David A. Marshall

On Biases in Tests of the Expecations Hypothesis of the Term Structure of Interest Rates

We document extreme bias and dispersion in the small sample distributions of five standard regression tests of the expectations hypothesis of the term structure of interest rates. These biases derive from the extreme persistence in short interest rates. We derive approximate analytic expressions for these biases, and we characterize the small-sample distributions of these test statistics under a simple first-order autoregressive data generating process for the short rate. The biases are also present when the short rate is modeled with a more realistic regime-switching process. The differences between the small-sample distributions of test statistics and the asymptotic distributions partially reconcile the different inferences drawn when alternative tests are used to evaluate the expectations hypothesis. In general, the test statistics reject the expectations hypothesis more strongly and uniformly when they are evaluated using the small-sample distributions, as compared to the asymptotic distributions.

Monetary policy and the term structure of nominal interest rates: evidence and theory

This paper explores how exogenous impulses to monetary policy affect the yield curve for nominally risk-free bonds. We identify monetary policy shocks using three distinct variants of the identified VAR methodology. All three approaches imply similar patterns for the effect of monetary policy shocks on the term structure: A contractionary policy shock induces a pronounced positive but short-lived response in short term interest rates, with a smaller effect on medium-term rates and almost no effect on long term rates. Because of their transitory impact, monetary policy shocks account for a relatively small fraction of the long-run variance on interest rates. The response of the yield curve to a monetary policy shock is unambiguously a liquidity effect rather than an expected inflation effect. We then ask whether a dynamic stochastic equilibrium model that incorporates nominal rigidities can replicate these patterns. We find that the limited participation model of Lucas (1990), Fuerst (1992), and Christiano and Eichenbaum (1995), is broadly consistent with the data, provided modest adjustment costs are imposed on monetary balances available to satisfy households cash-in-advance constraint.

Economic Determinants of the Nominal Treasury Yield Curve

We study the effect of different types of macroeconomic impulses on the nominal yield curve. We employ two distinct approaches to identifying economic shocks in VARs. Our first approach uses a structural VAR due to Gali (1992). Our second strategy identifies fundamental impulses from alternative empirical measures of economic shocks proposed in the literature. We find that most of the long-run variability of interest rates of all maturities is driven by macroeconomic impulses. Shocks to preferences for current consumption consistently induce large, persistent, and statistically significant shifts in the level of the yield curve. In contrast, technology shocks induce weaker and less robust patterns of interest rate responses, since they move real rates and expected inflation in opposite directions. Monetary policy shocks are the only macroeconomic shocks with a consistent and significant impact on the slope of the yield curve. We find no evidence that fiscal policy shocks induce any significant interest rate responses.

The implications of first-order risk aversion for asset market risk premiums

Existing general equilibrium models based on traditional expected utility preferences have been unable to explain the excess return predictability observed in equity markets, bond markets, and foreign exchange markets. In this paper, we abandon the expected-utility hypothesis in favor of preferences that exhibit first-order risk aversion. We incorporate these preferences into a general equilibrium two-country monetary model, solve the model numerically, and compare the quantitative implications of the model to estimates obtained from U.S. and Japanese data for equity, bond and foreign exchange markets. Although increasing the degree of first-order risk aversion substantially increases excess return predictability, the model remains incapable of generating excess return predictability sufficiently large to match the data. We conclude that the observed patterns of excess return predictability are unlikely to be explained purely by time-varying risk premiums generated by highly risk averse agents in a complete markets economy.

The Permanent Income Hypothesis Revisited

Measured aggregate U.S. consumption does not behave like a martingale. The authors develop and test two variants of the permanent income model which reflect that. In both, agents make decisions in continuous time. In one variant, martingale behavior holds; serial persistence in measured consumption reflects only time aggregation. In the other, serial persistence also reflects technology shocks, and martingale behavior does not hold. Using both structural and atheoretical econometric models, the authors find little evidence against either variant: aggregate quarterly U.S. data do not convincingly distinguish between their continuous time models. Copyright 1991 by The Econometric Society.

EQUITY-PREMIUM AND RISK-FREE-RATE PUZZLES AT LONG HORIZONS

The failure of consumption-based asset pricing models to match the stochastic properties of the equity premium and the risk-free rate has been attributed by some authors to frictions, transaction costs, or durability. However, such frictions primarily would affect the higher-frequency data components: Consumption-based pricing models that concentrate on long-horizon returns should be more successful. We consider two consumption-based models: time-separable utility, and the habit model of Constantinides. We estimate a vector ARCH model that includes the pricing kernel and the equity return, and use the fitted model to assess the models implications for the equity premium and for the risk-free rate. Neither model performs well at a quarterly horizon, but at longer horizons the Constantinides model can match the mean and the variance of the observed equity premium, captures time variation of the equity premium, and can better match the observed risk-free rate. We conclude that the equity-premium and risk-free-rate puzzles are primarily problems for shorter-horizon returns.

Can Costs of Consumption Adjustment Explain Asset Pricing Puzzles

We investigate Grossman and Laroques (1990) conjecture that costs of adjusting consumption can account, in part, for the empirical failure of the consumption-based capital asset pricing model (CCAPM). We incorporate small fixed costs of consumption adjustment into a CCAPM with heterogeneous agents. We find that undetectably small consumption adjustment costs can account for much of the discrepancy between the observed variance of nondurable aggregate consumption growth and the predictions of the CCAPM, and can partially reconcile nondurable consumption data with the observed equity premium. We conclude that the CCAPMs implications are nonrobust to extremely small adjustment costs. Copyright The American Finance Association 1999.

Cleared margin setting at selected central counterparties

Interviews with senior personnel at six of the world’s largest central counterparty clearing houses and research by financial markets staff shed light on regulations, principles, and best practices in margin setting for derivatives.

Financial crises and coordination failure: A comment

Abstract The three papers of this session link financial crises (explicitly or implicitly) to coordination failure . In Bryant (Journal of Banking and Finance, 2002), the possibility of coordination failure is due to complementarity in the productive technology. In Chui et al. (Journal of Banking and Finance, 2002), foreign lenders to a small country fail to coordinate on the optimal strategy rolling over short-term loans. Finally, Amable et al. (Journal of Banking and Finance, 2002) implicitly introduce coordination failure through a production function with external increasing returns to scale. This sort of “thick markets” externality can be viewed as a reduced form that stands for coordination problems in a non-Walrasian economy.

Comment on Search, Bargaining, Money, and Prices: Some Recent Results and Policy Implications

Trejos and Wright introduce a new dimension to the study of money, or, more precisely, the study of liquidity. Liquidity confers more than just purchasing power: It also confers bargaining power. If only a small fraction of the population possesses liquid assets, it is difficult for a seller to find a potential buyer with sufficient liquidity to support a transaction. It follows that the threat by a potential purchaser to walk away from a bargaining round caITies greater weight than if liquidity is more symmetrically distributed. This suggests a pathway for heterogeneity in money holdings to have real economic effects. Trejos and Wright incorporate this intuition into a model of production and exchange. They examine how prices, output, and social welfare can be affected by changes in the cross-sectional distribution of liquidity. Trejos and Wrights work represents a tour de force of theoretical modeling. However, the ultimate importance of this line of research will be determined by its contribution to our understanding of monetary non-neutrality and optimal monetary policy. In spite of its subtitle, the Trejos-Wright paper has little to say about these issues. The monetary variable in this paper, denoted M, is the fraction of agents holding money. M does not directly correspond to any policy variable at the disposal of a government or central bank. The paper refers to M as the money supply, an accurate label since, by construction, each agent possesses either one unit of money or none. However, to describe an increase in M as an expansion of the money supply is somewhat misleading, since the impact of a change in M on the economy is not due to a change in the total number of monetary units available, but to the change in the cross-sectional distribution of money. To apply the results of this model to actual questions of monetaxy policy requires specifying the linkage between policy instruments of the monetary authonty (such as the total supply of reserves available to the banking sector) and the cross-sectional distribution of liquidity. The substantive implications of the Trejos-Wright model depend on how this linkage is constructed. In this discussion, I first review the key intuition underlying the Trejos-Wright