Publicado nas Atas da 12th International Conference French

Finance Association, Univ. Genève

Faculdade de Economia da Universidade de Coimbra

Grupo de Estudos Monetários e Financeiros (GEMF)
Av. Dias da Silva, 165 – 3000 COIMBRA, PORTUGAL
http://www2.fe.uc.pt/~gemf

JOÃO SOUSA ANDRADE

JOSÉ SOARES DA FONSECA

CO-INTEGRATION AND VAR ANALYSIS OF THE TERM

STRUCTURE OF INTEREST RATES
an Empirical Study of the Portuguese Money
and Bond Markets

ESTUDOS DO GEMF
N.º 2 1997

PUBLICAÇÃO CO-FINANCIADA PELA JNICT

 CO-INTEGRATION AND VAR ANALYSIS OF THE TERM STRUCTURE
OF INTEREST RATES
An Empirical Study of the Portuguese Money and Bond Markets

João Sousa Andrade

University of Coimbra
Faculdade de Economia
sousandrade@gemini.ci.uc.pt

José Soares da Fonseca

University of Coimbra
Faculdade de Economia
jasfonseca@gemini.ci.uc.pt

Abstract

In this paper we implement a co-integration and a VAR test, in order to explain the
interdependence between a very short term interest rate of the Portuguese
interbanking money market, and a long term rate of the Portuguese bond market. The
first of these two tests shows that there exists co-integration of the first order, between
the two interest rates. The VAR test shows that there exists a long run
interdependence between these two variables.

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1. Introduction

The equilibrium models for the term structure of interest rate, are based on the
assumption that it can be explained by a small number of state variables. A short term
interest rate alone, a short term and a long term interest rate, a short term and the
spread between it and a long term, or an interest rate and the expected inflation have
been usually chosen to represent the state variables in the generality of the models.
The main difficulty with this type of models concerns the possibility of obtaining
an analytical solution to the equilibrium differential equation, which is achieved in
very few models, depending on the nature of the stochastic process followed by the
state variables. The models of Vasicek (1977), Cox, Ingersoll and Ross(1985), Schaeffer
and Schwartz (1984), and Longstaff and Schwartz (1992) are some of the very few ones
where such an analytical solution does exist.
The alternative consists of a numerical solution as proposed in the models of
Brennan and Schwartz (1982) and Hull and White (1994). This second type of solution
only allows to obtain approximations to equilibrium prices of the bonds.
The empirical test presented in this research is applied to the Portuguese
economy. The short term rate that has been used is the overnight interest rate of the
interbanking money market. The long term rate is an index of yield-to-maturity of the
fixed coupon Treasury bonds, and it refers to a ficticious bond with a Macaulay´s
duration of three years. One of the other state variables used is the growth rate of the
banking credit to the economy. This variable concentrates on the operational target of
the Central Bank to maintain the Escudo in the ERM of the EMS, and it reflects the
sustained stability of the real exchange rate.

The first part of the empirical tests that have been conducted consists of a co-
-integration analysis of variables. The second part consists of a VAR model, where
the spread between the long term and the short term interest rate, as wellas the
variation of the short rate are explained together with the growth rate of the banking
credit to the economy and the real exchange rate.

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2. Theoretical foundations of the estimations

The equilibrium models of the term structure of interest rates which are based
on the stochastic processes followed by a small number of state variables are
represented by Ito equations, as in the models of Vasicek (1977), Cox, Ingersoll and
Ross (1985) and others. The stochastic process followed by each state variable Xt is
represented by:

dX t = a( X t , t) dt + σ( X t , t ) dz x,t (1).

where a(Xt,t) is the drift, s(Xt,t) is the volatility and zx,t is a standard Wiener process.
In the present research the return on a long term bond is explained by an
equilibrium differential equation, where the state variables are the monetary short
term interest rate, rt, the growth rate of banking credit, bct and the real exchange rate,
xrt. The stochastic process followed by the short term interest rate is:

drt = a r ( rt , bc t , t ) dt + σr ( rt , bc t , t) dz r ,t
(2).

The stochastic process followed by the growth rate of banking credit i

dbc t = a bc ( rt , bc t , t) dt + σbc ( rt , bc t , t) dz bc,t

(3).

Applying Ito’s lemma, the instantaneous return of a zero coupon bond with a
price P=Pt,n, that pays 1 at t+n is:

dP µt θ θ
= dt + r dzr ,t + bc dz bc,t (4)
P P P P

In equation (4):

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 ∂P ∂P ∂P 1 ∂2 P 2 1 ∂2 P 2 ∂2 P
µt = + ar + a bc + σ + σ + ρ σσ (5)
∂t ∂rt ∂bc t 2 ∂rt2 r 2 ∂bc 2t bc ∂rt ∂bc t r ,bc r bc

and mt/P is the instantaneous expected return, ai and si are simpler representations of
the drift and the volatility of the stochatisc process of each state variable i, that were
defined in equations (2), and (3) , and ρr .bc is the correlation coefficient between the

Wiener processes associated to each state variables i and j. The stochastic components
of equation (5) are:

∂P
θr = σ
∂r r (6),
and
∂P
θbc = σ
∂bc bc (7).

Using Vasicek (1977) arbitrage method, applyied to the case of two state
variables, the next equilibrium differential equation for the term structure of interest
rates is obtained by:

µt θ θ
= rt + r λ r ,t + bc λ bc,t
P P P
(8).

where lr,t, and lbc,t, are the market prices of risk associated with the state variables.
The resolution of differential equation (10) gives the equilibrium price of a zero
coupon bond as an exponential function of the state variables:

[
Pt ,n = exp f ( rt , bc t , t) ] (9).

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 Because the yield to maturity of this bond, compounded continuously, Rt,n, is
given by:
ln Pt ,n
R t ,n = −
n (10),
this rate of interest can also be expressed as a function of the state variables:

R t ,n = g( rt , bc t , t)
(11).

In discret time, the return from holding this long term bond between dates t and
t+1 is:

ht , t +1 = ln Pt +1, n −1 − ln Pt , n (12).

The expected value of ht,t+1 is, by definition, E(ht,t+1) = mt/P. This means that the
expected return of the n maturity bond, between t and t+1 is, according to equation
(8), equal to the riskless short term interest rate plus a term premium, ft, that depends
on the partial derivatives of the price of the bond, the volatility of the state variables,
and their market prices of risk:

µt
= rt + φ t
P (13).

Replacing in the equation (12), Pt,n by exp(-nRt,n) and Pt+1,n-1 by exp[-(n-1)Rt,n], and
taking the expected value of ht,t+1, the equation (12) can be presented as a function of
the yields to maturity:

( )
E R t+1,n−1 − R t ,n =
1
n −1
(
R t ,n − rt +
1
φ)
n −1 t (14).

Solving (14) forward, between t and t+n-1, Rt,n can be represented as the sum of the
expected values of the short term interest rate plus a risk premium, p:

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 1 n−1
R t ,n = ∑ E( rt + i ) + π
n i= 0
(15).

Tzavalis and Wickens (1993) interpret the hypothesis of p being nul as an

evidence that the local expectations hypothesis can be verified. This hypothesis is
defined as an equilibrium situation where all the market prices of risk are equal to zero
and consequently the one period expected return in any bond is equal to the short
term interest rate. The assumption of these authors is based on the demonstration
presented by Mcculloch (1993), that the local expectation hypothesis is sustainable
under risk neutrality.
Even if the assumption of Tzavalis and Wickens can be accepted in the case of a
model with a single state variable, it can not be extended to the case of several state
variables. If the stochastic processes followed by these variables are correlated, it is not
possible, by Jensen’s inequality, to have a nul expected value of a risk premium, when
the market prices of risk of the state variables have, jointly, zero expected values.

3. Presentation of the data

The data used in the empirical tests of this paper is composed by the next
variables with observations from 02.01.93 to 31.12.95:
-the overnigth rate of interest in the interbanking money market with daily
observations,
-the daily index of the yield to maturity of fixed coupon Treasury bonds,
- the growth rate of the banking credit to the economy.

Our first task was to register the empty cases of the interest rate variables, in
order to create series with equal dimension. The empty cases were 106 for the short
term, and 39 for the long term interest rate. For the short term rate we have applied a
log-linear auto-regressive model of order five with constant. For the long term rate we
have applied a similar model of order two.

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 The second task has been the construction of a daily series for the two other
variables, the growth rate of the banking credit to the economy and the real exchange
rate, whose original series consisted of monthly observations. The daily values have
been calculated by an interpolation procedure of the logs of the original series.

4. The cointegration analysis

It has been suggested by the evolution of the interest rates and the growth of
bank credit that these three variables have a long-run relationship that can explain the
behaviour of the long term interest rate. We have investigated the presence of
cointegration between these variables by the Johansen procedure (Johansen & Juselius
(1990) and Hansen & Juselius (1995)).

The unity-roots tests we have done have produced unambiguous results for the first
differences of the variables.

Variable Lags ADF Critical t-value Ljung-Box

t-value (5%) (5)
DRC 3 -21.35 -2.87 4.65
DRL 0 31.28 -2.87 5.49
DTCN 0 -3.02 -1.94 .478
RL-RC 4 -3.09 -2.87 6.09

According to these results the hypothesis that all those variables are stationary, or zero
integrated, can not be rejected, because the ADF t-value depasses the critical value (at
5% of significance level), in all the variables.

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 Short and Long Interest Rates
40
RC
RL

35

30

25

20

15

10

5
1993 1994 1995

Figure 1.

Bank Credit Growth

22

20

18

16

14

12

10

6
1993 1994 1995

Figure 2.
Short and Long Interest Rates and Bank Credit Growth
40
TCN
RC
RL

35

30

25

20

15

10

5
1993 1994 1995

Figure 3.

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 The above figures are demonstrative of the influence of the Bank Credit Growth
on the difference between the long and the short term rate.
When we test the presence of cointegration relationships we obtain low values for the
‘tt’ of the ‘alpha’ coefficients associated with TCN. So we have decided to consider
this variable as weakly exogenous to RL and RC.
To correct the unusual movement of RC in April 1994 we have introduced a
dummy with unity values for the following days of that month: 6, 7 and 8. We have
included five lags in order to eliminate the presence of auto-correlation.
We have chosen two models of cointegration. The first one restricts the constant
to the cointegration space and the second one includes a constant in the unrestricted
model, and the trends that characterize the variables are not expressed in the
cointegration relation. In the above table we include the eigenvalues (l), the trace
statistics and the confidence values for 97.5%.

Model -1 Model - 2
λ Trace H0:r 97.5% λ Trace H0:r 97,5%
0.0718 62.57 0 22.065 0.0708 60.36 0 17.244
0.0072 5.51 1 10.733 0.0053 4.08 1 5.024

As we can see, we can retain for the 97,5% level one cointegration vector for the
two models. The resulting long-run equations are the following:
1) RL = 4.007 + 0.780 RC - 0.116 TCN
2) RL = 0.772 RC - 0.115 TCN
The coefficients on RC and TCN are very similar, in the period here analysed.
The constant in the first equation tells us that there exists a risk premium of 4%, and
that the liquidity in the economy has a positive influence in the long run rate, in the
sense that a greater growth credit, conduct to a decrease in that rate. Our results
confirm a well- known result in a decreasing inflation regime, or even a low inflation
stability regime, the growth of credit can influence the long-run rate of interest.

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5. The VAR Analysis

We have developed a VAR model with stationary variables. The endogenous variables
are the spread values of the long-run interest rate over the short-run rate (RL-RC) and
the first difference of the short-run rate (dRC). As exogenous variables we have the
constant, the dummy variable (d2), that we have already defined, and the first
difference of the growth rate of bank credit (dTCN). For the last variable we have
included 15 lags (from lag one to 15). The reason for this inclusion is the rejection of
auto-correlation of order one and order one to five that we obtain with it.
We began our test with two lags. The likelihood ratio test (Hamilton (1994, p. 296-8))
with the modification suggested by Sims (1980, p. 17) leads us to retain the four lag
model, where the F-statistic presents very high values, and a nul significance level in
both equations.The Chi-squared of order four had the value 4.72229 with a
significance level of 3.17%1.
We have obtained the following F-statistics for the four lag model:
Equation RL-RC
Variable F-Statistic Significance Level
RL-RC 1124.4460 0.000
dRC 15.0450 0.000

Equation dRC
Variable F-Statistic Significance Level
RL-RC 12.7932 0.000
dRC 15.7393 0.000

As we can see they exclude the null hypothesis even at the 0.5% level, which
means that we have obtained a very robust model at the level of regressors.

1
The Chi-squared for the system with three lags against the fourth lag was 60.4677,
which has a near zero significance level.

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6. The simulation of shocks over the short term interest rate, and over
the spread, and conclusions

We have applied the VAR model, presented above, to know the responses of
the endogenous variables to chocks over themselves . Figure 4 resumes the results with
the 95% confidence intervals, obtained by Monte-Carlo simulations.

Reply to Shocks

RL-RC dRC

RL-RC

Chock in Variable:

dRC

Figure 4.

This figure shows that a shock in the spread between the long and the short
term rates has, during three years, permanent effects over the spread, and null effects
over the variation of the short-term rate. On the other hand, a shock in the variation
of the short term rate has, during the same period of three years, a negligible effect
over the spread and an almost null effect over itself. This means that non-expected
fluctuations in the short term market for money have no permanent influence over the
spread. But if we have non-expected changes in the spread, theses changes have effects
that last by more than three years. According to this result, the credibility associated
with the economic policy doesn’t depend on short run fluctuations, but when it affects
the long-run rate of interest its effects are difficult to dissipate.

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 References

Brennan, M.J. and E. Schwartz (1982), " An Equilibrium Model of Bond Pricing
and a Test of Market Efficiency", Journal of Financial and Quantitative
Analysis, Vol. XVII, Nº 3, September, 301-329.
Cox, J. , J.C. Ingersoll and S.A. Ross (1985), "A Theory of the Term Structure
of Interest Rates", Econometrica, 53, 385-407.
Hansen, H. and K. Joselius(1995), Co-integration Analysis of Time Series,Ed.
RATS.
Hamilton, J. (1994), Time Series Analysis, Ed. Princeton University Press.
Hull, J. and A. White (1994), "Numerical Procedures for Implementing Term
Structure Models I: Single- Factor Models", The Journal of Derivatives, Fal,
1994, 7-16.
Longstaff, F. and E. Schwartz (1992), "Interest Rate Volatility and the Term
Structure: A Two-Factor General Equilibrium Model", The Journal of
Finance, Vol. XLVII, Nº 4, 1259-1282.
Mcculloch, J.H. (1993), "A Reexamination of Traditional Hypothesis about the
Term Structure: A Comment", The Journal of Finance, Vol. XLVIII, Nº 2,
779-789.
Schaeffer, S. and E. Schwartz (1984), "A Two-Factor Model of the Term
Structure: An Approximate Analytical Solution", Journal of Financial and
Quantitative Analysis,Vol. XIX, Nº 4, December, 413-424.
Sims, C. (1980), "Macroeconomics and Reality", Econometrica, 48, 1-48.
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Structure: the Evidence, IFA Working Paper 185, London Business Scholl.
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