nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒03‒31
five papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Term Structure Forecasting: No-Arbitrage Restrictions vs Large Information Set By Favero, Carlo A; Niu, Linlin; Sala, Luca
  2. Explaining the US Bond Yield Conundrum By Bandholz, Harm; Clostermann, Joerg; Seitz, Franz
  3. The Equity Premium: UK Industry Evidence. By Andrew Vivian
  4. Linear cointegration of nonlinear time series with an application to interest rate dynamics By Barry E. Jones; Travis D. Nesmith
  5. A General Formula for the WACC: A Reply By André Farber; Roland Gillet; Ariane Szafarz

  1. By: Favero, Carlo A; Niu, Linlin; Sala, Luca
    Abstract: This paper addresses the issue of forecasting the term structure. We provide a unified state-space modelling framework that encompasses different existing discrete-time yield curve models. Within such framework we analyze the impact on forecasting performance of two crucial modelling choices, i.e. the imposition of no-arbitrage restrictions and the size of the information set used to extract factors. Using US yield curve data, we find that: a. macro factors are very useful in forecasting at medium/long forecasting horizon; b. financial factors are useful in short run forecasting; c. no-arbitrage models are effective in shrinking the dimensionality of the parameter space and, when supplemented with additional macro information, are very effective in forecasting; d. within no-arbitrage models, assuming time-varying risk price is more favourable than assuming constant risk price for medium horizon-maturity forecast when yield factors dominate the information set, and for short horizon and long maturity forecast when macro factors dominate the information set; e. however, given the complexity and the highly non-linear parameterization of no-arbitrage models, it is very difficult to exploit within this type of models the additional information offered by large macroeconomic datasets.
    Keywords: factor models; forecasting; large data set; term structure of interest rates; Yield curve
    JEL: C33 C53 E43 E44
    Date: 2007–03
  2. By: Bandholz, Harm; Clostermann, Joerg; Seitz, Franz
    Abstract: We analyze if and to what extent fundamental macroeconomic factors, temporary influences or more structural factors have contributed to the low levels of US bond yields over the last few years. For that purpose, we start with a general model of interest rate determination. The empirical part consists of a cointegration analysis with an error correction mechanism. We are able to establish a stable long-run relationship and find that the behavior of bond yields, even during the last two years, can well be explained. Alongside the more traditional macroeconomic determinants like core inflation, monetary policy and the business cycle, we also include foreign holdings of US Treasuries. The latter should capture the frequently mentioned structural effects on long-term interest rates. Finally, our bond yield equation outperforms a random walk model in different forecasting exercises.
    Keywords: bond yields; interest rates; cointegration; inflation; forecasting
    JEL: E47 E43
    Date: 2007–02
  3. By: Andrew Vivian
    Abstract: Recent US research has suggested that market expected returns have fallen. Most studies propose this fall in market expected returns occurred during the 1990’s. Our UK empirical analysis finds a fall in expected returns in the 1990’s for the market index, but, in general, this is not evident across many segments of the market. Specifically,we find for the majority of UK industries a) over recent decades there has not been a general or overall fall in expected returns and b) there was not a common decline in expected returns during the 1990’s. We propose changing industry composition of the market portfolio rather than a decline in systematic risk is primarily responsible for this recent proposed fall in value-weighted market returns.
    Keywords: Equity Premium, Declining Returns, Industry Composition.
    JEL: G12 G15
    Date: 2007–03
  4. By: Barry E. Jones; Travis D. Nesmith
    Abstract: We derive a definition of linear cointegration for nonlinear stochastic processes using a martingale representation theorem. The result shows that stationary linear cointegrations can exhibit nonlinear dynamics, in contrast with the normal assumption of linearity. We propose a sequential nonparametric method to test first for cointegration and second for nonlinear dynamics in the cointegrated system. We apply this method to weekly US interest rates constructed using a multirate filter rather than averaging. The Treasury Bill, Commerical Paper and Federal Funds rates are cointegrated, with two cointegrating vectors. Both cointegrations behave nonlinearly. Consequently, linear models will not fully relicate the dynanics of monetary policy transmission.
    Keywords: Time-series analysis ; Cointegration ; Interest rates
    Date: 2006
  5. By: André Farber (Centre Emile Bernheim, Solvay Business School, Université Libre de Bruxelles, Brussels.); Roland Gillet (Université Paris1-Panthéon-Sorbonne, Paris and Centre Emile Bernheim, Solvay Business School, Université Libre de Bruxelles, Brussels); Ariane Szafarz (Centre Emile Bernheim, Solvay Business School, Université Libre de Bruxelles, Brussels, and DULBEA, Université Libre de Bruxelles.)
    Abstract: Farber, Gillet and Szafarz (2006) propose a general formula for the WACC in which the expected return on the tax shield appears explicitly. The classical Modigliani-Miller and Harris-Pringle WACC formulas for specific debt policies are then derived from the general formula after having determined the corresponding tax shield expected returns. Replying to Fernandez’ (2007) comment, this note explores, in addition, the validity of the general formula in the Miles-Ezzel setup with annual adjustment of the level of debt to maintain a constant market-value debt ratio.
    Keywords: WACC, value of tax shield.
    JEL: G30 G32 E22
    Date: 2007–03

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