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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, Finance and Accounting Department Working Paper Series n1000500, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  • Handle: RePEc:may:mayecw:n1000500
    as

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    File URL: http://repec.maynoothuniversity.ie/mayecw-files/N1000500.pdf
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    References listed on IDEAS

    as
    1. T. J. Flavin & M. G. Limosani, 2000. "Fiscal policy and the term premium in real interest rate differentials," Applied Financial Economics, Taylor & Francis Journals, pages 413-417.
    2. Engle, Robert F. & Kroner, Kenneth F., 1995. "Multivariate Simultaneous Generalized ARCH," Econometric Theory, Cambridge University Press, vol. 11(01), pages 122-150, February.
    3. Thomas J. Flavin & Michele G. Limosani, 1998. "Fiscal Policy and the Term Premium in Real Interest Rate Differentials," Economics, Finance and Accounting Department Working Paper Series n830498, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
    4. 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.
    5. Michele Limosani, 2000. "What Explains Real Interest Rate Differentials across European Countries?," STUDI ECONOMICI, FrancoAngeli Editore.
    6. 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.
    7. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," Review of Economic Studies, Oxford University Press, vol. 25(2), pages 65-86.
    8. Flavin, Thomas J. & Panopoulou, Ekaterini, 2009. "On the robustness of international portfolio diversification benefits to regime-switching volatility," Journal of International Financial Markets, Institutions and Money, Elsevier, pages 140-156.
    9. 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.
    10. Farrell, Joseph & Gibbons, Robert, 1989. "Cheap talk can matter in bargaining," Journal of Economic Theory, Elsevier, pages 221-237.
    11. 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.
    12. 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;

    JEL classification:

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

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