Interest Rate Volatility and Business Cycle Expectations

• Author: María‐Isabel Martínez‐Serna,Eliseo Navarro
• Date: 01 March 2015
• DOI: http://doi.org/10.1111/1468-2362.12061
• Published date: 01 March 2015

Interest Rate Volatility and

Business Cycle Expectations

Mar

ıa-Isabel Mart



ınez-Serna

y

and Eliseo Navarro

z

y

Department of Management and Finance, University of Murcia, Murcia,

Spain, and

z

Department of Economy and Management, University of

Alcal

a, Alcal

a de Henares, Madrid, Spain.

Abstract

One explanation for the usefulness of financial variables as tools for

economic forecasting is that they embody individual and firm expect-

ations of future economic conditions. In this paper, we analyse whether

interest rate volatility contains information on agent expectations which

are directly measured by confidence indicators. For the sake of robust-

ness, we use several different expectation indicators for the two countries

we analyse, the US and Germany. We propose using a forward-looking

measure of volatility: the implied volatility of one year cap options. We

find that implied volatility adds explanatory power to the yield spread

and to changes in the short rate, which are typical predictors of the

business cycle, and outperforms realized volatility.

I. Introduction

The forward- looking n ature of financi al markets provi des one exp lanation fo r

financial variables’power for predicting macroeconomi c growth. That is, th e prices

The authors acknowledge financ ial support from the g rant MEC ECO2011-281 34. M.-I. Mart



ınez-

Serna is grateful for t he financial support provid ed by Fundaci

on Cajamurcia.

International Finance 18:1, 2015: pp. 69–91

DOI: 10.1111/1468-2362.12061

© 2015 John Wiley & Sons Ltd

of financial assets embody individual and firm expectations of future economic

conditions. One of the main di fficulties in testin g this hypothesis conce rns the

problem of measuring expe ctations. For instan ce, past literature has relie d on the

rational expe ctations hypot hesis, using ex-p ost data on output or consu mption

growth as proxies for the ir expected value. In thi s paper, we attempt to overcome

the problem of modelli ng expectations by employing confidence ind icators as direct

measures of expected econ omic growth. These in dices (such as the IFO Bus iness

ClimateIndexortheConferenceBoardConsumerConfidence Index) can be

considered good proxies for agent expect ations because they are bas ed on surveys

in which respondents express whether they believe economic conditions will

improve or wor sen. More over, sever al papers h ave provid ed evid ence of t he

sentiment indices’predictive power for economic act ivity.

1

Regarding financial va riables, we focus in par ticular on the in formational content

of interest rates and their vol atilities with resp ect to expected econom ic growth.

Considerable empirical evidence indicates that the slope of the yield curve and the

change in the short rate are goo d predictors of future economic ac tivity in diffe rent

countries and time pe riods.

2

However, and more importantly, the recent literature

concerning tools for economic foreca sting has focused on the secon d moment of

financial asset returns as a measure of financial market uncertainty and has found

systematic movements in financ ial volatility to be countercycli cal; that is, volati lity

tends to increase during ha rsh times. In particul ar, the countercyclical behaviour of

interest rate volatility has been documented by Bansal a nd Zhou (2002), Sun (2005)

and Gerlach et al. (2006) in the US and several European countries.

Nevertheless, relatively lit tle empirical research ha s been devoted to the ability of

interest rate volatilit y to predict mac roeconomic variable s. Interest rate volatili ty

may be useful in forec asting economic a ctivity, as it proxies for uncer tainty in the

future path of interest rates and can the refore be considered a measurement of

uncertainty in e conomic and monetar y policies.

3

In this regard, this paper is related

to the recent and rapidly growing li terature on the importance of un certainty shocks

in explaining m acroeconomic fluctuat ions.

4

In general terms, a ccording to the real-

options explanat ion, uncertainty reduce s the level of consumption and invest ment

because it makes consumers and firm s more cautious about buying dur able goods

1

See, for example, Fuhrer (1993) , Matsusaka and Sbordone (1995) , Vuchelen (2004), Ludvigson

(2004) and Gelper a nd Croux (2010), among othe rs.

2

See Wheelock and Wohar (2009) and Kuosmanen an d Vataja (2011) for a review.

3

Using US data from 1994 to 2009, Ulrich ( 2012) documents that a proxy for uncer tainty regarding

economic and monetar y policy explains a rema rkable 50% of variation s in bond option implied

volatilities and i nterest rate volatilities.

4

Stock and Watson (2012) find that ‘the main contribution s to the decline in output and employment

during the recession are estimated to come from financi al and uncertainty shocks’(p. 26).

70 Mar



ıa-Isabel Mart



ınez-Serna and Eliseo Navarro

© 2015 John Wiley & Sons Ltd