target interest rate news effects on the asia pacific financ

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TARGET INTEREST RATE NEWS EFFECTS ON

THE ASIA PACIFIC FINANCIAL MARKETS

Do Quoc Tho Nguyen

School of Banking and Finance

The University of New South Wales

A dissertation submitted to the University of New South Wales in fulfillment of the

requirements for the degree of Doctor of Philosophy (PhD)

2009


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ORIGINALITY STATEMENT

I hereby declare that this submission is my own work and to the best of my

knowledge it contains no materials previously published or written by another

person, or substantial proportions of material which have been accepted for the

award of any other degree or diploma at UNSW or any other educational institution,

except where due acknowledgement is made in the thesis. Any contribution made to

the research by others, with whom I have worked at UNSW or elsewhere, is

explicitly acknowledged in the thesis. I also declare that the intellectual content of

this thesis is the product of my own work, except to the extent that assistance from

others in the project's design and conception or in style, presentation and linguistic

expression is acknowledged.

Signed

Date 09/09/2009..............


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ABSTRACT

This thesis is the first study that provides comprehensive empirical evidence

on both the impacts of the target interest rate news from the Reserve Bank of

Australia (RBA) on the Australian financial markets, and the spillover effects of the

target interest rate news from the US Federal Reserves (Fed) and the European

Central Bank (ECB) on the Asia Pacifics equity and currency markets.

This thesis contributes to the current literature in several ways. First, while

there is ample evidence in the literature suggesting that the markets would not react

to what is already expected but will react to the news, the current literature on the

RBAs target rate effects is still limited to the investigation of the overall

announcement impact on the first moment of the Australian market return only.

Therefore, this thesis firstly comprehensively investigates the impacts of the

unexpected components of the RBAs target rate announcements (or news) on the

first two moments of various segments of the Australian financial markets including

interest rate changes, the Australian dollar and stock market returns. In so doing, this

thesis contributes to the current literature on the impacts of domestic target interest

rate news.

Second, while the established literature seems to be missing a thorough

investigation of the spillover effects of the Feds and the ECBs news on the Asia

Pacific markets, this thesis provides comprehensive evidence on the spillover effects

of the Feds and the ECBs target rate news on both the mean and volatility of the

Asia Pacifics stock and currency returns. Furthermore, we not only document the

presence of the news spillover effects but also highlight the incremental explanatory

power of the target interest rate news in the presence of the indirect effects from the


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USs and euro areas markets to the Asia-Pacific markets. To this end, this thesis

contributes to the literature onspillover effects of foreign target interest rate news.

Third, while the literature is silent on how quickly the target interest rate

news is absorbed in foreign markets, this thesis takes a step forward and breaks down

the daily horizon into the overnight and the intraday horizons. In so doing, the thesis

examines the absorption speed of target rate news in the Asia-Pacific markets. This is

an important issue because there might be potential for a diverse array of response

dynamics across countries due to heterogeneous market developments, nature of

monetary policy synchronization, and financial and real integration with the U.S. and

the euro area.

Specifically, this thesis presents three independent empirical inquiries that

contribute to the literature on domestic and spillover effects of the target interest rate

news. Chapter 41 provides comprehensive empirical evidence for the impacts of the

RBAs target rate news on various segments of the Australian financial markets

during the period from 1998 to 2006. We also investigate the spillover effects of the

US Feds news on the Australian financial markets. We show that the RBAs and the

Feds news significantly affect the Australian financial markets in line with a priori

expectations. However, while the RBAs news raises volatility in the Australian

financial markets, the volatility was significantly lower in all market segments

following the Feds news.

1A shorter version of this chapter is published in Research in International Business and Finance,

22(3), pp. 378-395, 2008. It has also received the Best paper award at the 2008 International Business

and Economics Research conference, Nevada, USA.


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The spillover effects of the US Feds and the ECBs target interest rate news

on the mean and the volatility of twelve Asia Pacifics stock markets returns are

examined in Chapter 52

,

and seven Asia Pacific exchange rates against the US dollar

and the euro over the period 1999-2006 are carried out in Chapter 63. The spillover

effects on the conditional mean are generally consistent with the literature where a

majority of Asia Pacific stock markets shows significant negative returns and a

majority of currencies depreciates against the US dollar and the euro in response to

the Feds and the ECBs unexpected rate rises. Furthermore, in response to the two

target rate news, the conditional volatility of the Asia Pacific stock markets was

higher while the market calming effects have been observed for the currency markets

and both the Fed and the ECB news elicit persisting volatility responses. We

conjecture that as the ECBs news tends to confirm the Feds earlier decision, this

relationship might help reduce uncertainties in the Asia Pacific currency markets

upon the future path of target interest rates from both the Central Banks, which

ultimately results in into a lower volatility level.

These findings are important not only to the Asia Pacifics policy makers to

help them improve the conduct of monetary policy but also to market participants in

designing trading mechanisms as well as risk management strategies in response to

both domestic and external interest rate shocks. Furthermore, these findings also shed

2A shorter version of this chapter is published in Journal of International Financial Markets,

Institutions & Money 19 (3), pp. 415-431, 2009.

3A shorter version of this chapter is published in International Research Journal of Finance and

Economics, 20, pp. 27-45, 2008.


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light on the lead-lag relationship between the Fed and the ECB in making policy

decisions. The notion that the ECB follows the Fed in setting its policy is so strong

amongst market participants that empirical evidence seems to be crucial. Despite the

fact that the ECBs news arrives after the Feds news, this study provides evidence

that the ECBs news has its own merits in the Asia Pacific markets and helps resolve

differences in beliefs among market participants.


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ACKNOWLEDGEMENTS

Although only my name appears on the cover of this dissertation, I could

never have reached the heights or explored the depths without the help, support,

guidance and efforts of many people. I owe my gratitude to all those people who

have made this dissertation possible and because of whom my graduate experience

has been one that I will cherish forever.

I would like to gratefully thank my sole supervisor, Associate Professor Suk-

Joong Kim for his guidance, understanding, patience, and most importantly, his co-

authorship attitude instead of supervision during my graduate studies at the

University of New South Wales. His mentorship was paramount in providing a well-

rounded experience consistent with my long-term career goals.

I am also grateful to the guidance and endless support from Associate

Professor Toan Pham as well as fellow research students during my study at the

University of New South Wales. My special thanks also go to my colleagues at the

International Monetary Fund, Raghuram G. Rajan (now at the University of

Chicago), Stijn Claessens, Hali Edison, Susan Adams as well as Carl Hubbard at

Trinity University for valuable comments and suggestions that greatly improve this

thesis works. I would like to thank the examiners, Colm Kearney, Michael

McKenzie and Eliza Wu, for valuable comments and suggestions that greatly

enhance the thesis. I also would like to thank Stephen Ferris, Ali Fatemi, Ruggero

Bertelli and Craig Lewis for giving me opportunities to referee papers submitted to

your journals and Annual Meetings. I also would like to thank AusAID for

generously providing me this second scholarship to pursue this PhD study. I also


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acknowledge financial support from the University of New South Wales for

conference grants.

Finally, and most importantly, I would like to thank my wife Ha Phi. Her

support, encouragement, quiet patience and unwavering love were undeniably the

bedrock upon which the past seven years of my life have been built. Her tolerance of

my occasional vulgar moods is a testament in itself of her unyielding devotion and

love. I thank my son, Ty, for his companion everyday to the University and his

Childcare center as well as sharing with me his childhood overseas. I am also

grateful to my parents and Has parents for their faith in me. This thesis is dedicated

to my family!


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TABLE OF CONTENTS

Page

ABSTRACT ................................................................................................................... iii

ACKNOWLEDGEMENTS ......................................................................................... vii

LIST OF TABLES ........................................................................................................ xii

LIST OF FIGURES ..................................................................................................... xiv

LIST OF ABBREVIATIONS ....................................................................................... xv

LIST OF JOURNAL PUBLICATIONS FROM THE DISSERTATION ............ xviii

CHAPTER 1 -INTRODUCTION ................................................................................. 1

1.1. Objectives of the thesis ........................................................................................ 2

1.2. Contributions to the literature ........................................................................... 4

1.3. Thesis outline ..................................................................................................... 10

CHAPTER 2 -LITERATURE REVIEW OF TARGET RATE NEWS

EFFECTS ............................................................................................................ 12

2.1. The impacts of the central bank target interest rate on domestic

financial markets ........................................................................................................... 13

2.1.1. The debt markets ............................................................................................. 13

2.1.2. Stock markets .................................................................................................. 15

2.1.3. Exchange rates ................................................................................................. 18

2.1.4. The credit channel ........................................................................................... 19

2.2. The spillover effects of foreign target interest rate news ............................... 20

CHAPTER 3 -DATA AND ECONOMETRIC MODELING ISSUES .................... 24

3.1. Central banks target interest rate communications ..................................... 25

3.1.1. The RBAs cash rate target.............................................................................. 25

3.1.2. The U.S. Federal Reserves federal funds target rate ...................................... 27

3.1.3. The European Central Banks main refinancing rate target ............................ 28

3.2. Target interest rate news .................................................................................. 30

3.2.1. The RBAs cash rate news .............................................................................. 31

3.2.2. The Feds and the ECBs target rate news ...................................................... 32

3.3. Econometric methodology ................................................................................ 37

3.3.1. The RBAs effects on the Australians financial markets ............................... 39

3.3.2. The Feds spillover effects on the Australian financial markets ..................... 40

3.3.3. The Feds and the ECBs spillover effects on the Asia Pacific financialmarkets ........................................................................................................................ 41


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CHAPTER 4 -THE REACTION OF THE AUSTRALIAN FINANCIAL

MARKETS TO THE INTEREST RATE NEWS FROM THE RESERVE

BANK OF AUSTRALIA AND THE US FED ............................................................ 46

4.1. Introduction ....................................................................................................... 47

4.2. Data ..................................................................................................................... 50

4.2.1. Target interest rate announcement data ........................................................... 50

4.2.2. Target interest rate news .................................................................................. 52

4.2.3. Australian financial market daily returns ........................................................ 55

4.3. Empirical modeling issues ................................................................................ 56

4.3.1. Baseline EGARCH(1,1) model ....................................................................... 56

4.3.2. Overall news effects of the RBAs target interest rate news ........................... 57

4.3.3. Asymmetric effects of the RBAs target rate news ......................................... 60

4.3.4. Spillover effects of the US Feds target interest rate news ............................. 61

4.4. Empirical results ................................................................................................ 63

4.4.1. The baseline EGARCH(1,1) results ................................................................ 63

4.4.2. Overall effect of the RBAs target interest rate news...................................... 67

4.4.3. Asymmetric impacts of the RBAs target interest rate news .......................... 71

4.4.4. Spillover effects of the US Feds target interest rate news ............................. 73

4.4.5. Asymmetric spillover effects of the US Feds target interest rate news ......... 75

4.5. No-news effects .................................................................................................. 75

4.6. Conclusion .......................................................................................................... 76

CHAPTER 5 -THE SPILLOVER EFFECTS OF TARGET INTEREST RATE

NEWS FROM THE US FED AND THE EUROPEAN CENTRAL BANK ON

THE ASIA PACIFIC STOCK MARKETS ................................................................ 85

5.1. Introduction ....................................................................................................... 86

5.2. Data and empirical modeling issues ................................................................. 89

5.2.1. The Asia Pacific stock index returns ............................................................... 89

5.2.2. Empirical modelling ........................................................................................ 94

5.3. Empirical results ................................................................................................ 99

5.3.1. Baseline model results ..................................................................................... 99

5.3.2. The US Feds target interest rate news spillover effects ............................... 100

5.3.3. The ECBs target interest rate news spillover effects ................................... 107

5.4. Robustness checks ........................................................................................... 109

5.4.1. Joint spillover effect of the target interest rate news ..................................... 109

5.4.2. The role of indirect impacts ........................................................................... 1115.4.3. Policy cycle impacts ...................................................................................... 120


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5.4.4. Asymmetric effects ........................................................................................ 121

5.5. Conclusion ........................................................................................................ 129

CHAPTER 6 -TARGET INTEREST RATE NEWS EFFECTS ON THE ASIA

PACIFIC CURRENCY MARKETS ......................................................................... 1316.1. Introduction ..................................................................................................... 132

6.2. Data ................................................................................................................... 134

6.3. Empirical methodology ................................................................................... 136

6.3.1. Baseline EGARCH(1,1) model ..................................................................... 136

6.3.2. Target interest rate news spillover effects ..................................................... 139

6.4. Empirical results .............................................................................................. 141

6.4.1. Baseline models results ................................................................................ 141

6.4.2. The Feds target interest rate news spillover effects ..................................... 146

6.4.3. The ECBs target interest rate news spillover effects ................................... 148

6.5. Robustness checks ........................................................................................... 149

6.5.1. Joint spillover effects of the target interest rate news ................................... 149

6.5.2. Asymmetric effects ........................................................................................ 151

6.5.3. The Feds and the ECBs news effect on the USDEUR pair ........................ 158

6.6. Conclusion ........................................................................................................ 159

CHAPTER 7 -CONCLUSION AND DIRECTIONS FOR FURTHERRESEARCH .......................................................................................................... 161

7.1. Conclusion ........................................................................................................ 162

7.2. Directions for future research ........................................................................ 166

7.2.1. Higher frequency data ................................................................................... 166

7.2.2. Sectoral and firm level effects ....................................................................... 166

7.2.3. Determinants of the spillover effects ............................................................. 167

7.2.4. Other macroeconomic news spillover impacts .............................................. 168

APPENDICES ............................................................................................................. 169

REFERENCES ............................................................................................................ 177


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LIST OF TABLES

Page

Table 3.1- Descriptive statistics of the Feds and the ECBs target rate

announcements and news ........................................................................................... 36

Table 4.1 - Descriptive statistics of the RBAs and the Feds target rate news ......... 51

Table 4.2 - Wald test of the unbiasedness of expectations of monetary policy

announcements ........................................................................................................... 54

Table 4.3 - Descriptive statistics of the Australian financial market returns ............. 56

Table 4.4 -A priori expectations ................................................................................ 59

Table 4.5 - EGARCH(1,1) estimations of daily returns ............................................. 65

Table 4.6 - The RBAs news effects on the Australian financial markets ................. 70

Table 4.7 - The RBAs asymmetric surprises effects on the Australian financial

markets ....................................................................................................................... 72

Table 4.8 - Spillover effects of the Feds target rate news in the Australian financial

markets ....................................................................................................................... 79

Table 4.9 - Asymmetric spillover effects of the Feds target rate news in the

Australian financial markets ....................................................................................... 80

Table 4.10 - Nonews effects on the Australian financial markets .............................. 81

Table 5.1 - Descriptive statistics of the Asia Pacific stock markets returns ............. 92Table 5.2 - Granger causality tests for the Fed and the ECB ..................................... 98

Table 5.3 - Baseline model results ........................................................................... 101

Table 5.4 - The Feds target interest rate news spillover effects .............................. 106

Table 5.5 - The ECBs target interest rate news spillover effects ............................ 107

Table 5.6 - The US Feds and the ECBs Joint spillover effects .............................. 110

Table 5.7 - The Feds and the ECBs interest rate news effects estimated with

indirect effects via index return spillovers ............................................................... 112

Table 5.8 - The Feds and the ECBs interest rate news effects on domestic markets.................................................................................................................................. 114

Table 5.9 - Spillover effects of the USs and the euro areas stock markets on the

Asia Pacific markets ................................................................................................. 115

Table 5.10 - Marginal contribution of direct effect given indirect effect ................. 117

Table 5.11 - The policy cycle impacts ..................................................................... 122

Table 5.12 - The Fed and the ECB asymmetric effects ............................................ 125

Table 6.1 - Descriptive statistics of the Asia Pacific currency markets returns ...... 137

Table 6.2 - EGARCH(1,1) estimations of daily returns ........................................... 142Table 6.3 - The Feds and the ECBs target interest rate news spillover effects ..... 147


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Table 6.4 - Joint spillover effects of the US Feds and the ECBs target interest rate

news .......................................................................................................................... 153

Table 6.5 - Asymmetric news spillover effects ........................................................ 155

Table 6.6 - The Feds and the ECBs news effects on the USD/EUR pair .............. 158

APPENDICES

Appendix A - Macroeconomic announcements made on the same date as the RBA's

target rate announcements ........................................................................................ 170

Appendix B- Granger causality tests for the Fed and the RBA ............................. 171

Appendix C, Table C.1 - The US financial market returns and the US Feds target

interest rate news effects .......................................................................................... 174

Appendix D - Controlled macroeconomic announcements ..................................... 176


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LIST OF FIGURES

Page

Figure 5.1 - Testing horizons...................................................................................... 91

Figure 5.2 - Direct and indirect effects ..................................................................... 111


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LIST OF ABBREVIATIONS

ABS Australian Bureau of Statistics

ANZ Australia and New Zealand Banking Corporation

AUD Australian Dollar

CAB Current account balance

CAC French stock market index, Cotation Assiste en Continu

(Continuous Assisted Quotation)

CBA Commonwealth Bank of Australia

CBOT Chicago Board of Trade

CET Central European Time

CPI Consumer Price Index

DAX German stock market index (Deutscher Aktien Index)

DJIA Dow Jones Industrial Average Index

ECB European Central Bank

ESCB European System of Central Banks

EGARCH Exponential autoregressive conditional heteroscedasticity

EST Eastern standard time

EUR The Euro

Fed The United States Federal Reserve System

FOMC Federal Open Market Committee

GARCH Autoregressive conditional heteroscedasticity

GDP Gross Domestic Product

HICP Harmonised Index of Consumer Prices

HSI Hang Seng Index

IAPT International Asset Pricing Theory


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IDR Indonesian Rupiahs

JIC Jakarta Stock Exchange Composite Index

JPY Japanese Yen

KLCI Kuala Lumpur Stock Exchange Composite Index

KRW Korean Won

KRX100 Korea Exchange 100 Index

MPS MIT/Penn/Social Science Research Council (Modigliani

(1971)s model)

MRO Main refinancing operations

NAB National Australia Bank

NEER Nominal effective exchange rate

NKY Japanese NIKKEI 225 Index

NZD New Zealand Dollar

NZSE50FG New Zealand Exchange Limited 50 Free Float Total Return

Index

OMOs Open Market Operations

PCOMP Philippine Stock Exchange PSEi Index

PHP The Pilipino Peso (PHP)

RBA The Reserve Bank of Australia

RET Retail sales growth rate

RTT Retail trade

S&P/ASX 200 Standard & Poors/Australian Stock Exchange 200 Index

S&P500 Standard & Poor's 500 Index

SET Stock Exchange of Thai Index

SHCOMP Shanghai Stock Exchange Composite Index


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STI Singapores Straits Times Index

TD Trade deficit

TWD Taiwanese Dollar

TWSE Taiwan TWSE Index

UE Unemployment rate

USD The United States Dollar

WBC Westpac Banking Corporation


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LIST OF JOURNAL PUBLICATIONS FROM THE

DISSERTATION

1. A shorter version of Chapter 4 is published inResearch in International Businessand Finance 22 (3), pp. 378-395, 2008. It has also received the Best paper award

at the 2008 International Business and Economics Research Conference, Nevada,

USA.

2. A shorter version of Chapter 5 is published in Journal of International FinancialMarkets, Institutions & Money 19 (3), pp. 415-431, 2009.

3. A shorter version of Chapter 6 is published in International Research Journal ofFinance and Economics 20, pp. 27-45, 2008.


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CHAPTER 1 - INTRODUCTION


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"Policymakers often have to act, or choose not to act, even though we may not fully

understand the full range of possible outcomes, let alone each possible outcome's

likelihood."

Alan Greenspan, January 3, 2004

1.1. Objectives of the thesisSince the abandonment of monetary aggregate targeting in the mid-1980s,

central banks of advanced countries have moved to targeting policy interest rates and

public announcement of decisions on the interest rate target is a common practice in

most central banks. Any change in the target rate constitutes an adjustment in the

monetary policy stance, and the unexpected component of the change constitutes

news.

As the central banks target interest rate decisions impose interest rate risk to

most market participants, it is widely documented that in the days approaching a

central banks monetary policy meeting, market participants anticipate at least two

important factors. First, they will predict the direction of the target rate action, i.e.

whether the central bank will raise, cut or leave its target interest rate unchanged.

Second, they will also anticipate the magnitude of such policy action, i.e. by how

much the central bank will raise or cut its target rate? Accordingly, market

participants must take positions based upon their expectations of the impending

announcements of the central banks target interest rate stance. This expected part is,

thus, already factored into the market prices observed immediately prior to the

announcement. If the actual target rate announced is different from that already

priced, markets react to this surprise (or news) component accordingly. Therefore,


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central banks influence financial markets through the control over the target interest

rates and the markets expectation on the future courses of the respective target rates.

Furthermore, global financial markets have become increasingly integrated

over the past decades. During this integration process, monetary policies play a key

role in driving financial market linkages across national markets. Given the fast pace

of real and financial integration, it is widely recognised that target interest rate

decisions made by a central bank, especially policy decisions from the Fed, are

keenly monitored by not only the domestic market participants but also by foreign

market participants. However, the nature and the transmission channels through

which target interest rate news dissipates are still not well understood. In addition,

while the impact of the Feds monetary policy on domestic markets is well

documented for the US markets, the spillover impact of the Feds target rate news to

foreign markets is much less obvious.

This thesis empirically investigates the direct impacts of the target interest

rate news on the domestic financial markets, and the spillover effects from one

central bank to foreign financial markets. Specifically, this thesis presents three

empirical investigations that address the following important questions:

1. What are the nature, direction and magnitude of the impacts of theRBAs target interest rate surprises on the Australian financial

markets?

2. What are the nature, direction and magnitude of the spillover effectsof the Feds and the ECBs target rate news on the Asia Pacific

financial markets?


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3. The Feds and the ECBs target rate news would have both direct andindirect influences on foreign markets. Moreover, there is ample

evidence that the Asia Pacific markets are influenced by the USs and

the euro areas markets (the indirect effects). Therefore, given the

presence of such indirect effects, whether the Feds and the ECBs

target rate news has any incremental explanatory power?; and

4. How quickly is the target interest rate news from the Fed and the ECBabsorbed in the Asia Pacific markets?

1.2. Contributions to the literatureThis thesis is conceptually linked to two strands of the literature on the

monetary policy news. First, it contributes to the literature on the impacts ofdomestic

target rate news by empirically investigating the impacts of the RBAs target rate

news on the Australian financial markets via different channels ranging from interest

rates, stock markets, exchange rates, and credit channels (via bank lending

mechanism). Australian financial markets have been chosen as a case study in

Chapter 4 due to its growing importance and integration with other markets in the

Asia Pacific region and with the US. Furthermore, Australian financial markets are

regarded as efficient markets as Edey and Elliott (1988) found, thus market responses

to interest rate news could have been detected relatively quickly. Therefore, an

empirical test on the spillover impacts of the Feds target interest rate news on the

entire financial markets of a single country seems to be crucial before going further

to the extensive and detailed investigations for such effects on the stock markets and

the exchange markets of a large number of countries in the Asia-Pacific region in

Chapters 5 and 6. However, the current literature on the RBAs cash rate effect is


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limited to the investigation of the announcement impact on the first moment of

Australian market returns, see for example Gasbarro and Monroe (2004), and Diggle

and Brooks (2007). Therefore, a thorough investigation focusing on the impact of the

unexpected component (or news) of the RBAs target rate announcements would

provide direct and comprehensive evidence on the impacts of the RBAs target rate

news on the Australian financial markets.

Second, this thesis attempts to investigate the nature of the international

spillover effects of a central banks target rate news on foreign markets. While the

spillover impacts of the Feds news on some national markets have been

documented, 4 the literature is missing a thorough investigation of the spillover

effects of the Feds news on the Asia Pacific markets.This is a significant oversight

as the information leadership role of the US in the Asia Pacific region is well

documented, see inter alia Arshanapalli et al. (1995), Liu et al. (1998), Liu and Pan

(1997), Ghosh et al. (1999), Ng (2000), Miyakoshi (2003), Kim (2003, 2005),

Phylaktis and Ravazzolo (2005).5 In addition, while there are some studies focusing

4See for example, Bredin et al. (2005) examine the Feds news effects on the Irish stock market

volatility; Ehrmann and Fratzscher (2003, 2005a) investigate the Feds news effects on the euro area

money market returns, while Hausman and Wongswan (2006) examine such spillover effect on the

stock, debt and foreign exchange markets. The Feds interest rate news has shown to be transmitted to

these markets and the spillover effects are strongly felt. However, the transmission in the opposite

direction is found to be weak, see Ehrmann and Fratzscher (2005a).

5For Australia in particular, Kim and Sheen (2000) show that the Australian interest rates (90-day and

10-year rates) react strongly to the first and second moments of the corresponding US rate

movements. Masih and Winduss (2006) report a straightforward cointegration relationship between

the Australian and the US interest rates, whereas Narayan and Smyth (2004) show similar evidence


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on the first moment spillover effects of the Feds target interest rate news on foreign

markets, very limited evidence has been shown for the volatility spillover effects of

the Feds news. This significant gap needs to be addressed because the target rate

news does not only affect the direction of market movements in foreign markets (first

moment influence) but also influences the trading environment, and hence the level

of volatility (second moment effect). For example, Faff et al. (2009) shows that

conditional stock market return volatilities have contemporaneous and positive

systematic exposures to global return volatilities. Furthermore, Kearney (2000)

shows that the global equity markets volatility is caused mostly by volatility in the

US markets. Therefore, to the extent that the US stock market responds significantly

to the Feds news, and that the foreign markets look to the U.S markets for trading

momentum, there is potential for the Feds news to be significantly priced in foreign

markets, especially in the Asia Pacific region where both financial and real

integration with the US is growing rapidly.

Another oversight in the literature is the relative lack of investigation of the

spillover effects of the ECBs news.6 Given the increasing prominence of the euro

areas equity markets, and the increasing real and financial integration between the

Asia Pacific region with the euro area,7 there is strong potential that the ECBs news

for the stock markets. Moreover, Kim (2005) reports a direct causal information flow from the US

stock market to that of Australia.

6Although there are some recent studies on the impacts of the ECBs news on European stock

markets, see e.g. Bohl et al. (2008), and Bredin et al. (2009).

7The EU is the largest trading partner for Australia and China; second largest trading partner for

Hong Kong, New Zealand, Taiwan, and Thailand; the third for Indonesia, Japan, Malaysia, and


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would have spillover impacts on the financial markets in the latter. Finally and

importantly, the literature is silent on how quickly the news from a central bank is

absorbed in foreign markets.

Against this background, this thesis contributes to the current literature in

several ways. First, it provides comprehensive evidence for the impacts of the RBAs

target rate news on both the mean and volatility of the Australian interest rate

changes, the Australian dollar and stock market returns. In so doing, this thesis

contributes to the current literature on the impacts ofdomestic target rate news.

Second, this thesis fills significant gaps in the literature by providing

comprehensive evidence on the spillover effects of the Feds and the ECBs target

rate news on both the mean and volatility of the Asia Pacific stock and currency

market returns. Furthermore, the thesis not only documents the presence of the news

effects but also highlights the incremental explanatory power of the target interest

rate news in the presence of the indirect effects from the USs and euro areas stock

markets.

Third, in order to shed light on the adjustment speed of the Asia Pacific

markets to the Feds and the ECBs news, this thesis investigates the relative speed

of news absorption by breaking down the daily horizon into the overnight and the

intraday horizon. Thus, this thesis examines the extent of persistence effects, if any,

of the Feds and the ECBs news effects on the Asia-Pacific markets.

Singapore; and the fourth for Korea and the Philippines (see http://ec.europa.eu/trade/issues/bilateral/

data.htm).
http://ec.europa.eu/trade/issues/bilateral/http://ec.europa.eu/trade/issues/bilateral/


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This thesis presents three independent empirical inquiries on the impacts of

central banks target interest rate news on both domestic and foreign markets. In

particular, Chapter 48

provides comprehensive empirical evidence for the impacts of

the RBAs target rate news on various segments of the Australian financial markets,

namely debt, stock and foreign exchange markets. We show that the RBAs news

had a significant impact on the first moment of market returns/changes in line with a

priori expectations, and the conditional volatility in most of the markets was

significantly higher following the news. Asymmetric news effect is also observed for

the Australian interest rate changes where markets tended to respond more strongly

to unexpected rate rises than rate cuts. Furthermore, while the US Feds news

influences only the USD/AUD exchange rate, the Australian market volatility was

significantly lower in all market segments following the Feds news. These findings

are informative not only to the RBAs decision makers to improve its conduct of

monetary policy but also to market participants in designing trading mechanisms as

well as risk management strategies in response to both domestic and external interest

rate shocks.

Chapter 59 examines the spillover effects of the US Feds and the ECBs

target interest rate news on the market returns and return volatilities of twelve stock

markets in the Asia Pacific region over the period 1999-2006. In addition to close-to-

8A shorter version of this chapter is published in Research in International Business and Finance,

22(3), pp. 378-395, 2008.

9A shorter version of this chapter is published in Journal of International Financial Markets,

Institutions & Money 19 (3), pp. 415-431, 2009.


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close return over market close on calendar day t-1 to the close on calendar day t

(close-to-close), it is split into the overnight horizon over the close of day t-1 to the

open on day t(close-to-open), and the intraday horizon over the open on day tto the

close on day t (open-to-close). This enables us to capture the Asia Pacific stock

markets first reaction to the news (overnight returns) and delayed reactions, if any,

during the trading day in the Asia Pacific region (intraday returns). The news

spillover effects on the returns are generally consistent with the literature where a

majority of stock markets shows significant negative returns in response to

unexpected rate rises. Whilst the results of the speed of adjustment for the Feds

news are mixed across the markets, the ECB news was absorbed more slowly, in

general. The return volatilities of the Asia Pacific stock markets were higher in

response to the interest rate news from both sources. In addition, both the Fed and the

ECB news elicited delayed or persisting volatility responses. These findings have

important implications for the Asia Pacifics policy makers and market participants

alike in anticipating and managing potential spillover effects from the Feds and the

ECBs so as to have forward looking policy responses and hedging strategies.

Chapter 610 examines the spillover impacts of the US Feds and the ECBs

target interest rate news on the first two moments of seven Asia Pacific exchange

rates against the US dollar and the euro over the period 1999-2006. The spillover

effects on the mean are generally consistent with the literature where a majority of

currencies depreciates against the USD and the EUR in response to unexpected rate

10A shorter version of this chapter is published in International Research Journal of Finance and

Economics, 20, pp. 27-45, 2008.


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rises. Both the Fed and the ECB news elicited delayed or persisting volatility

responses. The ECBs news tends to confirm the Feds decision. This relationship

tends to help reduce volatility in the Asia Pacific currency markets. This finding

provides useful information for the Asia Pacific monetary authorities, especially

those who are targeting exchange rates, in designing and implementing their own

monetary policies. These are also useful to currency traders in designing forward

looking trading strategies. Furthermore, these findings also shed lights on the lead-

lag relationship between the Feds and the ECBs decision markings. The belief that

the ECB follows the Fed in setting its policy is so strong among market participants

such that empirical evidence seems to be crucial. Despite the fact that the ECBs

news arrives after the Feds news, this chapter provides evidence that the ECBs

news has its own merit in the Asia Pacific currency markets and helps to resolve

differences in belief among market participants.

In short, this thesis is the first study that provides comprehensive evidence on

the influence of the RBAs target interest rate news on the Australian financial

markets, and the spillover effects of the target interest rate news from the Fed and the

ECB on both the first two moments of the Asia Pacifics equity and currency

markets returns.

1.3. Thesis outlineThis thesis consists of seven chapters. Chapter 2 provides a literature review

of the target interest rate news effects. Chapter 3 discusses the methods of isolating

the unexpected component of the target interest rate announcements, and then

proceeds to discuss the key methodologies used for empirical investigations

contained in the following three chapters. Chapter 4 empirically investigates the


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domestic effects of the RBA as well as the spillover effects of the Fed on the first

two moments of the Australian debt, stock and currency markets. Chapters 5 and 6

focus on the spillover influences of the target interest rate news from the Fed and the

ECB on the first two moments of the Asia Pacific stock and currency market returns,

respectively. Chapter 7 concludes the thesis and offers directions for future research

in the area of target interest rate news effects.


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CHAPTER 2 - LITERATURE REVIEW OF TARGET

RATE NEWS EFFECTS


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2.1. The impacts of the central bank target interest rate on domestic financialmarkets

This section discusses the underlying theory and empirical evidence for the

influences of the central bank target interest rate on various domestic financial

markets including the debt, equity and currency markets, which are the focuses of

this thesis investigations.

2.1.1. The debt marketsAs Mishkin (1996) pointed out, to stimulate the economy the central bank

increases the money supply, lowering a short-term nominal target interest rate, e.g.

the Fed funds rate, resulting in lower short-term real interest rates assuming that the

central bank has the capability to conduct Open Market Operations (OMOs) in ways

such that it can vary the money supply to move the target interest rate in the desired

direction. The expectation hypothesis of the term structure suggests that lower

(higher) short-term real interest rates could result in lower or higher long-term real

interest rates depending on market expectations on the future paths of nominal rate

and inflation. The changes in long-term interest rates then stimulate (depress)

consumer and investor spending raising (lowering) Gross Domestic Product (GDP)

ultimately.

The effect of announcements of monetary policy changes on the entire yield

curve has been exhaustively investigated. Taylor (1995) shows that there is strong

empirical evidence for substantial interest rate effects on consumer and investment

spending through the interest rate channel. The earliest study in monetary

announcement effects is Cook and Hahn (1989), who first documented the


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connection between the Fed funds rate and market rates and showed that over the

1974-1979 period changes in the Fed funds rate had a significant positive impact on

the yields of US Treasury securities at all maturities. However, their results might

partly be due to a period of less systematic and transparent target interest rate

decision making.

The effect of a monetary policy decision on long-term rates might be

different from that on shorter-term rates. Changes at the long end of the yield curve

can at least in part be attributed to the markets views on the central banks

credibility or its capability to control inflation. Therefore, a tightening of monetary

policy can be compatible with a reduction in long-term interest rates if markets

perceive the tightening as a credible step by monetary authorities to reduce inflation

in the long-run (see e.g. Thornton, 1998). On the other hand, other studies argue that

the effects of news surprises at the short and medium maturities mainly reveal

information about market participants beliefs of the central banks reaction function

(see e.g. Haldane and Read, 2000).

In recent decades, as the market anticipation of monetary policy has

improved, some of the potential impact of a target rate change would have already

been incorporated into asset prices by the time the decision was made, causing the

response to the actual announcement event to diminish (see Roley and Sellon, 1995).

However, from technical perspectives, this might also be because of the failure to

distinguish between the expected and unexpected components of the news. In his

seminal work, Kuttner (2001) showed that Treasury yields did not respond to

changes in the Fed funds rate that were already anticipated, while there was a large

and significant impact of the unanticipated component of the interest rate


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announcement. Demiralp and Jorda (2004) find that long-term rates react much more

in unison during announcement days than at any other times. Recently, Valente

(2008) shows that the Feds target rate news not only significantly affect the term

structure of interest rates in the US but also spillover to Hong Kong and Singapore

interest rates.

On the volatility side, Lee (2006) empirically investigates the one-day

response of interest rate volatility to Fed funds target rate changes over the period

1989-2003 and find a positive relation between the Feds news and the volatility at

all maturities. The volatility response to an unanticipated Fed policy action is

relatively large and highly significant for short-term interest rates. However, interest

rates at long maturities are found to be responsive to target rate changes, even if they

are anticipated when estimations take into account of structural change in association

with the Fed's policy disclosure beginning in 1994.

Notwithstanding there is strong empirical evidence for the Feds news

impacts on interest rates at all maturities, Bernanke and Gertler (1995) pointed out

that the macroeconomic response to policy-induced interest rate changes is

considerably larger than that implied by conventional estimates of the interest

elasticity of consumption and investment. This suggests that mechanisms other than

the interest rates, e.g. asset prices including the stock prices and exchange rates, may

also be at work in the transmission of monetary policy to the economy.

2.1.2. Stock marketsIn principle, monetary policy decisions can be transmitted to the economy via

two channels of equity price movements: investment and wealth effects. Tobin's

Theory of Investment provides a mechanism by means of monetary policy affecting


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the economy through its influences on the valuation of equities (see Tobin, 1969).

Tobin defines q as the market value of firms relative to the replacement cost of

capital. If q is high, firms will invest more because adding capital is cheap as the

market price of firms is high relative to the replacement cost of capital. As a result,

investment spending will rise. On the other hand, when q is low, firms will not

purchase new investment goods because the market value of firms is low relative to

the cost of capital.

How does monetary policy stance affect q? Expansionary monetary policy

action can lead to a higherq in at least two ways. First, as lower interest rates leaving

investors with less attractive alternatives or they have more money to spend. An

attractive place to spend is in the stock market, thus, increasing demand for equities

and consequently raising equity prices. Furthermore, lower interest rates making

fixed income securities, e.g. bonds, less attractive relative to equities, thereby

causing the price of equities to rise. In short, an expansionary policy stance will lead

to higher equity prices, then a higherq, and thus higher investment spending.

This channel has been empirically tested in various studies with mixed

evidence. For example Blanchard et al. (1993) argue that as a result of fads, bubbles,

or the influence of uninformed traders, stock prices may deviate from fundamentals.

In such situations, managers may find it in their interests to ignore the signals arising

from asset markets and invest on their own superior information. They find that

given proxies for fundamentals market value appears to play a limited role in

determining investment. Bond and Cummins (2000) make a similar argument and

find that investment responds much more strongly to a measure of q constructed

from profit forecasts than q constructed using the stock market. Gilchrist and Leahy


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on volatility than negative surprises, which is consistent with both the leverage and

volatility feedback hypotheses advocated by Black (1976) and French et al. (1987).

2.1.3. Exchange ratesThe monetary policy effects run from interest rates to exchange rates via the

uncovered interest rate parity condition relating interest rate differentials to expected

exchange rate movements. Thus, a cut in the target interest rate relative to foreign

interest rates would lead to a weaker currency due to now relatively lower real

domestic interest rate and would stimulate net exports and the overall level of

aggregate demand.

There is strong evidence for the impacts of monetary policy on exchange

rates, such as Faust and Rogers (2003) and Faust et al. (2003) find delayed

overshooting effects of the Feds news on the British Pound and German

Mark/Euro, and such policy shocks can explain only a small portion of currency

variability. Andersen et al. (2003) and Ehrmann and Fratzscher (2005b) show that

the USs and the euro areas (and Germans news before 1999) macroeconomic news

have a significant impact on the US dollar-euro exchange rate. Fatum and Scholnick

(2008) find that the news component of a tightening (loosening) of US monetary

policy is associated with a same day appreciation (depreciation) of the US dollar

against the British Pound, German Mark, and Japanese Yen. Furthermore, Lobo et al.

(2006) report that changes in the Feds interest rate target are positively related to

changes in the value of the dollar, and also provide evidence for the asymmetric

impact of the Feds news where unexpected rate rises have a larger effect than

unexpected rate cuts for the Pound, Mark, and Canadian dollar, whereas the opposite

is true for the Japanese Yen.


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2.1.4. The credit channelAsset values also play an important role in the credit channel advocated by

Bernanke and Gertler (1995). Advocates for the credit channel suggest that monetary

policy affects not only the general level of interest rates but also the size of the

external finance premium. Bernanke and Gertler (1995) suggested two mechanisms

explaining the link between monetary policy actions and the external finance

premium: the balance sheet channel and the bank-lending channel.

In the balance sheet channel, asset prices are especially important in that they

determine the value of the collateral that firms and consumers may present when

obtaining a loan. In frictionless credit markets, a fall in the value of borrowers

collateral will not affect investment decisions. However, in the presence of

information or agency costs, declining collateral values will increase the premium

borrowers must pay for external finance, which in turn will reduce consumption and

investment. Thus, the impact of policy-induced changes in interest rates may be

magnified through this financial accelerator effect.

The bank-lending channel relies on credit market frictions where banks play a

central role as they are especially well suited to solve asymmetric information

problem in credit markets. The essential insight is that because banks rely on

reservable demand deposits as an important source of funds, contractionary monetary

policy, by reducing the aggregate volume of bank reserves, will reduce the

availability of bank loans. In turn, as most firms and households rely heavily or

exclusively on bank financing, a reduction in loan supply will ultimately depress

aggregate spending.


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The empirical evidence on the credit channel is somewhat mixed. For

example, Miron et al. (1994) and Driscoll (2004) find little support for the bank-

lending channel of monetary transmission. However, Kashyap et al. (1993), Kashyap

and Stein (2000), Bernanke (1996), and Peersman and Smets (2005) provide

supporting evidence for the bank-lending channel. The two studies that examine the

monetary transmission by looking at the response of disaggregated stock returns to

monetary shocks show opposite results. Warner and Georges (2001) find no evidence

supporting a credit channel. In contrast, consistent with the credit channel, Ehrmann

and Fratzscher (2004) document firm-level heterogeneity in the effect of monetary

news on stocks based on financial constraints.

2.2. The spillover effects of foreign target interest rate newsAs the global financial market is increasingly integrated, it is necessary to

understand the driving forces behind such integration. Among this, international

transmissions or spillover effects of monetary policy actions of a central bank to

foreign markets have attracted attention. Target rate news from major economies

might affect other national markets via at least three channels.11 Firstly, foreign

target rate news would directly affect domestic markets if domestic monetary

authorities were targeting exchange rates. An unexpected monetary policy stance in

the US, for example, would results in a corresponding action from other countries,

e.g. Singapore or Hong Kong, to maintain the exchange rate targets. Secondly, due to

increasing global financial integration, monetary policy news from the US, for

instance, might affect the markets in other countries via capital flows and other

11 See, for example Ehrman and Fratzscher (2003).


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arbitrage activities. The final channel is through real integration such that foreign

announcements might reveal important information about macroeconomic conditions

of other countries. For example, if foreign monetary policy decisions change

domestic macroeconomic conditions through effects on the terms of trade with the

trading partners, such decisions may provide news not only about foreign economic

conditions but also about the prospects of the domestic economy.12

The literature documents some evidence for the spillover impacts of the Feds

funds rate news on foreign markets. For example, Ehrmann and Fratzscher (2003,

2005a) show that interest rates in the US, Germany and euro area react strongly to

respective domestic target rate news. Furthermore, the response to foreign target rate

news differs across markets where both German and euro area markets respond

strongly to the Feds news, the opposite direction effect is weaker.

Another strand of the target rate spillover effect literature is to identify the

determinants of the spillover effects across markets. Ehrmann and Fratzscher (2006)

focus on the link between the US monetary policy and 50 foreign stock markets and

show that the US monetary policy news has significant and sizable effects on foreign

stock prices. Moreover, they provide evidence that a countrys real and financial

linkages with the world, and not the bilateral integration with the US, are key

determinants of cross-country variation in response. In particular, they show that the

sensitivity to US monetary policy news is higher in those countries that are more

integrated globally rather than bilaterally with the US in real and financial terms.

This suggests that domestic financial conditions in any country do not necessarily

12 See Ehrmann and Fratzscher (2005a) for further details.


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depend on the financial conditions in the US market, but on some other effects that

are due to the complex mechanisms of the global financial and real linkages. On

currency markets, Fratzscher (2008) analyses the link between economic

fundamentals, including the Feds news, and exchange rates from a cross sectional

perspective. He shows that the USs shocks, including the Feds news, exerted

heterogeneous impacts across 26 main currencies in the basket of the US dollar

trade-weighted nominal effective exchange rate (NEER). More importantly, he

shows that not only exchange rate regimes but also the degrees of financial

integration are key determinant of such heterogeneity in responses.

In a more comprehensive study, Hausman and Wongswan (2006) investigate

the Feds news impact on the stock, debt and foreign exchange markets of 49

countries including both developed and emerging markets. They also take a step

further to explore the transmission channels of the US monetary policy to foreign

economies via real economic linkages, financial linkages, and exchange rate regimes.

They find that foreign asset prices respond to the Feds news and cross-country

responses are related to a countrys exchange rate regime. Equities and interest rates

respond more strongly to the Feds news in countries with less flexible exchange rate

regime, while exchange rates respond less. Financial integration, proxied by equity

market capitalization owned by the US investors, and trade linkages with the US are

also strongly related to cross country responses.

In summary, this thesis is well related to two strands of the literature on the

monetary policy news impacts as highlighted above. First, it provides comprehensive

evidence on the target interest rate news on the key segments of the Australian

financial markets, namely debt, stock and foreign exchange markets. Second, this


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thesis documents and discusses evidence for the international spillover effects of the

Feds and the ECBs target interest rate news on both the conditional mean and

volatility of the Asia Pacific stock and exchange rate returns.


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This chapter begins with discussions on the institutional arrangements of key

policy interest rates targeted by three central banks considered in the later chapters.

Then, Section 3.2 shows how the unexpected component of the target rates is

generated and Section 3.3 discusses modeling issues.

3.1. Central banks target interest rate communicationsThe last two decades have witnessed a surge in central banks efforts to

improve policy transparency via various forms of policy communications to the

public. This is because there is a strong notion that a prerequisite for an independent

central bank is its accountability to the public. Therefore, central banks have

responsibilities to timely inform policy actions to the public and explain to the extent

possible the underlying rationales for such policy actions. Although central banks

with similar objectives follow different methods of communication to the public, a

common theme is that central banks would communicate their decisions on the target

interest rate to the public. The timing and details of this communication however

differ across central banks (see Blinderet al., 2008). The following sections briefly

provide backgrounds of the three central banks target rates: the RBAs cash rate, the

Fed funds rate and the ECBs main refinancing rate.

3.1.1. The RBAs cash rate targetThe Reserve Bank Act 1959, Section 10(2) states that It is the duty of the

Reserve Bank Board, within the limits of its powers, to ensure that the monetary and

banking policy of the Bank is directed to the greatest advantage of the people of

Australia and that the powers of the Bank ... are exercised in such a manner as, in the

opinion of the Reserve Bank Board, will best contribute to:


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(a) the stability of the currency of Australia;

(b) the maintenance of full employment in Australia; and

(c) the economic prosperity and welfare of the people of Australia.

In practice, the RBAs monetary policy's principal medium-term objective is

to control inflation. In line with previous understandings between the Federal

Government and the RBA in the Statement on the Conduct of Monetary Policy

issued in 2007, the Governor and the Treasurer agreed that the appropriate target for

monetary policy is to achieve an inflation rate of 2-3 per cent on average. Therefore,

the inflation target is the core of the Australian monetary policy framework. It

provides discipline for monetary policy decision-making, and serves as an anchor for

private sector inflation expectations.

The RBAs Board usually meets eleven times each year on the first Tuesday

of the month except in January to decide on its monetary policy stance. Therefore,

market participants know the meeting dates in advance. Through OMOs, by

managing the supply of funds available to banks in the official money market, the

RBAs Domestic Markets Department maintains conditions in the official money

market to keep the cash rate, which is the rate charged on overnight loans between

financial intermediaries, at or near an operating target decided by the Board.

From January 1990, the RBA started to publicly announce its monetary

policy decisions. From January 1998 until November 2007, the RBA Board's

decision to change or leave the cash rate unchanged is announced in a media release

at 9:30 am Australian EST (GMT+10) one day following the board meeting.Since

December 2007, a media release is issued at 2.30 pm after each Board meeting.


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3.1.2. The U.S. Federal Reserves federal funds target rateFederal Reserve Act, Section 2A states that the Board of Governors of the

Federal Reserve System and the FOMC shall maintain long-run growth of the

monetary and credit aggregates commensurate with the countrys long-run potential

to increase production, to promote effectively the goals of maximum employment,

stable prices and moderate long-term interest rates. However, it has been argued

that despite its multiple objectives, the Fed has traditionally placed more emphasis on

achieving price stability and, in recent years, there have been calls for a clearer price

stability mandate for the Fed (see e.g. Wynne, 1999 and Bernanke, 2003).

The major tool the Fed uses to influence the supply of reserves in the banking

system is OMOs conducted at the Federal Reserve Bank of New York. The short-

term objective for OMOs is specified by the FOMC. This objective can be a desired

quantity of reserves or a desired price (the Fed funds rate). 13 Although the Feds

objective for OMOs has varied over the years, during the 1980s, the focus gradually

shifted toward attaining a specified level of the Fed funds rate. Since 1994, the

FOMC has been announcing the Fed funds target rate after its regularly scheduled

(eight meetings a year) and ad hoc meetings at 2:00 pm US Eastern Standard Time

(EST, GMT-5), unless otherwise specified. After each meeting, the Fed provides a

short press release containing the decision, a concise explanation of its underlying

reasoning and sometime some forward-looking hints.

13The Fed funds rate is the interest rate at which depository institutions lend balances at the Fed to

other depository institutions overnight.


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Following is a typical example of the FOMCs press release after its meeting

on January 31, 2007.

The Federal Open Market Committee decided today to keep its target for

the federal funds rate at 5-1/4 percent.

Recent indicators have suggested somewhat firmer economic growth, and

some tentative signs of stabilization have appeared in the housing market. Overall,

the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and

inflation pressures seem likely to moderate over time. However, the high level of

resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing

of any additional firming that may be needed to address these risks will depend on

the evolution of the outlook for both inflation and economic growth, as implied by

incoming information.

As can be seen, the first paragraph clearly and concisely announces the

FOMCs target rate decision, i.e. to leave the Fed funds target rate unchanged. The

next two paragraphs state the underlying rationales for the decision and the last

paragraph offers some hints on the likelihood of the FOMCs decisions in the future

meetings.

3.1.3. The European Central Banks main refinancing rate targetArticle 105 (1) of the Maastricht Treaty states that the primary objective of

the European System of Central Banks (ESCB) shall be to maintain price stability

and that without prejudice to the objective of price stability, the ESCB shall support


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the general economic policies of the Community with a view to contributing to the

achievement of the objectives of the Community as laid down in Article 2. In this

respect, Article 2 states that the objectives of the Community are, inter alia, to ensure

a high level of employment (), sustainable and non-inflationary growth, and a

high degree of competitiveness and convergence of economic performance.

As the ECB was established as the core of the Eurosystem and the ESCB, the

Treaty thus establishes a clear hierarchy of objectives for the ECB and assigns

overriding importance to price stability. Moreover, the ECB has made public its

precise quantitative definition of price stability. The ECB has defined price stability

as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for

the euro area of below 2%. In the pursuit of price stability, the ECB aims at

maintaining inflation rates below, but close to, 2% over the medium term.

For the ECB, the interest rate on the main refinancing operations (MRO),

regular liquidity-providing reverse transactions with a frequency and maturity of one

week, is perceived to be the target policy interest rate as it plays a pivotal role in

pursuing the ECBs OMOs.14 Although the Governing Council meets twice a month,

it normally makes a monetary policy decision at the first of the two meetings, after

14The other key interest rates for the euro area are: (i) the rate on the deposit facility which banks can

use to make overnight deposits with the national central banks and normally provides a floor for the

overnight market interest rate; and (ii) the rate on the marginal lending facility, which banks can use to

obtain overnight liquidity from the national central banks against eligible assets, and this rate normally

provides a ceiling on the overnight market interest rate. These two rates are for standing facilities,

which aim to provide and absorb overnight liquidity, signal the general monetary policy stance and

bound overnight market interest rates.


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which a press release announcing the decision on the key ECB interest rates is made

at 1:45 pm Central European Time (CET, GMT+1). Thus, the ECBs Governing

Council has aligned its policy interest rate decision frequency closely with that of the

Fed.15 However, unlike the other two central banks, the ECB does not only release a

press statement with the policy decision but also holds a press conference on the

Governing Councils meeting day, including a question and answer (Q&A) session at

2:30 pm CET. This thesis empirically investigates the impact of news arising from

the ECBs press releases at 1:45 pm CET only.

3.2. Target interest rate newsEmpirical work that fails to decompose monetary policy changes into

expected and unexpected components is also likely to lead to biased results due to

errors in variables. In particular, a number of theories based on the assumption of

efficient markets would suggest that only unanticipated changes in policy should

influence asset prices immediately (i.e. on the announcement day of a monetary

policy change asset prices should respond only to the surprise element of such a

change). On the other hand, anticipated changes in policy should not affect asset

prices but instead such information should have already been factored into the asset

prices observed immediately prior to the announcement. Otherwise, arbitrage

opportunities would exist and markets would be deemed inefficient. Studies that

examine the influence of policy rate changes and fail to decompose actual changes

15This is the case since November 8, 2001 as announced by the President of the ECB. However, the

Governing Council can still decide to change the key ECB interest rates at any time regardless of

previously scheduled meetings if needed.


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into these two components are liable to lead to biased results. For example, Cook and

Hahn (1989) fail to take account of expected and unexpected changes in monetary

policy and so their results are not credible. Other studies that suffer from this

problem include Concoveret al. (1999) and Durham (2001).

Recent research has attempted to distinguish between unexpected and

expected changes in target interest rate announcements. The news component is

estimated by (i) the difference between the actual announcement and the

median/mean of market surveys; (ii) derivation of unexpected component from

future markets data; or (iii) derivation of expectations based on forecasts from

regression analysis then subtract these expectations from the actual announcements

for unexpected component. However, as liquidity and range of instruments offered in

the futures markets have been improving, one can directly derive a measure of the

surprise element on a continual basis using data on futures contracts. Therefore, the

second approach has become popular and is also used in this thesis.

3.2.1. The RBAs cash rate newsThe best proxy for Australian market expectation on the RBAs upcoming

target rate announcement is the 30-Day Interbank Cash Rate Futures contract.

However, the launch date for this contract was August 12, 2003, thus it is not

practical for this investigation. We instead use the market surveys of target interest

rates from January 1998 to December 2006. Days surrounding the RBAs target rate

announcements, the financial press reports what the market consensus was at the

time of each announcement. These reports were searched on the Factiva database

over a few days before and after the RBAs scheduled announcements. The

unbiasedness and efficiency of the expectation data generated this way has been


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tested and the results suggest that the market-based expectations are unbiased

predictors of the RBAs interest rate announcements where the null hypothesis

cannot be rejected even at 90% level of confidence. The news component of each

announcement is then the difference between the actual target rate change

announcement and the market expectation. Chapter 4 discusses this methodology of

news extraction in details.

3.2.2. The Feds and the ECBs target rate newsFor the Fed, some of the earlier studies employed market survey expectations

to proxy for expected target rate announcements (e.g. Reinhart and Simin, 1997).

However, recent studies have instead relied on market price-based proxies thanks to

the developments of the financial markets. Krueger and Kuttner (1996) find that the

Fed funds futures rate is an efficient predictor of the Fed funds target rate, and

therefore an appropriate market-based measure of policy expectations. Grkaynaket

al. (2007) later confirm this finding. In his seminal work, Kuttner (2001) uses the

Fed funds futures rates to separate the target rate changes into anticipated and

unanticipated components. He finds that the US Treasury bill, note and bond yields

responses to anticipated changes in the target rate are small, while the responses to

unanticipated changes are large and significant. Bomfim (2003) extends Kuttner

(2001) to asset return volatilities and finds that asset returns are more volatile

following announcements containing unexpected rate changes.

On the other hand, the early literature on the ECBs news employed price-

based proxies to gauge the market expectations on the ECBs target rate

announcements. However, the choice of market instruments differs across

researchers. Gasparet al. (2001) use EONIA (Euro OverNight Index Average, the


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effective overnight reference rate for the Euro) to gauge the probability attached to a

change in the ECBs target interest rate before the Governing Councils meeting.

Perez-Quiros and Sicilia (2002) propose a principal components approach that

utilizes the daily changes of different money market interest rates including the

EONIA, the one-week, one-, two- and three-month EONIA swap rates and the

closest three-month EURIBOR futures rates. Their approach is to extract the key

common component that shapes the evolution in all the above rates. Wrtz (2003)

measures the interest rate change expectations from the forward rate implied by the

one- and two-month EONIA swap rates. However, due to the high volatility and the

impacts of liquidity considerations rather than the monetary policy considerations as

identified by Bindseil (2002) in underbidding scenarios, it seems that the EONIA is

not the best proxy for the market expectation on the ECBs upcoming interest rate

announcements. Bernoth and Von Hagen (2004) find that the three-month EURIBOR

futures rate is an unbiased predictor of the euro area policy rate changes. Thus, the

literature seems to suggest that a market-based approach using futures rates would

provide us with the markets unbiased expectations on the ECBs upcoming interest

rate announcements. Ehrmann and Fratzscher (2003, 2005a) utilize the Reuterss

survey of 25-30 market participants conducted on the Friday before each meeting of

the ECBs Governing Council as a proxy for the market expectations on the

upcoming interest rate decision. However, these surveys fail to capture any change in

market expectations that occur between Friday and the actual announcement date.

Against this background, this thesis uses Kuttner (2001)s methodology to

generate the unexpected components of the Feds and the ECBs target rate

announcements from January 1999 to December 2006. Current-month Fed funds

futures contracts traded on the Chicago Board of Trade (CBOT) are used to extract


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the Feds news, and the three-month EURIBOR futures contracts traded on the

EUREX for the ECBs surprises.16

The news component of the Feds target rate announcement on day d of

month m can be derived from the implied change in the price of the futures contract.

Since the Fed funds futures settlement price is based on the monthly average of the

spot Fed funds rate, it is necessary to account for the number of days affected by the

announcement in that particular month as in equation (3.1). The 3-month EURIBOR

futures settlement price is based on the reference interest rate (EURIBOR) for three-

month euro term-deposits on the last trading day, and so the news component of the

ECBs target interest rate announcement is calculated as in equation (2.1) without the

scaling factorD/(D-d).

( )0 1,0,

= dmdmu ff

dD

Di

(3.1)

where: ui is the unexpected target rate change;

f0m, dis the current month Fed funds futures rate for the Fed and three-

month EURIBOR futures rate for the ECB;

f0m, d-1 is the futures rate on the day prior to the announcement;

D is the number of days in the month; and

D-dis the number of days in the month affected by the announcement.

16Although 1-month EONIA and EURIBOR Futures contracts are better proxies, the former was

introduced only on January 27, 2003, and the latter was delisted on March 16, 2004, hence they are

not practical for this study.


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The target interest rate data of the two central banks were obtained from their

respective websites.17 Panel A of Table 3.1 reports the breakdown of target rate

announcements into rate rises, rate cuts and unchanged sub-components. From

January 1999 to December 2006, the Fed and the ECB made 69 and 131 target rate

announcements, respectively. Of these, the Fed had 19 announcements with rate

changes (13 rate rises and 6 cuts) and 50 with no changes. The ECB made 21

announcements of the target rate changes (13 rises and 8 cuts) and 110 with no

change. Thus, most of the interest rate announcements contained no change (72% for

the Fed and 84% for the ECB).

Panel B of Table 3.1 reports the summary statistics for the interest rate news

series. While 35% of the Feds interest rate announcements were correctly

anticipated, only 26% of the ECBs interest rate announcements were correct

target interest rate news effects on the asia pacific financ

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