Konstantijn Maes

The Effect of Monetary Unification on German Bond Markets

We develop a benchmark against which the effects of ECB monetary policy on the German bond market can be evaluated. We first estimate an affine term structure model for the pre-EMU period linking the German yield curve with the Bundesbank monetary policy. The German monetary policy and its implied yield curve are then reprojected onto the EMU period. The reprojected yield curve differs significantly from the observed one. Short-term interest rates during the EMU period are significantly lower than they would have been in case the Bundesbank were still in charge of monetary policy. Furthermore, yield spreads increased substantially during the EMU period.

An Affine Model for International Bond Markets

We present and estimate a parsimonious multi-factor affine term structure model for joint bond markets. We extend the standard affine models by focusing on joint markets and by incorporating the exchange rate dynamics in the estimation procedure. Estimation is done by means of a Kalman filter algorithm. We find that our particular three factor model is quite successful in fitting bond correlations, both within and between national bond markets. Moreover, the model sheds light on some of the most persistent puzzles in empirical finance. Finally, we apply the model to test for international diversification gains in unhedged bond portfolios, conditional on the information that is present in the term structures of both countries. We find that exchange rate risk is sufficiently priced such that the inclusion of foreign bonds allows for an improved risk-return trade-off from the perspective of a domestic investor.

Estimation of a Joint Model for the Term Structure of Interest Rates and the Macroeconomy

In this paper, we present a stylized continuous time model integrating the macroeconomy and the bond markets. We use this framework to estimate (real) interest rate policy rules using information contained in both macroeconomic variables (i.e. output and inflation) and in the term structure of interest rates. We extend the standard Kalman filter procedure in order to estimate this model efficiently. Application to the U.S. economy shows that this model is able to estimate the macroeconomic dynamics accurately and that the standard feedback rule only in observable factors is not valid within this framework. Moreover, we find that observable macroeconomic variables do not explain much of the term structure. However, (filtered) stochastic central tendencies of these macroeconomic variables do. Finally, both observable and non-observable factors determine the risk premia and hence the excess holding returns of the bonds.

Monetary Unification and the Price of Risk: An Unconditional Analysis

In this paper we assess the effects of monetary unification in Europe on the pricing behavior in financial markets and more in particular on excess returns. We use the standard IAPT framework to analyze the role of the exchange rate in separating excess return pricing accross European countries. We find that, already in the decade prior to EMU, exchange rate changes do not (unconditionally) correlate strongly with financial market movements across countries. Consequently elimination of exchange rate variability through monetary unification is not likely to have had major implications for pricing behavior in EMU markets.

Do Exchange Rates Convert Prices of Risk Across Countries

Absence of arbitrage conditions impose important restrictions on the dynamics of bond and exchange rate returns. It can be shown that the exchange rate serves to convert prices of international undiversifiable risks from one currency to another. Put differently, arbitrage ensures that risk carries the same price in any two countries when evaluated from a particular viewpoint. As a consequence of this, expected returns should be equal after being converted to a common currency. We develop, estimate and test a linear 3-country asset pricing model for exchange risk hedged bond returns. Using US, UK, and German bond portfolio return data we find favorable evidence for the exchange rate being an unconditional converter of prices of risk across countries. Few other papers verify this important arbitrage pricing corollary.