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Explaining European Short-term Interest Rate Differentials: An Application of Tobin's Portfolio Theory

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  • Thomas J. Flavin

    ()
    (Economics, National University of Ireland, Maynooth)

  • Michele G. Limosani

    (Economics, Universita di Messina, Italy.)

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    Abstract

    This paper seeks to identify potential determinants of short interest rate differentials across European countries. We rely on the portfolio theory of Tobin to choose our set of risk factors and then assess the ability of these macroeconomic variables to influence both the conditional mean and volatility of interest rate differentials. The macroeconomic variables employed in the analysis may be loosely considered to reflect both domestic government fiscal and monetary policy and international influences.We find significant ARCH-in-mean effects, implying that the conditional volatility of the interest rate differential exerts an important influence in the determination of its mean value. There are also significant short-run contagion effects whereby volatility in the macroeconomic factors is transmitted to the overall riskiness of the differential which in turn impacts upon the level of the differential.

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    Bibliographic Info

    Paper provided by Department of Economics, Finance and Accounting, National University of Ireland - Maynooth in its series Economics, Finance and Accounting Department Working Paper Series with number n1000500.

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    Length: 18 pages
    Date of creation: May 2000
    Date of revision:
    Handle: RePEc:may:mayecw:n1000500

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    Web page: http://economics.nuim.ie
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    Keywords: Interest rate differentials; risk premium; multivariate ARCH;

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    1. Tobin, James, 1982. "Money and Finance in the Macroeconomic Process," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 14(2), pages 171-204, May.
    2. Jeffrey A. Frankel & Alan T. MacArthur, 1987. "Political vs. Currency Premia in International Real Interest Differentials: A Study of Forward Rates for 24 Countries," NBER Working Papers 2309, National Bureau of Economic Research, Inc.
    3. T. J. Flavin & M. G. Limosani, 2000. "Fiscal policy and the term premium in real interest rate differentials," Applied Financial Economics, Taylor & Francis Journals, vol. 10(4), pages 413-417.
    4. Thomas J. Flavin & Michael R. Wickens, 1998. ": A Risk Management Approach to Optimal Asset Allocation," Economics, Finance and Accounting Department Working Paper Series n851298, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
    5. Bollerslev, Tim & Engle, Robert F. & Nelson, Daniel B., 1986. "Arch models," Handbook of Econometrics, in: R. F. Engle & D. McFadden (ed.), Handbook of Econometrics, edition 1, volume 4, chapter 49, pages 2959-3038 Elsevier.
    6. Engle, Robert F. & Kroner, Kenneth F., 1995. "Multivariate Simultaneous Generalized ARCH," Econometric Theory, Cambridge University Press, vol. 11(01), pages 122-150, February.
    7. James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers 14, Cowles Foundation for Research in Economics, Yale University.
    8. Thomas J. Flavin & Michael R. Wickens, 2001. "A Risk Management Approach to Optimal Asset Allocation," Economics, Finance and Accounting Department Working Paper Series n1080301, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
    9. Michele Limosani, 2000. "What Explains Real Interest Rate Differentials across European Countries?," STUDI ECONOMICI, FrancoAngeli Editore, vol. 2000(71).
    10. repec:cup:etheor:v:11:y:1995:i:1:p:122-50 is not listed on IDEAS
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