Eli M. Remolona

The Credit Spread Puzzle

Why are spreads on corporate bonds much wider than would be implied by expected losses from default? Previous explanations of this puzzle have assumed that investors can diversify away the risk that actual losses in a corporate bond portfolio will exceed expected losses. However, the skewness in the distribution of corporate bond returns implies that achieving such diversification will require an extraordinarily large portfolio. We present evidence from the market for collateralised debt obligations suggesting that such large portfolios are unattainable. Hence, investors always face the risk that actual losses will exceed expectations. Credit spreads are so wide because they compensate investors for such risk.

The Term Structure of Announcement Effects

We analyze high-frequency responses of U.S. Treasury yields across the maturity spectrum to macroeconomic announcements. We find that surprises in the announcements evoke the sharpest reactions from the intermediate maturities, thus forming striking hump-shaped curves of announcement effects. We then fit an affine-yield model to the yield changes using the announcement surprises as GMM instruments. The model estimates imply that the announcements elicit larger shocks to an expected future target interest rate than to the current short-term interest rate and that different types of announcements generate different expectations about this target rate, how rapidly it will be approached, and how long it will be maintained.

What Moves Bond Prices

This article takes a close look at a year in the U.S. Treasury securities market and tries to explain the sharpest price changes. The authors attribute each of the twenty-five largest price shocks during August of 1993 to August 1994 period to a just-released macro-economic announcement. They also measure the bond markets average reaction to various announcements and the reactions to surprise in the announcements headline numbers. The strongest responses are found to come from the employment, producer price index, and fed funds target rate announcements. Significant responses to U.S. Treasury security auctions results are documented for the first time.

The Price Impact of Rating Announcements: Which Announcements Matter?

Credit rating agencies make multiple announcements, some of which are intended to reflect the latest information available about a firm and others of which are intended to provide a stable signal of credit quality. Using data on CDS spreads, we examine which of these different types of rating announcements contains pricingrelevant information. We find that all types, including changes in outlook, have a significant impact on CDS spreads. Even rating announcements preceded by similar announcements have an impact. The price impact is greatest for firms with split ratings, smallcap firms and firms rated near the threshold of investment grade.

A Ratings-Based Approach to Measuring Sovereign Risk

We propose a new approach to measuring sovereign default risk. We use sovereign credit ratings and historical default rates provided by credit rating agencies to construct a measure of ratings-implied expected loss. We compare our measure of expected loss from sovereign defaults with stand-alone credit ratings and also examine its relationship with credit default swap spreads. We show that our measure is more informative for measuring sovereign risk. We re-examine the fundamental determinants of sovereign risk and find further evidence to support the debt intolerance and original sin explanations for country risk. This study contributes an improved understanding of the value of sovereign credit rating teams in assessing the long-term country risks accompanying emerging market investments. Copyright

Managing Expectations by Words and Deeds: Monetary Policy in Asia and the Pacific

We examine some of the most basic devices that major central banks in Asia and the Pacific use to communicate with markets. First, we consider gradualism and reversal aversion in the setting of policy rates. We argue that in a world of uncertainty these patterns of behavior help market participants form expectations of future policy rates. Second, we analyse the statements released at the time of policy decisions and suggest that it is not so much the length of the statement that matters but the extent to which it focuses on forward-looking information. We then propose two tests for the effectiveness of central bank communication. The first is a version of the expectations hypothesis of the term structure of interest rates, which is a joint test of the effectiveness of communication and the informational efficiency of the domestic fixed-income market. The second is a surprises test, which compares the reaction of longer term interest rates to policy announcements with the reaction to macroeconomic news

What Was the Market's View of U.K. Monetary Policy? Estimating Inflation Risk and Expected Inflation with Indexed Bonds

A measure of the credibility of monetary policy is the inflation risk premium in nominal yields. This will be time varying and can be estimated by combining the information in the nominal term structure with that in the real term structure. We estimate these risk premia using a generalized CIR affine-yield model, with one factor driving the real term structure of monthly observations on two-year, five-year and ten-year UK index-linked debt and two factors driving the term structure of the corresponding nominal yields. Our estimates show that the inflation risk premium contributes on average about 100 basis points to nominal yields. Since the exit from the ERM this has fallen to 70 basis points, showing greater policy credibility. The inflation risk premium provides a correction to the break-even method of forecasting inflation and produces an unbiased forecast.

The Changing Shape of Fixed Income Markets

This paper provides a broad overview of recent changes in the worlds major fixed income markets. It analyses the forces driving change, shifts in the supply of and demand for debt securities, the ebb and flow of liquidity, and new benchmarks for price discovery. Together with several related papers prepared by central bank economists, it highlights the growing importance of private-sector debt instruments.

Price Formation and Liquidity in the U.S. Treasury Market: Evidence from Intraday Patterns Around Announcements

We identify striking adjustment patterns for price volatility, trading volume, and bid-ask spreads in the U.S. Treasury market when public information arrives. Using newly available high-frequency data, we find a notable lack of trading volume upon a major announcement when prices are most volatile. The bid-ask spread widens dramatically with price volatility and narrows just as dramatically with trading volume. Trading volume surges only after an appreciable lag following the announcement. High levels of price volatility and trading volume then persist, with volume persisting somewhat longer.

Uncovering Inflation Expectations and Risk Premiums from Internationally Integrated Financial Markets

Theory and empirical evidence suggest that the term structure of interest rates reflects risk premiums as well as market expectations about future inflation and real interest rates. We propose an approach to extracting such premiums and expectations by exploiting both the comovements among interest rates across the yield curve and between two countries, Canada and the United States. This approach involves estimating a multi-factor affine-yield model jointly for the two countries, in which we identify a common factor as representing real rate expectations and two other factors as representing two separate inflation expectations for the two countries. To estimate the model, we apply a Kalman filter to monthly data on zero-coupon bond yields for 2-year, 5-year and 10-year maturities as well as inflation. Our estimates suggest that Canadian inflation expectations were slow to adjust to a new inflation-targeting regime. We also find inflation-risk premiums that vary between 10 and 90 basis points in the two countries, with U.S. bonds commanding smaller premiums.