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.
The 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.
Model 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.
The results are helpful in diagnosing market sentiment and exchange rate risk pricing as China further internationalizes its currency.
The methodology can be easily extended to study yield curve responses to other scenarios of policy shocks or regime changes.
The authors acknowledge the support of the Natural Science Foundation of China with Grant Nos. 70903053 and 71273007 and Volkswagen Foundation for the project of “QE and Financial (In)stability”. We are grateful to two anonymous referees for helpful comments that greatly improved the paper from its previous working paper version titled “The Discrete-Time Framework of the Arbitrage-Free Nelson-Siegel Class of Term Structure Models”.
Hong, Z., Niu, L. and Zeng, G. (2019), "US and Chinese yield curve responses to RMB exchange rate policy shocks: An analysis with the arbitrage-free Nelson-Siegel term structure model", China Finance Review International, Vol. 9 No. 3, pp. 360-385. https://doi.org/10.1108/CFRI-12-2017-0239
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