A No-Arbitrage Analysis of Macroeconomic Determinants of Term Structures and the Exchange Rate

36 Pages Posted: 27 Feb 2007 Last revised: 17 Nov 2009

See all articles by Jun Yang

Jun Yang

Bank of Canada

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management

Date Written: January 15, 2009

Abstract

We study the joint dynamics of macroeconomic variables, bond yields, and the exchange rate in an empirical two-country New-Keynesian model complemented with a no-arbitrage term structure model. With Canadian and US data, we are able to study the impact of macroeconomic shocks from both countries on their yield curves and the exchange rate. The variance decomposition of the yield level shows that US monetary policy and aggregate supply shocks explain a majority of the unconditional variations in Canadian yields. They also explain up to 50% of the variations in the expected excess holding period returns of Canadian bonds. In addition, Canadian monetary policy shocks explain more than 70% of the variations in Canadian yields over short and medium forecast horizons. It also explains around 40% of the expected excess holding period returns of Canadian bonds. Both Canadian and US macroeconomic shocks help explain the dynamics of the exchange rate and the time-varying exchange risk premium.

Keywords: Exchange rates, Interest rates, Financial markets, Econometric and statistical methods

JEL Classification: E12, E43, F41, G12, G15

Suggested Citation

Yang, Jun and Chabi-Yo, Fousseni, A No-Arbitrage Analysis of Macroeconomic Determinants of Term Structures and the Exchange Rate (January 15, 2009). Available at SSRN: https://ssrn.com/abstract=965848 or http://dx.doi.org/10.2139/ssrn.965848

Jun Yang (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

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