Fabio Fornari

The Impact of News on the Exchange Rate of the Lira and Long-Term Interest Rates

This paper analyzes the impact of news on several Italian financial variables, paying particular attention to the effect on the conditional volatility of these variables. The analysis spans a period of great financial and political turbulence in Italy, including the rapid succession of three governments. News releases (articles on political and economic events collected daily from both the Italian and international economic press) are classified as unscheduled (mostly political) and scheduled (i.e. economic and monetary statistics whose announcement is expected by market participants). The analysis is divided into two phases: first, we estimate the impact of each single political and economic news item on asset price changes and their conditional variance; second, those items that are identified as significant in the first stage are then aggregated into six dummies according to their nature and origin and employed as exogenous variables in a trivariate Garch scheme. Results show that i) news affects both the first and the second moment of the daily changes in the analyzed variables; ii) there is a significant regime shift of the unconditional variance of the analyzed variables across the three different governments; iii) the conditional variances display a significant i?½ albeit rather small i?½ seasonal dayweek pattern; iv) contrary to the conventional view, the impact of news on the conditional variance is more pronounced for exchange rates than for Italian long-term interest rates.

SIGN- AND VOLATILITY-SWITCHING ARCH MODELS: THEORY AND APPLICATIONS TO INTERNATIONAL STOCK MARKETS

This paper develops two conditionally heteroscedastic models which allow an asymmetric reaction of the conditional volatility to the arrival of news. Such a reaction is induced by both the sign of past shocks and the size of past unexpected volatility. The proposed models are shown to converge in distribution to absolutely continuous Ito diffusion processes, as happens for other heteroscedastic formulations. One of the schemes developed in the paper--the Volatility-switching ARCH--differs from the existing asymmetric models insofar as it is able to capture a particular aspect of the behaviour of the volatilities, i.e., the reversion of their asymmetric reaction to news. Empirical evidence from stock market returns in six countries shows that such a model outperforms traditional asymmetric ARCH equations.

The Probability Density Function of Interest Rates Implied in the Price of Options

The paper contributes to the stochastic volatility literature by developing simulation schemes for the conditional distributions of the price of long term bonds and their variability based on non-standard distributional assumptions and volatility concepts; it illustrates the potential value of the information contained in the prices of options on long and short term lira interest rate futures for the conduct of monetary policy in Italy, at times when significant regime shifts have occured.

Modeling the changing asymmetry of conditional variances

Abstract We analyze the asymmetric response of the volatility to the arrival of shocks of opposite sign. After revising the major formulations developed so far to capture the phenomenon, a more general model is proposed; it cannot be rejected against three competing specifications when fitted to stock exchange indices returns.

What Does a Financial Shock Do? First International Evidence

In this paper we attempt to evaluate the quantitative impact of financial shocks on key indicators of real activity and financial conditions. We focus on financial shocks as they have received wide attention in the recent literature and in the policy debate after the global financial crisis. We estimate a panel VAR for 21 advanced economies based on quarterly data between 1985 and 2011, where financial shocks are identified through sign restrictions. Overall, we find robust evidence that financial shocks can be separately identified from other shock types and that they exert a significant influence on key macroeconomic variables such as GDP and (particularly) investment, but it is unclear whether these shocks are demand or supply shocks from the standpoint of their macroeconomic impact. The financial development and the financial structure of a given country are found not to matter much for the intensity of the propagation of financial shocks. Moreover, we generally find that these shocks play a role not only in crisis times, but also in normal conditions. Finally, we discuss the implications of our findings for monetary policy. JEL Classification: E44, E52, E58, G20

Volatility smiles and the information content of news

The paper investigates whether the impact of selected news - scheduled and un-scheduled - affects only the current conditional variance of financial prices or, by bringing new information to the market, induces also a revision of the implied variance, i.e. the variance expected to prevail over the life to maturity of an option. The latter phenomenon would signal that news is able to change permanently the consensus on the future economic environment. In addition to recent similar ana lyses which employ the at the money implied volatility to this aim, tests are also performed on the implied out of money and in the money volatilities. These are in fact extremely sensitive to lack of information about the future evolution of the price of the underlying asset: hence, their prices - as well as their implied volatilities - must change significantly after the occurrence of important events.

Does Business Cycle Risk Account for Systematic Returns from Currency Positioning? The International Perspective

Low-yielding currencies (relative to dollar interest rate and based on annual data) represent a strong hedging tool for a US investor in the event of a slowdown of the US economy, as shown in Lustig and Verdelhan (2007). In this paper we show that such a conclusion is far more general, holding jointly for representative agents in a number of countries (Australia, Canada, France, United Kingdom and United States) and for quarterly holding period returns, which are closer to the frequency at which portfolios are re-balanced. The prices of risk for nondurable and durable consumption growth explain the cross-sectional variation of average currency portfolio returns, as confirmed by high Rý coefficients. However, statistical significance of the coefficients, checked both individually and joint, does not exceed 10%. Overall, taking an economic standpoint, holding currencies that pay out low interest rates provides some means of insurance against economic slowdown in the domestic economy.

Asymmetries and non-linearities in economic activity

Industrial production is analysed for three countries. A GARCH framework is employed to model the conditional variances of the cycles, which are found to react asymmetrically to shocks of opposite sign; one of the three cases exhibits long-memory features. The ability of GARCH models at capturing all the heteroscedasticity of the data is tested against the null of deterministic chaos.

A stochastic variance model for absolute returns

Abstract Empirical research has shown that the autocorrelation function of a stationary series is maximised when the latter is raised to a positive power δ, which rarely coincides with two. Thus, both the GARCH and stochastic variance (SV) models fail to capture all the non-linear dependence of the data. The proposed model, in which δ equals one, improves the specification for the SV models.

Compensation for Volatility Risk in Interest Rate Derivatives

We use volatilities implied from interest rate swaptions to assess the size, the sign and the behavior through time of the compensation for volatility risk, for dollar, euro and pound rates at a daily frequency, between October 1998 and August 2006. The measurement of the volatility risk premium rests on a simple model according to which variance forecasts can be generated under the physical measure. Results show that between September 2001 and mid-2004 dollar implieds were embodying a large - negative - compensation for volatility risk, a component which was much smaller for the other two currencies. While the negative compensation for volatility risk is in line with previous studies focusing on other asset classes, we also document that it exhibits a significant term structure, more evident for dollar and euro rates than for pound rates. The volatility risk premium is strongly changing through time but much less than implied volatilities. Estimates of risk aversion based on the physical skewness and kurtosis of interest rate changes suggest that (minus) the vrp can almost directly be read as risk aversion, as the proportionality between the two is about 0.8. Also, compensation for volatility risk is positively related to expected volatility, although the relation is not completely linear. Daily compensation for volatility risk is influenced, as expected, by the level of the short term rate and its volatility as well as by a small but robust number of macroeconomic surprises. The latter induce more sizeable changes on compensation for volatility risk of dollar rates than in euro or pound rates.