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Extracting Information from Asset Prices: the Methodology of EMU Calculators

  • Carlo A. Favero
  • Francesco Giavazzi
  • Fabrizio Iacone
  • Guido Tabellini

This paper analyses how to extract market expectations from asset prices, with a particular example: using the term structure of interest rates to estimate the probability the market attaches to the event that a country, Italy, joins the European Monetary Union at a given date. The extraction of such a probability from the term structure is based on the presumption that the term structure contains valuable information regarding the markets' assessment of a country's chances to join the EMU. The case of Italy is interesting because in the survey regularly conducted by Reuters the probability of joining EMU in 1999 fluctuated between 0.07 and 0.15, while, during the same period, the measures of computed by financial houses -- also based on the term structure of interest rates -- have ranged between 0.5 and 0.8. The paper proposes a new method for computing these probabilities, and shows that the discrepancies between survey and market-based measures are not the result of market ine fficiencies, but depend on an incorrect use of the term structure to compute probabilities. The technique proposed in the paper can also be used to distinguish between convergence of probabilities and convergence of fundamentals, that is to find out whether an observed reduction in interest rate spreads signals a higher probability of joining EMU at a given time, or simply reflects improved fundamentals.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 113.

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Handle: RePEc:igi:igierp:113
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  1. Robert P. Flood & Peter M. Garber, 1981. "A Model of Stochastic Process Switching," NBER Working Papers 0626, National Bureau of Economic Research, Inc.
  2. Söderlind, Paul & Svensson, Lars E.O., 1997. "New Techniques to Extract Market Expectations from Financial Instruments," Seminar Papers 621, Stockholm University, Institute for International Economic Studies.
  3. Robert J. Shiller & John Y. Campbell & Kermit L. Schoenholtz, 1983. "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Cowles Foundation Discussion Papers 667, Cowles Foundation for Research in Economics, Yale University.
  4. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," NBER Working Papers 1885, National Bureau of Economic Research, Inc.
  5. Christiano, Lawrence J. & Eichenbaum, Martin & Evans, Charles L., 1997. "Sticky price and limited participation models of money: A comparison," European Economic Review, Elsevier, vol. 41(6), pages 1201-1249, June.
  6. Clarida, R. & Gertler, M., 1996. "How the Bundesbank Conducts Monetary Policy," Working Papers 96-14, C.V. Starr Center for Applied Economics, New York University.
  7. J. Weidmann, 1996. "The likelihood of European Monetary Union," BNL Quarterly Review, Banca Nazionale del Lavoro, vol. 49(199), pages 405-413.
  8. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 1994. "The effects of monetary policy shocks: evidence from the flow of funds," Proceedings, Federal Reserve Bank of Dallas, issue Apr.
  9. Robert P. Flood & Nancy Peregrim Marion, 1981. "Exchange-rate regimes in transition: Italy 1974," International Finance Discussion Papers 193, Board of Governors of the Federal Reserve System (U.S.).
  10. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring monetary policy," Working Papers in Applied Economic Theory 95-09, Federal Reserve Bank of San Francisco.
  11. Bernanke, Ben S. & Mihov, Ilian, 1997. "What does the Bundesbank target?," European Economic Review, Elsevier, vol. 41(6), pages 1025-1053, June.
  12. Gerlach, Stefan & Smets, Frank, 1997. "The term structure of Euro-rates: some evidence in support of the expectations hypothesis," Journal of International Money and Finance, Elsevier, vol. 16(2), pages 305-321, April.
  13. Bennett T. McCallum, 1994. "Monetary Policy and the Term Structure of Interest Rates," NBER Working Papers 4938, National Bureau of Economic Research, Inc.
  14. Angeloni, I. & Violi, R., 1997. "Long-Term Interest Rate Convergence in Europe and the Probability of EMU," Papers 322, Banca Italia - Servizio di Studi.
  15. J. Weidmann, 1996. "The likelihood of European Monetary Union," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 49(199), pages 405-413.
  16. repec:cup:cbooks:9780521389051 is not listed on IDEAS
  17. Christiano, Lawrence J & Eichenbaum, Martin, 1992. "Liquidity Effects and the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 82(2), pages 346-53, May.
  18. Sims, Christopher A & Stock, James H & Watson, Mark W, 1990. "Inference in Linear Time Series Models with Some Unit Roots," Econometrica, Econometric Society, vol. 58(1), pages 113-44, January.
  19. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  20. King, Mervyn, 1995. "Credibility and Monetary Policy: Theory and Evidence," Scottish Journal of Political Economy, Scottish Economic Society, vol. 42(1), pages 1-19, February.
  21. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
  22. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  23. Hendry, David F., 1995. "Dynamic Econometrics," OUP Catalogue, Oxford University Press, number 9780198283164, March.
  24. De Grauwe, Paul, 1996. "Forward Interest Rates as Predictors of EMU," CEPR Discussion Papers 1395, C.E.P.R. Discussion Papers.
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