We analyse the importance of jumps and the leverage effect on forecasts of realized
volatility in a large cross-section of 18 international equity markets, using daily realized
measures data from the Oxford-Man Realized Library, and two widely employed empirical
models for realized volatility that allow for jumps and leverage. Our out-of-sample forecast
evaluation results show that the separation of realized volatility into a continuous and a
discontinuous (jump) component is important for the S&P 500, but of rather limited value for
the remaining 17 international equity markets that we analyse. Only for 6 equity markets
are significant and sizable forecast improvements realized at the one-step-ahead horizon,
which, nevertheless, deteriorate quickly and abruptly as the prediction horizon increases.
The inclusion of the leverage effect, on the other hand, has a much larger impact on all 18
international equity markets. Forecast gains are not only highly significant, but also sizeable,
with gains remaining significant for forecast horizons of up to one month ahead.
Macroeconomic Factors and Equity Premium Predictability, (with Martin Tischhauser)
International Review of Economics and Finance,
Neely et al. (2014) have recently demonstrated how to efficiently combine information
from a set of popular technical indicators together with the standard Goyal and Welch (2008)
predictor variables widely used in the equity premium forecasting literature to improve out-of-sample forecasts of the equity premium using a small number of principal components.
We show that forecasts of the equity premium can be further improved by, first, incorporating
broader macroeconomic data into the information set, second, improving the selection
of the most relevant factors and combining the most relevant factors by means of a forecast
combination regression, and third, imposing theoretically motivated positivity constraints on the forecasts of the equity premium. Applying standard out-of-sample forecast evaluation
tests, we find that in particular our proposed forecast combination approach, which
combines forecasts of the most relevant Neely et al. (2014) and macroeconomic factors and
further imposes positivity constraints on the equity premium forecasts, generates statistically
significant and economically sizable improvements over the best performing model of
Neely et al. (2014). Out-of-sample R2 values can be as high as 1.75%, with (annualised) gains
in certainty equivalent returns of up to 3.35%, relative to the ALL factors forecasts of Neely
et al. (2014).
The Term Structure of Interest Rates in an estimated New Keynesian Policy Model, (with Philipp Lentner)
Journal of Macroeconomics,
We jointly estimate a New Keynesian Policy Model with a Gaussian affine
no-arbitrage specification of the term structure of interest rates, and assess
how important inflation, output and monetary policy shocks are as sources of
fluctuations in interest rates and the term premium. We work with observable
pricing factors and utilize the computationally convenient normalization of
Joslin et al. (2013b). This allows us to estimate the model needing to
restrict the parameters driving the market prices of risk. Using data for the
U.S. from 1962:Q1 to 2014:Q2, we find that inflation and the output gap account
for around 80% of the unconditional forecast error variance of bond yields at
the short and medium end of the term structure, while monetary policy shocks
account for around 20%. Bond yields respond to macroeconomic shocks only
gradually, peaking after about 4 quarters. This is due to sizable monetary
policy inertia estimates in our model. At the peak of the response, inflation
shocks increase bond yields by more than one-to-one, and output shocks by less
than one-to-one, which is consistent with a Taylor type monetary policy rule.
Our term premium estimate is strongly counter-cyclical and can capture salient
features of the term structure that constitute a puzzle in the expectations
Global Equity Market Volatility Spillovers: A Broader Role for the United States, (with Katja Gisler)
International Journal of Forecasting,
Rapach et al. (2013) have recently shown that U.S. equity market returns carry valuable
information to improve return forecasts in global equity markets. In this study, we extend
the work of Rapach et al. (2013) and examine if U.S. based equity market information can be
used to improve realized volatility forecasts in a large cross-section of international equity
markets. We use volatility data for the U.S. and 17 foreign equity markets from the Oxford
Man Institute’s realized library and augment for each foreign equity market our benchmark
HAR model with U.S. equity market volatility information. We show that U.S. equity market
volatility information substantially improves out-of-sample forecasts of realized volatility in
all 17 foreign equity markets that we consider. Forecast gains are not only highly significant,
but produce out-of-sample R2 values between 4.56% and 14.48%, with 12 of these being
greater than 10%. The improvements in out-of-sample forecasts remain statistically significant
for horizons up to 1 month ahead. A substantial part of the predictive gains are driven
by forward looking volatility as captured by the VIX.
Heterogeneous Agents, the Financial Crisis and Exchange Rate Predictability, (with Gion Donat Piras)
Journal of International Money and Finance,
We construct an empirical heterogeneous agent model which optimally combines
forecasts from fundamentalist and chartist agents and evaluates its out-of-sample
forecast performance using daily data covering an overall period from
January 1999 to June 2014 for six of the most widely traded currencies. We use
daily financial data such as level, slope and curvature yield curve factors,
equity prices, as well as risk aversion and global trade activity measures in
the fundamentalist agent’s predictor set to obtain a proxy for the market’s view
on the state of the macroeconomy. Chartist agents rely upon standard momentum,
moving average and relative strength index technical indicators in their
predictor set. Individual agent specific forecasts are constructed using a
flexible dynamic model averaging framework and are then aggregated into a model
combined forecast using a forecast combination regression. We show that our
empirical heterogeneous agent model produces statistically significant and
sizable forecast improvements over a random walk benchmark, reaching out-of-
sample R2 values of 1.41, 1.07, 0.99 and 0.74 percent at the daily one-step
ahead horizon for 4 out of the 6 currencies that we consider. Forecast gains
remain significant for horizons up to three-days ahead. The forecast
improvements are largely realised before and around the time of the Lehman
Brothers collapse. We show further that our model combined forecasts produce
economic value to a mean variance investor, yielding annualized Sharpe ratios of
around 0.89 and annualized performance fees in excess of 460 basis points.
Equilibrium Credit: The Reference Point for Macroprudential Supervisors, (with Martin Melecky)
Journal of Banking and Finance,
(Addon Material, 249KB).
Equilibrium credit is an important concept because it helps to identify excessive credit
provision in an economy. This paper proposes a structural approach to determine equilibrium
credit which is based on the long-run through-the-cycle transaction demand for credit.
Using a panel data set consisting of 49 high and middle-income countries from 1980 to 2010,
we show that there exists considerable variation in the cross-country estimates of the income
and price elasticities of credit and that the unit elasticity restriction implicitly imposed
by the credit-to-GDP ratio is strongly rejected by the data. This suggests that the credit-to-GDP
ratio is not appropriate to measure equilibrium credit. We show further that the
cross-sectional variation in the income and price elasticities of credit can be related to a
set of relevant economic, financial and institutional development indicators of a country.
The main determinants that explain the cross-sectional variation in the income and price
elasticities are financial depth, access to financial services, use of capital markets, efficiency
and funding of domestic banks, central bank independence, the degree of supervisory integration,
and the experience of a financial crisis. As an empirical illustration, we compute
equilibrium credit and credit gaps for eleven new EU member states using our structural
framework and compare it to credit gaps based on the Basel III approach.
World Bank Blog,
Globalmacromatters Blog, paper presented at the
2013 Cleveland Federal Reserve high level conference on Financial Stability.
Background paper to Chapter 6 of the
World Development Report 2014: Risk and Opportunity: Managing Risk for Development.
Macroprudential Stress Testing of Credit Risk: A Practical Approach for Policy Makers, (with Martin Melecky)
Journal of Financial Stability,
Drawing on the lessons from the global financial crisis and especially from
its impact on the banking systems of Eastern Europe, the paper proposes a
new practical approach to macroprudential stress testing. The proposed
approach incorporates: (i) macro-economic stress scenarios generated from
both a country specific statistical model and historical cross-country
crises experience; (ii) indirect credit risk due to foreign currency
exposures of unhedged borrowers; (iii) varying underwriting practices across
banks and their asset classes based on their relative aggressiveness of
lending; (iv) higher correlations between the probability of default and the
loss given default during stress periods; (v) a negative effect of lending
concentration and residual loan maturity on unexpected losses; and (vi) the
use of an economic risk weighted capital adequacy ratio as the relevant
outcome indicator to measure the resilience of banks to materialising credit
risk. We apply the proposed approach to a set of Eastern European banks and
discuss the results.
Our stress testing methodology was used by World Bank staff in technical assistance
missions (FSAPs) in a number of Balkan, Eastern European, and Middle Eastern countries.
The impact of ECB monetary policy decisions and communication on the yield curve, (with Claus Brand and Jarkko Turunen)
Journal of the European Economic Association,
We use intraday changes in money market rates to construct indicators of news
about monetary policy stemming separately from policy decisions and from official
communication of the ECB, and study their impact on the yield curve. We show that
communication may lead to substantial revisions in expectations of monetary policy and at the same time exerts a significant impact on interest rates at longer maturities.
Thereby, the maturity response pattern to communication is hump-shaped, while that
of policy decisions is downward sloping.
An estimated New Keynesian Policy Model for Australia, (with Martin Melecky)
The Economic Record,
(Additional Notes, 259KB).
An open economy New Keynesian policy model for Australia is estimated in this
study. We investigate how important external shocks are as a source of macroeconomic
fluctuations when compared to domestic ones. The results of our analysis suggest that
the Australian business cycle and domestic inflation are most affected by domestic demand
and supply shocks, respectively. However, domestic output also appears to be
strongly affected by foreign demand shocks, and domestic inflation by exchange rate
shocks. Domestic variables do not seem to be significantly affected by foreign supply
and monetary policy shocks.