Financial Research Papers
Our economists have a selection of research papers available to download. These documents are primarily targeted at those readers with an interest in
financial markets.
FRP 10: The Forecasting Accuracy of the World Interest Rate Model (WIRM)
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Author: David Rae
Released: November 1997
We test our World Interest Rate Model (WIRM) by
checking how well it has forecast in the year since it was built. The WIRM is used to
predict 10-year interest rates in 17 OECD countries, including New Zealand. We find the
model did a good job of picking the world-wide decline in bond yields since the middle of
1996, and performed particuarly well for US bonds. We also demonstrate how the WIRM can be
used for scenario analysis, by producing forecasts based on different assumptions about
world growth, inflation, and so on.
FRP 9: Forecasting Volatility
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(498KB)
Author: David Rae
Released: August 1997
Derivative markets have grown strongly in the
past few years. These markets can be thought of as places in which people 'trade
volatility'. Wherever there are traders, there is a demand for forecasters. This paper
compares different methods of forecasting volatility in New Zealand's financial markets.
In particular, we look at the volatility of short-term and long-term interest rates and of
exchange rates against the New Zealand Dollar. We compare eight different forecasting
methods, based on their ability to predict volatility out-of-sample.
FRP 8: New Zealand's Forward Exchange Market
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(522KB)
Author: David Rae
Released: August 1997
Why do high interest rate currencies tend to
appreciate? Standard economic theory predicts the opposite - interest arbitrage should
ensure that expected returns are equal in all currencies, in which case currencies with
high interest rates should depreciate on average. The fact that they do not has been
dubbed the forward premium puzzle. This paper investigates the puzzle in New Zealand's
forward market. Like overseas, the puzzle also exists in New Zealand. We discuss two
potential explanations. First, there is a time-varying risk premium in NZ's forward
market. This risk premium is related to volatility in the spot market and to NZ's net
foreign debt position. Second, expectations may not be rational. In particular, people
make systematic mistakes when forecasting inflation and therefore make mistakes in
predicting monetary policy. This may explain why high interest rate currencies tend to
appreciate rather than depreciate.
FRP 7: A World Interest Rate Model
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Authors: Brendan O'Donovan, Adrian Orr & David Rae
Released: November 1996
The National Bank's World Interest Rate Model (WIRM) is an econometric model of real long-term interest rates in 17 OECD countries. It
consists of three main parts. The first are the fundamentals, which depend on a country's
level of government debt, its current account history, its inflation record, and the
riskiness of its bond market. A key feature of the WIRM is that these factors are priced
equally across countries. The second part models the short run factors, including the
(temporary) influences of monetary and fiscal policy. Third, the model accounts for global
integration whereby bond markets in different countries are intimately
linked.
FRP 6: Exchange Rate Behaviour Under Inflation Targets
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(1,056KB)
Authors: Adrian Orr & David Rae
Released: June 1996
Over recent years several central banks have
implemented inflation targets as the primary objective of monetary policy. With this in
mind, this paper has two aims: to demonstrate the ways in which inflation targets alter
the behaviour of the exchange rate; and to show that being transparent about the ultimate
goal is not enough - the central bank must also be transparent about its operating
procedures. We compare the experiences of the Reserve Bank of New Zealand and the Bank of
Canada, and show how New Zealand's more transparent system has led to a significant drop
in financial volatility.
FRP 5: New Zealand's House Prices
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Authors: Brendan O'Donovan & David Rae
Released: May 1996
A house price boom has recently put a great deal
of pressure on monetary policy in New Zealand. We look at the behaviour and determinants
of house prices at both an aggregate and regional level. House prices have a number of
features that distinguish them from most other prices in the economy. They show strong
cycles, high volatility, pronounced boom-bust behaviour, asymmetries (booms are different
from busts), and strong regional differences. We model aggregate house prices within an
overall household consumption model, and then model the variation in prices across
regions, taking these unusual features into account.
FRP 4: Outlook for the NZD/AUD
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Author: Arthur Grimes
Released: November 1995
In this paper we develop an econometric model of
the NZ-Australia exchange rate. We find that the real exchange rate depends on each
country's terms of trade and on their relative current account balances. Interestingly, it
also depends on the US Dollar / Japanese Yen exchange rate. This effect exists because of
the way that monetary policy operates in New Zealand.
FRP 3: Inflation Linked Bonds: A New Zealand Guide
Released: February 1995
This document provides an introduction to index
linked securities. It covers the following topics. (1) The generic types of index linked
securities (ILS). (2) Past issues of ILS's overseas, and the lessons from their issuance
in the UK and Australia. (3) The rationale for investment in ILS's. (4) A detailed
discussion of New Zealand's ILS, the Capital Indexed Bond. (5) A comparison of the
performance of ILS's with other asset classes. (6) The main economic determinants of
yields on ILS's. (7) New Zealand's Reserve Bank Act and its implications for the conduct
of monetary policy in New Zealand. (8) A theoretical discussion of the determinants of
real interest rates.
FRP 2: The Determinants of New Zealand Bond Yields
Author: Arthur Grimes
Released: July 1994
This paper examines the key determinants of New
Zealand's 5 and 10 year bond yields. Econometric models are developed both for long run
'fundamentals' and for short run (monthly) yield changes. We find that NZ's bond yields
are driven by Australian and US yields, by NZ's short term interest rates, and by the
ratio of foreign debt to GDP. The equations are remarkably successful in forecasting NZ
bond yields: the average month-ahead prediction of each equation is within 5 basis points.
FRP 1: The Exchange Rate and Inflation: Are Trade Weights Best?
Author: David Rae
Released: July 1994
The Reserve Bank of New Zealand uses a
Trade-Weighted Exchange Rate Index (TWI) as one of its key monetary policy instruments.
However, when it comes to forecasting inflation, the TWI is not the best exchange rate
index. It places too much weight on the Australian Dollar and not enough weight on the US
Dollar. We construct an alternative index that forecasts inflation more accurately and
gives better signals on the firmness of monetary policy.
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