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j Dalvi Abstract In recent years, there has been renewed interest in the yield curve as a predictor of future economic activity. In this paper, we re-examine the evidence for this predictor for the Indian market. The paper tries to indicate how the yield curve spread in a government securities market may be used to indicate the future economic activity in an economy like India. The slope of the yield curve has often been considered as a leading economic indicator. The study suggests that the yield curve spread measured by the difference in the spot rates of 10-year and 3 months have predictive power to estimate the economic activity in terms of Index of Industrial production. Using the yield curve data from 1997-2011, the study has found that the yield curve spread can be used to estimate future economic activity.

Key words: Predicting power of Yield Curve, Indian Yield Curve, Inflation expectation, Recession, Industrial Production, IIP, Yield Spread, Probit Model, Logit Model

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1. Introduction

The pricing of fixed income instruments both sovereign and corporate is centered around the yield curve. The yield curve is used not only by market participants but also by the policy makers to figure out the scope of recession in particular and the shape of the economy in general. Market participants take positions in the market assuming that a unique interest rate is mapped to a specific maturity of a debt paper in a particular class and combining all the possible maturities against their corresponding yields in the same class results in a continuous curve that can be constructed that can describe the spot interest rate for each maturity. This is commonly called term structure of interest rates and very widely followed by all. As bonds of all maturities do not either exist or traded, it is a common practice to use various methods like bootstrapping or well accepted term structure models like Nelson, and Siegel, Nelson, Siegel and Svensson, Splines, etc. to construct a reasonably correct yield curve to represent the state of interest rate in the economy. Sovereign Bond yields are the building blocks of the term structure theories. It is extremely important to have a well-developed sovereign bond market so that a reasonably good sovereign yield curve can be constructed to helps banks to value their portfolio of sovereign bonds. The term structure of interest rates has important place in the financial market as all financial instruments are priced off the sovereign yield curve topping up with appropriate credit spread for the class. The spot yield curves can be used to construct the forward interest rates for various terms and these forward rates given expectation of the market participants about the future. Hence these indications are used by central banks in framing the monetary policy.

Simply put, a forward rate is an interest rate which starts on a future date for a particular term and ends at a date beyond that. Typically, market participants use implied forward rates estimated from the spot yield curve. This clearly implies that the spot curves shape most likely reflects market participants expectation of future interest rates. This is the logic of using spot rate to estimate the implied forwards. The information content and predictive

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power of a spot curve is based on the above premise. Forward rates indicate market participants of expected future inflation levels. Monetary authorities like central banks have a preference to look up forward rates for policy analysis. The forward curve can be split into short term and long-term segments in a more straightforward manner than the spot curve as the spot represent the expected average of forward rates.

Because of the central role it plays in pricing debt instruments, the spot curve need to be estimated with great deal of accuracy without which the valuation models will suffer from mispricing leading to unstable book values for banks as well for the policy makers. Invariably researchers use the government debt market as the basis for modelling the term structure. This is because the government market is the most liquid debt market in any country, and also because (in a developed economy) government securities are default-free, so that government borrowing rates are considered risk-free.

The motivation for studying the yield spread is of manifold. First, policy makers often need to make decisions today, based on expectations regarding future economic conditions. Although policymakers rely on a range of data and methods in forecasting possible future scenarios, movements in the yield curve have in the past proved useful, and could still represent a useful additional tool. Second, variations in the correlations between asset prices and economic activity might explain the workings of the macro-economy. Short term interest rate is typically lower in an economic downturn because decreased economic activity decreases private sector demand for credit; at the same time the monetary authority is likely to have decreased the policy rate in response to the slowdown. Further, the monetary authorities raise rates that precipitate the subsequent slowdown.

The purpose of this paper is to indicate how the yield curve spread in a government securities market may be used to indicate the future economic activity in an economy. The paper has been organized into sections to focus on some of the central aspects of the study. Section II describes the justification for using the spot yield curve as vehicle for deriving

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forward rates, allowing us to conclude that a spot curve has predictive content. Section III uses some historical examples of where curves predicted future short-rates, while section IV demonstrates the predictive power of the yield curve, section V explains the linkage of economic activity with spread, section VI demonstrates the Probit/Logit models using the spread to figure out recession, and section VII gives the concluding remarks.

2. Yield Curve Concepts

The term structure of spot rates depict a very consistent bundle of discount rates for all sovereign bonds through bonds observed prices are not consistent with the discount rates due to many idiosyncratic factors pertaining to a bond. Many bonds depict observed prices which are either rich or cheap to the curve due to bond specific reasons like liquidity, onthe-run, off-the-run, coupon, outstanding issues, auction factors, etc. The spot rate is the discount rate if a single future cash flow such as a T-bill. A multi period spot rate may be bifurcated into a product of one year forward rates. Hence, a given term structure of spot rates implies a specific term structure of forward rates if the 1-year and 2-year spot rates are given to us, we can easily figure out the annualized forward rate between 1 and 2 year. To generalize, we can put the same as

Any forward rate can be blocked today by simply buying x-period bullet cash flow at price with x=0 and hence and shorting units of bullet of y-year at price

. The spot rate can also be construed as a special case of forward rate .

Consistent with this approach, a market participant can take the observed prices (yields) of the bonds traded in the market and construct an average representative sovereign YTM curve using boot strapping. Using the said prices or yields, we can use various techniques and models to estimate a term structure of spot rates from where we can construct the noarbitrage implied one-year forward rate streams for the market. Alternatively, we can think

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the sovereign YTM curve as Par curve in the sense if the YTM curve is perfect representation of all information, and if Government decides to issue bonds across all maturities starting with one year and ending with the last point of the curve with an in between gap of 1 year, it will issue bonds at Par (100) with coupon equating with the yield. If Par curve would have been available in the market, then it would have been the best possible scenario but due to many idiosyncratic factors, we very rarely observe Par curves in emerging market like India.

Typically spot curve lies above the Par curve and forward is on top of spot. Order can be reversed when the spot curve is inverted. Intuitively, characterization of one curve is applicable to other curves. One year forward rates measure the marginal compensation for extending the maturity of an investment by one year whereas the spot is an average reward for the period. Hence spot rates are geometric average of one or more forward rates. Similarly, Par rate is average of one or more spot rates. The forward rates can be seen as break-even rates.

The spot and implied forward rate relationship can be best explained with an example. Suppose, we have 1-year spot rate at 7.5% and 2-year spot rate at 8.0%. The implied forward starting 1-year from now and ending 2-years from now (1-year from 1-year from now) is 8.50%. That implies, an investor investing in a zero (FV=100) for 2 years will have a value of 92.1639 at the beginning of second years. Using the spot rate, the present value of the zero paper is 85.7339. Hence, the return for next year is

Tenor 1 2 Spot 7.50% 8.00% Forward 7.50% 8.50% 92.1639 Pf 85.7339 Ps2 7.50% =Pf/Ps2 Value

Value at beginning of Second Year (F) Value at end of Today using spot rate for 2 years (S) Return over next year

The above example gives the break-even level of one year future spot rate or the one year forward rate starting one year from now and ending two years from now as 8.50%. One

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year rate has to increase by 100bps before the two-year zero underperforms the one year zero over the next year. If one year rate increases by less than 100bps, the capital loss of the two year zero will not fully compensate its initial yield advantage over the one year spot. Implied forwards are also used to estimate level of flattening needed by a trader to break even in a position.

The shape of the curve represents market expectation of future rate changes. A steeply upward curve indicates near term tightening by the central bank or rising inflation. When the market participants expect an upward change in the bond yield, the current term structure becomes upward sloping so that any long term bonds yield advantage and expected capital loss due to expected increase in yields exactly offsets each other. Similarly, expectations of yield declines and capital gains will lower current long term bond yields below the short term rates, making the term structure inverted. The markets expectation regarding the future level of rates influence the steepness of todays yield curve, the markets expectations regarding the future steepness of the yield curve influence the curvature of todays yield curve.

The spread (difference between short and long term yields) gives expectation about the future interest rates movements. This can be used by the policy makers as an important tool to frame policies to share the future of the economy by taking corrective measures. Among economists, there is a strong interest in looking at the ability of financial variables like bond yields to predict real economic variables, such as future economic growth (Estrella and Mishkin 1995).

A number of financial variables could conceivably have predictive power, but one in particular, the yield spread, has been shown in previous research to be a good indicator of future economic activity. The yield spread is the difference between two different interest rates usually the rate of a long term bond minus the rate on a short term bond.

3. Literature Review

Researchers, market participants as well as policy makers have long been searching for a way to forecast accurately the turning points of recessions. Since the 1990s, many leading indicators have been created to identify possible onset of recession. Kessel (1965) examined the predictive ability of the yield curve. In an extensive survey of leading indicators, Stock and Watson, in their1989 article, include the yield spread as a component of their leading indicators index. They included two yield spreads in their proposed Index of Leading Indicators the spread between the return on 6- month commercial paper and the 6-month Treasury bill, and the spread between the return on the 10-year Treasury and the 1-year Treasury. In four early essays, Evans (1987), Laurent (1988, 1989) and Keen (1989) offer the yield curves movements as a simple method for predicting real output. Bernanke and Blinder (1992) employ a non-linear model that demonstrates the yield spread better predicts real output than other monetary aggregates.

Haubrich and Dombrosky (1996), Ahrens (1999) and Phillips (1998/1999) compare the yield curve with other leading indicators and find the yield curve to be better. Haubrich and Dombrosky (1996), by using a linear model, find the yield spread to be a good predictor. Ahrens (1999) and Phillips (1998/1999) use regime-switching models and find the yield spread to be the most reliable and with the longest lead. In addition, Ahrens (1999) finds the predictive ability of the yield spread has remained strong across the entire period of M1:1959-M5:1995, in contrast to Bernanke and Blinder (1992) and Haubrich and Dombrosky (1996).The above articles all caution that, while the yield spread has been a helpful guide for monetary policy, it should not be used in isolation. Berk (1998) presents the survey of papers examining the relationship between the yield curve and real output. Estrella and Hardouvelis (1991) explored the usefulness of the term structure in predicting performance farther out. Using as their measure of spread the difference between the 10year treasury rate and the 3-month T-Bill rate, they find that the spread has a strong predictive power for real growth for horizons up to four years.

The results of Estrella and Hardouvelis (1991) were confirmed by Plosser and Rouwenhorst (1994. In 1995, Estrella and Mishkin tried to predict the occurrence of recession, a binary dependent variable. While other studies has performed linear regressions, Estrella and Mishkin used a probit model to see if a number of financial variables were useful in predicting whether or not the economy would be in recession. Of the variables they examined, the ones which performed best were the yield spread and the quarterly average change in the NYSE. Between these two, the performance of the NYSE was particularly strong over short time intervals of one and two quarters ahead, while the yield spread was the most accurate indicator between three and six quarters ahead.

In addition to looking at a probit model to predict recession as opposed to a model which predicts level of future growth, Estrella and Mishkin also looked at the out-of-sample performance of their indicators. Of all the variables, they found that the most accurate predictor out-of-sample was a composite of the NYSE and yield spread, with this composite deriving much of its short term power from the NYSE and its longer term power from the yield spread. Estrella and Mishkin show that, among financial variables and existing indexes of leading indicators, the simple yield spread is the best predictor of a recession four to six quarters in the future.

Estrella and Hardouvelis (1991) had shown that the relationship between real growth and the yield spread was not necessarily policy invariant changing monetary policy regimes could cause the relationship to change. They also point out that the relationship may not be stable over time. In order to address these issues, Estrella, Rodrigues, and Schich (2000) explored the issue of stability of the relationship between the slope of the yield curve and real output.

Feroli (2004) finds that the yield spread is related to the output gap, but that the relationship is a function both of how strongly the monetary authority targets the output gap and of how strongly the monetary authority insists on smoothing interest rate

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movements. He also notes a break in the predictive power of the yield curve, contrary to the work of Estrella, Rodrigues, and Schich (2000), with the start of the Volcker monetary policy regime in 1979.

Wright (2006) argues that adding the short term rate strengthens the in-sample forecasting results when using a probit model to predict recessions. Kucko and Chinn (2010) tested the predictive power of the yield curve for both US and European countries across time. They have found that the predictive power of the yield curve has deteriorated in recent times.

Kanagasabapathy and Goyal (2002) studied the predictive power of yield spread for Indian economy and found that the index of industrial production (as a proxy for economic activity) is positively correlated to yield spread. They found that the probability of slowdown increases when the yield spread falls. However, their study covered a small period (April 1996 to July 2001). During the period, the bond market liquidity was very low and they have used the monthly average secondary market yield to maturity on 10-year Gilts.

4. Yield Curve Data

The spot rate for Indian sovereign curve has been obtained using Nelson-Siegel functional form. The historical spot rate data period is from Jul1997 to Aug 2011 (about 14 years). Data sources are CCIL and NSE. The short term rate has been tracking the long term rates in India for a very long time. Looking at a plot of the rate on the 10-year treasury against the rate on the 3-month T-Bill, we see that the long rate has not been tracking the short rate recently nearly as closely as it has historically. We can see from the graph that, during the most recent period of releasing excess liquidity (and artificially bringing down the rates to low level) and tightening due to increase in inflationary pressure, the 10-year rate did not track the short rate up. The 10-year rate appears to be to be varying less in general since about April09. If the relationship between the 3-month rate and the 10-year rate has changed, then the fundamental information carried in the spread might have changed only recently. -------Insert Figure 2 about here ----9

The descriptive statistics of the spread data is given in Table-1. We have computed both median and mean spread as well as slope and results show that average spread has the lower standard deviation than the slope. Further, the median spread and slope are very close to the mean spread and slope respectively. Hence we have used the mean spread in our analysis. ------------ Insert Table 1 about here --------------------------Insert Figure 3 about here ---------------------------Insert Figure 4 about here ----------------

In so far as the relation between yield curve and economic fundamentals are concerned, one can have a rough idea using the famous IS-Curve framework. This equation defines the equilibrium in Goods market and can be written as:

Here, Y= Income of Economy, C= consumption level which is a function of Income; I= Investment in goods market which is a function of Interest rate and Income level; G= Government expenditure; and NX=Net export which is a function of exchange rate, domestic income and foreign income. Investment is the only term which is directly linked to Interest rates so we have focused our study on relation between interest rates and Investments. Going further, Investment is defined as: Where = Autonomous investment and b=Interest rate sensitivity of investment. As seen from the equation, Investment is inversely proportional to interest rates because when interest rates go up it becomes costly for the firms to borrow for either capacity enhancement or running day-to-day operation. As we know, short term bond rates (91-days T-Bills, for instance) are more responsive to change in policy rates than long term bonds (10-years) therefore with every single rise in policy rates by RBI, T-Bills rates go up but 10 Years-Bond rates may change marginally. This results in fall in the value of yield spread. Its very simple to comprehend therefore that yield spread bears positive relation with Investment. It means, if yield spread is going down (Short-term rates are going high) then Investment goes down because of the increase in cost of borrowing and vice-versa.

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In the figure, we can see that from March 2010, the Short term rates are constantly increasing while the long term rates are more or less same. This has put pressure on the Yield Spread which has reached to level of 0.14% in August 2011 (It was negative on Sep 22, 2011; Y.S. =-0.12%). The typical interpretation for negative yield spread ( is that in

the short end of the curve, we are expecting interest rates to go high to restrict the growth and inflation. In the long end of the curve, we expect rates to fall because, investor anticipates low inflation due to decrease in investment and consumption (Recession), so inflation risk in long term drops and therefore, the long term rates.

Index of Industrial Production (IIP) tells us about the growth of various sectors of economy. Its normally categorized into two ways- one separates it into Mining, Electricity, Manufacturing and General and other into Basic Goods, Capital Goods, Intermediate Goods and Consumer goods-Used based IIP. The data is available on the official website of RBI. The base used is 1993-94=100 instead of 2004-05=100 because in later base, we do not have data prior to 2005-06 for obvious reasons. The data given on the website is monthly basis and its converted to quarterly basis by simply taking arithmetic average of 3-months data. The same is done for calculating Average quarterly Yield Spread. Monthly IIP is equal to: The respective weights (Summation=1.00) are: =0.3557, =0.0926, =.2651, =.2866

Based on the above calculation, we have plotted the graph of IIP-Quarterly from March 1997 to Jun-2011.This graph has some seasonal attributes, as can be seen by IIP coming down on regular frequency. Usually, in every Quarter-1 of a financial year there is a drop in IIP figure compared to the Quarter-4 of last financial Year. Besides, the volatility of the IIP has increased in the recent past because of the unstable economic factors.

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Though, there are statistically advanced and sophisticated methods available to deal with seasonality but with a very simple and easy-to-apply approach we can deal with seasonality: [ ]

Where = Growth Rate of IIP on quarterly basis, t= Recent Quarter, t-4= same quarter in last financial year. This equation enables us to calculate the growth rate of say, Apr-Jun 2005 quarter on the basis of Apr-Jun 2004. This gives us the annual growth rate; we can divide it by 4 to get quarterly growth rates. ---------------Insert Figure 6 about here ----------------------Now, in Figure 6 we have plotted Yield spread and IIP growth rate together. Its quite interesting to see that the graphs of IIP and Yield spread move almost together and in the same direction. It proves the point we made during our discussion in previous sections that Yield spread and IIP Growth rate are positively correlated with each other. The reasoning for the same has already been discussed. One more important observation could be the time-lag which is followed by IIP Growth rate. The rates change at present affects the borrowing today which is used for future production and expansion plans. Therefore, if we face rate hikes today then its going to affect investment and production with a significant time lag.

6. Statistical Relation between Yield Spread and IIP:

Based on the Reasoning, data and graph we have seen, we can safely assume that there is a relation between Yield Spread and IIP Growth rate. We would try to find this relation using Simple Bivariate Regression model

Where,

=Yield

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We have run regression analysis for different forecast horizon to get the best possible fit for our model. The summary of the analysis is given below in Table - 2; -----------------------Insert Table 2 about here -------------

Necessary adjustment has been done in the lag structure for correcting standard error for the first order auto-correlation by including the autoregressive term as per the ChrochaneOrcutt procedure. We have values of correlation coefficient, Alpha, Beta, R-Square and Standard Error for different forecasting horizons (k=0, 1, 2, 3, 4) along with DW statistics. We have stopped the process at k=3 because the value of R-square is close to zero. The best possible forecasting horizon is k=1 with highest correlation coefficient (0.4027), highest Rsquare (0.07). However, the values for k=2 is also closer to the values we obtained with k=1. Therefore, we can use any of these forecasting horizons to forecast/predict the future IIP Growth rate.

For instance, lets assume that the yield spread of June 2009 quarter is equal to 4.19% and if we use k=1, then the IIP Growth rate of Sep 2009 (over Sep 2008 on quarterly basis) should be equal to= 1.35% + 0.1737*4.19% =2.08% (Real figure is 2.07%).

This relation (k=1, 2) can also be verified by looking carefully the graph of IIP Growth rate and Yield spread. Its easy to find that IIP Growth rate is lagging behind by one to two quarters only. The difference between predicted value and actual (using k=1) is presented in the graph below against the backdrop of normal distribution. ----------------------Insert Figure 7 about here ----------------------7. Probability of Recession:

As discussed in the previous sections, the main concern of all financial pundits is to predict the state of economy for say 1-4 quarters ahead and plan accordingly. But this job is not really easy. Even the yield spread predicts the economic indicators like IIP growth rates with

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average level of accuracy. The maximum explanation of IIP variance is 30% (value of RSquare for k=1) which leaves the remaining 70% to other variables. But we would attempt to figure out the possible percentage figure for recession in coming quarters using Yield spread. The nature of outcome is Binary (Either recession or not) so we will use two different models (see for reference: http://irving.vassar.edu/faculty/wl/Econ210/LPMf02.pdf) suitable to deal with binary outcomes, to calculate probabilities of recession for given forecast horizons.

a. Probit Model:

All variables stand for their standard notation. Last term is the error term. { ( ) ( ) ) is cumulative distribution function of . In Probit Model, we assume that

Here,

the error term follows standard normal distribution; This implies that Probability of recession=

b. Logit Model:

)= Normsdist ( Normsdist (

All variables stand for their standard notation. Last term is the error term. { ( ( ) ) is cumulative distribution function of ) we assume that the error term

Here,

does not follow Standard Normal Distribution but follows Logistic distribution. The Probability density function (PDF) for logistic distribution is

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------------------Table 3 about here ----------------------Using the above two equations, we have calculated Probability of recession for k=1 and k=2. The yield spread of quarter ending Jun 2011 is 0.81% which shows that the probability of recession (or simply, negative growth rate of IIP) in Quarter ending Sep 2011 and Quarter ending Dec-2011 is about 6.80% (according to Probit Model) and about 18.4% (according to Logit Model). When we extend the data, the average yield of quarter ending Sep-2011(most recent one) is around 0.20-0.30% and this gives the probability of recession in next 1-2 quarters, roughly equal to 8.04% (Probit model) and about 19.75% (Logit Model) which is little high.

8. In-Sample & Out-of-Sample Analysis:

In-Sample analysis uses full sample in fitting the models of interest. It considers all the data points available to build the model. However, Out-of-Sample fit is obtained from sequence of recursive or rolling regression. Many academicians support out-of-sample fit simply because they think that in-sample model has weaker predictive power and it often comes up with spurious results (Campbell and Thompson (2004)). Granger (1990,p3) writes that one of the main worries of the present methods of model formulation is that the specification search procedure produces model that fit the data spuriously well and also makes standard techniques of inference unreliable. However, we also have some

academicians who would prefer to use in-sample over out-sample- e.g. Inoue and Kilian (2002).

The discussion though is not about the preference but the results we get from these two models and their plausible inferences. One of the parameter which is very crucial in evaluating these models is Root Mean Square of Error- (see Haubrich and Dombrosky).

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This is nothing but the standard deviation of actual values and the values we have calculated based on our model.

RMSE of Out-of-Sample:

Before, calculating RMSE of Out-of-Sample model, we need to discuss the process through which we get the values of intercept and slope of this model. Hansen and Timmermann (2011) discusses at length about how to split the given sample between Estimation sample and Evaluation sample. Normally, we do not have any given set of formula available to do so but we try to minimize the value of p of slope for different split points and the minimum one is selected for modeling. In our case, we have about 48 data points (small data sets are often not reliable) and we tried to split the sample for estimation and evaluation purpose by regressing it for different split points. Hansen mentions in his paper that the value of p is close to zero at the upper part of the sample size. Our result confirms his point. ----------------------Insert Table 4 about here ---------------Note: =24 is the optimal split point for the data and k=1 and k=2 are almost equally accurate Then variance of the estimated value over real one is calculated. RMSE is calculated by the given formula:

Value of RMSE (which is nothing but standard error) for In-the-sample can be taken directly from the regression statistics table for k=1 and k=2.

RMSE (K=1) In-Sample Out-Sample 0.00718 0.00734 RMSE (K=2) 0.00735 0.00764

It simply states that value of Root Mean Standard error (RMSE) for In-sample and Out-sample is almost equal for k=1 and k=2. This model confirms that k=1 is slightly a better fit compared to k=2. It also confirms that In-sample model offers a good explanation for variability in growth rate of IIP 16

and the results have been authenticated by the nearly equal value of RMSE of Out-of-sample model. We can also conclude that In-sample regression analysis performs slightly better than out-of-sample (Haubrich and Dombrosky). 9. Conclusion:

This paper has explored the importance of the yield spread in forecasting future industrial production growth in India. Overall, when using the data series from 1997 to 2011, in sample results suggest the yield spread is indeed important and has significant predictive power when forecasting industrial production growth over a oneyear time horizon. The data suggest the yield curve possess good deal forecasting power for Indian economy. References BonserNeal, Catherine and Timothy R. Morley. 1997. Does the Yield Spread Predict Real Economic Activity? A Multicountry Analysis, Federal Reserve Bank of Kansas City Economic Review 82(3), pp. 3753. Chen, NaiFu. 1991. Financial Investment Opportunities and the Macroeconomy, Journal of Finance 46(2), pp. 52954. Council of Economic Advisors. 2009. The Economic Reoprt of the President Washington, DC: Government Printing Office. Davis, E. Philip and Gabriel Fagan. 1997. Are Financial Spreads Useful Indicators of Future Inflation and Output Growth in EU Countries? Journal of Applied Econometrics 12, pp. 701 14. Davis, E. Philip and S.G.B. Henry. 1994. The Use of Financial Spreads as Indicator Variables: Evidence for the United Kingdom and Germany, IMF Staff Papers 41, pp. 51725. Dotsey, Michael. 1998. The Predictive Content of the Interest Rate Term Spread for future Economic Growth, Fed. Reserve Bank Richmond Economic Quarterly 84:3, pp. 3151. Estrella, Arturo and Gikas Hardouvelis. 1991. The Term Structure as a Predictor of Real Economic Activity, Journal of Finance 46(2), pp.55576 Estrella, Arturo and Frederic S. Mishkin. 1997. The Predictive Power of the Term Structure of Interest Rates in Europe and the United States: Implications for the European Central Bank, European Economic Review 41, pp. 1375401.

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Estrella, Arturo; Antheony P. Rodrigues and Sebastian Schich. 2003. How Stable is the Predictive power of the Yield Curve? Evidence from Germany and the United States, Review of Economics and Statistics 85:3. Groen, Jan J.J. and George Kapetanios. 2009. Model Selection Criteria for Factor Augmented Regressions, Staff Report no. 363 (Federal Reserve Bank of New York, February). Hamilton, James D., and Dong Heon Kim. 2002. A Reexamination of the Predictability of Economic Activity Using the Yield Spread, Journal of Money, Credit and Banking 34(2), pp. 340360. Harvey, Cam 340360 pbell R. 1988. The Real Term Structure and Consumption Growth, J. Financial Economics 22, pp. 305333 Harvey, Campbell R. 1989. Forecasts of Economic Growth from the Bond and Stock Markets, Financial Analyst Journal 45(5), pp. 3845 Harvey, Campbell R. 1991. The Term Structure and World Economic Growth, Journal of Fixed Income (June), pp 719. Haurbrich, Joseph G. and Ann M. Dombrosky. 1996. Predicting Real Growth Using the Yield Curve, Federal Reserve Bank of Cleveland Economic Review 32(1), pp. 2634. Koenig, Evan, Sheila Dolmas, and Jeremy Piger. 2003. The Use and Abuse of RealTime Data in Economic Forecasting, Review of Economics and Statistics 85. Kozicki, Sharon. 1997. Predicting Real Growth and Inflation with the Yield Spread, Federal Reserve Bank Kansas City Economic Review 82, pp. 3957. Moneta, Fabio. 2003. Does the Yield Spread Predict Recessions in the Euro Area? European Central Bank Working Paper Series 294. Plosser, Charles I. and K. Geert Rouwenhorst. 1994. International Term Structures and Real Economic Growth, Journal of Monetary Economics 33, pp. 13356. Rudebusch, Glenn, Eric T. Swanson and Tao Wu. 2006. The Bond Yield Conundrum from a MacroFinance Perspective, Federal Reserve Bank of San Francisco Working Paper No. 200616. Sarno, Lucio and Giorgio Valente (2009), Exchange Rates and Fundamentals: Footloose or Evolving Relationship?," Journal of the European Economic Association 7(4), pp 786830.

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Smets, Frank and Kostas Tsatsaronis. 1997. Why Does the Yield Curve Predicte Economic Activity? Dissecting the Evidence for Germany and the United States, BIS Working Paper 49. Stock, James and Mark Watson. 1989. New Indexes of Coincedent and Leading Economic Indicators, NBER Macroeconomics Annual Vol. 4 pp. 351394. Stock, James and Mark Watson. 2005. Implications of Dynamic Factor Models for VAR Analysis, NBER Working Paper No. 11467 (July). Stock, James and Mark Watson. 2003. Forecasting Output and Inflation: The Role of Asset Prices, Journal of Economic Literature Vol. XLI pp. 788829. Warnock, Frank and Veronica Cacdac Warnock. 2006. International Capital Flows and U.S. Interest Rates, NBER Working Paper No. 12560. Wright, Jonathan. 2006. The Yield Curve and Predicting Recessions, Finance and Economic Discussion Series No. 200607, Federal Reserve Board, 2006. Wu, Tao. 2008. Accounting for the BondYield Conundrum, Economic Letter 3(2) (Dallas: Federal Reserve Bank of Dallas, February).

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Figure 1:

12.00% 11.50% 11.00% 10.50% 10.00% 9.50% 9.00% 8.50% 8.00% 7.50% 7.00% 1.0 2.0 3.0 4.0 Par 5.0 Spot 6.0 7.0 Forward 8.0 9.0 10.0

Figure 2:

Interest Rate Movement - 3 Months Vs 10 Yr

Jan-04

May-99

May-06

Mar-98

Mar-05

Nov-02

91D Tbills

10YR YLD

Figure-3:

20

Nov-09

Aug-11

Apr-02

Dec-99

Dec-06

Apr-09

Oct-98

Oct-05

Jan-97

Aug-97

Aug-04

Jun-03

Feb-01

Sep-01

Feb-08

Sep-08

Jun-10

Jan-11

Jul-00

Jul-07

0.1

spread/slope (%) -0.0075 0.0025 0.0125 0.0225 0.0325 0.0425

0.02

0.04

0.08

0.14

0.06

0.12

0

0.0525

Figure 4:

Figure 5:

Jan-97 Aug-97 Mar-98

Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 avgslp Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 medsp avgsp Jan-97

Jun-03

Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08 Apr-09 Nov-09 Y10 Y3M

21

Jun-10

Jan-11 Aug-11

Jan-06

Jul-06 medslp Jan-07 Jul-07 Jan-08 Jul-08

Jan-09

Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

125

175

225

275

325

375

425

0.00%

Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03

1.00%

2.00%

3.00%

4.00%

5.00%

Figure 6

Figure 7:

Mar-97 Oct-97 May-98 Dec-98 Jul-99 Feb-00 Sep-00 Apr-01

Nov-01

Jun-02 Jan-03 Aug-03

IIP Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

IIPG Mar-04 Oct-04 May-05 Dec-05 Jul-06 Feb-07 Sep-07 Apr-08 Nov-08 Jun-09 Sprd

IIP

22

Jan-10

Aug-10 Mar-11

35

30

25

20

Percent

15 10 5 0 -0.0225 -0.0175 -0.0125 -0.0075 -0.0025 0.0025 0.0075 0.0125 0.0175 0.0225 0.0275

Error

Table-1:

Parameters Average spread Average slope Median spread Median slope Mean 1.6922 1.7356 1.6996 1.7432 Standard deviation 1.0279 1.0543 1.0273 1.0536

Figure 2

Lags Lag k= 0 Lag K=1 Lag k=2 Lag K=3 Alpha 0.015 0.0135 0.015 0.01605 p-val 0.0001 0.0001 0.0001 0.0001 SE 0.00231 0.00245 0.00239 0.00234 beta 0.076 0.174 0.11 0.07 SE 0.089 0.091 0.088 0.085 p-val 0.4 0.062 0.216 0.412 R2 0.014 0.067 0.031 0.014 DW 1.73 1.721 1.787 1.935 Corr 0.295 0.403 0.365 0.192 RMSE 0.00757 0.00718 0.00735 0.00781

Table 3:

Yield Spread Lag -> 1.67 1.21 0.81 0.46 0.30 Probit Model k=1 k=2 5.05% 4.62% 5.94% 5.13% 6.80% 5.60% 7.64% 6.05% 8.04% 6.26% k=3 4.26% 4.56% 4.84% 5.09% 5.21% 23 k=1 16.25% 17.36% 18.38% 19.31% 19.75% Logit Model k=2 15.67% 16.35% 16.95% 17.50% 17.76% k=3 15.17% 15.59% 15.96% 16.30% 16.45%

Table-4:

=Split Point Out-of-the Sample Analysis p-value Beta p-value 0.116329 0.411431 0.056433 0.186514 0.523212 0.004012 0.050367 0.454241 0.00813 4.50E-06 0.000982 0.99569 p-value Beta p-value 0.050367 0.454241 0.00813 0.063197 0.486227 0.004188 0.006867 0.258259 0.147069

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