International Fixed Income Topic IIIB: Currency Risk and Bond Returns

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

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) – –Weekly movements in zeroes of 1yr-30yr maturities

Correlations Between Principal Components US UK JPN CAN FRA GER ITA

Average R-Squared of Foreign Term Structure on US Interest Rate Factors

Average R-Squared of Foreign Term Structure on US Interest Rate Factors & Exchange Rate

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

Recall Rates of Return on Bonds Consider a a foreign government bond. What is it’s US $ rate of return? Taking logs of the above and rearranging gives us This is approximately equal to: [yield] - [dur x (  r)] - %  S(Fn/$)

Mean $-adjusted Annualized Return

Volatility of $-adjusted Annualized Return

Correlations Between Returns US UK JPN CAN FRA GER ITA

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

% of $-adjusted Returns Explained by Own 1st Principal Component Estimated coefficient =-5 to -6

% of $-adjusted Returns Explained by Own 3 Principal Components

% of $-adjusted Returns Explained by Own 1st Principal Component & Exchange Rate Estimated coefficient =-5 to -6 on 1st comp & -1 on XR

% of $-adjusted Returns Explained by Own 3 Principal Components & Exchange Rate Estimated coefficient =-5 to -6

Recall: % of Volatility of $-adjusted Foreign Bond Due to Currency Risk