Financial Stress and Equilibrium Dynamics in Money Markets
41 Pages Posted: 17 Oct 2015
Date Written: October 15, 2015
Interest rate spreads are widely-used indicators of funding pressures and market functioning in money markets. Using weekly data from 2002 to 2015, we analyze money market dynamics in a long-run equilibrium framework where commonly-monitored spreads serve as error correction terms. We find strong evidence for nonlinearities with respect to levels of the spreads. We provide point and interval estimates for spread thresholds that quantify funding pressure points from a long-run perspective. Our results indicate significant asymmetry in the adjustment toward long-run equilibrium. We show that economically and statistically significant adjustments occur only following large shocks to risk premia. Additionally, we quantify shifts in interest rate volatilities in high spread regimes characterized by elevated funding stress as well as declining correlations between risky funding rates and relatively safe base rates in such environments.
Keywords: Cointegration, Constant conditional correlation model, GARCH, Money markets, Threshold models
JEL Classification: C32, E44, E52
Suggested Citation: Suggested Citation