Working Paper: CEPR ID: DP1676
Authors: Carlo A. Favero; Francesco Giavazzi; Fabrizio Lacone; Guido Tabellini
Abstract: This paper develops a particular technique for extracting market expectations from asset prices. We use the term structure of interest rates to estimate the probability the market attaches to a country, Italy, joining the European Monetary Union at a given date. The extraction of such a probability is based on the presumption that the term structure contains valuable information regarding the markets? assessment of a country?s chances of joining EMU. The case of Italy is interesting because in the survey regularly conducted by Reuters the probability that Italy joins EMU in 1999 fluctuated, in the first months of 1997, between 0.07 and 0.15 while during the same period the measures computed by financial houses ? which are based on the term structure of interest rates ? ranged between 0.5 and 0.8. The paper proposes a new method for computing these probabilities and shows that the discrepancies between survey and market-based measures are not the result of market inefficiencies, but of incorrect use of the term structure to compute probabilities. The technique proposed in the paper can also be used to distinguish between convergence of probabilities and convergence of fundamentals, that is to find out whether an observed reduction in interest rate spreads signals a higher probability of joining EMU at a given time, or simply reflects improved fundamentals. It could also be applied, more generally, to extract information on imminent changes in an exchange rate regime from asset prices.
Keywords: term structure of interest rates; expectational model; probabilities of entering EMU
JEL Codes: E43; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| upward biased probabilities from existing EMU calculators (C59) | probabilities computed using instantaneous forward rates (E43) |
| improved fundamentals (L10) | convergence of interest rates (E43) |
| market assessment of joining EMU (F36) | convergence of interest rates (E43) |
| convergence of fundamentals (F62) | reduction in the spread between Italian and German forward rates (E43) |
| change in market assessment of probability of Italy joining EMU (F31) | reduction in the spread between Italian and German forward rates (E43) |