International Fixed Income

1
International Fixed Income

• Topic IIIB
• Currency Risk and Bond Returns

2
Outline

• How Well Do U.S. Interest Rate Factors Explain
  Foreign Term Structures?
• Stylized Facts About Government Bond Returns.
• The Volatility of Government Bond Returns - A
  Data Analysis

3
I. Explaining Foreign Term Structure Movements
Using US Rates

• How much does the US term structure explain
  movements in the term structure across countries?
• Case study
• G7 countries (US,UK,JPN,CAN,GER,ITA,FR)
• 1996-1999
• Weekly movements in zeroes of 1yr-30yr maturities

4
Correlations Between Principal Components
US UK JPN CAN FRA GER
ITA
US UK JPN CAN FRA GER
ITA
5
Average R-Squared of Foreign Term Structure on US
Interest Rate Factors
6
Average R-Squared of Foreign Term Structure on US
Interest Rate Factors Exchange Rate
7
II. Stylized Facts About Government Bond Returns

• Look at -adjusted foreign government bond
  returns (i.e., portfolio of bonds across
  maturities)
• JP Morgan Indices for G7 countries
• Means, Volatilities and Correlations

8
Recall Rates of Return on Bonds
Consider a a foreign government bond. What is
its US rate of return?
Taking logs of the above and rearranging gives us
This is approximately equal to yield - dur
x (Dr) - DS(Fn/)
9
Mean -adjusted Annualized Return
10
Volatility of -adjusted Annualized Return
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Correlations Between Returns
US UK JPN CAN FRA GER
ITA
US UK JPN CAN FRA GER
ITA
12
III. What Explains Government Bond Returns?

• Relation between -adjusted government bond
  returns and US interest rate factors
• Relation between -adjusted government bond
  returns and theoretical factors
• Foreign principal component
• Foreign principal components (all 3)
• Foreign principal components exchange rate

13
of -adjusted Returns Explained by Own 1st
Principal Component
Estimated coefficient -5 to -6
14
of -adjusted Returns Explained by Own 3
Principal Components
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of -adjusted Returns Explained by Own 1st
Principal Component Exchange Rate
Estimated coefficient -5 to -6 on 1st comp -1
on XR
16
of -adjusted Returns Explained by Own 3
Principal Components Exchange Rate
Estimated coefficient -5 to -6
17
Recall of Volatility of -adjusted Foreign
Bond Due to Currency Risk