Testing for a flexible non-linear link between short-term Eurorates and spreads

Marcelo Fernandes

The European Journal of Finance, 2003, vol. 9, issue 2, 125-145

Abstract: This paper investigates the relationship between short-term interest rates and spreads in the Euromarket. Specifically, five Eurocurrency deposit rates are analyzed: the Belgian and French francs, the German mark, the Danish crown, and the British pound. A multivariate test for unit roots is performed and strongly rejects the null hypothesis of integration in the 1-month and 12-months rates of these Eurocurrencies, indicating that the spread cannot be seen as a cointegration vector. Notwithstanding, a codependence analysis shows that the spread can still be interpreted as a long-run relationship between the short- and long-term Eurorates. A flexible non-linear error correction model is then proposed for the short-term rate to take both the short- and long-run adjustments into account. The model fits the data quite well, and seems to provide a slightly better forecast accuracy than the random walk benchmark.

Date: 2003
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DOI: 10.1080/13518470110074855

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