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PhD Defense Mr. F.G.M. Van Holle, MA

Titel: Essays on Empirical Finance and Monetary Policy
Supervisor: Prof. J.J.A.G. Driessen
Co-supervisor: Dr. L. Baele

This PhD is a combination of three separate papers.  Two empirical papers and one literature study. The empirical papers are “Stock-Bond Correlations, Macroeconomic Regimes and Monetary Policy” (co-authored with Lieven Baele) and “The Dynamic Risk Profile of Currency Carry Strategies”. The literature study focuses on “Monetary Policy Transmission and the Impact on Financial Assets, the Real Economy and Inflation”, with special attention to the impact of the zero-lower bound.  

Stock-Bond Correlations, Macroeconomic Regimes and Monetary Policy

 Before 1999, the correlation between stock and government bond returns was typically positive.  Since the end of the 90’s, stock-bond correlations turned negative for a large set of developed market countries.  Understanding the drivers behind this change is important for balanced portfolio managers.  Changes in correlations between investment portfolio components have an impact on the risk profile of the portfolio.  In this paper, we link the evolution of stock-bond correlations for an international sample to both local and global regimes in inflation, the output gap and monetary policy.  We find that negative stock-bond correlations only occur during regimes of low to medium inflation, combined with an accommodating monetary policy.  The relationship becomes stronger for global regimes. In such an environment, a supportive monetary policy will push inflation away from a bad deflationary state.  On the one hand, this will increase the probability of positive inflation and hence negative bond returns, while stocks markets react positively.  This will generate the negative stock-bond correlation.  From the moment monetary policy turns restrictive, stock-bond correlations become significantly positive. This observation is highly relevant in the current environment of potential policy normalization by central banks after a decade of unseen stimulus.  Policy normalization could push stock-bond correlations back into positive territory resulting in a higher volatility of balanced investment portfolios.

The Dynamic Risk Profile of Currency Carry Strategies

Investors who buy high yielding currencies and finance this by selling low yielding currencies earn a significant premium of about 4%-5% per year (from a U.S. perspective). This is at odds with theory that states that the gain via the interest rate differential should be fully offset by an equivalent loss on the currency exposure.  Recent research indicates that these kind of strategies, are exposed to a mix of country specific currency risk, a higher probability of extreme negative returns, downside stock market risk, global currency volatility risk, liquidity risk and commodity price risk.  This paper contributes to a better understanding of the time-varying risk exposure of the currency carry strategy applied on the G10 currencies.  Risk exposure changes significantly over time and therefore, a dynamic model is needed.  Over a longer period, the dollar factor, the global currency volatility factor and the global skewness factor are highly relevant. Based on predictions by the dynamic model, one can substantially improve the return-risk trade-off by limiting the impact of the typical large negative corrections in the currency carry strategy. Transaction costs can be quite important for non-institutional investors.  Unless trades can be done at low costs, a quarterly rather than monthly rebalancing seems to maximize the excess return.  Finally, the G10 carry excess return is driven by only a few currencies (AUD, CAD, NZD and SEK) that are present in the long leg of the trade.

Monetary Policy Transmission and the Impact on Financial Assets, the Real Economy and Inflation
This literature study on monetary policy transmission studies the different dimensions of conventional and unconventional monetary policy.  The transmission through households, firms and banks to the real economy is still an active area of research. I identify different channels and many characteristics like size, capital structure, funding structure, market power, financial integration, regulation, … that dynamically interact and influence the transmission of monetary policy.  The recent unfolding of unconventional policy measures like QE and forward guidance further complicates the picture.  On the one hand are the effects on the real economy difficult to assess and, on the other hand, potential limits to these policies are also important.  A lot will depend on the credibility of the central bank to succeed.  Finally, the transmission is asymmetrical, i.e. restrictive monetary policy has a larger negative effect on financial markets compared to comparable stimulus.  I identify several factors like capital constraints, impact on bank profitability, higher risk taking when rates are low, leverage and the relationship between housing price changes and consumption to explain this asymmetry. Policy normalization should be handled with care and will take many years. Moving too fast will result in large financial market movements and could push the economy rapidly into a recession. When a new recession hits the economy at a time when central bank balance sheets are still large, policy credibility will be an issue. Moving too slow will result in inflationary pressure and more aggressive policy action in the future. Given the complexity of the transmission channels and the asymmetrical effects, this calibration is a challenging task.   Finally, a study of the literature revealed that in terms of modeling a lot of progress is needed to be able to simulate and assess the impact and effectiveness of monetary policy on the real economy and inflation.  The still low inflation after trillions of stimulus indicate that we do not yet fully understand the transmission.  Upgrading the standard models with financial frictions and asymmetrical effects should be an active field for future research.

Location: Cobbenhagen building, Ruth First room (access via Koopmans building)

Order the PhD thesis

When: 19 December 2017 16:00

Where: Route description Tilburg University campus