CAPITAL CHARGE FOR THE CREDIT GAP PRODUCTS

Capital Charge for the Credit Gap Products

Table of Content

Abstract3

Chapter 1:Introduction5

Introduction to the Topic5

Purpose of the study11

CHAPTER 2: Literature Review14

A Model for Asset Prices14

Specification Test for the Asset Price Volatility Function28

Asymptotic distribution of the test statistic35

Chapter 3: Methodology38

Data38

Chapter 4: Results45

The model45

Empirical results49

Capital adequacy52

Sensitivity analysis53

Changes in the bank's interest rate sensitivity gap54

Robustness checks and a Monte Carlo exercise81

Chapter 5: Conclusion93

Concluding remarks93

Reference101

Abstract

The dissertation shows that the Fed reacts to financial (in) stability indicators such as credit spreads over and beyond their information content on future inflation and future output. When credit spreads are rising, the Fed lowers the Fed Funds rate more than what would be required by a standard forward-looking Taylor rule. In a non-parametric framework, I show that, when credit spreads are on the rise, the probability that the Fed (Greenbook forecasts) will make a large error in forecasting future output and inflation increases. Thus, the Fed's behaviour could be seen as an insurance policy against the downside risks to the baseline forecasts, aimed at protecting the economy against an extreme event (a deflation), with a low probability of occurrence but with devastating consequences, should it occur.

As it is the case for every insurance policy, the Fed's has a cost. In the second chapter, we measure it by running counter-factual simulations in a VAR framework. We find that, if the Fed did not react to credit spreads per se (i.e. over and beyond their information content on future inflation and future output), output gap variability would be higher and inflation and interest-rate variability would be lower. Ultimately, the cost of the insurance policy over the last twenty-five years was minor: it did not produce any significant loss of economic welfare. We further investigated whether GDP revisions are mainly "noise" or "news". In particular, focusing on the first GDP estimates (the "advance" estimates), we analyse whether the Bureau of Economic Analysis could produce more accurate forecasts with a better use of the data at its disposal at the time of the releases. Exploiting the information from a large real-time macroeconomic data set (using a Dynamic Factor Methodology), we find that about 10% of GDP revisions can be forecasted at the time of the initial release. It is possible to utilize the (relative) predictability of the revisions in order to improve the accuracy of the first estimate.

Chapter 1:Introduction

Introduction to the Topic

Diffusion processes formulated in continuous time as stochastic differential equations, have been used in economics and finance to model stock prices, term structure of interest rates, exchange rates, and several other variables. The stochastic differential equation that defines a diffusion process like {Xt, t E [0, ooj] on the probability space (n, A, P) is given by

where {Wt, t ~ O} is a standard Brownian Motion. These equations involve two components: the conditional drift p,(t, Xt) and the conditional variation (T2 (t, Xt) of the process in the vicinity of each point visited by Xt.

Various parametrizations of the functions p,(-) and (T2 (-) has ...