Klaas Knot

Testing for long horizon UIP using PPP-based exchange rate expectations

Abstract This paper revisits the uncovered interest parity relation. It supplements existing work in two ways: It focuses on long instead of short-term interest rates, and, related to that, employs exchange rate expectations derived from purchasing power parity (PPP) instead of actual outcomes. Among the major floating currencies over the period 1975–1997, the paper cannot support the notion of further increases in UIP-validation beyond that associated with the wave of financial market liberalization and deregulation in the early 1980s.

Fiscal policy and interest rates in the European community

Abstract In the early 1980s government budget deficits widened in most industrialised countries. This paper examines whether government budget deficits and public debt in five European countries have pushed up interest rates. Given nearly perfect financial market integration in Europe, aggregated data were used to estimate a reduced-form model for the nominal interest rate. In contrast to the results for Italy, the aggregated model appears reasonably stable. Our findings support the view that government deficits have contributed to higher interest rates. However, there is also evidence in support of partial tax discounting.

INTEREST-RATE DIFFERENTIALS AND EXCHANGE-RATE POLICIES IN AUSTRIA, THE NETHERLANDS, AND BELGIUM

In this paper, the small, but persistent interest rate differentials via-a-vis Germany which have existed in Austria, the Netherlands, and Belgium are analysed. These interest differentials may be thought of to consist of three parts: expected exchange rate movements within the band, expected changes of the central rates and a risk premium. Following a similar test as proposed by Svensson, we examine the credibility of the exchange rate policy in these countries. According to this test the Belgian exchange rate policy clearly lacks credibility for most of the period under consideration. There are, however, serious problems applying this test to Belgium due to the dual exchange rate system. For Austria and the Netherlands we calculate interest differentials which are adjusted for expected exchange rate movements within the band. It appears that the differences between the adjusted and the unadjusted interest differentials can be substantial. The Granger-causal relationship between fundamentals like the rate of inflation, the government budget deficit and the current account is also quite different for the adjusted and the unadjusted interest differential, where the fundamentals have the highest explanatory power for the latter measure.

On the Determination of Real Interest Rates in Europe

In this paper a loanable funds model is estimated over the period 1959–1990 for the determination of after-tax expected real interest rates using aggregated data for four European countries under the assumption that high capital mobility in Europe implies a common capital market. It is concluded that real interest rates in the European Community were mainly driven by movements in temporary income, expected inflation, lagged investment, money growth, and the oil price. Moreover, our aggregate, model appears to be reasonably stable. Finally, individual country rates are shown to depend on the European rate as well as some country-specific variables, suggesting a limited degree of isolation from international financial markets for the countries concerned.

Do Financial Conglomerates Create or Destroy Value? Evidence for the EU

There is an ongoing debate whether firm focus creates or destroys shareholder value. Earlier literature has shown significant diversification discounts: firms that engage in multiple activities are valued less. Various factors are important in the size of the discount, for example cross-subsidization and agency problems. The extant literature, however, generally focuses on non-financial firms or traditional banking (cf (Laeven and Levine, 2007) and (Schmid and Walter, 2006)). Our paper focuses specifically on the valuation of bank-insurance conglomerates. We find no universal diversification discount but significant variability. Size, complexity and risk seem to be important determinants.

Toward an econometric target zone model with endogenous devaluation risk for a small open economy

Abstract A number of econometric target zone models is estimated for the Belgian franc and the Dutch guilder vis-a-vis the deutsche mark, with a particular focus on the modeling of endogenous devaluation risk. Both currencies can be characterized by mean reversion, whereas the theoretical S-effect is observed only for the Belgian franc. Exchange rate volatility can be adequately modeled by means of a GARCH(1,1) process. For the Belgian franc, exchange rate tensions have been induced by movements in the inflation differential vis-a-vis Germany and the level of foreign exchange reserves, whereas for the Dutch guilder the interest rate differential vis-a-vis Germany and the level of foreign exchange reserves have been particularly important.

Deficit Announcements and Interest Rates

Abstract In this paper the deficit announcement effect methodology is applied to the case of the Federal Republic of Germany, to examine whether and to what degree unforeseen government budget deficits raise interest rates. The period studied is 1987–93. Using information on deficit projections from the Ministry of Finance, the Bundesbank, and the Council of Economic Advisers, we find a positive association between “news” about the consolidated government budget deficit and the long-term interest rate. The announcement effect is only significant in the period before the unification. This association is, however, only significant if the information comes from the Bundesbank and the Council of Economic Advisers. This conclusion is not affected if money supply announcements are taken up in the analysis. Our results suggest that this positive relationship between budget deficits and interest rates is due to crowding-out.

The term structure of UIP: evidence from survey data

This note focuses on uncovered interest parity (UIP) in the short and medium run using survey-based exchange rate expectations. Analysing the major world currencies over the period 1985–1998 the paper finds that the validity of the UIP relation increases with the term of the investment, thereby supporting the theoretical notions developed by literature.

Co-Movements in Long-Term Interest Rates and the Role of PPP-Based Exchange Rate Expectations

This paper investigates international co-movement in bond yields by testing for uncovered interest parity (UIP). Existing work is supplemented by focusing on long instead of short-term interest rates and by employing exchange rate expectations derived from purchasing power parity (PPP) instead of actual outcomes. Among the major currencies during 1975-97, the paper does not find a further increase in co-movement beyond that associated with the wave of financial market liberalization in the early 1980s. Given the similarity between PPP-based UIP tests and those employing actual exchange rate outcomes, the value added of the former lies mainly with data availability.

Virtual and composite fundamentals in the ERM

A latent-variable approach is applied to identify the appropriate driving process for fundamental exchange rates in the ERM. From the time-series characteristics of so-called virtual fundamentals and composite fundamentals, a significant degree of mean reversion can be asserted. The relative degree of mean reversion across countries closely corresponds to often assumed degrees of economic integration vis-a-vis Germany as well as documented degrees of credibility of the exchange rate policies pursued. Convergence in fundamentals appears to be larger under the new EMS than in the previous years but has again diminished after German unification and the subsequent widening of the ERM bands in 1993. Copyright 1999 by The editors of the Scandinavian Journal of Economics.