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The information in the Mexican term structure of interest rates: capital market implications
Journal of International Financial Markets, Institutions and Money 9 (1999) 149 – 161
The information in the Mexican term structure of interest rates: capital market implications Jorge Gonzalez a, Roger Spencer a,*, Daniel Walz b b
a Department of Economics, Trinity Uni6ersity, San Antonio, TX 78212, USA Department of Business Administration, Trinity Uni6ersity, San Antonio, TX 78212, USA
Received 1 August 1997; accepted 1 August 1998
Abstract This paper employs the term structure approach to examine Mexican security markets during the recent period of political and economic turmoil. We investigate the characteristics of these markets and the forecast applicability of the pure expectations hypothesis to interest rates in Mexico. We find that both forward rates and spot rate spreads are found to have significant forecasting ability for future spot rates for Mexico. Both forecasting approaches suggest greater predictive ability during the period of higher interest rates and general economic volatility (1995–1996) than the more stable economic environment of the early 1990s (1991–1994). © 1999 Elsevier Science B.V. All rights reserved. Keywords: Term structure; Mexican capital markets; Pure expectations hypothesis JEL classification: G15; F30; F47
1. Introduction Shifts in international capital flows are frequently associated with changing institutions, political environments and changing relative security returns. All of these factors have contributed to the wild fluctuations in foreign capital inflows that Mexico has experienced during the 1990s. Foreign investors found the Mexican financial market very attractive during the first half of this decade. Portfolio investment into this nation escalated from US$351 million during 1989 to US$28.9 billion in 1993. However, following the December 1994 peso devaluation massive * Corresponding author. Tel.: +1-210-7367222; fax: + 1-210-7367255. E-mail address: [email protected] (R. Spencer) 1042-4431/99/$ - see front matter © 1999 Elsevier Science B.V. All rights reserved. PII: S 1 0 4 2 - 4 4 3 1 ( 9 9 ) 0 0 0 0 4 - 9
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outflows of capital took place. During 1995 close to US$10 billion in portfolio investment left Mexico. Nevertheless, by 1996 Mexico had once again regained the trust of many investors and US$13.6 billion flowed into the country’s financial markets1. It can be speculated that a large volume of the capital that has been shifting into and out of Mexico over the past few years has moved without a sound understanding of this market. Since it appears that the Mexican financial market will continue to attract large inflows of foreign investment in the future it is imperative to study its operation closely. Many of the financial techniques that have been developed to study the US market might be applied to the Mexican financial market as well. The forecasting potential of the pure expectations hypothesis (PEH) is one example of such a tool. The PEH suggests that forward interest rates predict future spot rates. The PEH is normally identified with the growing term structure of interest rates literature which associates the forecasting potential of the term structure not only with interest rate movements, but also with future inflation, monetary policy and a host of macroeconomic outcomes. Much of the term structure research to date has been directed toward US security markets, but a number of studies have emerged recently which apply variations of the term structure approach to markets outside the US, particularly European security markets. Given the identification of US investors with Mexican security markets, it seems appropriate to examine these markets in the context of the term structure methodology. In this paper, we employ the term structure approach to examine Mexican security markets during the recent period of political and economic turmoil to learn more about the characteristics of these markets and the forecast applicability of the PEH to interest rate movements in Mexico. The organization of the paper calls for this introduction to be followed by a review of recent capital market developments and selected term structure literature. Next, we present the basic methodology and capital market data. Our empirical results are then discussed. We conclude with a brief summary of our findings.
2. Recent capital market developments and literature The institutional structure of Mexican capital markets differs significantly from that of US capital markets. Can research techniques developed for and applied primarily to U.S. capital markets have relevance for Mexico? This section of the paper briefly covers capital market distinctions and recent PEH literature. Although the central banks of both the US and Mexico have changed operating procedures considerably over the past two decades, it seems clear that the US central bank acts with greater independence of the administration or Treasury (at least since the 1951 Treasury – Federal Reserve Accord) than does its Mexican 1 Portfolio investment data were obtained from the Banco de Mexico web page located at http:// www.banxico.org.mx
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counterpart. For example, the Mexican central bank was accused in 1994 of deliberately withholding information about Mexican international reserves to advance the policies of the sitting administration. A recent Federal Reserve Bank of Minneapolis Quarterly Re6iew article reported the controversy: When Mexican and US officials met in Washington, DC to arrange for emergency financing in the spring of 1994, they held a press conference, on April 26. During the press conference, Mexican officials were asked about the current level of international reserves, but the officials would not disclose it. According to one report, ‘‘when someone asked (Mexican Finance Minister Pedro Aspe) how (the lending agreement) would affect the level of Mexico’s reserves, he refused, point-blank, to say how much Mexico had in reserves. He said…that the central bank was now independent: yet he refused to let the Governor of the Bank of Mexico, Miguel Mancera, answer’’ (Braun et al., 1996). The close association between the Mexican central bank and Treasury implies that expectations about interest rates may be formed differently than in the US. In Mexico, the two institutions jointly determine the optimal quantity of government bonds to be supplied at any time and the preferred maturity structure. The term applied to this practice is ‘filling the cup’. The Treasury is primarily concerned with finding the cheapest financing, whether at the short or long end of the yield curve. During times of economic upheaval it is not uncommon for the Treasury to stop issuing long-term bonds in order to avoid paying the relatively high interest rates that the market would demand. Another significant difference between the Mexican and US government debt markets is the maturity period of long-term debt. While the US government issues bonds with maturities of up to 30 years, in recent years Mexico has rarely issued peso-denominated bonds with maturities beyond 1 year. As a result of these institutional arrangements, Mexico’s yield curve is likely, ceteris paribus, to be ‘flatter’ than a ‘market driven’ yield curve. So long as there are capital market participants beyond the Mexican Treasury and central bank, however, private forces will form expectations of the yield curve and of future movements in interest rates. The institutional process may associate expectations of future securities developments with political activities or periods of economic turmoil, but expectations will be formed, perhaps in a manner consistent with the PEH. During 1994, Mexico’s capital markets were rocked by a myriad of political events: an armed insurrection in the southern state of Chiapas; the assassination of the leading presidential candidate; the kidnapping of prominent businessmen; political scandals; presidential elections; and the transfer of power from President Salinas to President Zedillo. These events fueled several speculative attacks on the capital markets, with the most severe taking place in March and November. In spite of this turmoil Mexico’s financial authorities managed to hold off financial disaster until December2. One might also conclude that the authorities succeeded in 2 Capital market difficulties encountered by the Mexican Treasury and central bank during 1994 are discussed in Calvo and Mendoza (1996), Gil-Diaz and Carstens (1996), Eichengreen and Portes (1997) and Braun et al. (1996). See also Edwards (1996) for a comparison of the economic crises of Mexico and Chile.
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stabilizing the market expectations of private sector participants until the end-ofyear ‘herding behavior’, as termed by Calvo and Mendoza (1996). Some studies of the Mexican capital markets have applied US-oriented financial concepts to Mexico. Schwartz (1992) and Thornton (1995) conducted two recent long-term studies of the Mexican markets. Schwartz (1992) focused on periods when the Mexican government reduced the public debt’s maturity to avoid an increasing long-term debt premium triggered by devaluation expectations. He also found that such theories as ‘crowding out’ helped explain movements in real interest rates. The results of Thornton (1995) supported the existence of a ‘Fisher effect’ between interest rates and inflation during the 1978–1994 period. With respect to the PEH itself (another financial concept usually associated with the US), it should be noted that Hardouvelis (1994) was able to reject its application only for the US, finding that it appeared to explain the term structure among the other G7 countries quite well, despite the variance among financial institutions across the several countries involved. Other researchers have obtained varying results across countries in testing whether forward interest rates conform to the statistical implications of the PEH, in particular, whether forward rates, in fact, predict future spot rates. Using survey data, Froot (1989) found that expectations of short-term rates do not conform to the PEH, but long-term interest rate expectations are generally consistent with the PEH. Mishkin (1990) found that short-term interest rates (less than 6 months maturity) conform (somewhat weakly) to the PEH during the years from 1964 to 1986. Young and Fowler (1990) rejected the PEH for long-term bonds in Australia for the 1980 – 1988 period. Lewis (1991) found evidence of systematic ex-post pricing errors for long-term bonds during the 1979–1982 period of nonborrowed reserve targeting by the Federal Reserve. Mills (1991) examined British interest rates over a very long period (1870–1988) and rejected the PEH for the period up to World War I and the interwar period. However, he found that the PEH generally held for bonds in the Post-World War II period, with the exception of perpetuities. Ilmanen (1996) found that forward rates are poor predictors of future spot rates. In fact, he found that long-term rates tended to move away from the direction implied by forward rates. Elton et al. (1996) looked at longer maturity yields and rejected the PEH, finding evidence of time-varying risk premia. Finally, Engsted (1996) found that the spread between short and longer term rates in Denmark had significant forecasting ability of future short-term rates, as implied by the PEH, only in periods of interest rate volatility, a subject which we investigate later in this paper.
3. Methodology and data Shiller et al. (1983) showed that that if the market conforms to the pure expectations hypothesis of the term structure, the i-period-ahead forward rate on a (n−i )-period bond (ifn − i ) can be expressed in terms of current bond yields and durations:
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i
fn − i =
Dn (rn ) −Di (ri ) Dn −Di
153
(1)
where Dn is the duration of an n period maturity bond and rn is current yield on an n period maturity bond. For bills, duration is equal to maturity. Thus Eq. (1) can be expressed as: i
fn − i =
n(rn ) − i(ri ) n −i
(2)
For the case of one period forward rates, Eq. (2) simplifies to: i
f1 =i +1(ri + 1) −i(ri )
(3)
The PEH assumes that forward rates equal expected future spot rates. Thus, if the PEH has real forecasting ability, it might be expected that the current difference between forward and current rates might predict the subsequent change in rates: Drt = a +b( ft − 1 −rt − 1) + o
(4)
Drt is the change in the spot rate over time t, ft − 1 is the forward rate at time t− 1, rt − 1 is the spot rate at time t − 1 and o is an error term. Numerous studies (Fama, 1984; Fama and Bliss, 1987; and more recently Mizrach, 1996) found that Eq. (4) has little predictive ability for US rates. We estimate Eq. (4) for Mexican rates, however, as a strong test of the PEH. A second approach for testing the predictive ability of the term structure has been to test the predictive ability of current yield spreads for subsequent changes in rates (Campbell and Shiller, 1991 and Engsted, 1996). Generally, the model tested has been of the form: DRt =a + b(St − 1) + ot
(5)
where DRt is the change in the j period spot rate for time t, St − 1 is the spread between the yield on a j+ 1 month maturity Mexican rate and j maturity Mexican rate for time t − 1, and o is an error term. This is the model we test as well. If the sampling period is shorter than the shortest bond holding period examined, i.e. if weekly data are used to investigate monthly returns, the errors from both Eqs. (4) and (5) will be serially correlated. Specifically, the errors from both Eqs. (4) and (5) should follow a moving average process. If, in the case of Eq. (5), t represents the sampling period, the moving average process will have an order of m− 1, where m is the maturity of the bond in terms of the sample estimation period. Thus, if we were investigating the forecasting ability of the spread between 6 month and 3 month bills, sampled on a weekly basis, we might expect the errors to follow a moving average with an order of 12. If interest rate volatility changes over the period in which either Eqs. (4) and (5) are estimated, we might expect the errors to be heteroscedastic as well. We use a computationally simplified version of the Newey and West (1987) method developed by Godfrey (1987) to correct for serial correlation and heteroscedasticity among the errors. The Godfrey (1987) version of the Newey and West procedure is available in SHAZAM—the econometric modeling package we use for data analysis in this paper.
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The data consist of the bond yields to maturity for Bank of Mexico peso-denominated bonds (CETES) issued in original maturities of l month (28 days), 3 months (90 days) and 6 months (180 days). Longer-term maturities would have been desirable, but were not issued on a consistent basis at various times of economic uncertainty during the l990s. The data were sampled on a weekly basis covering the period from January 1991 through December 1996. The data were analyzed for two sub-periods as well as for the entire sample. The two periods are from January 1991 – December 1994 and January 1995–December 1996. These sub-periods were chosen to reflect two distinct periods in the recent financial history of Mexico. The first period represents a period of relative economic, political and financial stability. The January 1995–December 1996 period is one of great financial upheaval, including the aftermath of the dramatic peso devaluation, continued political uncertainty, and the U.S.-backed financial rescue package for Mexico.
4. Empirical results Table 1 presents descriptive statistics for the Mexican bond rates over the sample period. This table illustrates the profound differences in the general level of interest rates between the two sub-periods. For example, the mean rate for one month bonds during the January 1991 – December 1994 period was 16.03% while the mean rate for the January 1995 – December 1996 period was 32.99%. The standard deviation of returns also showed significant variation over the sample period. The sample standard deviation for 3 month rates over the January 1991–December 1994 period was only 3.31% while the standard deviation for the January 1995–December 1996 period for 3 month rates was 10.94%. Table 1 also indicates that the short-term term structure of interest rates in Mexico was flat over the entire sample period as well as both sub-periods. This may be evidence of one aspect of Mexican financial institutions ‘filling the cup’-that is, borrowing at the cheapest rate along the term structure. Table 1 Summary statistics for Mexican interest rates: January 1991–December 1996 Time period
Bond maturity
Mean
Std. Dev.
Minimum
Maximum
January 1991–December 1994
1 3 6 1 3 6 1 3 6
16.03 16.49 16.44 32.99 33.87 33.82 21.99 22.59 22.55
3.20 3.31 3.32 11.46 10.94 10.39 10.71 10.17 10.02
8.81 9.13 9.85 13.15 13.10 13.00 8.81 9.13 9.85
24.30 24.65 24.30 60.98 59.00 59.99 60.98 59.00 59.99
January 1995–December 1996
January 1991–December 1996
Month Month Month Month Month Month Month Month Month
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Table 2 Correlation coefficients for Mexican interest rates: January 1991–December 1996 Time period
Bond maturity
1 Month
January 1991–December 1994
3 6 3 6 3 6
0.9657 0.9493 0.9226 0.7887 0.9361 0.8412
January 1995–December 1996 January 1991–December 1996
Month Month Month Month Month Month
3 Month
0.9798 0.8772 0.9112
Table 2 displays the correlations among the three Mexican rates. Table 2 illustrates that the yields of the three Mexican government bonds are highly correlated over the entire sample period. For example, the correlation between the 1 and 3 month Mexican CETES rates was 0.9361 over the 1991–1996 period. The lowest correlation, between the 1 and 6 month rates during the 1995–1996 period, was still 0.7887. This result is indicative of generally parallel shifts in the term structure occurring in Mexico over the 1991–1996 period. Fig. 1 displays the one month rate in Mexico over the 1991–1996 time period. The graph illustrates that the one month rate dramatically changed at the end of 1994, with both the rate and the volatility of the rate increasing. The graph also indicates that while the one month rate declined during 1996, it is still significantly higher than in the pre-peso crisis period of 1991–1994. Thus, the figure graphically illustrates the structural shift of Mexican rates and the reason to investigate the 1991–1994 and 1995 – 1996 sub-periods, as well as the whole sample period3,4. Fig. 2 displays the spread between the 3 month forward rate and 3 month spot rate in Mexico over the 1991 – 1996 time period. The graph illustrates that the spread dramatically decreased at the end of 1994. This decrease was followed by a significant increase in the spread throughout 1995–1996. Thus, Fig. 2 graphically illustrates the structural shift in the relationship between Mexican forward and spot rates and provides further reason to investigate the 1991–1994 and 1995–1996 sub-periods, as well as the whole sample period. Table 3 presents the autocorrelation and heteroscedasticity-adjusted results of estimating Eq. (4) for the 3 month maturity interest rates of Mexico. That is, this table presents findings regarding the ability of the 3 month forward rate in Mexico to predict the subsequent 3 month change in the 3 month rate. The results indicate that 3 month forward rates have significant forecasting ability during both sub-pe-
3 The CUSUMSQ test, originally developed by Brown et al. (1975), also indicates significant structural change in the sample occurs at the end of 1994. The test indicates no comparable structural change occurring during either the 1991–1994 or 1995– 1996 sub-periods. 4 The 3 and 6 month interest rates in Mexico move in an analogous manner relative to the 1 month rate. All three Mexican rates share the same major break point at the end of 1994 and react similarly to subsequent shocks.
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Fig. 1. One month rates in Mexico (January 1991–December 1996).
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Fig. 2. Forward rate — spot rate spread (January 1991–December 1996).
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riods as well as the overall sample period. The results also indicate that Mexican forward rates have somewhat greater predictive ability (in terms of level of statistical significance) during the period of most economic turmoil (1995–1996). This result seems counterintuitive. One might think a priori that the forecast errors between actual rate changes and rate changes predicted by forward rates would increase rather than decrease in periods of significant interest rate volatility. Interest rate changes become more difficult to predict. One hypothesis consistent with these findings would be that arbitrage opportunities are potentially greater in periods of interest rate volatility than relative stability. Thus, market participants with superior interest rate forecasts can use these forecasts to engage in interest rate arbitrage among bonds of differing maturities. Table 4 presents the results of autocorrelation and heteroscedasticity-adjusted estimation of Eq. (5) for the Mexican CETES rates. The difference in results for the two sub-periods is quite striking. For the 1991–1994 period, none of the various spot rate differentials (3 month rate – 1 month rate, etc.) had significant ability to forecast subsequent spot rate changes. For the 1995–1996 period, all tested spot rate differentials showed significant forecasting ability. The spot rate differentials were generally found to have significant predictive ability for the entire 1991–1996 period as well. This was true for every tested spot rate differential except the 3 month/1 month differential predicting 3 month rate changes. The signs of the estimated coefficients for Eq. (5) are generally consistent with what common sense might indicate. If, for example, the spread between the 6 and 1 month rates is large by historical standards, we would expect the 6 month rate to decline and the 1 month rate to increase. Thus, we would expect the coefficient for this spread variable to be positive when predicting the change in the 1 month rate. We would also expect the coefficient for this spread variable to be negative when predicting the change in the 6 month rate. The signs of all significant coefficients (with the exception of the 3 – 1 month rate differential predicting subsequent 3 month rate changes) were of the predicted sign. Table 3 Forecasting ability of three month forward rates for Mexico (estimation of Eq. (4))a Independent
Time period
Variable
January 1991– December 1994
January 1995– December 1996
Overall (1991– 1996)
3 Month forward rate—3 month spot rate (lagged 3 months) Constant
0.551 (2.54**) 1.49 (0.601) 0.72
0.28 (3.29***) 1.25 (0.770) 0.78
0.255 (3.78***) 1.60 (2.29) 0.76
R2 a
t-Statistics are in parentheses. ** Significant at the 0.01 level. *** Significant at the 0.001 level.
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Table 4 Forecasting ability of spot rate spreads for Mexico (Estimates of b in Eq. (5))a Dependent variable
Independent variable
Estimate of b
January 1991– December 1994
January 1995– December 1996
Overall (1991– 1996)
D1 month rate
(3 month rate–1 month rate) [lag 1]
−0.07 (−0.22)
0.78 (6.18)***
0.22 (4.04)*
D3 month rate
(3 month rate–1 month rate) [lag 1]
0.07 (1.38)
0.29 (4.78)***
−0.03 (−1.15)**
D6 month rate
(6 month rate–1 month rate) [lag 1]
−0.07 (−1.02)
−0.23 (3.36)***
−0.19 (−3.72)***
D3 month rate
(6 month rate–3 month rate) [lag 3]
−0.16 (−0.37)
0.34 (4.72)***
0.22 (4.14)***
a
t-Statistics are in parentheses. * Significant at the 0.05 level. ** Significant at the 0.01 level. *** Significant at the 0.001 level. Lagged values are enclosed in brackets
The result that Mexican term structure spreads have significantly greater predictive ability during the period of most economic turmoil (1995–1996) seems counterintuitive. However, Engsted (1996) has recently observed that interest rate spreads have more predictive ability in periods of greater interest rate volatility in the case of Denmark. Thus, our empirical results are not entirely unique5 And again, it may be that arbitrage opportunities are potentially greater in periods of interest rate volatility than relative stability. Thus, as we noted before, market participants with superior interest rate forecasts can use these forecasts for arbitrage gains.
5. Summary Major shocks to the Mexican economy in recent years present an opportunity to investigate the informational content of the term structure of interest rates under vastly changing economic conditions. For comparison, we present summary statistics and regressions for Mexican interest rates over recent time periods. Our results indicate that 3 month forward rates do have significant forecasting ability for future spot rates for the entire 1991 – 1996 period, as well as the 1991–1994 and 1995– 1996 sub-periods. Somewhat counter-intuitively, the forward rate predictability is at its highest for Mexico during the period of greatest interest rate volatility (1995– 5
Employing a somewhat different methodology and time period, Galindo (1995) also obtained evidence that the term structure for public bonds in Mexico contains information useful for forecasting purposes.
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1996). We also find spot rate spreads have significant predictive ability as well. Again, somewhat surprisingly, we find spot rate spreads predict rate changes most significantly during the volatile 1995 –1996 period. This result is consistent with recent findings for Danish securities by Engsted (1996).
Acknowledgements We wish to acknowledge the very helpful comments of an anonymous referee for valuable contributions to the development of this article.
References Braun, R., Mukherji, A., Runkle, D., 1996. Delayed financial disclosure: Mexico’s recent experience. Fed. Reserve Bank Minneapolis Quart. Rev. 8, 13 – 21. Brown, R., Durbin, J., Evans, J., 1975. Techniques for testing the constancy of regression relationships over time. J. Royal Stat. Soc. B37, 149–163. Calvo, G., Mendoza, E., 1996. Petty crime and cruel punishment: lessons from the Mexican debacle. Am. Econ. Rev. 86, 170–175. Campbell, J., Shiller, R., 1991. Yield spreads and interest rate movements: a bird’s eye view. Rev. Econ. Studies 58, 495-514. Edwards, S., 1996. Exchange-rate anchors, credibility and inertia: a tale of two crises, Chile and Mexico. Am. Econ. Rev. 86, 176–180. Eichengreen, B., Portes, R., 1997. Managing financial crises in emerging markets. In: Maintaining Financial Stability in a Global Economy—A Symposium Sponsored by the Federal Reserve Bank of Kansas City, 193–226. Elton, E., Gruber, M., Mei, J., 1996. Return generating process and the determinants of term premiums. J. Bank Finan. 20, 1251–1264. Engsted, T., 1996. The predictive power of the money market term structure. Int. J. Forecast. 12, 289 – 308. Fama, E., 1984. The information in the term structure. J. Finan. Econ. 13, 509 – 528. Fama, E., Bliss, R., 1987. The information in long-maturity forward rates. Am. Econ. Rev. 77, 680 – 692. Froot, K., 1989. New hope for the expectations hypothesis of the term structure of interest rates. J. Finan. 44, 283–305. Galindo, L., 1995. La hipo´tesis de expectativas en el mercado de CETES en Me´xico: 1990 – 1995. Estudios Econ. 10, 67–88. Gil-Diaz, F., Carstens, A., 1996. One year of solitude: some pilgrim tales about Mexico’s 1994 – 1995 crisis. Am. Econ. Rev. 86, 164–169. Godfrey, L., 1987. Discriminating between autocorrelation and misspecification in regression analysis: an alternative test strategy. Rev. Econ. Stat. 69, 128 – 134. Hardouvelis, G., 1994. The term structure spread and future changes in long and short rates in the G7 countries: is there a puzzle? J. Monetary Econ. 33, 255 – 283. Ilmanen, A., 1996. Market rate expectations and forward rates. J. Fixed Income 6, 8 – 21. Lewis, K., 1991. Was there a ‘peso’ problem in the US term structure of interest rates: 1979 – 1982? Int. Econ. Rev. 32, 159–173. Mills, T., 1991. The term structure of UK interest rates: tests of the expectations hypothesis. J. Appl. Econ. 23, 599–606. Mishkin, F., 1990. What does the term structure tell us about future inflation? J. Monetary Econ. 25, 77 – 95.
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Mizrach, B., 1996. The information in the term structure: a non-parametric investigation. J. Forecasting 15, 137 –154. Newey, W., West, K., 1987. A simple, positive definite heteroscedasticity and autocorrelation consistent covariance matrix. Econometrica 55, 703–708. Schwartz, M., 1992. Interest rate determination and the maturity structure of domestic public debt: the case of Mexico. Dissertation. University of California at Los Angeles. Shiller, R., Campbell, J., Schoenholtz, K., 1983. Forward rates and future policy: interpreting the term structure of interest rates. Brookings Papers Econ. Activity 1, 173 – 217. Thornton, J., 1995. The adjustment of nominal interest rates in Mexico: a study of the Fisher effect. Appl. Econ. Lett. 3, 255–257. Young, I., Fowler, D., 1990. Some evidence on the term structure of interest rates: how to find a black cat when it’s not there. J. Acc. Finan. 30, 21 – 26.
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The information in the Mexican term structure of interest rates: capital market implications Jorge Gonzalez a, Roger Spencer a,*, Daniel Walz b b
a Department of Economics, Trinity Uni6ersity, San Antonio, TX 78212, USA Department of Business Administration, Trinity Uni6ersity, San Antonio, TX 78212, USA
Received 1 August 1997; accepted 1 August 1998
Abstract This paper employs the term structure approach to examine Mexican security markets during the recent period of political and economic turmoil. We investigate the characteristics of these markets and the forecast applicability of the pure expectations hypothesis to interest rates in Mexico. We find that both forward rates and spot rate spreads are found to have significant forecasting ability for future spot rates for Mexico. Both forecasting approaches suggest greater predictive ability during the period of higher interest rates and general economic volatility (1995–1996) than the more stable economic environment of the early 1990s (1991–1994). © 1999 Elsevier Science B.V. All rights reserved. Keywords: Term structure; Mexican capital markets; Pure expectations hypothesis JEL classification: G15; F30; F47
1. Introduction Shifts in international capital flows are frequently associated with changing institutions, political environments and changing relative security returns. All of these factors have contributed to the wild fluctuations in foreign capital inflows that Mexico has experienced during the 1990s. Foreign investors found the Mexican financial market very attractive during the first half of this decade. Portfolio investment into this nation escalated from US$351 million during 1989 to US$28.9 billion in 1993. However, following the December 1994 peso devaluation massive * Corresponding author. Tel.: +1-210-7367222; fax: + 1-210-7367255. E-mail address: [email protected] (R. Spencer) 1042-4431/99/$ - see front matter © 1999 Elsevier Science B.V. All rights reserved. PII: S 1 0 4 2 - 4 4 3 1 ( 9 9 ) 0 0 0 0 4 - 9
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outflows of capital took place. During 1995 close to US$10 billion in portfolio investment left Mexico. Nevertheless, by 1996 Mexico had once again regained the trust of many investors and US$13.6 billion flowed into the country’s financial markets1. It can be speculated that a large volume of the capital that has been shifting into and out of Mexico over the past few years has moved without a sound understanding of this market. Since it appears that the Mexican financial market will continue to attract large inflows of foreign investment in the future it is imperative to study its operation closely. Many of the financial techniques that have been developed to study the US market might be applied to the Mexican financial market as well. The forecasting potential of the pure expectations hypothesis (PEH) is one example of such a tool. The PEH suggests that forward interest rates predict future spot rates. The PEH is normally identified with the growing term structure of interest rates literature which associates the forecasting potential of the term structure not only with interest rate movements, but also with future inflation, monetary policy and a host of macroeconomic outcomes. Much of the term structure research to date has been directed toward US security markets, but a number of studies have emerged recently which apply variations of the term structure approach to markets outside the US, particularly European security markets. Given the identification of US investors with Mexican security markets, it seems appropriate to examine these markets in the context of the term structure methodology. In this paper, we employ the term structure approach to examine Mexican security markets during the recent period of political and economic turmoil to learn more about the characteristics of these markets and the forecast applicability of the PEH to interest rate movements in Mexico. The organization of the paper calls for this introduction to be followed by a review of recent capital market developments and selected term structure literature. Next, we present the basic methodology and capital market data. Our empirical results are then discussed. We conclude with a brief summary of our findings.
2. Recent capital market developments and literature The institutional structure of Mexican capital markets differs significantly from that of US capital markets. Can research techniques developed for and applied primarily to U.S. capital markets have relevance for Mexico? This section of the paper briefly covers capital market distinctions and recent PEH literature. Although the central banks of both the US and Mexico have changed operating procedures considerably over the past two decades, it seems clear that the US central bank acts with greater independence of the administration or Treasury (at least since the 1951 Treasury – Federal Reserve Accord) than does its Mexican 1 Portfolio investment data were obtained from the Banco de Mexico web page located at http:// www.banxico.org.mx
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counterpart. For example, the Mexican central bank was accused in 1994 of deliberately withholding information about Mexican international reserves to advance the policies of the sitting administration. A recent Federal Reserve Bank of Minneapolis Quarterly Re6iew article reported the controversy: When Mexican and US officials met in Washington, DC to arrange for emergency financing in the spring of 1994, they held a press conference, on April 26. During the press conference, Mexican officials were asked about the current level of international reserves, but the officials would not disclose it. According to one report, ‘‘when someone asked (Mexican Finance Minister Pedro Aspe) how (the lending agreement) would affect the level of Mexico’s reserves, he refused, point-blank, to say how much Mexico had in reserves. He said…that the central bank was now independent: yet he refused to let the Governor of the Bank of Mexico, Miguel Mancera, answer’’ (Braun et al., 1996). The close association between the Mexican central bank and Treasury implies that expectations about interest rates may be formed differently than in the US. In Mexico, the two institutions jointly determine the optimal quantity of government bonds to be supplied at any time and the preferred maturity structure. The term applied to this practice is ‘filling the cup’. The Treasury is primarily concerned with finding the cheapest financing, whether at the short or long end of the yield curve. During times of economic upheaval it is not uncommon for the Treasury to stop issuing long-term bonds in order to avoid paying the relatively high interest rates that the market would demand. Another significant difference between the Mexican and US government debt markets is the maturity period of long-term debt. While the US government issues bonds with maturities of up to 30 years, in recent years Mexico has rarely issued peso-denominated bonds with maturities beyond 1 year. As a result of these institutional arrangements, Mexico’s yield curve is likely, ceteris paribus, to be ‘flatter’ than a ‘market driven’ yield curve. So long as there are capital market participants beyond the Mexican Treasury and central bank, however, private forces will form expectations of the yield curve and of future movements in interest rates. The institutional process may associate expectations of future securities developments with political activities or periods of economic turmoil, but expectations will be formed, perhaps in a manner consistent with the PEH. During 1994, Mexico’s capital markets were rocked by a myriad of political events: an armed insurrection in the southern state of Chiapas; the assassination of the leading presidential candidate; the kidnapping of prominent businessmen; political scandals; presidential elections; and the transfer of power from President Salinas to President Zedillo. These events fueled several speculative attacks on the capital markets, with the most severe taking place in March and November. In spite of this turmoil Mexico’s financial authorities managed to hold off financial disaster until December2. One might also conclude that the authorities succeeded in 2 Capital market difficulties encountered by the Mexican Treasury and central bank during 1994 are discussed in Calvo and Mendoza (1996), Gil-Diaz and Carstens (1996), Eichengreen and Portes (1997) and Braun et al. (1996). See also Edwards (1996) for a comparison of the economic crises of Mexico and Chile.
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stabilizing the market expectations of private sector participants until the end-ofyear ‘herding behavior’, as termed by Calvo and Mendoza (1996). Some studies of the Mexican capital markets have applied US-oriented financial concepts to Mexico. Schwartz (1992) and Thornton (1995) conducted two recent long-term studies of the Mexican markets. Schwartz (1992) focused on periods when the Mexican government reduced the public debt’s maturity to avoid an increasing long-term debt premium triggered by devaluation expectations. He also found that such theories as ‘crowding out’ helped explain movements in real interest rates. The results of Thornton (1995) supported the existence of a ‘Fisher effect’ between interest rates and inflation during the 1978–1994 period. With respect to the PEH itself (another financial concept usually associated with the US), it should be noted that Hardouvelis (1994) was able to reject its application only for the US, finding that it appeared to explain the term structure among the other G7 countries quite well, despite the variance among financial institutions across the several countries involved. Other researchers have obtained varying results across countries in testing whether forward interest rates conform to the statistical implications of the PEH, in particular, whether forward rates, in fact, predict future spot rates. Using survey data, Froot (1989) found that expectations of short-term rates do not conform to the PEH, but long-term interest rate expectations are generally consistent with the PEH. Mishkin (1990) found that short-term interest rates (less than 6 months maturity) conform (somewhat weakly) to the PEH during the years from 1964 to 1986. Young and Fowler (1990) rejected the PEH for long-term bonds in Australia for the 1980 – 1988 period. Lewis (1991) found evidence of systematic ex-post pricing errors for long-term bonds during the 1979–1982 period of nonborrowed reserve targeting by the Federal Reserve. Mills (1991) examined British interest rates over a very long period (1870–1988) and rejected the PEH for the period up to World War I and the interwar period. However, he found that the PEH generally held for bonds in the Post-World War II period, with the exception of perpetuities. Ilmanen (1996) found that forward rates are poor predictors of future spot rates. In fact, he found that long-term rates tended to move away from the direction implied by forward rates. Elton et al. (1996) looked at longer maturity yields and rejected the PEH, finding evidence of time-varying risk premia. Finally, Engsted (1996) found that the spread between short and longer term rates in Denmark had significant forecasting ability of future short-term rates, as implied by the PEH, only in periods of interest rate volatility, a subject which we investigate later in this paper.
3. Methodology and data Shiller et al. (1983) showed that that if the market conforms to the pure expectations hypothesis of the term structure, the i-period-ahead forward rate on a (n−i )-period bond (ifn − i ) can be expressed in terms of current bond yields and durations:
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i
fn − i =
Dn (rn ) −Di (ri ) Dn −Di
153
(1)
where Dn is the duration of an n period maturity bond and rn is current yield on an n period maturity bond. For bills, duration is equal to maturity. Thus Eq. (1) can be expressed as: i
fn − i =
n(rn ) − i(ri ) n −i
(2)
For the case of one period forward rates, Eq. (2) simplifies to: i
f1 =i +1(ri + 1) −i(ri )
(3)
The PEH assumes that forward rates equal expected future spot rates. Thus, if the PEH has real forecasting ability, it might be expected that the current difference between forward and current rates might predict the subsequent change in rates: Drt = a +b( ft − 1 −rt − 1) + o
(4)
Drt is the change in the spot rate over time t, ft − 1 is the forward rate at time t− 1, rt − 1 is the spot rate at time t − 1 and o is an error term. Numerous studies (Fama, 1984; Fama and Bliss, 1987; and more recently Mizrach, 1996) found that Eq. (4) has little predictive ability for US rates. We estimate Eq. (4) for Mexican rates, however, as a strong test of the PEH. A second approach for testing the predictive ability of the term structure has been to test the predictive ability of current yield spreads for subsequent changes in rates (Campbell and Shiller, 1991 and Engsted, 1996). Generally, the model tested has been of the form: DRt =a + b(St − 1) + ot
(5)
where DRt is the change in the j period spot rate for time t, St − 1 is the spread between the yield on a j+ 1 month maturity Mexican rate and j maturity Mexican rate for time t − 1, and o is an error term. This is the model we test as well. If the sampling period is shorter than the shortest bond holding period examined, i.e. if weekly data are used to investigate monthly returns, the errors from both Eqs. (4) and (5) will be serially correlated. Specifically, the errors from both Eqs. (4) and (5) should follow a moving average process. If, in the case of Eq. (5), t represents the sampling period, the moving average process will have an order of m− 1, where m is the maturity of the bond in terms of the sample estimation period. Thus, if we were investigating the forecasting ability of the spread between 6 month and 3 month bills, sampled on a weekly basis, we might expect the errors to follow a moving average with an order of 12. If interest rate volatility changes over the period in which either Eqs. (4) and (5) are estimated, we might expect the errors to be heteroscedastic as well. We use a computationally simplified version of the Newey and West (1987) method developed by Godfrey (1987) to correct for serial correlation and heteroscedasticity among the errors. The Godfrey (1987) version of the Newey and West procedure is available in SHAZAM—the econometric modeling package we use for data analysis in this paper.
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The data consist of the bond yields to maturity for Bank of Mexico peso-denominated bonds (CETES) issued in original maturities of l month (28 days), 3 months (90 days) and 6 months (180 days). Longer-term maturities would have been desirable, but were not issued on a consistent basis at various times of economic uncertainty during the l990s. The data were sampled on a weekly basis covering the period from January 1991 through December 1996. The data were analyzed for two sub-periods as well as for the entire sample. The two periods are from January 1991 – December 1994 and January 1995–December 1996. These sub-periods were chosen to reflect two distinct periods in the recent financial history of Mexico. The first period represents a period of relative economic, political and financial stability. The January 1995–December 1996 period is one of great financial upheaval, including the aftermath of the dramatic peso devaluation, continued political uncertainty, and the U.S.-backed financial rescue package for Mexico.
4. Empirical results Table 1 presents descriptive statistics for the Mexican bond rates over the sample period. This table illustrates the profound differences in the general level of interest rates between the two sub-periods. For example, the mean rate for one month bonds during the January 1991 – December 1994 period was 16.03% while the mean rate for the January 1995 – December 1996 period was 32.99%. The standard deviation of returns also showed significant variation over the sample period. The sample standard deviation for 3 month rates over the January 1991–December 1994 period was only 3.31% while the standard deviation for the January 1995–December 1996 period for 3 month rates was 10.94%. Table 1 also indicates that the short-term term structure of interest rates in Mexico was flat over the entire sample period as well as both sub-periods. This may be evidence of one aspect of Mexican financial institutions ‘filling the cup’-that is, borrowing at the cheapest rate along the term structure. Table 1 Summary statistics for Mexican interest rates: January 1991–December 1996 Time period
Bond maturity
Mean
Std. Dev.
Minimum
Maximum
January 1991–December 1994
1 3 6 1 3 6 1 3 6
16.03 16.49 16.44 32.99 33.87 33.82 21.99 22.59 22.55
3.20 3.31 3.32 11.46 10.94 10.39 10.71 10.17 10.02
8.81 9.13 9.85 13.15 13.10 13.00 8.81 9.13 9.85
24.30 24.65 24.30 60.98 59.00 59.99 60.98 59.00 59.99
January 1995–December 1996
January 1991–December 1996
Month Month Month Month Month Month Month Month Month
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Table 2 Correlation coefficients for Mexican interest rates: January 1991–December 1996 Time period
Bond maturity
1 Month
January 1991–December 1994
3 6 3 6 3 6
0.9657 0.9493 0.9226 0.7887 0.9361 0.8412
January 1995–December 1996 January 1991–December 1996
Month Month Month Month Month Month
3 Month
0.9798 0.8772 0.9112
Table 2 displays the correlations among the three Mexican rates. Table 2 illustrates that the yields of the three Mexican government bonds are highly correlated over the entire sample period. For example, the correlation between the 1 and 3 month Mexican CETES rates was 0.9361 over the 1991–1996 period. The lowest correlation, between the 1 and 6 month rates during the 1995–1996 period, was still 0.7887. This result is indicative of generally parallel shifts in the term structure occurring in Mexico over the 1991–1996 period. Fig. 1 displays the one month rate in Mexico over the 1991–1996 time period. The graph illustrates that the one month rate dramatically changed at the end of 1994, with both the rate and the volatility of the rate increasing. The graph also indicates that while the one month rate declined during 1996, it is still significantly higher than in the pre-peso crisis period of 1991–1994. Thus, the figure graphically illustrates the structural shift of Mexican rates and the reason to investigate the 1991–1994 and 1995 – 1996 sub-periods, as well as the whole sample period3,4. Fig. 2 displays the spread between the 3 month forward rate and 3 month spot rate in Mexico over the 1991 – 1996 time period. The graph illustrates that the spread dramatically decreased at the end of 1994. This decrease was followed by a significant increase in the spread throughout 1995–1996. Thus, Fig. 2 graphically illustrates the structural shift in the relationship between Mexican forward and spot rates and provides further reason to investigate the 1991–1994 and 1995–1996 sub-periods, as well as the whole sample period. Table 3 presents the autocorrelation and heteroscedasticity-adjusted results of estimating Eq. (4) for the 3 month maturity interest rates of Mexico. That is, this table presents findings regarding the ability of the 3 month forward rate in Mexico to predict the subsequent 3 month change in the 3 month rate. The results indicate that 3 month forward rates have significant forecasting ability during both sub-pe-
3 The CUSUMSQ test, originally developed by Brown et al. (1975), also indicates significant structural change in the sample occurs at the end of 1994. The test indicates no comparable structural change occurring during either the 1991–1994 or 1995– 1996 sub-periods. 4 The 3 and 6 month interest rates in Mexico move in an analogous manner relative to the 1 month rate. All three Mexican rates share the same major break point at the end of 1994 and react similarly to subsequent shocks.
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Fig. 1. One month rates in Mexico (January 1991–December 1996).
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Fig. 2. Forward rate — spot rate spread (January 1991–December 1996).
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riods as well as the overall sample period. The results also indicate that Mexican forward rates have somewhat greater predictive ability (in terms of level of statistical significance) during the period of most economic turmoil (1995–1996). This result seems counterintuitive. One might think a priori that the forecast errors between actual rate changes and rate changes predicted by forward rates would increase rather than decrease in periods of significant interest rate volatility. Interest rate changes become more difficult to predict. One hypothesis consistent with these findings would be that arbitrage opportunities are potentially greater in periods of interest rate volatility than relative stability. Thus, market participants with superior interest rate forecasts can use these forecasts to engage in interest rate arbitrage among bonds of differing maturities. Table 4 presents the results of autocorrelation and heteroscedasticity-adjusted estimation of Eq. (5) for the Mexican CETES rates. The difference in results for the two sub-periods is quite striking. For the 1991–1994 period, none of the various spot rate differentials (3 month rate – 1 month rate, etc.) had significant ability to forecast subsequent spot rate changes. For the 1995–1996 period, all tested spot rate differentials showed significant forecasting ability. The spot rate differentials were generally found to have significant predictive ability for the entire 1991–1996 period as well. This was true for every tested spot rate differential except the 3 month/1 month differential predicting 3 month rate changes. The signs of the estimated coefficients for Eq. (5) are generally consistent with what common sense might indicate. If, for example, the spread between the 6 and 1 month rates is large by historical standards, we would expect the 6 month rate to decline and the 1 month rate to increase. Thus, we would expect the coefficient for this spread variable to be positive when predicting the change in the 1 month rate. We would also expect the coefficient for this spread variable to be negative when predicting the change in the 6 month rate. The signs of all significant coefficients (with the exception of the 3 – 1 month rate differential predicting subsequent 3 month rate changes) were of the predicted sign. Table 3 Forecasting ability of three month forward rates for Mexico (estimation of Eq. (4))a Independent
Time period
Variable
January 1991– December 1994
January 1995– December 1996
Overall (1991– 1996)
3 Month forward rate—3 month spot rate (lagged 3 months) Constant
0.551 (2.54**) 1.49 (0.601) 0.72
0.28 (3.29***) 1.25 (0.770) 0.78
0.255 (3.78***) 1.60 (2.29) 0.76
R2 a
t-Statistics are in parentheses. ** Significant at the 0.01 level. *** Significant at the 0.001 level.
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Table 4 Forecasting ability of spot rate spreads for Mexico (Estimates of b in Eq. (5))a Dependent variable
Independent variable
Estimate of b
January 1991– December 1994
January 1995– December 1996
Overall (1991– 1996)
D1 month rate
(3 month rate–1 month rate) [lag 1]
−0.07 (−0.22)
0.78 (6.18)***
0.22 (4.04)*
D3 month rate
(3 month rate–1 month rate) [lag 1]
0.07 (1.38)
0.29 (4.78)***
−0.03 (−1.15)**
D6 month rate
(6 month rate–1 month rate) [lag 1]
−0.07 (−1.02)
−0.23 (3.36)***
−0.19 (−3.72)***
D3 month rate
(6 month rate–3 month rate) [lag 3]
−0.16 (−0.37)
0.34 (4.72)***
0.22 (4.14)***
a
t-Statistics are in parentheses. * Significant at the 0.05 level. ** Significant at the 0.01 level. *** Significant at the 0.001 level. Lagged values are enclosed in brackets
The result that Mexican term structure spreads have significantly greater predictive ability during the period of most economic turmoil (1995–1996) seems counterintuitive. However, Engsted (1996) has recently observed that interest rate spreads have more predictive ability in periods of greater interest rate volatility in the case of Denmark. Thus, our empirical results are not entirely unique5 And again, it may be that arbitrage opportunities are potentially greater in periods of interest rate volatility than relative stability. Thus, as we noted before, market participants with superior interest rate forecasts can use these forecasts for arbitrage gains.
5. Summary Major shocks to the Mexican economy in recent years present an opportunity to investigate the informational content of the term structure of interest rates under vastly changing economic conditions. For comparison, we present summary statistics and regressions for Mexican interest rates over recent time periods. Our results indicate that 3 month forward rates do have significant forecasting ability for future spot rates for the entire 1991 – 1996 period, as well as the 1991–1994 and 1995– 1996 sub-periods. Somewhat counter-intuitively, the forward rate predictability is at its highest for Mexico during the period of greatest interest rate volatility (1995– 5
Employing a somewhat different methodology and time period, Galindo (1995) also obtained evidence that the term structure for public bonds in Mexico contains information useful for forecasting purposes.
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1996). We also find spot rate spreads have significant predictive ability as well. Again, somewhat surprisingly, we find spot rate spreads predict rate changes most significantly during the volatile 1995 –1996 period. This result is consistent with recent findings for Danish securities by Engsted (1996).
Acknowledgements We wish to acknowledge the very helpful comments of an anonymous referee for valuable contributions to the development of this article.
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