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Relationship between Treasury bills and Eurodollars: Theoretical and Empirical Analyses

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  • Cheng-few Lee

    ()

  • Keshab Shrestha

    ()

  • Robert Welch

    ()

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    Abstract

    In this paper, we derive an equilibrium relationship between the yields on Eurodollar and Treasury bills based on equivalent martingale results derived by Harrison and Kreps ( 1979 ) and Harrison and Pliska ( 1981 , 1983 ) as well as the corporate debt pricing model developed by Merton ( 1974 ). The derived equilibrium relationship incorporates the models used by Booth and Tse ( 1995 ) and Shrestha and Welch ( 2001 ) as special cases. The equilibrium relationship indicates that the conditional volatility of the yield on Eurodollars explains the variation in the TED spread. We empirically test the equilibrium relationship using a GARCH-M model and the concept of fractional cointegration. We use both the ex ante data implied by the respective futures contracts as well as the ex post spot data with daily, weekly and monthly frequencies. We find empirical support for the Equilibrium relationship. Copyright Springer Science+Business Media, LLC 2007

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    File URL: http://hdl.handle.net/10.1007/s11156-006-0006-7
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    Bibliographic Info

    Article provided by Springer in its journal Review of Quantitative Finance and Accounting.

    Volume (Year): 28 (2007)
    Issue (Month): 2 (February)
    Pages: 163-185

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    Handle: RePEc:kap:rqfnac:v:28:y:2007:i:2:p:163-185

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    Web page: http://springerlink.metapress.com/link.asp?id=102990

    Related research

    Keywords: Stationary; Fractional cointegration; TED spread;

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    1. Francis X. Diebold & Glenn D. Rudebusch, 1990. "On the power of Dickey-Fuller tests against fractional alternatives," Finance and Economics Discussion Series 119, Board of Governors of the Federal Reserve System (U.S.).
    2. Cheung, Yin-Wong & Lai, Kon S, 1993. "A Fractional Cointegration Analysis of Purchasing Power Parity," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(1), pages 103-12, January.
    3. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, 04.
    4. Sowell, Fallaw, 1990. "The Fractional Unit Root Distribution," Econometrica, Econometric Society, vol. 58(2), pages 495-505, March.
    5. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
    6. Fung, Hung-Gay & Isberg, Steven C., 1992. "The international transmission of eurodollar and US interest rates: A cointegration analysis," Journal of Banking & Finance, Elsevier, vol. 16(4), pages 757-769, August.
    7. Fung, Hung-Gay & Lo, Wai-Chung, 1995. "An Empirical Examination of the Ex Ante International Interest Rate Transmission," The Financial Review, Eastern Finance Association, vol. 30(1), pages 175-92, February.
    8. Lo, Andrew W, 1991. "Long-Term Memory in Stock Market Prices," Econometrica, Econometric Society, vol. 59(5), pages 1279-313, September.
    9. Harrison, J. Michael & Pliska, Stanley R., 1983. "A stochastic calculus model of continuous trading: Complete markets," Stochastic Processes and their Applications, Elsevier, vol. 15(3), pages 313-316, August.
    10. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
    11. Dickey, David A & Fuller, Wayne A, 1981. "Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root," Econometrica, Econometric Society, vol. 49(4), pages 1057-72, June.
    12. Harrison, J. Michael & Pliska, Stanley R., 1981. "Martingales and stochastic integrals in the theory of continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 11(3), pages 215-260, August.
    13. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
    14. Nelson, Daniel B., 1990. "Stationarity and Persistence in the GARCH(1,1) Model," Econometric Theory, Cambridge University Press, vol. 6(03), pages 318-334, September.
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