Discussion Paper Details

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Title: Do We Need Multi-Country Models to Explain Exchange Rate, Interest Rate and Bond Return Dynamics?

Author(s): Robert J Hodrick and Maria Vassalou

Publication Date: November 2001

Keyword(s): bond returns, Exchange rates, interest rates and multi-country models

Programme Area(s): Financial Economics

Abstract: This Paper examines characterizations of the dynamics for first and second moments of the one-month interest rate, the 12-month excess bond return and exchange rates. The countries considered are the US, Germany, Japan and the UK. Our tests are based on the implications of multi-country versions of the Cox, Ingersoll and Ross (1985) class of term structure models. Multi-country models are in several cases better able to explain the dynamics of one-month interest rates and the 12-month excess bond returns than one-country models. Furthermore, in some cases, they can also explain the dynamics of the exchange rates better than two-country models. Multi-country models are particularly useful for explaining the second moment of the one-month US interest rate, the second moments of the 12-month excess bond returns in US, Germany and Japan, as well as the first moment of the rate of appreciation of the Deutsche mark relative to the US dollar. In addition to results based on asymptotic distributions, we also provide inference using the small-sample distributions of test statistics.

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Bibliographic Reference

Hodrick, R and Vassalou, M. 2001. 'Do We Need Multi-Country Models to Explain Exchange Rate, Interest Rate and Bond Return Dynamics?'. London, Centre for Economic Policy Research.