Volatility Transmission in the European Money Market

Transcription

1 Volailiy Transmission in he European Money Marke Dieer Nauz Goehe Universiy Frankfur Chrisian J. Offermanns Goehe Universiy Frankfur and Deusche Bundesbank This version: February 23, 2007 Absrac The European overnigh rae (Eonia) is he operaional arge of he European Cenral Bank (ECB) ha signals he moneary policy sance and anchors he erm srucure of ineres raes. This paper empirically invesigaes he ransmission of Eonia volailiy o longer-erm money marke raes. Disinguishing beween seasonal Eonia volailiy due o e.g. calendar effecs and non-seasonal volailiy which may be closer relaed o uncerainy abou he policy inenions of he ECB reveals a significan volailiy ransmission even for he welve-monh rae. We also examine how he ECB s new operaional framework inroduced in March 2004 has influenced he Eonia and he ransmission of volailiy along he yield curve. Keywords: Volailiy ransmission; Operaional framework of cenral banks; Ineres rae dynamics JEL classificaion: E43; E52 We would like o hank Ben Craig, Joachim Grammig and Flemming Würz for commens and suggesions. Financial suppor by he German Research Foundaion (DFG) hrough NA-385/4-1 is graefully acknowledged. The views presened in his paper are hose of he auhors and do no necessarily reflec hose of he Deusche Bundesbank. nauz@wiwi.uni-frankfur.de. offerman@wiwi.uni-frankfur.de.

2 1 Inroducion The inerbank money marke for overnigh lending is he key channel hrough which moneary policy is execued. Overnigh raes, like he US Federal funds rae or he European Eonia 1 rae, are he operaional arges of cenral banks ha do no only signal he moneary policy sance, bu also anchor he erm srucure of ineres raes. As a consequence, cenral banks ry o avoid excess volailiy of he overnigh rae for wo reasons. Firs, confusing financial marke paricipans abou he policy-inended ineres rae level, high volailiy of overnigh raes hampers he communicaion of he moneary policy sance and, hus, decreases he ransparency of moneary policy. And, second, here is a danger ha volailiy a he shor end of he erm srucure is ransmied along he yield curve o longer erm ineres raes wih poenial disoring effecs on invesmen and consumpion decisions. This paper provides new evidence on how volailiy of he Eonia rae affecs longer-erm ineres raes in he Euro area. Wih a view o he perceived risks of high ineres rae volailiy, cenral banks increasingly have adoped moneary policy insrumens designed for smoohing overnigh ineres raes. In paricular, he European Cenral Bank (ECB) recenly reorganized is operaional framework in order o miigae he disurbing impac of rae change expecaions on he Eonia rae. 2 Specifically, he ECB shorened he mauriy of is main refinancing operaions and synchronized he iming of he reserve mainenance periods wih he Governing Council s ineres rae decisions. However, hese raher involved measures could have had addiional effecs for he Eonia and he ineres raes in he inerbank money marke. For example, he shorer mauriy of he main refinancing operaions could have made banks refinancing more difficul, more risky and, hus, more expensive. Thus, he new framework may have conribued o he recenly observed, puzzling, uninended and persisen increase of he spread beween he Eonia and he ECB s key policy rae (see e.g. European Cenral Bank, 2006b, p. 34). I has also been argued ha he new framework helped lowering he volailiy of he Eonia, see European Cenral Bank (2006a) and Durré 1 The Eonia (European OverNigh Index Average) is published by he European Banking Federaion (FBE) as a weighed average of he overnigh raes repored by a panel of approx. 50 banks ha have he highes business volume in he Euro area money marke. For more informaion abou he Eonia and furher shor-erm ineres raes, see he Euribor websie of he FBE a hp:// 2 Furher examples include he Fed s redefiniion of he discoun rae as an upper bound of he Federal funds rae (Furfine, 2003) and he Bank of England s inroducion of volunary reserve requiremens as a liquidiy buffer for banks (Clews, 2005). 1

3 and Nardelli (2007). In order o shed more ligh on hese issues, we will invesigae how he new framework affeced he dynamics and he volailiy of he Eonia as well as he ransmission of Eonia volailiy along he yield curve. Our sudy builds on earlier work on Eonia dynamics, where he effecs of he new framework could no be considered simply due o daa availabiliy. Following Würz (2003) or Pérez Quirós and Rodríguez Mendizábal (2006) he ime-varying paern of Eonia volailiy is esimaed in an EGARCH framework. In conras o hese conribuions, however, we follow Benio e al. (2006) and Nauz and Offermanns (2007) and specify he corresponding mean equaion as an error-correcion equaion where he Eonia adjuss o deviaions from he ECB s key policy rae (i.e. he minimum bid rae in he main refinancing operaions) and a forward spread reflecing he influence of rae expecaions. Based on his exended model of Eonia dynamics, we include he resuling esimae of he condiional Eonia volailiy as explanaory variable for he condiional volailiy of longer erm ineres raes. Following e.g. Ayuso e al. (1997) and Moschiz (2004), his seems a naural way of esing for volailiy ransmission along he yield curve. According o Ayuso e al. (1997), volailiy ransmission need no be independen of he level of overnigh rae volailiy. Ye, even more imporan, volailiy ransmission may depend on he naure of Eonia flucuaions. While seasonal effecs in Eonia volailiy are usually well undersood by he marke and need no increase he volailiy of longer erm raes, non-seasonal Eonia volailiy should be closer relaed o uncerainy abou he moneary policy sance. Our empirical resuls confirm ha only non-seasonal Eonia volailiy is ransmied along he yield curve. In paricular, we find ha volailiy of longer erm raes significanly increased during he so-called underbidding episodes when markes were parly confused abou he ECB s ineres rae decisions. The remainder of he paper is organized as follows. Secion 2 briefly reviews he ECB s operaional framework before and afer he reform in 2004 and discusses how cerain insiuional deails have affeced he dynamics and he volailiy of he Eonia. Secion 3 presens he empirical model for he Eonia and examines he impac of he new framework on he adjusmen dynamics and he volailiy of he Eonia. Secion 4 shows how condiional Eonia volailiy esimaed in Secion 3 is ransmied o longer erm ineres raes. Secion 5 summarizes our main resuls and concludes. 2

4 2 The Eonia and he operaional framework of he ECB 2.1 How he ECB seers he overnigh rae The ECB s main refinancing operaions and he key policy rae Like many oher cenral banks in indusrial counries, he European Cenral Bank implemens moneary policy by seering he very shor-erm ineres raes in he inerbank money marke. In paricular, he overnigh rae Eonia plays a cenral role in signalling he sance of moneary policy. I is herefore of crucial imporance ha he Eonia closely follows he ECB s key policy rae se by he Governing council and ha is volailiy remains well conained, compare European Cenral Bank (2006a). The ECB s key ineres rae has been always implemened via is weekly main refinancing operaions (MROs) ha deermine he liquidiy of he European banking secor. From 1999 o June 2000, MROs had been conduced as fixed rae enders where banks simply bid he amoun of refinancing hey wish o receive a a pre-announced rae ha deermined he ineres rae level inended by he cenral bank. Unforunaely, however, he fixed rae ender procedure led banks o overbid, i.e. hey increasingly exaggeraed heir demand for reserves, see Nauz and Oechssler (2006). In June 2000, he ECB sopped banks overbidding by swiching o a variable rae ender forma, a sandard muli-uni aucion augmened by a minimum bid rae. Since June 2000, he MRO minimum bid rae is he ECB s key ineres rae. Sanding faciliies The minimum bid rae is no he only official ineres rae se by he ECB o seer he Eonia. Ineres raes of wo sanding faciliies, he marginal lending and he deposi faciliy, where banks can lend and deposi overnigh liquidiy a shor noice define an ineres rae corridor ha bounds he volailiy of he Eonia. The ECB s key policy rae has always been he midpoin of he corridor because he opporuniy cos of holding posiive or negaive balances a he cenral bank should be equal a he cenral bank s arge rae, see Bindseil (2004). In pracice, however, i is difficul o ensure he symmery of opporuniy coss, because ransacions wih privae marke paricipans are no perfec subsiues for similar ransacions wih he cenral bank, see e.g. Whiesell (2006). 3

5 The widh of he ineres rae corridor has ypically been 200 basis poins. Of course, seing he marginal lending rae equal o he deposi rae would eliminae Eonia volailiy compleely. However, a zero widh corridor is no a sensible opion for he cenral bank because of he unpredicable effecs of drying up rading in he inerbank money marke. The implicaions of insiuional deails in a cenral bank s operaional framework on he behavior of overnigh raes are no always obvious. For example, Pérez Quirós and Rodríguez Mendizábal (2006) demonsraed ha he ECB s deposi faciliy does no only lower Eonia volailiy bu has also significan effecs on he predicabiliy of he Eonia a he end of he reserve mainenance period. Minimum reserves and seasonal Eonia volailiy Minimum reserves are an inegral par of he ECB s operaional framework. They enlarge he srucural liquidiy shorage and possibly conribue o he conrol of moneary expansion. More imporanly, however, minimum reserves creae a liquidiy buffer for banks since reserve holdings can be averaged over he mainenance period. The ECB s minimum reserve sysem is herefore a paricular powerful ool o smooh he Eonia wihin he reserve mainenance period. 3 A he end of he mainenance period, however, liquidiy shorages or excess reserves can lead o sharp ineres rae peaks and roughs. A similar kind of seasonal volailiy is also observed a he firs day of he reserve period and a he end of each monh. The following analysis of volailiy ransmission akes ino accoun ha hese dramaic increases of Eonia volailiy are emporary, well undersood by he marke and, herefore, less problemaic for he communicaion of moneary policy. In paricular, a cerain exen of end of period volailiy may even improve banks incenives o inves in an efficien reserve managemen. Fine uning operaions On several occasions, he ECB execued fine-uning operaions o manage he liquidiy siuaion in he marke o avoid large ineres rae flucuaions. Alhough he ECB has ypically been very relucan o inervene in he inerbank marke on such an ad hoc basis, he frequency of fine uning operaions has recenly increased, see European Cenral Bank (2006a) and Foonoe 5. 3 If funds are seen as perfec subsiues wihin a reserve period, risk neural banks should arbirage away any expeced ineres rae movemens wihin a reserve period. As a consequence, he ineres rae should behave like a maringale, i.e. pas observaions should have no predicive conen. However, he empirical evidence on he maringale hypohesis is mixed, see e.g. Hamilon (1996). 4

6 Figure 1: The ECB s ineres rae corridor and he Eonia spread Righ scale: Eonia (solid line) and ECB key raes (dashed line: minimum bid rae, doed lines: deposi and marginal lending faciliies). Lef scale: Difference beween Eonia and he minimum bid rae (Eonia spread). The shaded area refers o he period afer he reform in he ECB s operaional framework in March The ineres rae corridor Figure 1 depics he ime series of he Eonia (i), he ECB s policy rae (i ), he marginal lending and deposi rae and he Eonia spread defined as i i. Apparenly, he ECB has been very successful in seering he Eonia. The Eonia never lef he ineres rae corridor and apar from a few ouliers, ypically occurring a he end of he reserve mainenance period, he Eonia follows he policy rae of he ECB closely. While uni-roo ess show ha he Eonia should be reaed as a non-saionary I(1) variable, he Eonia spread is clearly saionary, see Table 2 in Secion 3. Therefore, he link beween he Eonia and he ECB s policy rae is very much in line wih he noion of a long-run level relaionship. In his sense, he Eonia and he policy rae are coinegraed and any equaion explaining he dynamics of he Eonia should enail he lagged Eonia spread as an error-correcion erm, see Benio e al. (2006) and Nauz and Offermanns (2007). 5

7 2.2 The puzzling increase of he Eonia spread A slighly posiive Eonia spread (i i ) is ofen called naural because he collaeral cos for refinancing via he inerbank money marke and he ECB s refinancing operaions differ, see e.g. Würz (2003). Furhermore, i seems plausible ha a policy rae implemened as a minimum bid rae ends o be somewha lower han relaed marke ineres raes. 4 Table 1 presens some descripive saisics on he Eonia spread for he periods before and afer he inroducion of he new framework in March Because of he numerous endof-period ouliers, he median and he inerquarile range give a more reliable picure on he Eonia s cenral endency and variaion. A firs sigh he Eonia spread seems slighly less volaile during he new framework. More ineresingly, however, he median of he Eonia spread has increased over ime from five o eigh basis poins. Table 1: Descripive saisics on ineres rae spreads Old framework New framework Jun Mar Mar Aug Mean Median Sd. dev. IQR Mean Median Sd. dev. IQR i i f i Noes: Firs and second momens of he Eonia spread (i i ) and he one-monh/one-monh forward spread (f i ) during he variable rae ender period. IQR denoes he inerquarile range. This remarkable increase in he Eonia spread was no inended by he cenral bank and i seems ha i is neiher clear why i happened nor wheher his upward rend will coninue. Since Ocober 2005, he ECB has communicaed o marke paricipans is uneasiness abou he upward rend in he spread beween he Eonia and he minimum bid rae, see European Cenral Bank (2006a, p. 33). In fac, he ECB has repeaedly alloed up o wo billion Euros excess liquidiy (i.e. above he benchmark allomen) in all MROs of a mainenance period, bu even hese srong measures could no bring he Eonia spread back o is former level. 5 Given former esimaes of he liquidiy effec in he 4 In fac, he average spread beween he U.S. Federal Funds rae and he more symmeric Federal Funds rae arge has been much lower in recen years, compare Thornon (2006). 5 This explains he higher frequency of fine-uning operaions under he new framework. Since November 2005 he ECB has used fine-uning operaions on a regular basis o absorb he resuling liquidiy surplus on he las day of he mainenance period. 6

8 Euro area, he non-response of he Eonia o he excess liquidiy provided by he ECB is surprising. Moschiz (2004) and Würz and Krylova (2004), for example, esimaed ha a permanen increase of reserves by one billion Euro will decrease he Eonia by eigh and seven basis poins, respecively. Explaining he puzzling rise in he Eonia spread is no he aim of he curren sudy. I demonsraes, however, he imporance of more research on he deerminans, he dynamics and he volailiy of overnigh raes. 2.3 The ECB s new operaional framework When ineres raes began o fall in auumn 2000, he ECB experienced ha using he minimum bid rae in is main refinancing operaions as key policy rae is no wihou problems. In paricular, when banks expeced an ineres rae cu, hey underbid, i.e. banks bid less han heir acual liquidiy needs in he hope ha hey would subsequenly be able o refinance a a lower ineres rae cos once key ECB ineres raes had been reduced. 6 On several occasions, underbidding prevened he ECB from injecing he necessary amoun of reserves ino he money marke. As a resul, he Eonia increased sharply alhough everyone expeced ineres raes o decrease, see Figure A.1 in he Appendix. Therefore, banks underbidding did no only impede he ECB s liquidiy managemen and increased banks refinancing cos, i also increased he volailiy of he Eonia o undesired levels ha obscured moneary policy signals. In conras o he seasonal Eonia volailiy sirred by calendar effecs, hese underbidding episodes are a ypical example for non-seasonal volailiy ha may well be ransmied o longer erm ineres raes. Wih he inroducion of he new operaional framework in March 2004, he ECB solved he underbidding problem by miigaing he role of rae expecaions on banks bidding behavior. Under he old framework, underbidding could occur a each of he weekly MROs, i.e. wihin as well as a he end of he mainenance period. If a rae cu was expeced wihin he reserve period, reserve averaging allowed banks o pospone refinancing o he end of he reserve period where ineres raes are expeced o be lower. Under he new framework, he ECB linked he saring daes of he reserve mainenance periods o he Governing council meeings for which decisions on policy raes are scheduled 6 Pu differenly, banks underbid because he minimum bid rae in he curren aucion prevened hem from bidding a lower ineres raes. Looking a he Bundesbank s experience wih aucions wihou minimum bid rae, Linzer e al. (2003) sugges ha omiing he minimum bid rae in he ECB s MROs would have been an alernaive soluion o he underbidding problem. 7

9 such ha policy rae changes always ake effec as of he sar of he new reserve period. As a consequence, underbidding wihin he reserve period has sopped making sense, simply because he ECB promised ha here will be no policy rae changes wihin he reserve period anymore. However, under he old framework underbidding even occurred a he end of he reserve period. Since weekly MROs had a mauriy of wo weeks, he las MRO of a reserve period overlapped in he subsequen period where he ECB s policy rae could change. Therefore, even wih he new iming of reserve periods and ineres rae changes, banks would have underbid in he las MRO of a reserve period. To avoid his overlap of rae change expecaions, he second major change o he operaional framework was o shoren he mauriy of he MROs from wo weeks o one week. From March 2004 o Augus 2006, key ECB ineres raes have been seadily increased from 2% o 3%. Thus, alhough here is no obvious reason why he new framework should no have removed he disurbing impac of rae cu expecaions, here has been no real sress es so far. In fac, even under he new framework he role of rae expecaions on he Eonia rae remains unclear. For example, in conras o he ECB s inenions, rae hike expecaions apparenly lead o an increase in he Eonia in November 2005, see European Cenral Bank (2006b). Moreover, rae hike expecaions migh also have conribued o he increase of he Eonia spread described above. In view of he ineresing role of rae expecaions on he Eonia, our empirical equaion specified o esimae he dynamics and he volailiy of he Eonia before and afer he new framework accouns for prevailing rae expecaions. Specifically, we follow e.g. Würz (2003) and include a forward spread in our regressions o check wheher he impac of rae expecaions on he Eonia has acually declined. Since underbidding was cosly for Euro area banks, hey generally approved he new framework. Ye some concerns were relaed o addiional operaional risks associaed wih he move away from he overlapping main refinancing operaions. In fac, if a bank does no achieve he necessary amoun of refinancing in he las MRO of a reserve period, a far greaer proporion of he oal refinancing volume is affeced han under he old framework wih overlapping operaions. Banks migh herefore be inclined o make price-boosing safey bids in order o avoid an underallomen of reserves, compare Deusche Bundesbank (2003). In he wors case, his bidding behavior could make refinancing more expensive. 8

10 The ECB s overall assessmen of he new framework is posiive. According o European Cenral Bank (2006a), hese changes significanly improved he efficiency of is operaional framework and even reduced he volailiy of he Eonia. In he following, we will es wheher he new framework has affeced Eonia volailiy and is ransmission along he yield curve. 3 An empirical model for he Eonia 3.1 Daa and model specificaion Our empirical analysis of Eonia dynamics and is volailiy uses daily daa for he represenaive Euro overnigh rae Eonia (i) and he ECB s key policy rae (i ) defined as he MRO minimum bid rae. There is evidence ha boh, he level (Nauz, 1997) and he volailiy (Nauz, 1998) of he overnigh rae can be affeced by he aucion rule applied in he cenral bank refinancing operaions. We hus concenrae on he recen variable rae ender period running from June 27, 2000 o Augus 9, This sample gives us 966 and 631 observaions before and afer he inroducion of he new operaional framework, respecively. Furhermore, we used Eonia swap raes published by Reuers o consruc he one-monh rae in one-monh forward rae (f) for measuring he prevailing ineres rae expecaions. Specifically, high or low values of he forward spread (f i ) should indicae wheher he marke expec ineres raes o increase or decrease, see e.g. Würz (2003). Apar from a few excepions (compare Figure A.1), he developmen of he forward rae indicaes ha he ECB s ineres rae decisions have been well anicipaed by he marke, see Figure 2 and Gaspar e al. (2001). Similar o he resuls already discussed for he Eonia spread, uni roo ess indicae ha he forward spread is also a saionary variable, compare Table 2. This implies ha he forward spread can be inerpreed as a second long-run level relaion affecing he Eonia dynamics. Therefore, a naural saring poin of he empirical analysis of he Eonia is an error-correcion equaion ha incorporaes boh, he lagged Eonia spread, i i, as well as he lagged forward spread, f i, as error-correcion erms. 9

11 Figure 2: Forward spread Righ scale: One-monh/one-monh forward rae (solid line) and ECB policy rae (dashed line). Lef scale: Difference beween boh ineres raes (forward spread). The shaded area refers o he period afer he reform in he ECB s operaional framework in March In order o accoun for he ime-varying paern of Eonia volailiy, he condiional mean and volailiy of he Eonia rae are esimaed in an EGARCH framework: 7 i = µ + m α m D m (i i ) 1 + m β old m D m (1 D new )(f i ) 1 + m β new m D m D new (f i ) 1 and + p φ 1,k i k + k=1 k=1 q φ 2,k f k + θ X + σ ε (1) log(σ 2 ) = ω 0 + ω 1 log(σ 1) 2 ε 1 + ω 2 + ω ε ρ Z + ν (2) σ 1 σ 1 where ε is a normally disribued i.i.d. error wih zero mean and uni variance and σ 2 denoes he condiional Eonia variance. 7 The key feaure of he EGARCH model is ha i allows for differen impacs of posiive and negaive innovaions on condiional variances. While his asymmery plays a significan role for measuring Eonia volailiy, he variance equaions of longer-erm raes are well-specified using symmeric ARCH models. Durré and Nardelli (2007) sugges realised volailiy based on inraday daa as an alernaive measure of Eonia volailiy. 10

12 Table 2: Saionariy of ineres rae spreads Old framework New framework Jun Mar Mar Aug i i f i Noes: ADF uni-roo ess of he Eonia spread (i i ) and he one-monh/one-monh forward spread (f i ) over he variable rae ender period. ( ) denoes significance a he 5% (1%) level. Equaions (1) and (2) include hree groups of dummy variables o capure several feaures of he ECB s operaional framework ha may affec Eonia dynamics and is volailiy. Firs, he srengh of adjusmen of he Eonia o he ECB key policy rae (α) may change over he reserve period. In paricular, he response of he Eonia o he policy rae should be weaker a he end of he reserve period, i.e. during he days afer he las MRO, when reserve averaging ges less effecive. Recall ha deviaions from he policy rae are ypically sronges a he las day of he reserve period. Accordingly, he adjusmen should be pariculary srong a he very firs day of he reserve period when he Eonia comes back o he former ineres rae level. Similar effecs may occur wih respec o he influence of rae expecaions (β), compare Figure 2. In order o accoun for he differen regimes of Eonia adjusmen o boh, he Eonia spread as well as he forward spread, we included he dummy variables D m D begin = 1 if is he firs day in he reserve period and D begin wih m = begin, wihin, end, where afer he las allomen day unil he end of he reserve period and D end and D wihin = 1 D begin D end. = 0 oherwise, D end = 1 = 0 oherwise, The second se of dummy variables solely consiss of D new and refers o he inroducion of he ECB s new framework in March Specifically, we defined D new = 0 and D new = 1 for before and afer March 2004, respecively. Since he new framework was inroduced in order o miigae he influence of rae expecaions on he curren Eonia, Equaion (1) allows for a differen role of forward raes before and afer he new framework. 8 The hird se of dummies conrols for several calendar effecs as well as special evens like he cash change-over in January 2002, he erroris aacks a Sepember 11, 2001 or 8 We also checked wheher he adjusmen o he Eonia spread has changed bu found no significan impac of he new framework. 11

13 he underbidding episodes discussed in Secion 2.3. A deailed descripion of all dummy variables comprised in he vecor X (for he mean equaion) and Z (for he variance equaion) is provided wih he ables. Finally, noe ha we included D new ino he condiional variance equaion o invesigae wheher he new framework has affeced he condiional variance of he Eonia. 3.2 Eonia dynamics and volailiy: empirical resuls Table 3 summarizes he empirical resuls for he condiional mean and he volailiy of he Eonia. In line wih he noion of an equilibrium relaion beween he Eonia and he ECB policy rae, we find a significan wihin-period adjusmen (ˆα wihin = 0.198) of he Eonia o deviaions from he Eonia spread. Moreover, as expeced, he response is paricularly srong a he firs day while i becomes insignifican a he end of he reserve period. A similar paern is found for he adjusmen of he Eonia o he forward spread. Independen of he inroducion of he new framework (indicaed by he dummies D new and 1 D new, respecively), here is evidence for a significan impac of rae expecaions on he Eonia wihin and, paricularly, a he beginning of he reserve period. In conras, forward raes canno explain he flucuaions of he Eonia a end-of-period days. Ineresingly, he significance of he forward spread wihin period even slighly increased, no decreased, wih he inroducion of he new framework. Inroducing D new in he mean equaion, we allowed for a possible mean shif in he Eonia spread or any oher explanaory variable due o he new framework. However, he esimae obained for he corresponding coefficien (θ new = 0.002) proved o be insignifican. Le us now urn o he resuls obained for he Eonia variance equaion. All calendar effecs and special evens dummies show he expeced sign. In paricular, here has been a remarkable increase in Eonia volailiy a he various underbidding days (ρ ubidday = 5.484). Moreover, he inroducion of he new framework has indeed decreased he condiional variance of he Eonia boh, wihin and a he end of he reserve period. The significan coefficiens (ρ new wihin = 0.996, ρnew end = 0.498) reveal ha he relaive decline in Eonia volailiy has been even more pronounced wihin period. Therefore, he reducion of Eonia volailiy since March 2004 is no only due o he ECB s fine-uning operaions which have been increasingly applied o sabilize ineres rae end-of-period since November

14 Eonia spread Table 3: Eonia dynamics and volailiy Dependen variable: i Dependen variable: log(σ 2 ) EGARCH α begin ω (93.1) α wihin (6.06) α end (1.07) Forward spread: old framework βbegin old (5.73) βwihin old (2.04) (12.10) ω (11.98) ω (4.77) New framework ρ new wihin (6.83) ρ new end (2.60) βend old (0.68) Seasonal effecs Forward spread: new framework ρ begin βbegin new (9.56) βwihin new (4.43) (5.77) ρ end (8.82) ρ las (4.62) βend new (0.00) Oher effecs Calendar and oher effecs ρ Jan θ eos (4.44) θ eoy (2.32) θ new (1.14) µ (1.37) Noes: Esimaed parameers from Equaions (1) (2), (2.37) ρ Sep11, (2.42) ρ ubidday (7.98) ω (9.58) i = µ + m α m D j (i i ) 1 + m β old m Dj (1 Dnew )(f i ) 1 + m β new m Dj Dnew (f i ) φ 1,k i k + φ 2,k f k + θ eos D eos + θ eoy 2001 eoy 2001 D + θ new D new + σ ε k=1 k=1 log(σ 2 ) = ω 0 + ω 1 log(σ 1) 2 ε 1 + ω 2 σ + ω ε ρ new wihin (1 Dend )D new + ρ new end 1 σ Dend D new 1 + ρ begin D begin + ρ ubidday D ubidday + ρ end D end + ρ las D las + ν + ρ Jan 2002 Jan 2002 D + ρ Sep11, 2001 Sep11, 2001 D where D eos eoy 2001 refers o he las day of he semeser, and D and DJan 2002 capure he urbulences due o he Sep11, 2001 cash changeover in he Euro area a he end of he year 2001 and during January 2002, respecively. D equals 1 a he day afer Sepember 11, 2001, and D ubidday equals 1 a he allomen day of an underbidding episode. Absolue -values in parenheses are compued using heeroskedasiciy-consisen sandard errors, ( ) denoes significance a he 5% (1%) level. 13

15 Figure 3 depics he ime series of he esimaed condiional sandard deviaion of he Eonia. The regular peaks are end-of-period effecs, he larges peak, however, is on Sepember 11, The ime series plo also shows he reducion in Eonia volailiy since March In he following, he corresponding condiional Eonia variance shall be employed o examine how Eonia volailiy is ransmied along he yield curve. 1.6 Figure 3: Eonia volailiy Noes: The figure shows he esimaed condiional sandard deviaion of daily Eonia raes resuling from Equaions (1) and (2). 4 Volailiy ransmission The previous secion showed ha insiuional deails of he ECB s operaional framework explain a considerable par of he dynamics and he volailiy of he Eonia. This secion invesigaes how he volailiy of he Eonia affecs ineres raes wih longer mauriies, i.e. how Eonia volailiy is ransmied along he yield curve. To ha aim, we follow e.g. Ayuso e al. (1997) and Moschiz (2004) and include he previously esimaed condiional Eonia volailiy as explanaory variable in an equaion explaining he condiional volailiy of longer-erm ineres raes. 14

16 In he following, we consider he ransmission of Eonia volailiy for daily Euribor ineres raes (r j ) wih a mauriy of one week, as well as one, hree, six, nine, and welve monhs (j = 1w, 1m, 3m, 6m, 9m, 12m). Sandard uni-roo ess show ha hese ineres raes are inegraed of order one, while heir deviaions from he ECB s policy rae (r j i ) can be seen as saionary. Accordingly, all ineres raes are muually coinegraed and he mean equaions of he longer erm ineres raes r j are specified as error-correcion equaions: r j = µ j + α j (r j i ) 1 + β j (r j r j ) 1 p p + ϕ j,k r j k + ϕ j,k r j k + ϑ jx + u j, (3) k=1 k=1 where u j, N(0, σ 2 j, ) and X refers o a vecor of calendar dummies. For all Euribor raes r j, he mean equaions include he deviaion from he minimum bid rae (r j i ) and he spread beween r j and he rae wih subsequen mauriy (r j ) as error-correcion erm. Addiional ineres rae spreads proved o be insignifican. In accordance wih he expecaions heory of he erm srucure, he spread beween r j and he longer erm rae r j proxies prevailing rae expecaions. 9 The main resuls for he mean equaions are summarized in Table A.1 in he Appendix. As expeced, he immediae impac of he policy rae on r j (ˆα j ) decreases wih he mauriy of he money marke rae. Furhermore, according wih he expecaions heory of ineres raes, he adjusmen o he longer erm spread ( ˆβ j ) is significanly posiive for all j. For all mauriies, he auocorrelogram of he squared residuals of (3) srongly suggess o model he condiional variance as an ARCH(6) process: σ 2 j, = ψ j,0 + + δ seas j 6 k=1 D seas ψ j,k u 2 j, k + γubid j D ubid ˆσ 2 + δ nonseas j + γj new D new (1 D seas )ˆσ 2 + δj new D newˆσ 2 + η j, (4) Moreover, he ARCH(6) model is also suggesed by sandard model selecion crieria. For sake of robusness, he variance equaions of longer erm raes were esimaed by he consisen wo-sep approach which yielded by far he mos reliable resuls. 9 Noe ha hese longer-erm rae expecaions were no included in he volailiy equaions employed by Ayuso e al. (1997) and Moschiz (2004). 15

17 Table 4: Eonia volailiy ransmission along he yield curve Seasonal volailiy δ seas j (1.95) Non-seasonal volailiy δ nonseas Dependen variable: condiional variance of r j 1 Week 1 Monhs 3 Monhs 6 Monhs 9 Monhs 12 Monhs (0.27) j New framework (2.27) δ new j (0.45) γ new j (1.95) Underbidding (7.34) (0.03) j γ ubid ARCH (10.36) (0.30) (10.93) (0.33) (2.43) (1.26) (9.68) (6.06) (0.71) (1.30) (11.13) (1.01) (2.06) (3.69) (8.93) (1.00) (3.06) (2.15) ψ j, (3.53) (4.16) (2.75) (4.26) (6.05) (1.43) (7.61) (0.87) (3.61) (1.42) (7.26) 6 k=1 ψ j,k Noes: Esimaed parameers for Equaion (4) σ 2 j, = ψ j,0 + + δ seas j 6 k=1 D seas ψ j,k û 2 j, k + γubid j ˆσ 2 + δnonseas j D ubid + γj new D new (1 D seas )ˆσ 2 + δnew j D new ˆσ 2 + η j, All coefficiens, excep he AR parameers, have been scaled up by Absolue -values in parenheses, ( ) denoes significance a he 5% (1%) level. 16

18 The esimaion resuls for he various variance equaions (4) are summarized in Table 4. We accouned for he inroducion of he new operaional framework in wo ways. Firs, we muliplied Eonia volailiy wih he dummy variable D new o es wheher he ransmission of Eonia volailiy has been influenced by he new framework. However, we did no find his ype of influence of he new framework, i.e. for all mauriies he corresponding coefficiens δ new j were clearly insignifican. Second, we included D new as a separae variable o check wheher he volailiy of an ineres rae has changed since March In fac, since he inroducion of he new framework he average condiional variance has declined for nearly all mauriies under consideraion, i.e. γ new < 0. Seasonal Eonia volailiy should no have a major impac on he communicaion of moneary policy and, hus, on he volailiy of longer erm ineres raes. To accoun for he specific role of seasonal volailiy, we defined he dummy variable D seas = min(1, D end + D eom + D firs ), comprising all seasonal calendar effecs relevan for Eonia volailiy, and muliplied D seas wih Eonia volailiy ˆσ 2. Accordingly, δ nonseas j, i.e. he coefficiens of (1 D seas )ˆσ 2 measure he response of he longer erm rae r j o non-seasonal Eonia volailiy. We expec ha only non-seasonal Eonia volailiy can reflec uncerainy abou he moneary policy sance. Table 4 confirms ha he ransmission of seasonal Eonia volailiy (δ seas ) is small and insignifican a all mauriies. In conras, he response o non-seasonal Eonia volailiy (δ nonseas ) is significanly posiive for all longer-erm money marke raes, even for he welve-monh rae. Eonia volailiy is paricularly relevan if i is sirred by uncerainy abou moneary policy signals. Consider, for example, he underbidding episodes capured by he dummy variable D ubid when Eonia volailiy sharply increased due o unclear moneary policy signals, see Figure A.1. For all ineres raes, he corresponding coefficiens γ ubid are posiive and highly significan, indicaing ha he volailiy of longer erm raes is paricularly high when moneary policy communicaion is no effecive. Therefore, he ECB s new operaional framework has lowered he volailiy of money marke raes boh, direcly (solving he underbidding problem) and indirecly because i lowered he average Eonia volailiy which is ransmied along he yield curve. 17

19 5 Conclusions This paper presened new evidence on he dynamics of he European money marke raes, he deerminans of heir volailiy and, in paricular, he ransmission of overnigh rae (Eonia) volailiy along he yield curve. One focus of our analysis has been on he effecs of he ECB s new operaional framework inroduced in March Shorening he mauriy of is main refinancing operaions and synchronizing he iming of is ineres rae decisions wih he reserve mainenance periods, he ECB sopped banks underbidding by miigaing he disurbing impac of rae change expecaions on he Eonia. Our resuls sugges ha he new framework reduced he volailiy of all money marke raes under consideraion: direcly, because volailiy was pariculary high during he former episodes of underbidding, and indirecly, because he new framework also decreased Eonia volailiy which we found o be parly ransmied o longer erm raes. Ye, he role of rae expecaions for he Eonia remains puzzling. In paricular, even under he new framework, he Eonia adjuss significanly o a forward spread reflecing he prevailing rae expecaions. Thus, rae hike expecaions may have conribued o he recen increase of he spread beween he Eonia and he ECB s policy rae. According o Ayuso e al. (1997), volailiy ransmission may depend on he level of overnigh rae volailiy. In his paper, we argue ha i may be even more criical o ake ino accoun ha volailiy ransmission may depend on he source and naure of Eonia flucuaions. Alhough Eonia volailiy is paricularly high a he end of he reserve mainenance period or a he end of monh, his seasonal volailiy should no impede he communicaion of moneary policy and he signalling role of he Eonia. In fac, we found ha seasonal Eonia volailiy is no ransmied o longer erm ineres raes. However, non-seasonal volailiy, defined as condiional Eonia variance esimaed a days unrelaed o seasonal effecs, is significanly ransmied along he yield curve. Our resuls show ha even he condiional variance of he welve-monh rae is affeced by an increase of non-seasonal Eonia volailiy. This indicaes ha ransmission of Eonia volailiy along he yield curve is a relevan issue if Eonia flucuaions are sirred by uncerainy abou moneary policy signals. 18

20 A Appendix Figure A.1: Non-seasonal Eonia volailiy Noes: The figure is aken from he ECB s monhly bullein, Augus

21 Table A.1: Euribor mean dynamics Dependen variable: r j 1 Week 1 Monh 3 Monhs 6 Monhs 9 Monhs 12 Monhs Adjusmen o Eonia spread α j (3.14) (0.25) Adjusmen o longer-erm rae β j (4.33) (5.08) Noes: Esimaed parameers from Equaion (3), (0.72) (3.25) r j = µ j + α j (r j i ) 1 + β j (r j r j ) (0.39) (2.10) (0.26) (1.61) 5 ϕ j,k r j k + k=1 + ϑ May11, 2001 May11, 2001 D + ϑ Sep18, 2001 Sep18, 2001 D + u j, 5 k=1 ϕ j,k r j k (1.98) where r j May11, 2001 Sep18, 2001 refers o he ineres rae wih mauriy subsequen o mauriy j, and D and D capure srong ineres rae cus a May 11, 2001, and a Sepember 18, Absolue -values in parenheses are compued using heeroskedasiciy-consisen sandard errors, ( ) denoes significance a he 5% (1%) level. For breviy, deailed resuls are no presened bu can be obained from he auhors. References Ayuso, J., Haldane, A. G., and Resoy, F. (1997). Volailiy Transmission along he Money Marke Yield Curve. Welwirschafliches Archiv, 133(1): Benio, F., Leon, A., and Nave, J. (2006). Modeling he Euro Overnigh Rae. Mimeo. Bindseil, U. (2004). Moneary Policy Implemenaion. Oxford Universiy Press, Oxford. Clews, R. (2005). Implemening Moneary Policy: Reforms of he Bank of England s Operaions in he Money Marke. Bank of England, Quarerly Bullein. Deusche Bundesbank (2003). The Eurosysem s Moneary Policy Framework - Experience o Dae and Measures o Improve is Efficiency. Monhly Repor, March. Durré, A. and Nardelli, S. (2007). Volailiy in he Euro Area Money Marke: Effecs from he Moneary Policy Operaional Framework. European Cenral Bank, Working Paper. European Cenral Bank (2006a). The Eurosysem s Operaional Framework and he Volailiy of he Overnigh Rae. Monhly Bullein, July. European Cenral Bank (2006b). Liquidiy Condiions and Moneary Policy Operaions from 9 Nov 2005 o 7 Feb Monhly Bullein, March. Furfine, C. H. (2003). Sanding Faciliies and Inerbank Borrowing: Evidence from he Federal Reserve s New Discoun Window. Inernaional Finance, 6(3):

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