Anastasios Evgenidis

Does the Yield Spread Retain its Forecasting Ability During the 2007 Recession? A Comparative Analysis

We review spread’s predictive ability by implementing a number of linear and probit models. We conduct a comparative analysis of the forecasting performance of various specifications by focusing on the last three major US economic slowdowns: 1990, 2001 and 2007. The results indicate that although linear models are useful in predicting the 1990 and 2001 decline in economic activity, none of these give signal of the major 2007 decline in output. Moreover, we find evidence that there is more information in the shape of the yield curve about the future economic activity than that provided by the spread alone. We also document that probit models are doing well in signalling the onset of 2007 subprime crisis although they fail to capture its duration.

An explanation of spread’s ability to predict economic activity: A regime switching model

Purpose - – For over two decades numerous studies have provided evidence on the predictive ability of the yield spread for real economic growth. While all this large literature has focussed on how well the spread helps predict real activity, none of these has given an answer on why the spread predicts. The purpose of this paper is to deal with this issue by trying to find an answer on the reason and the economic conditions under which the spread proves to be so powerful predictor of economic activity. Design/methodology/approach - – The authors examine whether the explanation of spread’s predictive ability lies behind interest rate volatility supposing that the economy oscillates between high- and low-volatility regimes. For this reason the authors nest GARCH models into Markov regime switching models. Findings - – When the authors assume that the economy simply oscillates between different regimes, interest rate volatility does not explain the spread’s predictive ability. However, the authors obtain a very interesting result when the authors augment the conditional variance with a level effects term. This ensures that in an environment with high levels of interest rates – in which the rational agents expect the economy to slow down – there is a greater possibility for the economy to switch to a high-volatility regime. Under these economic conditions, interest rate volatility appears to be the reason of spread’s predictive power from one up to three years. Originality/value - – This study contributes to the relevant literature by providing an explanation on the reason and the economic conditions under which the spread proves to be so powerful predictor of economic activity.

A Robust Pricing of Specific Structured Bonds with Coupons

Purpose - – The purpose of this paper is to present an innovative model to evaluate the fair price of a subset of structured products for a hypothetical US structured bond. Design/methodology/approach - – The authors assume that interest rates dynamics are described by the Cox–Ingersoll–Ross process. They conduct robustness checks by stress testing against parameter and model uncertainty. Findings - – The fair value of the bond is robust under any parameter or model misspecification. In addition, a change in the price seems to be more sensitive to long-term yields rather than short-or mid-term yields. The authors provide a better understanding of the relationship between bond prices and business cycles: a slight change in the current structure would have a significant effect on the bond price only during economic expansions. Social implications - – The recent global financial crisis has led policymakers and the financial press to blame financial innovation through accusations of structured products being highly complex. Much of the criticism is based on the fact that investors were not able to properly price and fully understand the risks of their investments. Regulators should ensure proper pricing of these products to protect both the investors and the system. Fair pricing is important for bond issuers, governments or corporations to design their product at an attractive price for investors. Originality/value - – This paper fills a gap in the extant literature by providing an innovative model based on an Euler–Maruyama Monte Carlo scheme to price structured products.