Session III: Financial integration...Session III: Financial integration Leading paper: Philipp Hartmann Lorenzo Cappiello Peter Hördahl Arjan Kadareja Simone Manganelli European Central

What effects is EMU having on the euro area and its member countries? 16 – 17 June 2005, Frankfurt am Main

Session III: Financial integration Leading paper:

Philipp Hartmann Lorenzo Cappiello Peter Hördahl Arjan Kadareja Simone Manganelli European Central Bank

The Impact of the Euroon Financial Markets

Lorenzo Cappiello, Philipp Hartmann, Peter Hördahl, Arjan Kadareja, Simone Manganelli

What effects is EMU having on the euro area and its member countries?

Frankfurt, 16-17 June 2005

Disclaimer: The views expressed in this paper are only the authors’ and do not necessarily reflect the

views of the ECB or the Eurosystem

European Central Bank, DG Research

Introduction

• The Lisbon Agenda has put the integration of the European financial system high on the agenda

• Objective: Increase the competitiveness of the European economy

• Various reforms over time, for example– Single European Act 1987– Liberalization of capital flows 1990– Second Banking Directive 1992– Financial Services Action Plan 1999-2005– Green Paper on financial sector policies 2005-2010

• EMU is, arguably, the largest monetary union in human history and one major factor in the integration and competitiveness of the European financial system

Plan of the paper and presentation

• We look at changes in the European financial system and at the impact of the euro from two main perspectives

• Micro-financial developments (Part 1)– Objective: Integration of European financial markets– Short term: Time-varying return correlations– Long term: Structural breaks in spillover probabilities

• Macro-financial developments (Part II)– Objective: Interaction of monetary policy with financial

markets through the term structure of interest rates– Changes in macroeconomic fundamentals– Changes in risk premia

• For central bankers both are important and belong together

Part 1

Asset return dynamics before and after the euro:Integration of stock and government bond

markets

• Dynamic conditional correlation GARCH model by Engle (2002)– Daily volatilities and correlations– Parametric estimation

• Estimation: Two-step procedure– (i) Univariate GARCH models– (ii) Model correlation of standardized asset returns

• Structural breaks– dummy variable in the covariance matrix

corresponding to the introduction of the euro

Time-varying correlations and variances

( )( ) ( ) 11121 111 −−− +′+−−+−−−= tttttt badbadba QεεQQQ

{ } { } 2121 /tt

/tt diagdiag −−= QQQCorr

Conditional volatility of government bond returns

10 Year government bond returns : conditional volatility

0.00E+00

1.00E-04

2.00E-04

3.00E-04

4.00E-04

5.00E-04

6.00E-04

7.00E-04

02/01/92

02/05/9

202/0

9/9202/01/9

302/0

5/9302/09/9

302/0

1/94

02/05/94

02/09/94

02/01/95

02/05/95

02/09/9

502/0

1/9602/05/9

602/0

9/9602/01/9

702/0

5/97

02/09/97

02/01/98

02/05/98

02/09/9802/0

1/99

02/05/99

02/09/99

02/01/0

002/0

5/0002/09/0

002/0

1/0102/05/0

102/0

9/01

02/01/02

02/05/0

202/0

9/0202/01/0

302/0

5/03

02/09/03

02/01/04

02/05/04

02/09/04

02/01/0

5

USA UK Italy Spain Netherlands Germany France

Conditional correlations of equity index returns

Stock returns : Conditional correlations vs Germany

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

02/0

1/92

02/0

5/92

02/0

9/92

02/0

1/93

02/0

5/93

02/0

9/93

02/0

1/94

02/0

5/94

02/0

9/94

02/0

1/95

02/0

5/95

02/0

9/95

02/0

1/96

02/0

5/96

02/0

9/96

02/0

1/97

02/0

5/97

02/0

9/97

02/0

1/98

02/0

5/98

02/0

9/98

02/0

1/99

02/0

5/99

02/0

9/99

02/0

1/00

02/0

5/00

02/0

9/00

02/0

1/01

02/0

5/01

02/0

9/01

02/0

1/02

02/0

5/02

02/0

9/02

02/0

1/03

02/0

5/03

02/0

9/03

02/0

1/04

02/0

5/04

02/0

9/04

02/0

1/05

France UK Italy Netherlands Spain Sweden

Conditional correlations of government bond returns

10 Year government bond returns : Conditional correlations vs Germany

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

02/0

1/92

02/0

5/92

02/0

9/92

02/0

1/93

02/0

5/93

02/0

9/93

02/0

1/94

02/0

5/94

02/0

9/94

02/0

1/95

02/0

5/95

02/0

9/95

02/0

1/96

02/0

5/96

02/0

9/96

02/0

1/97

02/0

5/97

02/0

9/97

02/0

1/98

02/0

5/98

02/0

9/98

02/0

1/99

02/0

5/99

02/0

9/99

02/0

1/00

02/0

5/00

02/0

9/00

02/0

1/01

02/0

5/01

02/0

9/01

02/0

1/02

02/0

5/02

02/0

9/02

02/0

1/03

02/0

5/03

02/0

9/03

02/0

1/04

02/0

5/04

02/0

9/04

02/0

1/05

France Italy Netherlands Spain UK

Spillover probabilities from quantile regressions

• Basic tool of analysis: Conditional probability

tt yx , Yt

Xt qq θθ ,Market returns, θ-quantiles, θ∈(0,1)

[ ][ ]⎪⎩

⎪⎨⎧

>θ>>

≤θ<<≡θ

θθ

θθ

0.5 if

0.5 if Xtt

Ytt

Xtt

Ytt

t qx|qyPr

qx|qyPr)(p

• Three step procedure:– Estimate individual time-varying quantiles for X and Y– Construct indicator functions I(yt< qθt

Y) and I(xt< qθtX)

– Run OLS regression with euro effect dummy Dt:

( ) ( ) ( ) ttXttt

Xttt

Yttt DqxIqxIqyI

iiε+<γ+<α=< θθθθθ

Illustration of integration in the “co-movement box”

Perfect Integration

Perfect Segmentation

0.5

0.5

θ

p(θ)1

10

Increased integration

Decreased integration

Equity market integration

France / Germany

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97

independence line prob. before 1999 prob. after 1999 95% conf. interval

Euro Area - 5 Big Economies

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97

independence line prob.before 1999 prob.after 1999


Euro Area - Small Economies

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97

independence line prob.before 1999 prob.after 1999

Large versus small euro area country stock markets


Euro area / Japan

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97



Euro area / USA

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97

independence line prob.before 1999 prob.after 1999 95% conf.interval

Government bond market integration

France / Germany

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97


Big countries / Germany

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97

independence line prob. before 1999 prob. after 1999


Small countries / Germany

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97

independence line prob. before 1999 prob. after 1999

Large versus small euro area country bond markets

Part II

Asset pricing before and after the euro:The behavior of the term structure

Affine macro-finance model: Macro-economy

[ ] ( ) π−π+π ε+δ+πµ−+πµ=π ttxtttt xE 11 1

[ ] ( ) [ ]( ) xttttrtxttxt ErxxEx ε+π−ζ−µ−+µ= +−+ 111 1

( ) [ ]( )[ ] ttttttt rxEr ηργππβρ +++−−= −+ 1*

11

*

* t*t

*t uπ

−π+πφ=π 1

• Inflation:

• Output gap:

• Forward-looking Taylor rule (rt is policy instrument):

• Perceived inflation target (unobservable):

Macro model solution

• Let X1 be the vector of predetermined variables, which include lags of x, π, r, contemporaneous values of π*, and the shocks

• Let X2 be the vector of not predetermined variables, which include the contemporaneous values of x and π and forward-looking expectations of these variables as well as rt

• The solution provides two matrices M and C such that:

t,t,t, 1111 ξ+= −MXX

t,t, 12 CXX =

• Yield to maturity are derived assuming absence of arbitrage opportunities and specifying a process for the stochastic discount factor (sdf)

• Market prices of risk are assumed to be affine in the state vector (Duffie, 2002), i.e. the state of the economy determines the compensation for bearing risk

• The macro model, coupled with the assumptions on the sdf, determines yields to maturity:

Term structure of bond yields

t,nnnty 1XBA ′+=

• Yields to maturities depend on predetermined variables through:– Expectations on the short term interest rate– A risk (or term) premium, i.e. a compensation for risk

Term structure of bond yields

Impact of the euro on fundamentals

[ ] ( ) πεπππ ttx

ttteuropre

t xE +×+−+=−

−−+

−

)10054.0(

211)011.0( 2

10038.0132.01132.0

[ ] ( ) πεπππ ttx

ttteurot xE +×+−+=

−

−−+

)10028.1(

211)054.0( 2

10905.0152.01152.0

[ ] ( ) [ ]( ) xttttttt

europret ErxxEx επ +−−−+= +−+

−1)023.0(11)029.0(

027.0303.01303.0

[ ] ( ) [ ]( ) xttttttt

eurot ErxxEx επ +−−−+= +−+ 1)123.0(11)159.0(

109.0396.01396.0

( ) [ ]( ) tttttteuropre

t rxEr ηππ ++⎟⎠⎞⎜

⎝⎛ +−−= −+

−1)015.0()925.0(

*1)855.0(

976.0243.1087.2976.01

( ) [ ]( ) tttttteuro

t rxEr ηππ ++⎟⎠⎞⎜

⎝⎛ +−−= −+ 1)052.0()459.0(

*1)044.0(

925.0404.0016.1925.01

• Inflation:

• Output gap:

• Monetary policy rule:

)001.0(

2 022.010 =×πσ

)002.0(

2 015.010 =×πσ

)004.0(

2 097.010 =×xσ

)005.0(

2 041.010 =×xσ

)001.0(

2 040.010 =×ησ

)002.0(

2 014.010 =×ησ

Impact of the euro on risk premia

Term structure of average risk premia


Initial response of risk premia to a monetary policy shock


Estimated risk premia and components of premia

Conclusions

• Paper combined a micro-financial and a macro-financial perspective on the effects of the euro

• Micro: Financial integration– Reduced bond market volatility but not stock markets– Significantly increased stock market return correlations

among large but not small euro area countries– But also some increase with the US, but not global– Increased bond market correlations, also several small– Co-movements of stock and bond markets signal

significant progress in integration– Catalyst effect of the euro– Benefits sovereigns, investors and corporations– Financial integration a relatively successful program

under the Lisbon Agenda– Other areas: Banking, retail etc.

Conclusions

• Macro: Term structure and monetary policy– Variability of risk premia has decreased with EMU, related

to a reduction in macroeconomic volatility– On average, however, they are similar to before– Increases in the market prices of risk have offset the

reduction in macroeconomic volatility– Fundamental drivers of risk premia have not changed– Hence, the central bank can extract rate expectations

from the yield curve equally well as before EMU– It can even be more confident in the accuracy of its

analysis due to the reduced variability of premia– Communication with the market may be more effective

• Euro had significant positive effects on markets, although also other factors may have played a role

Annex

Further charts

United Kingdom / Germany

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97



United Kingdom / Germany

0.00

0.25

0.50

0.75

1.00

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97




Impulse response of inflation to a monetary policy shock

Documents

Session III: Financial integration...Session III: Financial integration Leading paper: Philipp Hartmann Lorenzo Cappiello Peter Hördahl Arjan Kadareja Simone Manganelli European Central