1. STOCK BOND MONET MARKET AND EXCHANGE RATE MEASURING INTERNATIONAL FINANCIAL TRANSMISSION Califano Michele Calorì Federica Čermák Jiří Krbilova Helena Lucchetta Giuseppe JEM044 –International Finance 28 April 2015

2. INTRODUCTION FINANCIAL MARKETS INTEGRATION ITS NATURE AND TRANSMISSION CHANNELS Modelling of transmission channels Strength and scope of linkages Contemporaneous coefficients (endogeneity) USA and Euro area Short-term interest rates, bond yields and equity market returns and exchange rate INTERNATIONAL CROSS-MARKET SPILLOVERS TRANSMISSION OF SHOCKS THROUGH THIRD MARKETS

3. LITERATURE REVIEW Domestic transmition International linkages (individual asset prices) USA Negative correlation between stock returns and bond yields (recent work) Strong reaction of equity prices to monetary policy shocks Bond and equity prices react on economic fundamentals news Macroeconomic news explain only small share of equity market spillovers (mature economies) Country-specific shocks vs. Bilateral trade and financial linkages Linkages through trade and capital flows – exchange rate linkages stronger during financial distress

4. PAPER´S ADDED VALUE  Comparison to Andersen et al. (2007) High frequency data → Lower frequency data 4 years time period → 20 years time period Analysis of subsystems → Analysis of full model MAIN IDEA: Analyzing the interaction of the domestic and international transmission of financial market shocks across various asset classes allowing for indirect influencing.

5. METHODOLOGY The paper assumes following Structural Model:

6. METHODOLOGY Main focus being matrix A which can be written as: Where: α parameters –spillovers across asset prices within the USA and EU β parameters – international spillovers γ parameters – USD- EUR exchange rate spillover

7. DATA The analysis focuses on financial linkages between the US and Euro area Considering: 1.Money markets 2.Bonds markets 3.Equity markets 4.Foreign exchange markets Period 1989-2008 Money marketBond marketEquity market USA3-m Treasury bill rate10-y TreasuryS&P 500 Index EU3-m Interbank rate 10-y German gov bondS&P Euro index Exchenge rate USD-DEM (pre 1999) USD-EUR (post 1999) Problem of the partial overlapping btw US market and EU market 2-days return for all the asset

8. RESULTS INTERNATIONAL TRANSMISSION CHANNEL DIRECT INDIRECT EXCHANGE RATE MARKETVARIANCE DECOMPOSITIONROBUSTNESS TESTS

9. TAB I. PARAMETER ESTIMATES USING STRUCTURAL FORM MODEL α parameters indicate the spillover across domestic asset prices within the USA and within the EA β parameters indicate the international spillovers between USA and Euro Area (EA) γ parameters indicate the spillovers from and to the US dollar-euro exchange rate 1)DIRECT EFFECTS STRUCTURAL-FORM MODEL

10. INTERNATIONAL TRANSMISSION CHANNEL – DIRECT We restrict all parameters that relate to international spillover across different markets to zero in the structural-form model, such that we will only report those parameters that show international spillover effects across the same market as well as those for the exchange rate. r t US = 0.0008 ∙ r t EA – 0.0038 ∙ e t +… b t US = 0.4402 ∙ b t EA + 0.0678 ∙ e t +… s t US = 0.0594 ∙ s t EA – 0.1324 ∙ e t +… r t EA = 0.1704 ∙ r t US + 0.0043 ∙ e t +… b t EA = 0.4892 ∙ b t US – 0.0596 ∙ e t +… s t EA = 0.6269 ∙ s t US + 0.7071 ∙ e t + … IMPLICATIONS: USA spillover to EA are substantially larger and estimated at much higher levels of statistical significance Statistical significance more pronounced for the effect on the european markets than USA, where only bond market are affected in a significant fashion US equity mkt do not respond to exchange rate movement, instead EA mkt increase by a substantial amount following an appreciation of EUR r t EA = euro area money market b t EA = euro area bond market s t EA = euro area equity market

11. RESULTS INTERNATIONAL TRANSMISSION CHANNEL DIRECT OVERALL (DIRECT+INDIRECT) EXCHANGE RATEVARIANCE DECOMPOSITIONROBUSTNESS TESTS

12. TAB II. PARAMETER ESTIMATES USING REDUCED-FORM MODEL spillovers of shocks that occur via other asset prices. REDUCED-FORM MODEL OBTAINED. 2) INDIRECT EFFECTS REDUCE-FORM MODEL

13. SPILLOVERS FROM USA AREA ASSETS TO THREE EURO ASSET RETURNS = data statistically insignificant P.S.: The exchange rate in defined as US dollar in units of euro r t EA =euro area money market b t EA = euro area bond market s t EA = euro area equity market μ t EA = foreign exchange market

14. SPILLOVERS FROM EURO AREA ASSETS TO THREE USA ASSET RETURNS P.S.:The exchange rate in defined as US dollar in units of euro r t EA = euro area money market b t EA = euro area bond market s t EA = euro area equity market μ t EA = foreign exchange market = data statistically insignificant

15. RESULTS INTERNATIONAL TRANSMISSION CHANNEL EXCHANGE RATE MARKET VARIANCE DECOMPOSITION ROBUSTNESS TESTS

16. RESPONSE OF THE EXCHANGE RATE Direct effects Implications: +1% increase in bond yields in USA brings to a 3.5% appreciation of US dollar. +1% increase in money market in USA brings to a depreciation of US dollar of less than 1%. The USA equity market is not statistically significant in determinating the exchange rate. Impact of US variables on the exchange rate P.S.:The implications are valid in both directions

17. RESPONSE OF THE EXCHANGE RATE Direct effects Impact of EA variables on the exchange rate Implications: +1% increase in EA money market brings to a depreciation of euro of 0.38% +1% increase in bond yields in EA brings to an apreciation of euro of 4,3% The European equity market does not have a statistically significant impact on the exchange rate P.S.:The implications are valid in both directions

18. RESPONSE OF THE EXCHANGE RATE Overall Effects Implications: Remind that in construncting the overall effect we used the reduced form model. Differently from the direct effect, on the overall effect we notice that an increase in short interest rate in USA leads to an appreciation of USA dollar ( in the direct form was the opposit). The other outcomes are similar also if the effects are less accentuated. Both USA and EA equity market do not have a statistically significance on the exchange rate.

19. RESULTS INTERNATIONAL TRANSMISSION CHANNEL EXCHANGE RATE MARKET VARIANCE DECOMPOSITION ROBUSTNESS TESTS

20. VARIANCE DECOMPOSITION Having identified and analized the domestic and international transmission of shocks Time to assessing the impact on the financial markets system. VARIANCE DECOMPOSITION The variance decomposition indicates the amount of information each variable contributes to the other variables in the autoregression. OUR GOAL: How much of developments in domestic financial markets are explained by shocks in foreign markets and how much is due to domestic factor? What is the role of the common shocks and exchange rate?

21. GRAPH I. DECOMPOSITION OF VARIANCE

22. FINDINGS: 1. The key result is that a significant and large share of the behavior of financial markets is explained by foreign asset prices. US financial markets are mainly determined nationally US money mkt, EA bonds yields explained 1,2% US bond mkt,12,3% EA (bonds mkt) US stock market, 3,9% EA(bonds mkt ) Average of all Euro Area effects on US financial markets is 6% A much larger share of EA financial market movement are driven by US financial market. EA money mkt, 14% US (money mkt) EA bonds mkt, 35% US (bond mkt) EA stock market, US 12% (bond mkt) and 21% (stock mkt) Average of all US effects on Euro Area financial markets is 30%

23. FINDINGS: Exchange rates have a similar importance for US and EA bond mkt 2,5% of movements in each market Equity mkt the EA is substantially more affected by the exchange rate, in EA 7,5% of variance, in US just 1,8% 2.The common factor explain up to 3% of the variance of the different financial markets. 3.On average, 30% of the variance of three euro area financial assets is accounted for by US developments, whereas a still sizeable smaller share of, on average, around 6% of US financial mkt movements are due to euro area developments. 4.US and Euro area financial markets are closely linked. 5.This link is not only within asset classes but also across financial assets. 6.These results stress that over the period (1989-2008) financial markets in both regions were to a large extent driven by US shocks.

24. RESULTS INTERNATIONAL TRANSMISSION CHANNEL EXCHANGE RATE MARKET VARIANCE DECOMPOSITION ROBUSTNESS TESTS

25. ROBUSTNESS ANALYSIS 1.Test whether different approaches to defining the euro data have a relevant impact on the thrust of results; 2.Look into possible differences depending on the position in the business cycle or the incidence of major international financial crises; 3. Test whether changes in a number of technical modeling assumption affect results.

26. RESULTS OF I ROBUSTNESS TEST : The effect of US short rates on those in the euro area construct is reduced while those in the other direction are magnified. Increasing linkage of financial market ( US and EA); Euro area substantially more strongly affected by the USA than vice versa.

27. RESULTS OF 2 ROBUSTNESS TEST : EXCLUDING RECESSIONS : Parameters are robust; Reduced linkage from the USA to EA, and an intensified linkage in the other direction; US short-term interest rates decouples from those in the EA; Europe is more dependent on the development in USA; EXCLUDING FINANCIAL CRISES : US decouples from Europe Development in Europe are following those in the US more closely US developments are more important than EA developments

28. RESULTS OF 3 ROBUSTNESS TEST : Main result : US dominance goes through in all these robustness tests. Direction and importance of the trasmission of shocks is LARGELY ROBUST.

29. CONCLUSIONS Asset prices react strongest to other domestic asset price shocks; There are substantial international spillovers, both within and across asset classes; International cross-market spillovers are significant both statistically as well as economically; Direct transmission of financial shocks within asset classes is often magnified substantially through indirect spillovers through other asset prices. (Bond yields  increase is of the order of 50%); Indirect spillovers through other asset prices, which are found to increase substantially the international transmission of shocks within asset classes; Dominance of US markets as the main driver of global financial markets: US financial markets explain, on average around 30% of movements in euro area financial markets, whereas euro area markets account only for about 6% of US asset price changes;