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US and Chinese yield curve responses to RMB exchange rate policy shocks

US and Chinese yield curve responses to RMB exchange rate policy shocks Using a discrete-time version of the arbitrage-free Nelson–Siegel (AFNS) term structure model, the authors examine how yield curves in the US and China react to exchange rate policy shocks as China introduces gradual reforms to make its exchange rate regime more flexible. The paper aims to discuss this issue.Design/methodology/approachThe authors characterize the specification of the discrete-time AFNS model, prove the uniqueness of the solution for model identification, perform specification analysis on its canonical form and detail the MCMC estimation method with a fast and reliable prior extraction step.FindingsModel decomposition reveals that in the US yield responses, changes in risk premia for medium- to long-term yields dominate changes in yield expectation for short- to medium-term yields, indicating that the portfolio rebalancing effect due to varying risk perception is stronger than the signaling effect due to policy rate expectation.Practical implicationsThe results are helpful in diagnosing market sentiment and exchange rate risk pricing as China further internationalizes its currency.Originality/valueThe methodology can be easily extended to study yield curve responses to other scenarios of policy shocks or regime changes. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png China Finance Review International Emerald Publishing

US and Chinese yield curve responses to RMB exchange rate policy shocks

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Publisher
Emerald Publishing
Copyright
© Emerald Publishing Limited
ISSN
2044-1398
DOI
10.1108/cfri-12-2017-0239
Publisher site
See Article on Publisher Site

Abstract

Using a discrete-time version of the arbitrage-free Nelson–Siegel (AFNS) term structure model, the authors examine how yield curves in the US and China react to exchange rate policy shocks as China introduces gradual reforms to make its exchange rate regime more flexible. The paper aims to discuss this issue.Design/methodology/approachThe authors characterize the specification of the discrete-time AFNS model, prove the uniqueness of the solution for model identification, perform specification analysis on its canonical form and detail the MCMC estimation method with a fast and reliable prior extraction step.FindingsModel decomposition reveals that in the US yield responses, changes in risk premia for medium- to long-term yields dominate changes in yield expectation for short- to medium-term yields, indicating that the portfolio rebalancing effect due to varying risk perception is stronger than the signaling effect due to policy rate expectation.Practical implicationsThe results are helpful in diagnosing market sentiment and exchange rate risk pricing as China further internationalizes its currency.Originality/valueThe methodology can be easily extended to study yield curve responses to other scenarios of policy shocks or regime changes.

Journal

China Finance Review InternationalEmerald Publishing

Published: Aug 16, 2019

Keywords: Arbitrage-free Nelson–Siegel term structure model; Exchange rate risk; Macro-finance; Yield curve; E43; F31

References