Impact of the Subprime Crisis on the Comovement of International Bond Markets

Presented by Sanket Jain

Introduction
Bond markets represent a large segment of international asset markets and understanding the linkages between them is important for designing effective portfolio diversification strategies Significant comovement across international bond markets - the benefit of international diversification might not be realized in the long term In prior empirical work the results are inconclusive regarding the nature of stability of the relation in the long run We investigate the comovement of bonds across the subprime crisis

Data
Three countries have been chosen for the analysis the US, Germany and Italy The 10 year government bond yield data in cash market has been collected for each of these countries from Bloomberg Data has been divided into two periods:
B series 240 weekly data from Dec 2002 to Jun 2007 D series 240 weekly data from Jul 2007 to Jan 2012

Test for non-stationarity

The individual series were tested for non-stationarity by using the Augmented Dickey Fuller test
Result of unit root test for B series
B Series US GERMANY ITALY 5% Critical Value -2.873390 -2.863742 -2.863742 ADF t stats -2.578863 -2.011045 -1.987088 P value 0.0992 0.2820 0.2925

Result of unit root test for D series

D Series US GERMANY ITALY 5% Critical Value -2.873390 -2.873390 -2.873648 ADF t stats -1.479390 -1.443001 -3.658487 P -value 0.5425 0.5608 0.0053

Based on the test results, only the US and Germany come out to be non-stationary

Methodology
Engle and Granger (1987) pointed out that a linear combination of two or more non-stationary series may be stationary The non-stationary time series are said to be cointegrated if such a stationary linear combination exists The stationarity of such linear combination is checked by creating a residual series of their regression and testing it for stationarity If cointegration exists we will run VAR-VECM on the original series If there are not sufficient evidences of cointegration than we will run VAR model on the first difference series

Test for co-integration

Regression test is conducted on the possible linear combinations of non-stationary series
Result of the unit root test of the residual series for various regressions (B series)
B Series US-GERMANY GERMANY-ITALY ITALY-US US-GERMANY-ITALY Regression equation (eviews) Ubb c gbb Gbb c ibb Ibb c ubb Ubb c gbb ibb 5% critical value -2.873390 -2.873390 -2.873390 -2.873990 ADF t-stats -2.178420 -2.097432 -1.135047 -3.042777 p-value 0.2148 0.2460 0.7022 0.0325

Result of the unit root test of the residual series for various regressions (D series)
D Series US-GERMANY Regression equation (eviews) Ubb c gbb 5% critical value -2.873390 ADF t-stats -2.277442 p-value 0.1802

VAR-ECM
VAR-ECM results for B series data
Equation: D(IBB) = 0.2785*( IBB(-1) - 1.0590*GBB(-1) 0.2591*UBB(-1) + 1.1621) - 0.8254*D(IBB(-1)) + 0.7171*D(GBB(-1)
Cointegrating Eq: IBB(-1) CointEq1 1.000000 -1.059026 GBB(-1) (0.04719) [-22.4413] -0.259081 UBB(-1) (0.04477) [-5.78675] C 1.162059 D(UBB(-1)) D(UBB(-2)) C D(GBB(-1)) D(GBB(-2)) D(IBB(-1)) D(IBB(-2)) Error Correction: CointEq1 D(IBB) 0.278455 [ 4.26813] -0.825394 D(GBB) 0.300951 [ 4.65475] -0.747201 D(UBB) 0.348141 [ 3.82091] -0.742775

[-2.39753]
-0.088261

[-2.19008]
-0.034790

[-1.54486]
0.244410

[-0.25552]
0.717060

[-0.10163]
0.612507

[ 0.50665]
0.676159

[ 2.04913]
-0.024274 [-0.06907] 0.119450 [ 1.51453] 0.122942 [ 1.55401] 0.000603 [ 0.11413]

[ 1.76621]
-0.100789 [-0.28937] 0.130911 [ 1.67489] 0.144376 [ 1.84149] 0.000526 [ 0.10047]

[ 1.38354]
-0.450580 [-0.91795] 0.088565 [ 0.80405] 0.161160 [ 1.45862] -0.004029 [-0.54591]

VAR results
VAR results for D series Equation: RETGBA = 0.1902*RETUBA(-2) - 0.2336*RETGBA(-2) + 0.3689
RETUBA -0.088020 RETUBA(-1) (0.09342) [-0.94215] 0.126498 RETUBA(-2) (0.09291) [ 1.36150] -0.028682 RETGBA(-1) (0.11063) RETGBA -0.028614 (0.07794) [-0.36711] 0.190240 (0.07752) [ 2.45422] 0.002932 (0.09230) R-squared Adj. R-squared Sum sq. resids S.E. equation F-statistic Log likelihood Akaike AIC Schwarz SC Mean dependent S.D. dependent 0.020456 0.003640 6367.577 5.227682 1.216462 -728.8251 6.166598 6.239544 0.373487 5.237223 0.031538 0.014912 4432.180 4.361448 1.896921 -685.7081 5.804270 5.877217 0.347890 4.394336 253.7949 243.2433 -1329.208 11.25385 11.39974

[-0.25925]
-0.113560 RETGBA(-2) (0.11027) [-1.02985] 0.413934 C (0.34186) [ 1.21083]

[ 0.03177]
-0.233645 (0.09200) [-2.53972] 0.368943 (0.28521) [ 1.29357]

Determinant resid covariance (dof adj.) Determinant resid covariance Log likelihood Akaike information criterion Schwarz criterion

Impulse Response
The effect of the US return series over Germany return series is prolonged It takes around 4 lags for Germany return data to absorb the effect of the US return
Response to Cholesky One S.D. Innovations 2 S.E.
Response of RETUBA to RETUBA
6 6

Response of RETUBA to RETGBA

-2 1 2 3 4 5 6 7 8 9 10

-2 1 2 3 4 5 6 7 8 9 10

Response of RETGBA to RETUBA

4 3 2 1 0 -1 -2 1 2 3 4 5 6 7 8 9 10 4 3 2 1 0 -1 -2 1

Response of RETGBA to RETGBA

10

Variance Decomposition
Shows the proportion of the movement in one variable due to their own shocks, versus shocks to other variables
Variance Decomposition
Variance Decomposition of RETUBA: Period 1 2 3 4 5
Variance Decomposition of RETGBA: Period 1 2 3 4 5 Cholesky Ordering: RETUBA RETGBA S.E. 5.227682 5.257223 5.280361 5.281322 5.281491 RETUBA 100.0000 99.97236 99.56134 99.55630 99.55201 RETGBA 0.000000 0.027642 0.438661 0.443702 0.447990

S.E. 4.361448 4.363718 4.429928 4.430686 4.431823

RETUBA 51.17940 51.22974 50.11165 50.12809 50.10252

RETGBA 48.82060 48.77026 49.88835 49.87191 49.89748

Conclusions
There are evidence of cointegration between the bonds in B series data, thus there exists a long term relationship between the bond yields before the start of subprime crisis As the bond yields were cointegrated there was no benefit from diversification among these countries For D series data, a large proportion of movement in Germany bond yields is contributed by the shocks in US bond yields

Thank You