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

Author

Listed:
  • Thomas J. Flavin

    (Economics, National University of Ireland, Maynooth)

  • Michele G. Limosani

    (Economics, Universita di Messina, Italy.)

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.

Suggested Citation

  • Thomas J. Flavin & Michele G. Limosani, 2000. "Explaining European Short-term Interest Rate Differentials: An Application of Tobin's Portfolio Theory," Economics Department Working Paper Series n1000500, Department of Economics, National University of Ireland - Maynooth.
    • Handle: RePEc:may:mayecw:n1000500
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    References listed on IDEAS

    as
    1. Engle, Robert F. & Kroner, Kenneth F., 1995. "Multivariate Simultaneous Generalized ARCH," Econometric Theory, Cambridge University Press, vol. 11(1), pages 122-150, February.
    2. Michele Limosani, 2000. "What Explains Real Interest Rate Differentials across European Countries?," STUDI ECONOMICI, FrancoAngeli Editore, vol. 2000(71).
    3. 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.
    4. Thomas J. Flavin & Michael R. Wickens, 1998. ": A Risk Management Approach to Optimal Asset Allocation," Economics Department Working Paper Series n851298, Department of Economics, National University of Ireland - Maynooth.
    5. Frankel, Jeffrey A. & MacArthur, Alan T., 1988. "Political vs. currency premia in international real interest differentials : A study of forward rates for 24 countries," European Economic Review, Elsevier, vol. 32(5), pages 1083-1114, June.
    6. 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.
    7. 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.
    8. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 25(2), pages 65-86.
    9. repec:cup:etheor:v:11:y:1995:i:1:p:122-50 is not listed on IDEAS
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    More about this item

    Keywords

    Interest rate differentials; risk premium; multivariate ARCH;
    All these keywords.

    JEL classification:

    • F3 - International Economics - - International Finance
    • G1 - Financial Economics - - General Financial Markets

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