Interest rate movements and inflation risk in the Philippines

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Interest rate movements and inflation risk in the
Philippines

• Alma dela CruzDavid DickinsonEuro-Philippines
  Network on Banking and FinanceASIA-LINK research
  workshop27 August 2007

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Outline of presentation

• Introduction
• Related Literature
• Framework
• Methodology
• Preliminary Estimates

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Introduction

• The research done so far is part of a longer
  study whose objective is to model interest rate
  movements in the Philippines.
• The framework chosen was the CCAPM which requires
  us to estimate the inflation risk premium.
• This presentation is limited to the estimates of
  inflation risk in the Philippines obtained from a
  BEKK model to be used in future empirical work on
  CCAPM based interest rate modeling
• The literature on inflation risk is related to
  the nominal and real interest rate relationship
  which is reviewed next.

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Related Literature 1

• Barnea, A., Dotan, A, and J, Lakonishok (1979)
  The Effect of Price Level Uncertainty on the
  Determination of Nominal Interest Rates Some
  Empirical Evidence, Southern Economic Journal,
  Vol. 46, No. 2, pp. 609-614
• Benninga, S., and A. Protopapadakis, (1983), Real
  and Nominal Interest Rates under Uncertainty The
  Fisher Theorem and the Term Structure, Journal of
  Political Economy, Vol. 91, No. 5 pp. 856-867.
• Chan, L., (1994), Consumption, inflation risk,
  and real interest rates An empirical analysis,
  Journal of Business, Vol. 67 No. 1, 69-96.
• Shome, D., Smith, S., and J. Pinkerton, (1988)
  The Purchasing Power of Money and Nominal
  Interest Rates A Re-Examination, Journal of
  Finance, Vol. 43, No. 5, pp. 1113-1125.

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Related Literature 2

• The Fisher hypothesis under certainty i r ?,
  where ? is the inflation rate.
• When uncertainty is present, the nominal rate is
  the sum of the real rate and expected inflation.
• Incorporating uncertainty to the analysis
  inevitably leads to a nonlinear relationship.
  Benninga and Protopapadakis (1983) show that in
  addition to expected inflation, a covariance term
  (between the real value of an asset and
  inflation) that shows purchasing power riskiness
  and a term due to Jensens inequality showing
  inflation variability is needed to explain the
  relation more fully.
• Subsequent articles make use of the CCAPM as the
  framework in analysing the relation. This
  framework is discussed next.

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Framework - 1

• The representative agent in the CCAPM solves a
  consumption/portfolio allocation problem by
  maximizing an intertemporal expected utility
  function

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Framework - 2

• The standard solution to the problem is a set of
  Euler equations

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Framework - 3

• Assume CRRA utility function. Apply this to the
  above solution for a one period bond to get its
  nominal price

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Framework - 4

• Linearize the nominal asset price in the previous
  slide to get We are interested in
  estimating the covariance term above. Chan(1994)
  takes the product of residuals of univariate time
  series regressions on purchasing power growth and
  consumption growth to obtain estimates of
  covariance risk. Here, we make use of
  multivariate GARCH to produce estimates of
  covariance risk.

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Methodology - BEKK
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Quarterly Data

• Data sources Sample quarterly, 1986
  2005Real consumption National Statistical
  Coordinating BoardCPI National Economic
  Development Authority Quarterly Macroeconometric
  Model
• Interest rates to be used in the interest rate
  model 91 day Treasury bills rate Bangko
  Sentral ng PilipinasMoney market rate IFS
  CDROM, March 2006Discount rate IFS CDROM,
  March 2006_________________Notes Consumption
  was deseasonalized using the X12 method MATLAB
  was used in the estimation

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DATA graphical representation
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BEKK estimates
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Volatility estimates
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Estimate of inflation risk
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Unit Root tests
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GMM estimates