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Macro variables, term structure of interest rates, and exchange rates

Sen Dong, 2006
Faculty Advisor: Andrew Ang
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The first chapter is based on a coauthored paper with Andrew Ang and Monika Piazzesi. It estimates Taylor (1993) rules and identify monetary policy shocks using no-arbitrage pricing techniques. Long-term interest rates are risk-adjusted expected values of future short rates and thus provide strong over-identifying restrictions about the policy rule used by the Federal Reserve. The no-arbitrage framework also accommodates backward-looking and forward-looking Taylor rules. We find that inflation and GDP growth account for over half of the time-variation of time-varying excess bond returns and we attribute almost all of the movements in the term spread to inflation. Taylor rules estimated with no-arbitrage restrictions differ significantly from Taylor rules estimated by OLS, and monetary policy shocks identified with no-arbitrage techniques are less volatile than their OLS counterparts.

In Chapter 2, I study the role of macro variables in explaining the foreign exchange risk premium and the dynamics of exchange rates in a no-arbitrage term structure model. Expected exchange rate changes are determined by interest rate differentials across countries and risk premia, while unexpected changes are driven by innovations to macroeconomic variables, which are amplified by time-varying market prices of risk. Estimating the model with US/German data, I find that the correlation between the model-implied exchange rate changes and the data is over 60%. The model implies a countercyclical foreign exchange risk premium with macro risk premia playing an important role in matching the deviations from Uncovered Interest Rate Parity. I find that the output gap and inflation drive about 70% of the variance of forecasting the conditional mean of exchange rate changes.

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