Third International Moscow Finance Conference

The Macroeconomic Determinants of Financial Predictability

In this paper we take a first pass at formalising the underlying questions and articulating a pertinent theory for predictability. The fundamental construct we will employ is the well-know family of dynamic stochastic general equilibrium macroeconomic models that form the foundation of business cycle theory, growth theory, monetary theory and nearly every other inter-temporal equilibrium construct whose attributes can be conveniently related to the data. We show that under fairly general assumptions the neo classical growth model implies that the stochastic process characterising equity returns is stationary and mean reverting. This forms the theoretical underpinnings of predictability.

Systemic Risk, Sovereign Yields and Bank Exposures in the Euro Crisis

Since 2008, euro-area sovereign yields have diverged sharply, and so have the corresponding CDS premia. At the same time, banks’ sovereign debt portfolios featured an increasing home bias. We investigate the relationship between these two facts, and its rationale. First, we inquire to what extent the dynamics of sovereign yield differentials relative to the swap rate and CDS premia reflect changes in perceived sovereign solvency risk or rather different responses to systemic risk due to the possible collapse of the euro. We do so by decomposing yield differentials and CDS spreads in a country-specific and a common risk component via a dynamic factor model. We then investigate how the home bias of banks’ sovereign portfolios responds to yield differentials and to their two components, by estimating a vector error-correction model on 2008-12 monthly data. We find that in most countries of the euro area, and especially in its periphery, banks’ sovereign exposures respond positively to increases in yields. When bank exposures are related to the country-risk and common-risk components of yields, it turns out that (i) in the periphery, banks increase their domestic exposure in response to increases in country risk, while in core countries they do not; (ii) in most euro area banks respond to an increase in the common risk factor by raising their domestic exposures. Finding (i) hints at distorted incentives in periphery banks’ response to changes in their own sovereign’s risk. Finding (ii) indicates that, when systemic risk increases, all banks tend to increase the home bias of their portfolios, making the euro-area sovereign market more segmented.