Essays in international finance and applied econometrics

Abstract

The thesis consists of three essays in the fields of international finance and applied econometrics. The first chapter analyzes the co-movement of market premia for rare adverse events, addressing the important issue of contagion. The second chapter studies the impact of rare adverse events on the estimates of the risk-aversion coefficient and on household's portfolio composition. This chapter shows that the threat of a rare disaster justifies household's positive bond holdings. Finally, the last chapter studies if the information not contained in the domestic yield curve, but contained in the foreign yield curve helps to predict future dynamics of domestic yields. The first chapter proposes a novel approach to assessing volatility contagion across equity markets. More specifically I decompose the variance risk premia of three major stock indices into: crash and non-crash risk components and analyse their cross-market correlations. I find that crash-risk premia exhibit higher correlations than non-crash risk premia, implying the existence of volatility contagion. This suggests that investors believe that equity returns will be more highly correlated across countries during market crashes than during more normal times. The main result of the analysis holds when I apply other measures of co-movement as well as when I allow correlation to be time varying. Moreover I document that crash-premia constitute a large portion of the overall variance risk premia, highlighting the importance of crash-risks. Unlike the existing literature, my approach to testing the existence of volatility contagion does not rely on short periods of financial distress, but allows for crash-risk premia to be computed in tranquil times. The second chapter assesses the impact of the Peso problem on the econometric estimates of the risk aversion coefficient. Rietz (1988) and subsequently Barro (2006) showed that the introduction of the crash risk allows the canonical general equilibrium framework to generate data consistent equity premia even under low risk aversion of the representative agents. They argue that the original data used to calibrate these models suffer from a Peso problem (i.e. does not encounter a crash state). To the best of my knowledge the impact of their Peso problem on the estimation of the risk aversion coefficient has not to date been evaluated. This chapter seeks to remedy this. I find that crash states that are internalized by economic agents, but are not realized in the sample, generate only a small bias in the estimates of the risk aversion coefficient. I also show that the introduction of the crash state has a strong bearing on the household's portfolio composition. In fact, under the internalized crash state scenario, households exhibit positive bond holdings even in a frictionless environment. In the third chapter, co-authored with Andrew Meldrum and Peter Spencer, we show, using data on government bonds in Germany and the US, that 'overseas unspanned factors' - constructed from the components of overseas yields that are uncorrelated with domestic yields - have significant explanatory power for subsequent domestic bond returns. This result is remarkably robust, holding for different sample periods, as well as out of sample. By adding our overseas unspanned factors to simple dynamic term structure models, we show that shocks to those factors have large and persistent effects on domestic yield curves. Dynamic term structure models that omit information about foreign bond yields are therefore likely to be mis-specified.