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Time-varying risk premia in emerging markets: Explanation by a multi-factor affine term structure model

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Abstract

From the empirical viewpoint, the Expectation Hypothesis Theory (EHT) of the term structure of interest rates has been extensively tested and rejected for US term structure data. Dai and Singleton [6] show that under the settings of Affine term structure models it is possible that one matches both the historical term structure dynamics and capture an important stylized fact that have contradicted the EHT: Time-varying risk premia. In emerging markets, economic conditions tend to be much less stable than in developed markets. For this reason, if risk premia is dynamic in such markets, intuition would suggest that it is more volatile than in developed markets, implying a stronger statistical rejection of the EHT. In this paper, we verify the robustness of Dai and Singleton's results under these more extreme market conditions. We estimate an arbitrage free Affine Gaussian model for the term structure of swaps in the Brazilian market. We propose an extensive empirical analysis which consists on: defining the optimal number of factors to be used in the model, estimating the model, giving interpretation to the state variables in terms of risk factors, and studying the model implied risk premia. In the end, we propose an application for risk management of interest rates futures portfolios.
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... Tab ak and Andrade (2001), Lima and Issler (2003) and Brito et al. (2003) test the ex p ectations hyp othesis for Brazil, whereas Tab ak (2003) and Tab ak and Tab ata (2005) ex amine the resp onse of the term structure to modifications in the targ et of the short-term rate. Almeida (2004) estimates a standard affine term structure model to assess its adeq uacy and ap p licab ility in the Brazilian case. Finally, Silveira (2005) and Matsumara and Moreira (2005) were the first to op enly use macroeconomic variab les in a yield curve model, in order to try to ex p lain the dynamics of the term structure of interest rates in Brazil 1 . ...
... All p arameters are strong ly sig nificant 13 . The standard deviations of the measurement errors for the 1,2, 3, 4, 6 and 12 month yields are, resp ectively, 14, 0, 7, 10, 17 and 95 b asis p oints, slig htly lower than those ob tained in Almeida (2004). The time variation in the risk p remium dep ends g reatly on the yield curve slop e factor, which contains the hig hest coefficients (in module) of matrix λ 1 . ...
... ,Lima and Issler (2003),Brito et al. (2003) andAlmeida (2004) reject, at least p artially, the validity of the ex p ectations hyp othesis and, therefore, I have to sp ecify λ 1 = 0. ...
Chapter
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In this chapter I characterize the relationship between macroeconomic variables and the terms structure of interest rates using the recent macro-finance approach adapted to the case of an emerging economy and applying it to Brazil. I find that macro variables help to explain the dynamics of the yield curve in emerging markets, specially in periods of high volatility. Moreover, the notion of great external vulnerability of emerging economies is confirmed by the strong role of the nominal exchange rate change, which explains up to 37% of the variation in yields in Brazil. However, the model does a poor job in forecasting yields during the financial crisis of 2008. This fact seems to be related to the strong fall in international commodity and industrial goods prices (in dollar terms), which limited the passthrough from the strong depreciation of the exchange rate to inflation.
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Under inflation targeting, monetary policy conduction is strongly related with the credibility of the regime. As far as is known, there are no empirical studies that measure the influence of the credibility of the inflation targeting regime on long term interest rate. Hence, based on the assumption that greater credibility reduces the interest rate spread, and based on preliminary evidence that the credibility and the spread are negatively correlated, the paper aims at investigating the influence of credibility on long term interest rates.
... Figure 7 presents 1-year bond and volatility risk premiums. For the bond, risk premium can be interpreted as minus the covariance between its return and the Stochastic Discount Factor 27 See Duffie and Singleton (1997) for an implementation with U.S. data, and Almeida (2004) for an implementation with Brazilian data. 28 θ is extracted in a way to match USV constraints and is not inverted from the cross section of bonds, nor from option prices. ...
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