators, market microstructure.
    JEL: F31 F32 G15
    Date: 2004–07
  69. By: Klaus Adam (European Central Bank, DG Research); Roberto M. Billi (Center for Financial Studies)
    Abstract: We determine optimal discretionary monetary policy in a New-Keynesian model when nominal interest rates are bounded below by zero. Nominal interest rates should be lowered faster in response to adverse shocks than in the case without bound. Such ‘preemptive easing’ is optimal because expectations of a possibly binding bound in the future amplify the effects of adverse shocks. Calibrating the model to the U.S. economy we find the easing effect to be quantitatively important. Moreover, the lower bound binds rather frequently and imposes significant welfare losses. Losses increase further when inflation is partly determined by lagged inflation in the Phillips curve. Targeting positive inflation rates reduces the frequency of a binding lower bound, but tends to reduce welfare compared to a target rate of zero. The welfare gains from policy commitment, however, appear significant and are much larger than in the case without lower bound.
    Keywords: nonlinear policy; zero lower bound; liquidity trap.
    JEL: C63 E31 E52
    Date: 2004–08
  70. By: Albert J. Menkveld (Vrije Universiteit Amsterdam FEWEB); Yiu C. Cheung (University of Amsterdam - Faculty of Economics & Econometrics (FEE)); Frank de Jong (University of Amsterdam - Faculty of Economics & Econometrics (FEE))
    Abstract: We study sovereign yield dynamics and order flow in the largest euro-area treasury markets. We exploit unique transaction data to explain daily yield changes in the ten-year government bonds of Italy, France, Belgium, and Germany. We use a state space model to decompose these changes into (i) a “benchmark” yield innovation, (ii) a yield spread common factor innovation, (iii) country-specific innovations, and (iv) (transitory) noise. We relate changes in each of these factors to national order imbalance and find that Italian order imbalance impacts the common factor innovation, French and Belgian order imbalance impact country-specific innovations, and German order imbalance only changes yields temporarily. Order imbalance, however, does not have explanatory power for the most important factor: benchmark yield innovations.
    Keywords: Government bond, order imbalance, euro, international.
    JEL: G10 G15 G18
    Date: 2004–08
  71. By: Jens Tapking (European Central Bank, DG Payment Systems and Market Infrastructure); Jing Yang (Bank of England)
    Abstract: This paper surveys intergenerational altruism in neoclassical growth models. It first examines Barro's approach to intergenerational altruism, whereby successive generations are linked by recursive altruistic preferences. Individuals have an altruistic concern only for their children, who in turn also have altruistic feelings for their own children. The conditions under which the Ricardian equivalence (debt neutrality) theorem applies are specified. The effectiveness of fiscal policy is further analysed in the context of an economy populated by heterogeneous families differing with respect to their degree of intergenerational altruism. Other forms of altruism, referred to as ad hoc altruism, are also examined, along with their implications for fiscal policy.
    Keywords: Securities trading and settlement, vertical and horizontal integration, substitutes and complements.
    JEL: G21 G15 L13
    Date: 2004–08
  72. By: Silvia Ardagna (Wellesley College, Department of Economics, 106 Central Street Wellesley, MA 02481, USA.)
    Abstract: Using a panel of OECD countries from 1960 to 2002, this paper shows that financial markets value fiscal discipline. Interest rates, particularly those of long-term government bonds, decrease when countries' fiscal position improves and increase around periods of budget deteriorations. Stock market prices surge around times of substantial fiscal tightening and plunge in periods of very loose fiscal policy. In addition, the paper shows that results depend on countries' initial fiscal conditions and on the type of fiscal consolidations. Fiscal adjustments that occur in country-years with high levels of government deficit, that are implemented by cutting government spending, and that generate a permanent and substantial decrease in government debt are associated with larger reductions in interest rates and increases in stock market prices.
    Keywords: Fiscal stabilizations; fiscal expansions; interest rates; stock market prices.
    JEL: E62 E44 H62
    Date: 2004–09
  73. By: Ulrich Bindseil (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); Andres Manzanares (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); Benedict Weller (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.)
    Abstract: This paper explores the role of central bank capital in ensuring that central banks focus on price stability in monetary policy decisions. The paper goes beyond the existing literature on this topic by developing a simple, but comprehensive, model of the relationship between a central bank's balance sheet structure and its inflation performance. The first part of the paper looks at solvency, i.e. under which conditions the "economic" capital (i.e. the discounted long term P&L) of a central bank always remains positive, despite adverse shocks, assuming a stability oriented monetary policy. The second part shows that in practice, capital is important for central banks beyond the issue of positive economic capital, when taking realistic assumptions regarding central bank independence. Capital thus remains a key tool to ensure that central banks are unconstrained in their focus on price stability in monetary policy decisions.
    Keywords: Central Bank Capital; Central Bank Independence.
    JEL: E42 E58
    Date: 2004–09
  74. By: Julius Moschitz (Universitat Autònoma de Barcelona, Dept. d’Economia i d’Història Econòmica, 08193 Bellaterra, Barcelona, Spain.)
    Abstract: The overnight interest rate is the price paid for one day loans and defines the short end of the yield curve. It is the equilibrium outcome of supply and demand for bank reserves. This paper models the intertemporal decision problems in the reserve market for both central and commercial banks. All important institutional features of the euro area reserve market are included. The model is then estimated with euro area data. A permanent change in reserve supply of one billion euro moves the overnight rate by eight basis points into the opposite direction, hence, there is a substantial liquidity effect. Most of the predictable patterns for the mean and the volatility of the overnight rate are related to monetary policy implementation, but also some calendar day effects are present. Banks react sluggishly to new information. Implications for market efficiency, endogeneity of reserve supply and underbidding are studied.
    Keywords: Money markets; EONIA rate; Liquidity effect; Central bank operating procedures.
    JEL: E52 E58 E43
    Date: 2004–09
  75. By: Ricardo de O. Cavalcanti; Andrés Erosa; Tod Temzelides (University of Pittsburg.)
    Abstract: We build on our earlier model of money in which bank liabilities circulate as medium of exchange, and investigate the provision of liquidity for a range of central-bank regulations dealing with the potential of bank failure. In our model, banks issue inside money under fractional reserves, facing the event of excess redemptions. They monitor the float of their money issue and make reserve-management decisions which affect aggregate liquidity conditions. Numerical examples demonstrate bank failure when returns to banking are low. Central-bank interventions, injecting more funds or making interest payments proportional to holdings of reserves, may improve banks’ returns and society’s welfare, followed by a reduction in bank failure.
    Keywords: Private money creation; liquidity.
    JEL: E4 E5
    Date: 2004–09
  76. By: Astrid Van Landschoot (National Bank of Belgium and Ghent University.)
    Abstract: In this paper, we investigate the determinants of the Euro term structure of credit spreads. More specifically, we analyze whether the sensitivity of credit spread changes to financial and macroeconomic variables depends on bond characteristics such as rating and maturity. According to the structural models and empirical evidence on credit spreads, we find that changes in the level and the slope of the default-free term structure, the market return, implied volatility, and liquidity risk significantly influence credit spread changes. The effect of these factors strongly depends on bond characteristics, especially the rating and to a lesser extent the maturity. Bonds with lower ratings are more affected by financial and macroeconomic news. Furthermore, we find that liquidity risk significantly increases credit spreads, especially on lower rated bonds.
    Keywords: Credit risk; Structural models; Nelson-Siegel.
    JEL: C22 E47 G15
    Date: 2004–10
  77. By: Yener Altunbas (Centre for Banking and Financial Studies, SBARD, University of Wales Bangor, Gwynedd, Bangor, LL57, 2DG, United Kingdom.); David Marqués Ibáñez (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.)
    Abstract: An unprecedented process of financial consolidation has taken place in the European Union over the past decade. Building on earlier US evidence, we examine the impact of strategic similarities between bidders and targets on post-merger financial performance. We find that, on average, bank mergers in the European Union resulted in improved return on capital. By making the assumption that balance-sheet resource allocation is indicative of the strategic focus of banks, we also find significantly different results for domestic and cross-border mergers. For domestic deals, it could be quite costly to integrate dissimilar institutions in terms of their loan, earnings, cost, deposits and size strategies. For cross-border mergers and acquisitions (M&As), differences of merging partners in their loan and credit risk strategies are conducive to a higher performance whereas diversity in their capital, cost structure as well as technology and innovation investments strategies are counterproductive from a performance standpoint.
    Keywords: Banks; M&As; strategic similarities.
    JEL: G21 G34
    Date: 2004–10
  78. By: Christian Ewerhart (Postal address for correspondence: Institute for Empirical Research in Economics, Winterthurerstrasse 30, CH-8006 Zurich, Switzerland;.); Nuno Cassola (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); Steen Ejerskov; Natacha Valla
    Abstract: In certain market environments, a large investor may benefit from building up a futures position first and trading subsequently in the spot market (Kumar and Seppi, 1992). The present paper identifies a variation of this type of manipulation that might occur in money markets with an interest rate corridor. We show that manipulation involving the use of central bank facilities would be observable only sporadically. The probability of manipulation decreases when the central bank uses an active liquidity management. Manipulation can also be reduced by widening the interest rate corridor.
    Keywords: Money market; corridor system; manipulation.
    JEL: D84 E52
    Date: 2004–10
  79. By: Robert-Paul Berben (De Nederlandsche Bank, Monetary and Economic Policy Department, Westeinde 1, P.O. Box 98, 1017 ZN Amsterdam, Netherlands.); Alberto Locarno (Banca d´Italia,Via Nazionale 91, 00184 Rome, Italy.); Julian Morgan (European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, Germany.); Javier Valles (Banco de España, Research Department, Alcalá 50, 28014 Madrid, Spain.)
    Abstract: This paper examines possible explanations for observed differences in the transmission of euro area monetary policy in central bank large-scale macroeconomic models. In particular it considers the extent to which these differences are due to differences in the underlying economies or (possibly unrelated) differences in the modelling strategies adopted for each country. It finds that, against most yardsticks, the cross-country variations in the results are found to be plausible in the sense that they correspond with other evidence or observed characteristics of the economies in question. Nevertheless, the role of differing modelling strategies may also play a role. Important features of the models - for instance in the treatment of expectations or wealth - can have a major bearing on the results that may not necessarily reflect differences in the underlying economies.
    Keywords: Monetary transmission; macroeconometric models; euro area differences.
    JEL: C53 E52 E37
    Date: 2004–10
  80. By: Leo Kaas (Department of Economics, University of Vienna, Hohenstaufengasse 9, 1010 Vienna, Austria.)
    Abstract: The paper analyzes how the removal of barriers to entry in banking affect loan competition, bank stability and economic welfare. We consider a model of spatial loan competition where a market that is served by less efficient banks is opened to entry by banks that are more efficient in screening borrowers. It is shown that there is typically too little entry and that market shares of entrant banks are too small relative to their socially optimal level. This is because efficient banks internalize only the private but not the public benefits of their better credit assessments. Only when bank failure is very likely or very costly, socially harmful entry can occur.
    Keywords: Entry deregulation; Bank competition.
    JEL: D43 D82 G21
    Date: 2004–11
  81. By: Giulia Iori (Department of Mathematics, Kings College Strand, London WC2R 2LS, United Kingdom.)
    Abstract: This paper compares securities settlement gross and netting architectures. It studies settlement risk arising from exogenous operational delays and compares settlement failures between the two architectures as functions of the length of the settlement interval under different market conditions. While settlement failures are non-monotonically related to the length of settlement cycles under both architectures, there is no clear cut ranking of which architecture delivers greater stability. We show that while, on average, netting systems seem to be more stable than gross systems, rare events may lead to contagious defaults that could affect the all system. Furthermore netting system are very sensitive to the number and initial distribution of traded shares.
    Keywords: Security clearing and settlement; gross and net systems; systemic risk.
    JEL: C6 D4 G20 O33
    Date: 2004–11
  82. By: Matthieu Bussière (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Winfried Koeniger (Institute for the Study of Labor (IZA), P.O. Box 7240, Schaumburg-Lippe Str. 7/9, D-53072 Bonn, Germany; Finance and Consumption in the EU, European University Institute.)
    Abstract: The academic literature has so far little to say about the underlying causes of the large structural asset and liability imbalances of emerging markets that frequently contributed to financial crises. The aim of the paper is to contribute to filling this gap by proposing a theoretical model that links currency and maturity mismatches with real volatility in the economy. We show that if (i) a significant share of the debt is denominated in foreign currency-creating a currency mismatch- and (ii) borrowing is constrained by solvency, then currency mismatch can create and exacerbate a maturity mismatch. An important feature of the model is that higher economic or political uncertainty tightens solvency constraints and tilts the debt profile towards short term debt, thereby increasing the volatility of output. Taking the model implications to the data, we find empirical support for the model’s predictions using data for 28 emerging market economies.
    Keywords: Maturity mismatch; currency mismatch; uncertainty; debt; emerging markets.
    JEL: F34 F36
    Date: 2004–11
  83. By: Francis Breedon (The Business School, Imperial College London, South Kensington Campus, 53 Prince’s Gate, London SW7 2AZ, United Kingdom); Paolo Vitale (Department of Economics and Land History, Gabriele D’Annunzio University, Viale Pindaro 42, 65127 Pescara, Italy)
    Abstract: We propose a simple structural model of exchange rate determination which draws from the analytical framework recently proposed by Bacchetta and van Wincoop (2003) and allows us to disentangle the liquidity and information effects of order flow on exchange rates. We estimate this model employing an innovative transaction data-set that covers all direct foreign exchange transactions completed in the USD/EUR market via EBS and Reuters between August 2000 and January 2001. Our results indicate that the strong contemporaneous correlation between order flow and exchange rates is mostly due to liquidity effects. This result also appears to carry through to the four FX intervention events that appear in our sample.
    Keywords: Order Flow; Foreign Exchange Micro Structure; Exchange Rate Dynamics.
    JEL: D82 G14 G15
    Date: 2004–12
  84. By: Darius P. Miller (Southern Methodist University, Cox School of Business); John J. Puthenpurackal (Ohio University)
    Abstract: This paper examines the potential benefits of security fungibility by conducting the first comprehensive analysis of Global bonds. Unlike other debt securities, Global bonds’ fungibility allows them to be placed simultaneously in bond markets around the world; they trade, clear and settle efficiently within as well as across markets. We test the impact of issuing these securities on firms’ cost of capital, issuing costs, liquidity and shareholder wealth. Using a sample of 230 Global bond issues by 94 companies from the U.S. and abroad over the period 1996-2003, we find that firms are able to lower their cost of (debt) capital by issuing these fungible securities. We also document that the stock price reaction to the announcement of Global bond issuance is positive and significant, while comparable domestic and Eurobond issues over the same time period are associated with insignificant changes in shareholder wealth.
    Keywords: Global bonds; security fungibility; cost of capital; international capital raising
    JEL: F3 G1 G3
    Date: 2005–01
  85. By: Karlo Kauko (Monetary Policy and Research Department, Bank of Finland)
    Abstract: Central securities depositories (CSDs) have opened mutual links, but most of them are seldom used. Why are idle links established? By allowing a foreign CSD to offer services through the link the domestic CSD invites competition. The domestic CSD can determine the cost efficiency of the rival by charging suitable fees, and prevent it from becoming more competitive than the domestic CSD. By inviting the competitor the domestic CSD can commit itself not to charge monopoly fees for secondary market services. This enables the domestic CSD to charge high fees in the primary market without violating investors’ participation constraints.
    Keywords: securities settlement systems, central securities depositories, network industries, access pricing
    JEL: G29 L13
    Date: 2005–01
  86. By: Vicente Pons-Sanz (Yale School of Management)
    Abstract: This paper uses a unique sample of 175 Spanish equity offerings from 1985 to 2002 to test who benefits from IPO underpricing and why. Institutions receive nearly 75% of the profits in underpriced issues, while they have to bear only 56% of the losses in overpriced offerings. Superior information regarding first day underpricing cannot completely explain the institutional abnormal profits. Underwriters are better informed about the companies they take public, and use that information to favor their long term clients. The preferential treatment of institutional investors, however, does not come at the expense of retail investors. Retail investors earn positive profits from participating in the new issues market. The driving factor behind the relative retail large allocation in overpriced issues when compared to underpriced offerings is not the underwriter allocation bias in favor of institutional investors. Retail investors subscribe more heavily to underpriced issues, consistent with individuals being partially informed.
    Keywords: Initial Public Offerings, Allocations, Retail Investors, Winner's Curse
    JEL: G32 G24
    Date: 2005–01
  87. By: Claudia M. Buch (Department of Economics, Eberhard Karls Universität Tübingen); John C. Driscoll (Federal Reserve Board); Charlotte Ostergaard (Department of Finance, Norwegian School of Management)
    Abstract: Taking the mean-variance portfolio model as a benchmark, we compute the optimally diversified portfolio for banks located in France, Germany, the U.K., and the U.S. under different assumptions about currency hedging. We compare these optimal portfolios to the actual cross-border assets of banks from 1995-1999 and try to explain the deviations. We find that banks over-invest domestically to a considerable extent and that cross-border diversification entails considerable gain. Banks underweight countries which are culturally less similar or have capital controls in place. Capital controls have a strong impact on the degree of underinvestment whereas less political risk increases the degree of over-investment.
    Keywords: International banking, portfolio diversification, international integration
    JEL: G21 G11 E44 F40
    Date: 2005–01
  88. By: Marco Da Rin (Department of Economics and Finance, Turin University); Giovanna Nicodano (Department of Economics and Finance, Turin University); Alessandro Sembenelli (Department of Economics and Finance, Turin University)
    Abstract: We study how public policy can contribute to increase the share of early stage and high-tech venture capital investments, thus helping the development of active venture capital markets. A simple extension of the seminal model by Holmstrom and Tirole (1997) provides a theoretical base for our analysis. We then explore a unique panel of data for 14 European countries between 1988 and 2001. We have several novel findings. First, the opening of stock markets targeted at entrepreneurial companies positively affects the shares of early stage and high-tech venture capital investments; reductions in capital gains tax rates have a similar, albeit weaker, effect. Second, a reduction in labor regulation creases the share of high-tech investments. Finally, we find no evidence of a shortage of supply of venture capital funds, and no evidence of an effect of increased public R&D spending on the share of high-tech or early stage venture capital investments.
    Keywords: Venture Capital; Capital Gains Tax; Public R&D Expenditure; Barriers to Entrepreneurship; Stock Markets; Public Policy
    JEL: G10 G24 H20 O30
    Date: 2005–01
  89. By: Giacomo Calzolari (Department of Economics, University of Bologna); Gyöngyi Lóránth (London Business School)
    Abstract: This paper examines prudential regulation of a multinational bank (MNB hereafter) and shows how regulatory intervention depends on the liability structure and insurance arrangements for non local depositors (i.e. on the representation form for foreign units). Shared liability among the MNB’s units gives higher incentives for regulatory intervention than when units are legally separate entities. Cross-border deposit insurance provides lower incentives to intervene than when the regulator only has to compensate local depositors. We study the impact of shared liability and deposit insurance arrangements on regulators’ incentives to monitor and acquire information on MNB’s activities. Furthermore, by describing regulatory intervention and monitoring we also draw implications on the MNB’s preferences over the form representation for foreign units, and discuss the effects of regulators’ behavior on both MNB’s lobbying and international resources shifting.
    Keywords: Multinational Banks, Prudential Regulation, Representation Form, Subsidiary, Branch
    JEL: L51 F23 G21 G28
    Date: 2005–01
  90. By: Yiu Chung Cheung (Department of Financial Management, University of Amsterdam); Frank de Jong (Faculty of Economics and Econometrics, University of Amsterdam); Barbara Rindi (Department of Economics, Bocconi University)
    Abstract: We study the microstructure of the MTS Global Market bond trading system, which is the largest interdealer trading system for Eurozone government bonds. Using a unique new dataset we find that quoted and effective spreads are related to maturity and trading intensity. Securities can be traded on a domestic and EuroMTS platform. We show that despite the apparent fragmentation of trading, both platforms are closely connected in terms of liquidity. We also study the intraday price-order flow relation in the Euro bond market. We estimate the price impact of order flow and control for the intraday trading intensity and the announcement of macroeconomic news. The regression results show a larger impact of order flows during announcement days and a higher price impact of trading after a longer period of inactivity. We relate these findings to interdealer trading and to the structure of European bond markets.
    Keywords: Bonds markets, Microstructure, Order flow
    JEL: F31 C32
    Date: 2005–01
  91. By: Elias Papaioannou (London Business School)
    Abstract: This paper uses a large panel of bilateral bank flow data to assess how institutions and politics affect international capital -bank in particular- flows. The following key findings emerge: 1) The empirical "gravity" model is the benchmark in explaining the volume of international banking activities. 2) Conditioned on standard gravity factors (distance, GDP, population), well-functioning institutions are a key driving force for international bank flows. Specifically, foreign banks invest substantially more in countries with i) uncorrupt bureaucracies, ii) high-quality legal system, and iii) a non-government controlled banking system. 3) Beyond institutions, politics exert also a firstorder impact. 4) The European Integration process has spurred cross-border banking activities between member states. These results are robust to various econometric methodologies, samples and the potential endogeneity of institutional characteristics. The strong institutions/politics-bank flows nexus has strong implications for asset trade and international macro theories, which have not modelled these relationships explicitly.
    Keywords: banks, capital flows, institutions, law and finance, politics
    JEL: F34 F21 G21 K00
    Date: 2005–02
  92. By: Vincent Brousseau (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Andrés Manzanares (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper studies frictions in the euro area interbank deposit overnight market, making use of high frequency individual quote and trade data. The aim of the analysis is to determine, in a quantitative way, how efficient this market is. Besides a comprehensive descriptive analysis, the approach used defines a measure of the friction arising for each single transaction, by which we understand an (small) initial loss accepted by a counterparty, and the corresponding gain made by the other counterparty. The evolution of total daily frictions is then put into perspective comparing it with the frictions arising if flows corresponded to the optimal solution of a “cash transportation problem”. The main conclusions of this exercise are that overall frictions, although small in absolute size, tend to increase strongly whenever the overnight rate becomes volatile. Some tentative explanations for this are given, relying on the introduced methodology.
    Keywords: Financial market microstructure; Money Market; Market friction; Network optimization problems.
    JEL: D4 E52 C61
    Date: 2005–02
  93. By: Olli Castrén (External Developments Division, DG-Economics, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper uses data on currency options prices for the exchange rates of the three largest new EU member states Poland, Czech Republic and Hungary vis-à-vis the euro and the US dollar to estimate the risk-neutral density (RND) functions and the density interval bands. Analysing the RNDs, we find that only some of the implied moments on the Polish zloty exchange rate systematically move around policy events, while the implied moments on the RNDs on the Czech koruna and Hungarian forint show more systematic changes. Regarding the HUF/EUR currency pair, monetary policy news have a significant impact on all moments, while changes in implied standard deviation signal a higher probability of interest rate changes by the Hungarian central bank. The more marked results for HUF/EUR exchange rate could reflect the fixed exchange rate regime prevailing throughout the sample period.
    Keywords: Foreign exchange rate market sentiment; monetary policy news; currency options data.
    JEL: E52 F31 G15
    Date: 2005–02
  94. By: Cyril Monnet (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Erwan Quintin (Federal Reserve Bank of Dallas, 2200 N. Pearl St., Dallas,TX 75201, USA.)
    Abstract: We describe a dynamic model of financial intermediation in which fundamental characteristics of the economy imply a unique equilibrium path of bank and financial market lending. Yet we also show that economies whose fundamental characteristics have converged may continue to have very different financial structures. Because setting up financial markets is costly in our model, economies that emphasize financial market lending are more likely to continue doing so in the future, all else equal.
    Keywords: Financial Systems; Financial Markets; Financial Institutions; Banks; Convergence.
    JEL: L16 G10 G20 N20
    Date: 2005–02
  95. By: Olli Castrén (Corresponding author: DG-Economics, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Stefano Mazzotta (McGill University - Faculty of Management, 1001 Sherbrooke St.West, Montreal, Quebec H3A1G5, Canada.)
    Abstract: We compare option-implied correlation forecasts from a dataset consisting of over 10 years of daily data on over-the-counter (OTC) currency option prices to a set of return-based correlation measures and assess the relative quality of the correlation forecasts. We find that while the predictive power of implied correlation is not always superior to that of returns based correlations measures, it tends to provide the most consistent results across currencies. Predictions that use both implied and returns-based correlations generate the highest adjusted R2s, explaining up to 42 per cent of the realised correlations. We then apply the correlation forecasts to two policyrelevant topics, to produce scenario analyses for the euro effective exchange rate index, and to analyse the impact on cross-currency co-movement of interventions on the JPY/USD exchange rate.
    Keywords: Correlation forecasts; currency options data; effective exchange rate.
    JEL: F31 G15
    Date: 2005–02
  96. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt, Germany); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Roberto Rigobon (Massachusetts Institute of Technology, Cambridge MA 02142-1347, USA.)
    Abstract: The paper presents a framework for analyzing the degree of financial transmission between money, bond and equity markets and exchange rates within and between the United States and the euro area. We find that asset prices react strongest to other domestic asset price shocks, and that there are also substantial international spillovers, both within and across asset classes. The results underline the dominance of US markets as the main driver of global financial markets - US financial markets explain, on average, more than 25% of movements in euro area financial markets, whereas euro area markets account only for about 8% of US asset price changes. The international propagation of shocks is strengthened in times of recession, and has most likely changed in recent years - prior to EMU, the paper finds smaller international spillovers.
    Keywords: International financial markets; integration; transmission; financial market linkages; identification; heteroskedasticity; asset pricing; United States; euro area.
    JEL: E44 F3 C5
    Date: 2005–03
  97. By: Joseph G. Pearlman (London Metropolitan University – Department of Economics, Finance and International Business (EFIB), 84 Morgate, London EC2M 6SQ, United Kingdom.)
    Abstract: We investigate the role of economic transparency within the framework of one of Townsend’s models of ‘forecasting the forecasts of others’. The equilibrium has the property that ‘higher order beliefs’ are coordinated into a finite-dimensional setup that is amenable to address monetary policy issues. We focus here on the role of public information about the money supply, and find that it should be fully revealing.
    Keywords: Transparency; central banks; asymmetric information; public information.
    JEL: D82 E58
    Date: 2005–03
  98. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper assesses the change in Federal Reserve policy introduced in 1999, with the publication of statements about the outlook for monetary policy (and later about the balance of risks) immediately after each FOMC meeting. We find that markets anticipated monetary policy decisions equally well under this new disclosure regime than before, but arrived at their expectations in different ways. Under the new regime, markets extract information from the statements, whereas before, they needed to revert to other types of Fed communication in the inter-meeting periods, and come to their own assessment of the implications of macroeconomic data releases. Taken together, these findings suggest that the Fed's new disclosure practice may indeed have improved transparency in the sense that information is now released to the markets at an earlier time and with clearer signals, but that the Fed can extract less information from observing market reactions to macroeconomic data releases.
    Keywords: Transparency; monetary policy; announcements; communication; disclosure.
    JEL: E43 E52 E58 G12
    Date: 2005–03
  99. By: Marcus Miller (Department of Economics, University of Warwick, Coventry, CV47AL, England, CSGR and CEPR.); Olli Castrén (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany); Lei Zhang (Corresponding author: Department of Economics, University of Warwick, Coventry, CV47AL, England, and CSGR.)
    Abstract: In an analytically tractable model of the global economy, we calculate the Pareto improvement where a country experiencing a favourable supply side shock consumes more against expected future output and spreads the risk by selling shares. With capital inflows to finance the ‘New Economy’ significantly exceeding the current account deficit, however, we show that selling shares globally at inflated prices – due to ‘irrational exuberance’ and distorted corporate incentives – can generate significant international transfers when the asset bubble bursts. The analysis complements recent econometric studies which appeal to financial factors to explain why the European economy was so strongly affected by the recent US downturn.
    Keywords: Capital flows; moral hazard; international transmission of shocks.
    JEL: F41 F32 G15
    Date: 2005–03
  100. By: Carlos Bernadell (European Central Bank, Kaiserstraße 29, D-60311 Frankfurt am Main, Germany); Joachim Coche (European Central Bank, Kaiserstraße 29, D-60311 Frankfurt am Main, Germany); Ken Nyholm (European Central Bank, Kaiserstraße 29, D-60311 Frankfurt am Main, Germany)
    Abstract: This paper presents a new framework allowing strategic investors to generate yield curve projections contingent on expectations about future macroeconomic scenarios. By consistently linking the shape and location of yield curves to the state of the economy our method generates predictions for the full yield-curve distribution under different assumptions on the future state of the economy. On the technical side, our model represents a regimeswitching expansion of Diebold and Li (2003) and hence rests on the Nelson-Siegel functional form set in state-space form. We allow transition probabilities in the regimeswitching set-up to depend on observed macroeconomic variables and thus create a link between the macro economy and the shape and location of yield curves and their time-series evolution. The model is successfully applied to US yield curve data covering the period from 1953 to 2004 and encouraging out-of-sample results are obtained, in particular at forecasting horizons longer than 24 months.
    Keywords: Regime switching; scenario analysis; yield curve distributions; state space model.
    JEL: C51 C53 E44
    Date: 2005–04
  101. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany)
    Abstract: The paper assesses the communication strategies of the Federal Reserve, the Bank of England and the European Central Bank and their effectiveness. We find that the effectiveness of communication is not independent from the decisionmaking process in the committee. The paper shows that the Federal Reserve has been pursuing a rather individualistic communication strategy amid a collegial approach to decision-making, while the Bank of England is using a collegial communication strategy and highly individualistic decision-making. The ECB has chosen a collegial approach both in its communication and in its decisionmaking. Assessing these strategies, we find that predictability of policy decisions and the responsiveness of financial markets to communication are equally good for the Federal Reserve and the ECB. This suggests that there may not be a single best approach to designing a central bank communication and decisionmaking strategy.
    Keywords: Communication; monetary policy; committee; effectiveness; strategies; Federal Reserve; Bank of England; European Central Bank.
    JEL: E43 E52 E58 G12
    Date: 2005–05
  102. By: Katrin Tinn (London School of Economics, Financial Markets Group, Houghton Street, London, WC2A 2AE, United Kingdom)
    Abstract: This paper investigates prices and endogenous research decision for financial assets. In rational expectations models with public information, higher order beliefs make investors to overweight the public information relative to underlying fundamentals. The extent of this mispricing is higher if the variance of private signals is relatively high. The model presented in this paper extends this setting by incorporating the research cost decision and endogenising the variance of the private signals that short-lived investors obtain in each period. It turns out that investors will be less willing to research in periods when there is an alternative asset with high return available. Furthermore, the optimal research decision will depend on the time left to the maturity of the asset. This explains, in a rational setting, why long lived assets like stocks may be priced based on the public information rather than research on fundamentals.
    Keywords: Financial markets imperfections; heterogeneous information; research costs.
    JEL: G12 G14
    Date: 2005–06
  103. By: Mariassunta Giannetti (Stockholm School of Economics, ECGI, and CEPR, Department of Finance and SITE, PO Box 6501, S 11 383 Stockholm, Sweden); Steven Ongena (CentER – Tilburg University and CEPR, Department of Finance, PO Box 90153, NL 5000 LE Tilburg,The Netherlands)
    Abstract: An extensive empirical literature has documented the positive growth effects of equity market liberalization. However, this line of research ignores the impact of financial integration on a category of firms crucial for economic development, i.e. the small entrepreneurial firms. This paper aims to fill this void. We employ a large panel containing almost 60,000 firm–year observations on listed and unlisted companies in Eastern European economies to assess the differential impact of foreign bank lending on firm growth and financing. Foreign lending stimulates growth in firm sales, assets, and leverage, but the effect is dampened for small firms. We also find that firms started during the transition period of 1989-1993 – arguably the most connected businesses – benefit least from foreign bank entry. This finding suggests that foreign banks can help mitigate connected lending problems and improve capital allocation.
    Keywords: Foreign bank lending; emerging markets; competition; lending relationships.
    JEL: G21 L11 L14
    Date: 2005–06
  104. By: André Meier (European University Institute,Via della Piazzuola 43, 50133 Firenze, Italy); Gernot J. Müller (Goethe University Frankfurt, Mertonstr. 17, 60054 Frankfurt am Main, Germany)
    Abstract: Financial frictions affect the way in which different components of GDP respond to a monetary policy shock. We embed the financial accelerator of Bernanke, Gertler and Gilchrist (1999) into a medium-scale Dynamic General Equilibrium model and evaluate the relative importance of financial frictions in explaining monetary transmission. Specifically, we match the impulse responses generated by the model with empirical impulse response functions obtained from a vector autoregression on US time series data. This allows us to provide estimates for the structural parameters of our model and judge the relevance of different model features. In addition, we propose a set of simple and instructive specification tests that can be used to assess the relative fit of various restricted models. Although our point estimates suggest some role for financial accelerator effects, they are actually of minor importance for the descriptive success of the model.
    Keywords: Monetary Policy; Output Composition; Financial Frictions; Minimum Distance Estimation.
    JEL: E32 E44 E51
    Date: 2005–07
  105. By: Andrea Ferrero (Department of Economics, New York University, 269 Mercer Street – 7th floor, New York, NY 10003, USA)
    Abstract: This paper addresses the question of the joint conduct of fiscal and monetary policy in a currency union. The problem is studied using a two-country DSGE framework with staggered price setting, monopolistic competition in the goods market, distortionary taxation and nominal debt. The two countries form a currency union but retain fiscal policy independence. The policy problem can be cast in terms of a tractable linear-quadratic setup. The stabilization properties and the welfare implications of the optimal commitment plan are compared with the outcome obtained under simple implementable rules. The central result is that fiscal policy plays a key role to smooth appropriately the impact of idiosyncratic exogenous shocks. Fiscal rules that respond to a measure of real activity have the potential to approximate accurately the optimal plan and lead to large welfare gains as compared to balanced budget rules. Monetary policy shall focus on maintaining price stability.
    Keywords: Currency Union; Optimal Policy; Flexibility; Welfare.
    JEL: E63 F33 F42
    Date: 2005–07
  106. By: Matthieu Bussière (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany); Gernot J. Müller (Goethe University Frankfurt, Mertonstr. 17, D-60325 Frankfurt am Main, Germany)
    Abstract: Currently the U.S. is experiencing record budget and current account deficits, a phenomenon familiar from the "Twin Deficits" discussion of the 1980s. In contrast, during the 1990s productivity growth has been identified as the primary cause of the US current account deficit. We suggest a theoretical framework which allows to evaluate empirically the relative importance of budget deficits and productivity shocks for the determination of the current account. Using a sample of 21 OECD countries and time series data from 1960 to 2003 we find little evidence for a contemporaneous effect of budget deficits on the current account, while country-specific productivity shocks appear to play a key role.
    Keywords: Current account, productivity, investment, budget deficit.
    JEL: E62 F32 F41
    Date: 2005–08
  107. By: Zheng Liu (Department of Economics, Emory University,Atlanta, GA 30322, USA, and CIRPÉE, Canada); Evi Pappa (Department of Economics,The London School of Economics and Political Science, Houghton Street, London WC2A 2AE, UK, and IGIER – Bocconi University and CEP, Italy)
    Abstract: This paper presents a new argument for international monetary policy coordination based on considerations of structural asymmetries across countries. In a two-country world with a traded and a non-traded sector in each country, optimal independent monetary policy cannot replicate the natural-rate allocations. There are potential welfare gains from coordination since the planner under a cooperating regime internalizes a terms-of-trade externality that independent central banks tend to overlook. Yet, with symmetric structures across countries, the gains are quantitatively small. If the size of the traded sector differs across countries, the gains can be sizable and increase with the degree of asymmetry. The planner's optimal policy not only internalizes the terms-of-trade externality, it also creates a terms-of-trade bias in favor the country with a larger traded sector. Further, the planner tries to balance the terms-of-trade bias against the need to stabilize fluctuations in the terms-of-trade gap.
    Keywords: International Policy Coordination; Optimal Monetary Policy; Asymmetric Structures; Terms-of-Trade Bias.
    JEL: E52 F41 F42
    Date: 2005–08
  108. By: Alain Durré (European Central Bank); Pierre Giot (Department of Business Administration & CEREFIM, University of Namur and CORE at Université catholique de Louvain.)
    Abstract: This paper assesses the possible contemporaneous relationship between stock index prices, earnings and long-term government bond yields for a large number of countries and over a time period that spans several decades. In a cointegration framework, our analysis looks at three hypotheses. First, is there a long-term contemporaneous relationship between earnings, stock prices and government bond yields? Second, does a deviation from this possible long-run equilibrium impact stock prices such that the equilibrium is restored? Third, do government bond yields play a significant role in the long-run relationship or does the latter only involve stock prices and earnings? We also study the short-term impact of changes in long-term government bond yields on stock prices and discuss our short-term and long-term results in light of the recent developments regarding the so-called Fed model.
    Keywords: Stock indexes; earnings; long-run relationships; interest rates; inflation; market valuation.
    JEL: C13 C22 F31 G14
    Date: 2005–08
  109. By: Patrick Van Roy (European Centre for Advanced Research in Economics and Statistics (ECARES),Universite Libre de Bruxelles)
    Abstract: This paper simulates the minimum capital requirements for the wholesale exposures of a medium-sized bank in each EMU country depending on the credit rating agencies chosen by the bank to risk-weight its exposures in the standardised approach to credit risk in Basel II. Three main results emerge from the analysis. First, although the use of different combinations of credit rating agencies leads to significant differences in minimum capital requirements, these differences never exceed 10 percent of EMU banks’ regulatory capital for wholesale exposures on average. Second, the standardised approach provides a small regulatory capital incentive for banks to use several credit rating agencies to risk-weight their exposures. Third, the minimum capital requirements for the wholesale exposures of EMU banks will be higher in Basel II than in Basel I. I also show that the incentive for banks to engage in regulatory arbitrage in the standardised approach to credit risk is limited.
    Keywords: New Basel Capital Accord; capital requirements; credit rating agencies.
    JEL: G21 G28
    Date: 2005–08
  110. By: Gabe de Bondt (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Benoit Mojon (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Natacha Valla (Banque de France, B.P. 140-01, 75049 Paris Cedex 01, France.)
    Abstract: This paper analyses the pricing of bank loans and deposits in euro area countries. We show that retail bank interest rates adjust not only to changes in short-term interest rates but also to long-term interest rates. This result, which is arguably intuitive for long-term retail bank rates, is also confirmed for bank interest rates on short-term instruments. The transmission of changes in short-term market interest rates along the yield curve is found to be a key factor explaining the sluggishness of retail bank interest rates. We also show that in the cases where we cannot reject that the adjustment of retail rates has changed since the introduction of the euro, this adjustment has become faster.
    Keywords: Retail bank interest rates; market interest rates; euro area countries.
    JEL: E43 G21
    Date: 2005–09
  111. By: Rui Albuquerque (Boston University School of Management, 595 Commonwealth Avenue, Boston, MA 02215, USA.); Gregory H. Bauer (William E. Simon Graduate School of Business Administration, Carol Simon Hall, University of Rochester, Rochester, NY 14627, USA.); Martin Schneider (Department of Economics at New York University, 9 Mercer St., 7th floor, New York, NY 10003, USA.)
    Abstract: This paper considers the role of foreign investors in developed-country equity markets. It presents a quantitative model of trading that is built around two new assumptions: (i) both the foreign and domestic investor populations contain investors of different sophistication, and (ii) investor sophistication matters for performance in both public equity and private investment opportunities. The model delivers a unified explanation for three stylized facts about US investors’ international equity trades - (i ) trading by US investors occurs in bursts of simultaneous buying and selling, (ii ) Americans build and unwind foreign equity positions gradually and (iii ) US investors increase their market share in a country when stock prices there have recently been rising. The results suggest that heterogeneity within the foreign investor population is much more important than heterogeneity of investors across countries.
    Keywords: Asymmetric information; Heterogenous investors; Asset pricing; International equity flows; International equity returns.
    JEL: F30 G12 G14 G15
    Date: 2004–02
  112. By: Ulrich Bindseil (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Tobias Linzert (Goethe University Frankfurt, Department of Economics, Mertonstr. 17-21, 60054 Frankfurt am Main, Germany.); Dieter Nautz (Goethe University Frankfurt, Department of Economics, Mertonstr. 17-21, 60054 Frankfurt am Main, Germany.)
    Abstract: This paper employs individual bidding data to analyze the empirical performance of the longer term refinancing operations (LTROs) of the European Central Bank (ECB). We investigate how banks’ bidding behavior is related to a series of exogenous variables such as collateral costs, interest rate expectations, market volatility and to individual bank characteristics like country of origin, size, and experience. Panel regressions reveal that a bank’s bidding depends on bank characteristics. Yet, different bidding behavior generally does not translate into differences concerning bidder success. In contrast to the ECB’s main refinancing operations, we find evidence for the winner’s curse effect in LTROs. Our results indicate that LTROs do neither lead to market distortions nor to unfair auction outcomes.
    Keywords: Monetary Policy Instruments of the ECB; Auctions; Winner’s Curse; Panel Analysis of Bidding Behavior.
    JEL: E52 D44
    Date: 2004–05
  113. By: Peter Galos; Kimmo Soramäki (Corresponding author: Directorate General Payment Systems and Market Infrastructures, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
    Abstract: The paper analyses the consequences of an isolated, sudden and unexpected failure of a bank in alternative interbank payment system designs. We assess the exposures and the contagion by a counterfactual analysis assuming that payments currently settled by the pan-European large-value payment system, TARGET, are settled in alternative payment systems - an unsecured end-of-day net settlement system and a secured net settlement system with limits on intraday credit, with collateral and loss-sharing. The results indicate that systemic consequences of one bank's failure on the solvency of other banks can be rather low. If risk management techniques such as legal certainty for multilateral netting, limits on exposures, collateralisation and loss sharing are introduced, the systemic consequences can be mitigated to a high degree. How, and under which circumstances the analyzed failures would render other banks illiquid to meet their payment obligations is outside the scope of the paper.
    Keywords: Payment systems, Systemic risk, TARGET, Contagion.
    JEL: E42 G21
    Date: 2005–07

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