Credit Shock
Revisiting the Financial Crisis: The Effect of Credit Shocks on Bond Yields
Ram Yamarthy∗ New York University Mark J. Bertus Prize Winner
From the financial crisis, it was apparent that traditional indicators such as real activity and inflation were insufficient to explain spikes in bond yields. I discover the effect of credit indicators on bond yields by estimating a Gaussian six-factor affine model of term structure. One of these factors is a credit variable that I construct using a principal component analysis of notable indicators. Using impulse response functions, I find that positive credit movements raise interest rates at all maturities. Furthermore, shocks to credit have a greater immediate impact compared to those of real activity which are milder and more persistent.
1
Introduction
I examine the impact of credit shocks on bond yields by estimating a Gaussian affine term structure model, using Ang and Piazzesi (2003). My contribution to the model is a credit factor that I construct using a principal component analysis of notable credit variables. After determining parameters for our model through a numerical optimization of a likelihood function, our model supports yield data for the past twenty years. To understand the impact of the credit factor, I implement impulse response functions on bond yields. I find that positive shocks to credit raise bond yields at all maturities of the yield curve. Because our credit variable is constructed such that positive shocks imply a looser credit environment, it is expected that positive impulses lower interest rates. In this way, our results contradict our expectations. Further, we find that credit shocks have an immediate impact on the yield curve while real activity has a milder and more persistent effect. We have some possible explanations for these findings which includes our particular construction of the credit variable and the validity of our large parametric maximum likelihood estimation.
I am greatly
Ram Yamarthy∗ New York University Mark J. Bertus Prize Winner
From the financial crisis, it was apparent that traditional indicators such as real activity and inflation were insufficient to explain spikes in bond yields. I discover the effect of credit indicators on bond yields by estimating a Gaussian six-factor affine model of term structure. One of these factors is a credit variable that I construct using a principal component analysis of notable indicators. Using impulse response functions, I find that positive credit movements raise interest rates at all maturities. Furthermore, shocks to credit have a greater immediate impact compared to those of real activity which are milder and more persistent.
1
Introduction
I examine the impact of credit shocks on bond yields by estimating a Gaussian affine term structure model, using Ang and Piazzesi (2003). My contribution to the model is a credit factor that I construct using a principal component analysis of notable credit variables. After determining parameters for our model through a numerical optimization of a likelihood function, our model supports yield data for the past twenty years. To understand the impact of the credit factor, I implement impulse response functions on bond yields. I find that positive shocks to credit raise bond yields at all maturities of the yield curve. Because our credit variable is constructed such that positive shocks imply a looser credit environment, it is expected that positive impulses lower interest rates. In this way, our results contradict our expectations. Further, we find that credit shocks have an immediate impact on the yield curve while real activity has a milder and more persistent effect. We have some possible explanations for these findings which includes our particular construction of the credit variable and the validity of our large parametric maximum likelihood estimation.
I am greatly
References: Figure 1: Real Activity and Inflation (1990 - 2010) 15 Real GDP CPI (core) 10 Figure 2: Credit Conditions (1990 - 2010) 25 20 15 10 Growth (YOY, %) 5 0 −5 −10 −15 −20 −25 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Consumer Credit Commerical & Industrial Loans 19 Figure 3: Macroeconomic Factors (1990 - 2010) 20 Figure 4: Average Model Yields (1990 - 2010)