Peter Sellin

Monetary Policy and the Stock Market: Theory and Empirical Evidence

This paper gives a comprehensive review of the literature on the interaction between real stock returns, inflation, and money growth, with a special emphasis on the role of monetary policy. This is an area of research that has interested monetary and financial economists for a long time. Monetary economists have been interested in the question whether money has any effect on real stock prices, while financial economists have investigated whether equity is a good hedge against inflation. Empirical studies show that money can be helpful in predicting future stock returns. Empirical evidence also suggest that equity is not a good hedge against inflation in the short run but may be so in the long run. The short-run negative relation between stock returns and inflation can easily be explained by theoretical models. If the central bank conducts a countercyclical monetary policy this will result in a negative relation between inflation and stock returns, while if it conducts a procyclical policy we could observe a positive relation. According to both theoretical and empirical studies investors receive an inflation risk premium for holding equity. Copyright 2001 by Blackwell Publishers Ltd

Value at Risk for Derivatives

Value at Risk is close to becoming the method of choice for assessing risk exposures faced by financial firms. The assets and liabilities in the firms risk portfolio are mapped onto a smaller set of standard factors, whose variances and correlations are given (estimated) The returns variance for the entire position is computed and the desired cutoff value for the lower tail of the portfolios returns distribution, under the typical assumption of joint lognormality, gives an estimate of the Value at Risk. But this procedure runs into large problems when derivatives with non-linear payoffs are included in the portfolio, an it also can be very difficult to implement with non-Gaussian returns. El Jahel, Perraudin, and Sellin present a new technique that greatly extends the range of assets and returns distribution that can be handled conveniently in a VaR calculation. For example, their framework easily accommodates non-linear payoffs, fat-tailed returns distributions, and stochastic volatility. It begins by computing the characteristic function for the whole portfolio, which is used to determine the first four moments of the returns distribution. Finally, an approximating distribution selected from a general family of distributions is fitted to these moments, and becomes the distribution used for VaR calculations. As the article shows, the results are distinctly more accurate than standard approaches.

Exchange rates and long-term bonds

Tentative evidence suggests that the empiricalfailure of uncovered interest parity (UIP) is confined to short-term interest rates. Tests of UIP for long-term interest rates are however hampered by various data problems. By focusing on short investments in long-term bonds, these data problems can be avoided. We study the relationship between the US dollar - Deutsch Mark exchange rate and German and American bond rates. The hypothesis that expected returns to investments in bonds denominated in the two currencies are equal cannot be rejected. This result is not simply due to low power as the beta-coefficients are close to unity. For the corresponding short-term interest rates, the typical finding of a large and significantly negative beta-coefficient is confirmed.

The Equilibrium Rate of Unemployment and the Real Exchange Rate: An Unobserved Components System Approach

We set up and estimate a structural unobserved components open economy model for the rate of unemployment and the real exchange rate in Sweden. This approach enables us to simultaneously determine changes in both cyclical and equilibrium rates. Our results show that the Natural Rate/NAIRU has increased by approximately 1.5 percentage points since the 1970s, driven by a depreciation of the equilibrium exchange rate, changes in taxes, active labor market policies and demographic factors. Thus, the results indicate that the dramatic changes in the Swedish unemployment rate during the 1990s mainly was a cyclical phenomenon. After five devaluations in the 1970s and early 1980s the krona was allowed to float on 19 November 1992. The depreciating trend continued during the floating rate period. Our model successfully explains this development as being driven by changes in terms of trade, demographics and structural government deficits. The change in the rate of inflation is found to be quite sensitive to the unemployment gap. An increase in cyclical unemployment by 1 percentage point will reduce inflation by approximately 0.6 percentage points within a year.

Stochastic dominance, tax-loss selling and seasonalities in Sweden

This paper examines two potential explanations of the January effect in the Swedish stock market for the period from January 1919 to December 1994; The tax-loss selling hypothesis and the omitted risk factor hypothesis. We document significantly higher returns in both January and July over the sample period. In addition, there is a seasonal pattern in the variances of the monthly returns. There also seems to be an interaction between the variance and the mean effects. We identify six different tax regimes where capital gains and losses are treated differently, and test whether tax regime changes have an influence on the January effect. Price pressures and rebounds implied by the tax-loss selling hypothesis are also analysed. Finally, we use the concept of stochastic dominance to study if the higher returns are due to compensation to investors for bearing higher risk. However, we find no support for either of the proposed hypotheses.

A Latent Factor Model of European Exchange Rate Risk Premia

The floating of a number of European currencies in 1992-93 created a new body of data on foreign exchange risk premia, or deviations from uncovered interest rate parity (UIP). In this paper, excess returns to investments in SEK, NOK, FIM, GBP, ITL and ESP against the DEM are investigated. First, univariate GARCH-M models are estimated for each currency and UIP is tested. UIP fares as badly on this data set as in most other studies. Then a latent factor GARCH model that takes common effects in the different currency markets into account is applied. The risk premia are modelled as functions of time varying factor variances. A Kalman filter is used to identify the unobservable risk factors. A one-factor model that allows for idiosyncratic risk seem to fit the data quite well. However, the puzzling finding is made that the factor risk does not appear to be priced. Copyright @ 1999 by John Wiley & Sons, Ltd. All rights reserved.

A Simultaneous Model of the Swedish Krona, the US Dollar and the Euro

In this paper we simultaneously estimate the real exchange rates between the Swedish Krona, the US Dollar and the Euro. A prime candidate for explaining the exchange rate movements is relative potential output. Since this variable is unobservable, cyclical and potential output are estimated in an unobserved components framework together with a Phillips curve. Our empirical exchange rate results are in line with theory. Increases in relative potential output and the terms of trade strengthen the exchange rate, while a relative increase of the fraction of middle-aged people in the population and budget deficits depreciate the exchange rate. The estimates suggest that the recent deterioration of the relative budget situation for the US versus Europe is a prime candidate for explaining the USD/EUR exchange rate change lately.

The Intertemporal Capital Asset Pricing Model with returns that follow Poisson jump–diffusion processes

Capital market equilibrium is derived in a model where asset returns follow a mixed Poisson jump–diffusion process. In the resulting modified Capital Asset Pricing Model (CAPM) expected returns are still linear in beta, but in addition premia have to be paid to compensate the investor for taking on jump risk. When jump risk is diversifiable in the market portfolio the model is reduced to the standard CAPM. Jumps are found to be prevalent in the daily returns of the market indices in the 18 countries investigated. A continuous return process does not give an adequate description of the market returns in any of the countries investigated.

Using a New Open Economy Macroeconomics Model to Make Real Nominal Exchange Rate Forecasts

In this paper we undertake an out-of-sample evaluation of the ability of a model to forecast the Swedish Krona’s real and nominal effective exchange rate, using a cointegrating relation between the real exchange rate, relative output, terms of trade and net foreign assets (or alternatively the trade balance). The cointegrating relation is derived from a theoretical model of the New Open Economy Macroeconomics type. The forecasting performance of our estimated vector error correction model is quite good once the dynamics of the model have been augmented with an interest rate differential.