Elena Kalotychou

Early warning systems for sovereign debt crises: The role of heterogeneity

Sovereign default models that differ in their treatment of unobservable country, regional and time heterogeneities are systematically compared. The analysis is based on annual data over the 1983-2002 period for 96 developing economies. Inference-based criteria and parameter plausibility overwhelmingly favour more complex models that allow the link between the probability response and the fundamentals to vary over time and across countries. However, out-of-sample forecast evaluation using several loss functions and equal-predictive-ability tests suggests that simplicity beats complexity. Parsimonious pooled logit models produce the most accurate sovereign default forecasts and outperform the naive benchmarks.

On sovereign credit migration: A study of alternative estimators and rating dynamics

Different estimators of rating transition matrices have been proposed in the literature but their behaviour has been studied mainly in the context of corporate ratings. The finite-sample bias and variability of three sovereign credit migration estimators is investigated through bootstrap simulations. These are a discrete multinomial estimator and two continuous-time hazard rate methods, one of which neglects time heterogeneity in the rating process whereas the other accounts for it. Panel logit models and spectral analysis are utilized to study the properties of the rating process. The sample consists of Moodys ratings 1981-2004 for 72 industrialized and emerging economies. Hazard rate estimators yield more accurate default probabilities. The time homogeneity assumption leads to underestimating the default probability and greater migration risk is inferred upon relaxing it. There is evidence of duration dependence and downgrade momentum effects in the rating process. These findings have important implications for economic and regulatory capital allocation and for the pricing of credit sensitive instruments.

How do UK Banks React to Changing Central Bank Rates

This paper explores the interest rate transmission mechanism using a broad disaggregated sample of UK deposit and credit products. For a large proportion of rates the adjustment speed is time-varying, switching among four regimes according to the direction of the policy rate and its effect on the disequilibrium gap. In general, this sign asymmetry implies faster adjustment to the long run path when the policy rate revision widens the gap. There is evidence of curvature in the catch-up effect towards equilibrium, namely, large gaps entail a disproportionately faster correction although mainly for deposits. The size of the policy rate change also impacts the adjustment speed. The notable heterogeneity found across financial institutions/products regarding the presence of these nonlinear patterns raises important questions on how to assess the effectiveness of monetary policy. The cross-section heterogeneity uncovered can be explained to some extent by diversification, profit volatility, product range, market concentration and menu costs.

Volatility and trading activity in Short Sterling futures

The objective of the present study is to examine the interplay between information, trading volume and volatility in Short Sterling futures. More specifically, the paper concentrates on the role of liquidity variables as conduits of information arrival and whether such variables could be an exclusive platform of the markets information set. The analytical framework employed to examine the interaction among those factors is based on the conditional volatility family of techniques. The approach is well suited as it naturally leads to examine the interaction among volatility and sources of information. In an attempt to identify proxies of information and their role in determining volatility, four main conclusions have emerged. First, the empirical findings suggest that both volume and open interest exhibit a positive correlation with volatility. Second, based on the current methodology, one can observe the persistence and importance of GARCH effects after accounting for liquidity. Third, the liquidity variables remain significantly exogenous compared with other studies. Finally, although both liquidity variables are found significant, their role as vehicles of transmitting information is proved to be weak with respect to the information itself.

Modeling Dependence in CDS and Equity Markets: Dynamic Copula with Markov-Switching

We propose a flexible dynamic copula with Markov-switching to model the dependence between the iTraxx Europe CDS market and the underlying equity market. The model is able to reproduce extreme return clustering and asymmetry by allowing for two time-varying dependence regimes, low or “normal” and high or “crash”, both at the centre and tails of the bivariate distribution. In-sample statistical criteria support the Markov-switching dynamic copula. Empirically, we identify high dependence regimes that coincide with the recent credit crunch and the Greek and European sovereign debt crises. A portfolio Value-at-Risk simulation to generate one-day-ahead trading limits highlights the economic significance of the proposed copula through regulatory loss functions that consider the frequency and the magnitude of out-of-sample exceptions.

Interest rate fluctuations and the UK financial services industry

The article explores the relationship between short-term interest rates and the equity returns of the UK financial services industry. Based on the arbitrage pricing theory, the present study seeks to answer the sensitivity and pricing questions. The former is tested with a linear two-index model attempting to identify any interest rate risk exposure of these stock returns. The latter, however, is examined using a nonlinear multivariate analysis based on the Seemingly Unrelated Regression Equations (SURE) model by imposing cross- and within-equation constraints on the estimated parameters. The econometric analysis unveils a significant negative interest rate effect and the existence of a risk premium incorporated in the expected returns of portfolios consisting of these stocks.

Modeling Sovereign Debt Crises using Panels

This paper compares rival sovereign default models that differ in how country-, region- and time-specific effects are treated. The quality of the models is gauged using inference-based criteria and the plausibility of estimates. An out-of-sample forecast evaluation framework is deployed based on statistical- and economic-loss functions, naive benchmarks and equal-predictive-ability tests. The inference metrics overwhelmingly favor more complex models that allow for time-varying country heterogeneity. However, simplicity beats complexity in terms of forecasting. Pooled logit models that simply control either for regional heterogeneity or for time effects produce the most accurate forecasts and outperform the naive models.

The Anatomy of Sovereign Credit Contagion

We analyze the channels for the cross-border propagation of sovereign credit risk in the international sovereign debt market. We study sovereign credit contagion through the immediate effects of credit events as defined by CDS spread jumps on the credit spreads of other regional sovereigns and on the rest of the world. We find that such “fast and furious” contagion has been primarily a regional phenomenon, however, a global “slow-burn” spillover of credit events was also in force during the recent European debt crisis. We are able to model the protracted spillover mechanism through the effects of identified sovereign credit events on a global sovereign risk factor and time varying country-specific factor loadings.