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Session Overview
APE-10: Sovereign funding markets
Thursday, 22/Aug/2019:
8:30 - 10:00

Session Chair: Andrea Buraschi, Imperial College Business School
Session Chair: Melissa Prado, Nova School of Business and Economics
Location: D -106

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Mind the (Convergence) Gap: Forward Rates Strike Back!

Andrea Tamoni1, Alberto Plazzi2, Andrea Berardi3, Michael Markovich4

1London School of Economics, United Kingdom; 2Universita della Svizzera italiana and SFI; 3Universita Ca' Foscari Venezia; 4Credit Suisse

Discussant: Claudio Tebaldi (Bocconi University)

Variation in expected yield changes contaminates bond risk premia information that is contained in forward rates. We show that the difference between the natural rate of interest and the current level of monetary policy stance, dubbed Convergence Gap (CG), forecasts changes in yields and helps identify whether forward rates reflect expectations of future interest rates or risk premia. Compared to a model with only forward rates, adding the CG significantly raises the $R^2$ in the forecasting regression of bond excess returns and delivers bond risk premia that are more countercyclical. The importance of CG remains robust out-of-sample, and in countries other than the U.S. Further, its inclusion brings significant economic gains in the context of dynamic conditional asset allocation. Overall, our results underscore the importance of revisions in monetary policy for bond predictability.

efa2019-APE-10-300-Mind the (Convergence) Gap.pdf

Default Risk and the Pricing of U.S. Sovereign Bonds

Robert F. Dittmar1, Alex Hsu2, Guillaume Roussellet3, Peter Simasek2

1University of Michigan, United States of America; 2Georgia Technological University; 3McGill University

Discussant: Savitar Sundaresan (Imperial College London)

United States Treasury securities are \col{traditionally} viewed in academics and practice as being free of default risk. In principle, nominal outstanding Treasury debt can always be repaid by issuing fiat currency. The same does not hold true, however, for inflation-indexed debt. This leads the latter to embed lower rate of recovery in case of default. We examine the relative pricing of nominal and inflation-indexed debt in the presence of risk of default. We show empirically that the breakeven inflation between nominal Treasury securities and TIPS is significantly related to the premium paid on U.S. credit default swaps (CDS), controlling for measures of liquidity and slow-moving capital. This evidence motivates us to model the prices of nominal and inflation-protected securities in a no-arbitrage setting. Our model shows that breakeven inflation is related to perceptions of differing rates of recovery in the two markets. The estimated model provides evidence that most of the TIPS mispricing after the crisis can be attributed to the exposure to default risk.

efa2019-APE-10-1080-Default Risk and the Pricing of US Sovereign Bonds.pdf

Liquidity Risk and Funding Cost

Alexander Bechtel1, Angelo Ranaldo1, Jan Wrampelmeyer2

1University of St. Gallen, Switzerland; 2VU Amsterdam

Discussant: Ilaria Piatti (University of Oxford)

We propose and test a new channel for the link between funding liquidity risk and interest rates in short-term funding markets. Borrowers with high liquidity risk are willing to pay a markup to lock in their short-term funding, independent of credit and (market) liquidity risk premia demanded by lenders. We test the channel using unique bank-level data and uncover systematic and persistent differences in borrowers’ funding liquidity risk that lead to systematic and persistent heterogeneity in funding costs. Our results have important implications for financial stability, the transmission of monetary policy, and banks’ asset and liability management.

efa2019-APE-10-1301-Liquidity Risk and Funding Cost.pdf

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