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Deviations from Covered Interest Rate Parity
We find that deviations from the covered interest rate parity (CIP) condition imply large, persistent, and systematic arbitrage opportunities in one of the largest asset markets in the world. Contrary to the common view, these deviations for major currencies are not explained away by credit risk or transaction costs. They are particularly strong for forward contracts that appear on banks' balance sheets at the end of the quarter, pointing to a causal effect of banking regulation on asset prices. The CIP deviations also appear significantly correlated with other fixed income spreads and with nominal interest rates.
Journal Article
Interest Rates under Falling Stars
Macro-finance theory implies that trend inflation and the equilibrium real interest rate are fundamental determinants of the yield curve. However, empirical models of the term structure of interest rates generally assume that these fundamentals are constant. We show that accounting for time variation in these underlying long-run trends is crucial for understanding the dynamics of Treasury yields and predicting excess bond returns. We introduce a new arbitrage-free model that captures the key role that long-run trends play in determining interest rates. The model also provides new, more plausible estimates of the term premium and accurate out-of-sample yield forecasts.
Journal Article
Banking on Deposits: Maturity Transformation without Interest Rate Risk
We show that maturity transformation does not expose banks to interest rate risk—it hedges it. The reason is the deposit franchise, which allows banks to pay deposit rates that are low and insensitive to market interest rates. Hedging the deposit franchise requires banks to earn income that is also insensitive, that is, to lend long term at fixed rates. As predicted by this theory, we show that banks closely match the interest rate sensitivities of their interest income and expense, and that this insulates their equity from interest rate shocks. Our results explain why banks supply long-term credit.
Journal Article
Exchange Rates, Interest Rates, and the Risk Premium
The uncovered interest parity puzzle concerns the empirical regularity that high interest rate countries tend to have high expected returns on short term deposits. A separate puzzle is that high real interest rate countries tend to have currencies that are stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two findings have apparently contradictory implications for the relationship of the foreign-exchange risk premium and interest-rate differentials. We document these puzzles, and show that existing models appear unable to account for both. A model that might reconcile the findings is discussed.
Journal Article
A Model of Mortgage Default
In this paper, we solve a dynamic model of households' mortgage decisions incorporating labor income, house price, inflation, and interest rate risk. Using a zero-profit condition for mortgage lenders, we solve for equilibrium mortgage rates given borrower characteristics and optimal decisions. The model quantifies the effects of adjustable versus fixed mortgage rates, loan-to-value ratios, and mortgage affbrdability measures on mortgage premia and default. Mortgage selection by heterogeneous borrowers helps explain the higher default rates on adjustable-rate mortgages during the recent U.S. housing downturn, and the variation in mortgage premia with the level of interest rates.
Journal Article
Monetary Policy Expectations at the Zero Lower Bound
We show that conventional dynamic term structure models (DTSMs) estimated on recent U.S. data severely violate the zero lower bound (ZLB) on nominal interest rates and deliver poor forecasts of future short rates. In contrast, shadow-rate DTSMs account for the ZLB by construction, capture the resulting distributional asymmetry of future short rates, and achieve good forecast performance. These models provide more accurate estimates of the most likely path for future monetary policy—including the timing of policy liftoff from the ZLB and the pace of subsequent policy tightening. We also demonstrate the benefits of including macroeconomic factors in a shadow-rate DTSM when yields are constrained near the ZLB.
Journal Article
Linear-Rational Term Structure Models
We introduce the class of linear-rational term structure models in which the state price density is modeled such that bond prices become linear-rational functions of the factors. This class is highly tractable with several distinct advantages: (i) ensures non-negative interest rates, (ii) easily accommodates unspanned factors affecting volatility and risk premiums, and (iii) admits semi-analytical solutions to swaptions. A parsimonious model specification within the linear-rational class has a very good fit to both interest rate swaps and swaptions since 1997 and captures many features of term structure, volatility, and risk premium dynamics—including when interest rates are close to the zero lower bound.
Journal Article