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Summary : Country and Currency Risk

JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS VOL. 33, NO. 2, JUNE 1998

Country and Currency Risk Premia in an
Enrierging Market

Ian Domowitz, Jack Glen, and Ananth Madhavan*

Abstract

The magnitude and determinants of credit and currency risks are topics of considerable
importance. This paper uses data on peso- and dollar-denominated debt issued by the
Mexican government to identify currency and country risk premia. We show that shocks
in equity and debt market returns translate into long-term increases in the premium de-
manded by investors with respect to currency and country factors. Country and currency
premia help explain equity returns and closed-end fund discounts. Additional evidence is
provided showing that investors did not anticipate the magnitude or timing of the currency
devaluation of December 1994 and the subsequent financial crisis.

I. Introduotion

This paper uses unique term-structure data obtained from the primary mar-

ket for Mexican sovereign debt to analyze the magnitudes and determinants of

credit and currency risks. The Mexican government issues both local and dollar-

denominated debt instruments. These instruments allow us to isolate the two

major components of the risk premia demanded by investors without recourse

to indirect statistical procedures. The first component—the currency (peso) pre-

mium measured as the yield spread between peso and dollar-denominated Mex-

ican sovereign debt—represents the compensation for risks associated with ad-

verse movements in the exchange rate. The second component—the country

(credit) risk premium measured as the yield spread between dollar-denominated

Mexican government debt and U.S. Treasury bills—represents the risk that the

• Domowitz, Department of Economics and Institute for Policy Research, Northwestern University,
Evanston, IL 60208; Glen, Economics Division, International Finance Corporation, Washington, DC
20433; and Madhavan, Department of Finance, University of Southern California, Los Angeles, CA
90089. Funding from the World Bank is greatly appreciated. Domowitz also thanks the Institute for
Policy Research, Northwestern University, for support. Special thanks are due to Michael Pettis and
George Nishiotis for assistance in obtaining the interest rate and closed end fund data used here, and
to Mark Coppejans for expert research assistance. We thank Warren Bailey (the referee), Steve Brown
(the editor), Margaret Forster, Robert Hodrick, and Aris Protopapadakis for their helpful comments.
Seminar participants at the Atlanta Finance Forum (Georgia State, Georgia Tech, Emory, and the
Atlanta Federal Reserve Bank), New York University, and the UCLA/UCIAJSC Finance Conference
provided many helpful suggestions. Any errors are entirely the authors’ own.

189

190 Journal of Financial and Quantitative Analysis

government might “default” on its obligations by delaying or refusing to repay
the debt or to restrict the movement of capital outside of the country.’

An analysis of these components is important for both practical and aca-
demic reasons. Sovereign borrowing is a significant source of capital for devel-
opment in emerging markets, and debt instruments often carry significant premia
over their counterpart equivalents in more mature markets such as the United
States because of concerns over credit and currency risk. Concerns over related
risk factors have played a major role in triggering recent financial crises in South-
cast Asian nations. Consequently, there is considerable interest in isolating the
relative economic importance of investors’ perceptions of currency and country
risk. The observed premia help us to understand better the evolution of beliefs
regarding country and currency risk, and the role of exogenous events in deter-
mining the cost of capital for both the public and private sectors. In this regard,
the term structure of currency and country risks may contain important informa-
tion about investors’ beliefs regarding future economic events. Indeed, recent
studies by Ferson and Harvey (1991), (1993), Bailey and Jagtiani (1994), Bai-
ley and Chung (1995), and Bekaert and Harvey (1995) show that expected stock
returns reflect exposure to macroeconomic and financial risks.

The relation between currency and country risk and returns in financial mar-
kets is an important issue. Intuition suggests that investors will revise their beliefs
regarding future currency and country risks following price movements in the debt
and equity markets. Alternatively, changes in risk premia may anticipate future
volatility in these markets, or common factors may affect both risk premia and
market volatility. Finally, we examine the relation between our measures of cur-
rency and country risk premia and the premium/discount of price over net asset
value for Mexican closed-end funds traded in the United States. The closed-end
fund premium is of interest because it is a measure of international capital market
segmentation. We also examine separately the ability of risk premia to predict
closed-end fund returns and changes in fund net asset values.

Our analysis yields several interesting findings:

i) Both currency and country risk premia arc economically significant, im-
plying that borrowing costs can be substantially lowered by reducing the per-
ceived risks of a currency devaluation and sovereign default. This is especially
important for emerging markets where outside capital is scarce and costly.

ii) Changes in currency and country risk are weakly correlated, suggesting
that these two risk components do indeed refiect exposure to economically distinct
factors.

iii) The term structure of interest rates and its priced components reflects
rational expectations of future movements in rates and risk premia.

iv) There is no evidence that investors anticipated the major devaluation of
the peso in December 1994, which may help explain why the devaluation led to a
loss of confidence in Mexico by foreign investors.

‘ The isolation of country and currency premia via interest rate compari.sons is not new to this
paper, but is relatively unexplored. See, for example. Bailey and Chung (1995) and Frankel and
Okongwu(l996).

Donnowitz, Glen, and Madhavan 191

v) Country and currency risk premia rise in response to volatility in debt
and equity markets. These increases are persistent, suggesting that a reduction in
volatility in financial markets may lower interest rates over long horizons.

vi) The discount for the Mexico closed-end fund, which captures off-shore
demand or sentiment towards Mexican investments, decreases with both currency
and country risk.

vii) Equity returns to the fund based on both U.S. market prices and net asset
values are systematically related to our risk premia, suggesting that both currency
and country risks are priced factors in the return-generating process.

The paper is closely related to several disparate literatures. Our analysis of
currency and country risk premia is complementary to studies that directly esti-
mate these components and use them to analyze financial markets. In particular.
Bailey and Chung (1995) use local and dollar-denominated interest rates to cre-
ate a factor for currency risk in a multi-factor model of equity returns. Similarly,
Frankel and Okongwu (1996) emphasize the importance of currency and coun-
try risk factors in the context of emerging market monetary policy and capital
controls. De Santis and Gerard (1997), by contrast, use statistical procedures to
isolate indirectly the currency component of the risk premium. The investigation
of the intertemporal behavior of risk premia within the context of the expectations
hypothesis is similar to that in Barr and Campbell (1995), who examine expected
inflation using a term structure model. Cumby and Evans (1995) analyze alterna-
tive models of the dynamics of default in a probabilistic setting, and demonstrate
that the market can distinguish between current and future credit quality. Campa
and Chang (1995) test the expectations hypothesis with respect to a term structure
of implied options volatilities, i.e., risk as opposed to risk premia, in the foreign
exchange market. Our analysis of the 1994 devaluation adds to existing litera-
ture on that topic (Lustig (1995), Bailey, Chan, and Chung (1997), and references
therein). Our examination of capital market segmentation in the context of the
relation between the closed-end fund premium and currency and country risk fac-
tors parallels the work of Bailey, Chan, and Chung (1997); it is also consistent
with Domowitz, Glen, and Madhavan (1997), who provide direct evidence on
internal market segmentation in the domestic equity market. Finally, the paper
complements the recent literature (see, e.g., Claessens and Pennacchi (1996)) on
the pricing of Brady bonds.

The paper is organized as follows: Section II describes the institutional struc-
ture of the market and develops our measures of currency and country risk pre-
mia; Section III provides a framework to analyze term structure of interest rates
and risk premia under rational expectations; Section IV contains empirical results
concerning term structure; Section V analyzes the dynamic relation between the
risk premia and volatility in debt and equity markets; Section VI contains results
on the relation between risk premia and the closed-end fund premium and equity
returns; and Section VII concludes.

192 Journai of Financial and Quantitative Analysis

II. Institutions and Data

A. Fixed-Income Securities in Mexico

The federal government of the United Mexican States issues several different
fixed-income securities. In recent years, the most important of these are Certifi-
cados de la Tesoreria (Cetes) and Bonos de la Tesoreria (Tesobonos). Both Cetes
and Tesobonos are short-term pure diseount notes issued at weekly auctions for
a variety of maturities.^ Subsequent to the auctions, a secondary market for the
instruments exists. Our analysis focuses on the weekly primary auction prices
that determine a yield to maturity. Restricting our attention to the primary market
also circumvents possible problems with secondary market prices that may not be
entirely representative in periods of illiquidity.

The difference between the two instruments lies in the manner in which the
return to the lender is calculated. A Cetes is a simple peso-denominated note
whose yield to maturity is determined by the discount demanded at the time of
issue. Payment is made in pesos at the time of maturity with no adjustment for
changes in the value ofthe peso relative to other currencies or Mexican inflation.
Tesobonos are more complicated. They are also peso-denominated instruments
issued at a discount, but the principal amount paid at maturity is indexed to the
peso-dollar exchange rate.-* Consequently, the Tesobono is essentially a dollar-
denominated security, subject to the added risk that the Mexican government will
suspend convertibility and renege on its promise regarding indexation.”*

B. Construction and Interpretation of Risk Premia

Define by rj the nominal risk-free yield on a dollar-denominated U.S. Trea-
sury bill at time t with maturity in ; periods, C the yield on a Cetes bill at time t
with (• periods to maturity, and similarly define by V, the yield on a Tesobonos bill.
The Tesobonos rate V, can be thought of as the riskless treasury bill yield, r, plus
a risk premium, denoted by 7 ,̂,, which represents the compensation required by
investors for the possibility that the issuer will “default” on its obligation. Default

^At year-end 1994, total Mexican internal public debt was NP171.3 billion, or slightly more than
$50 billion at the then-prevailing exchange rate. Of that amount, 55% consisted of Tesobonos, with
another 23% accounted for by Cetes. Tesobonos were not as important in previous years, having
grown from less than 1 % of the total at year-end 1992, with much of the growth taking place in early
1994. Subsequent to the December 1994 devaluation ofthe peso, the market for Tesobonos collapsed
and they now account for only a fraction of the total public debt once again. See Umlauf (1993) for
details with respect to the structure of the auction market.

‘Tesobonos are a reincarnation of a previous instrument, Pagafes, with the switchover between the
two instruments taking place in 1991 when exchange controls were eliminated and the controlled and
market exchange rates were unified. For an examination of the links between the Cetes and Pagafes
markets, see Khor and Rojas-Suarez (1991). The Mexican government also issues bonds that are
indexed to Mexican inflation, known as Ajustabonos, but these were not as popular as Cetes during
our sample period.

“Capital controls were imposed in 1982 following the debt crisis and subsequent devaluation. See
Melvin and Schlagenhauf (1985) for a description of the effect those controls had on eurodollar interest
rates paid by Mexican borrowers. During the period of our study, Mexican banks made insurance
against such controls available to investors for a nominal premium of 10-20 basis points. Following
the December 1994 devaluation, the government offered investors a choice between payment in dollars
and payment in indexed pesos in an attempt to reduce investor concerns over repayment (see, e.g.,
Lustig(1995)).

Domowitz, Glen, and Madhavan 193

in this context is defined to be either a pure default (non-payment) or a refusal to
convert pesos into dollars (which imposes a significant cost on the lender). Then,
we can define the “country” or credit risk premium as

(1) iL = T-r.

Next, we can think of nominal, peso-denominated Cetes bond yield as the real
risk-free U.S. Treasury bill yield (i.e., the nominal yield less U.S. inflation), plus
terms that captures expected inflation in Mexico and compensation for real cur-
rency and credit (country) risks. Thus, we can write the Cetes yield as

(2) C = rj + ^ ^ – ^ ^ + T̂^̂ + Ti,,,

where TT ,̂ is expected Mexican inflation over the remaining life of the bill, TT̂ ,.,
is corresponding U.S. expected inflation, and 7^, is the real risk premium paid to
investors for the risk that changes in the exchange rate will affect the real value of
their investment. Using equation (1), the nominal currency (peso) risk premium
is

(3″) -y’ = -y’ + TT’ – TT’ — C’ – V

Thus, the nominal currency risk premium is the spread between Cetes and Teso-
bono yields, which consists of a compensation for foreign exchange variability
risk (see, e.g., Lewis (1995)) and expected peso depreciation. Note that the credit
risk premium, 7^,, is implicitly assumed to be the same for both instruments be-
cause they are issued by the same entity and are, hence, subject to the same pure
default (non-payment) and convertibility risks. One can argue that the credit risk
on Cetes is lower than for Tesobonos because they are peso-denominated and
the government can print an unlimited amount of pesos for repayment purposes.
This is misleading, however, because Tesobonos are also peso-denominated, al-
beit indexed to the exchange rate. The credit risk premium for Cetes bonds rep-
resents compensation for the risk that the government will unexpectedly devalue
the expected purchasing power of the bond by printing pesos. Such an event is
almost certainly likely to be associated with similar reduction in the real value of
Tesobonos through the imposition of capital controls.

C. Empirical Evidence on the Magnitude of Risk Premia

We obtained data on effective yields to maturity from weekly primary debt
auctions (both Cetes and Tesobono) for the period beginning July 1993 through
the end of November 1994 through Bloomberg Financial Markets. The instru-
ments are issued with maturities ranging from seven to 360 days, but not all ma-
turities are issued every week. For the sample used in this study, the most common
(and highest volume) maturities were 91 and 182 days. These two instruments are
the focus of our study. Additional data on weekly U.S. Treasury bill yields in the
primary market were obtained from Datastream. Finally, we obtained a monthly
series of the Consumer Price Index for Mexico from the International Monetary
Fund (IMF).

194 Journal of Financial and Quantitative Analysis

Sample statistics for the 91- and 182-day Cetes, Tesobonos, currency premia,
and country premia are presented in Table 1. We report separate sample statistics
for the two years to better isolate the effects of the major political and economic
events in Mexico in 1994. Both the country and currency premia are economically
significant. The median 91-day currency (or peso) premium, for example, was
8.4% in 1993. but actually declined to 6.9% in 1994. The corresponding figures
for the country premia are 2.0 and 2.4%, respectively, which are large considering
the short maturities of the instruments.

Series and Year

Cetes (91-day)
1993
1994

Cefes (182-day)
1993
1994

Tesobonos (91-day)
1993
1994

Tesobonos (182-day)
1993
1994

Currency premium (91-day)
1993
1994

Currency premium (182-day)
1993
1994

Country premium (91-day)
1993
1994

Country premium (182-day)
1993
1994

TABLE 1

Summary Statistics

Mean

0.136
0.142

0.134
0.140

0.051
0.066

0.053
0.071

0.085
0.076

0.080
0069

0.022
0.023

0.026
0.028

Median

0.139
0.145

0.137
0.143

0.051
0.068

0.052
0.074

0.089
0.075

0.084
0.065

0.020
0.024

0.024
0.027

Standard Deviation

0.012
0.027

0.013
0.022

0.002
0.010

0.003
0.011

0.012
0.020

0.013
0.015

0.007
0.008

0.007
0.008

This table contains summary statistics on traded instruments and derived risk premia in the
Mexican debt market for 91-day and 182-day maturities. The data for Cetes (government
securities denominated in pesos) and Tesobonos (government securities denominated in
dollars, payable in pesos at the official exchange rate) are annualized effective yields cal-
culated from the Mexican government’s weekly primary auctions, from the beginning of July
1993 through the end of November 1994. The currency risk premium (peso premium) is
calculated as the arithmetic difference between Cetes and Tesobonos yields, where yield
is expressed as a decimal (i.e., 5% is 0.05). The country risk premium (country premium)
is calculated as the difference between the Tesobonos yield and the yield on U.S. Treasury
bills. Data reported are the mean and median yields and premia and the standard deviation
of the yields and premia, all in decimals.

The relative magnitude of the currency premia refiects the risks investors
attributed to peso inflation and exchange rate devaluation.’ We also compute a

‘Mexicans are taxed on all income, both foreign and domestic, so that Mexican interest rates
will adjust to reflect any tax differences between the United States and Mexico. Further, tax rates

Domowitz, Glen, and Madhavan 195

real currency premium where we assumed a naive (random walk) model for ex-
pectations regarding inflation. Inflation in Mexico was relatively stable over this
period and more sophisticated models provide little additional gains. Specifically,
the real premium is computed as the nominal currency (peso) premium minus the
difference between the U.S, and Mexican expected inflation rates, based on (an-
nualized) percentage changes in the respective Consumer Price Indices over the
month prior to the auction. The median real premium for the 91-day maturity (not
reported in Table 1) is 3.2 and 4,5% in 1993 and 1994, respectively. Similar val-
ues of 3,0 and 3,6% are obtained for the 182-day maturity. Although considerably
smaller than the nominal values, these figures are still economically significant,

D, Variation in Risk Premia over Time

While the summary statistics provide valuable information on the behavior
of the different variables, they also conceal much of what took place. Figure 1
graphs the Mexican country and currency risk premia. Except for March 1994 and
a brief period in early 1995, the currency premium greatly exceeded the country
premium. The currency premium declined substantially over the eight months
that preceded the assassination of presidential candidate Luis Colosio in March
1994; the country premium remained flat over most of this time, falling only
shortly before the assassination. Both premia increased in March, although the
increase in the country premium took place prior to the assassination and the
increase in the currency premium was much larger and followed the assassination.
Following the assassination, the country premium declined until, by the time of
the August 1994 presidential election, it had reverted to its pre-assassination level.
The increase in the currency premium was more persistent, and never quite fell
back to its previous level. Also notable in the graph is the effect of the December
1994 devaluation that led to dramatic increases in both premia. Given the sudden
and dramatic swing that took place at that time, our analysis is constrained to the
pre-devaluation period,

III. The Term Structure of Rates and Risk Premia

A. Definitions

The term structures for Cetes and Tesobonos, respectively, are defined as

(4) r^ = c-d,,

(5) r’l = T’,-T{.

Most research on the term structure has been restricted to interest rates. The
underlying risk premia, in this case, can be constructed from traded securifies

for Mexican investors on ordinary income are 38—40% for the highe.st income group. U.S. investors
would pay a similar rate on income earned in Mexico and then get a credit for the amount paid on
their U.S. tax return. There is no capital gains tax in Mexico. Given the .similarity in tax rates in the
two countries, and the symmetric treatment of income, it is unlikely that the differences in rates are
driven by tax factors. Of course, the variation in interest rate differentials over time is unrelated to tax
factors.

196 Journal of Financial and Quantitative Analysis

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Donnowitz, Glen, and Madhavan 197

and, as such, they too are subject to the same economic arguments that support
the expectations hypothesis.^ Assuming that TT ,̂ = TT’^” for small values of n,
equations (1) and (2) yield the following term structure variables for the currency
and country risk premia, respectively,

(6) r;{ = %,-%, = d – d, – [ri – Ti,

Equation (6) indicates that the term structure of the currency premium can be
measured using only the observable rates of return from the Cetes and Tesobonos.
In equation (7), the term structure ofthe country risk premium contains a term for
the term premium in risk-free rates. In what follows, that premium is assumed to
be equal to zero.^

The summary statistics in Table 1 suggest that there were substantial term
structure differences between the two underlying debt instruments. On average,
there was only a rather small term premium in the Cetes rates in 1993, with a
slightly downward-sloping term structure in 1994. This is surprising given the
devaluation that occurred at the end of the year, but consistent with respect to
movements in risk-adjusted returns. Volatility of the rates for the two maturi-
ties was roughly comparable. The Tesobono term structure is notably different,
with the long rate being slightly higher in 1993, but sharply higher in 1994. The
downward-sloping Cetes term structure reveals itself again in the currency pre-
mium term structure, which is downward sloping, on average, in both 1993 and
1994. Like the Tesobonos, however, the country risk premium term structure re-
tains its positive slope in both periods.

B. Time Variation in Currency and Country Risk and Term Premia

Figure 2 illustrates the term premium for both the Cetes and Tesobonos.
Both premia display a remarkable level of short-term volatility over time, with
substantial shifts taking place from week to week. Perhaps most notable is the
tendency for the Cetes premium to be negative, especially in 1994, whereas the
Tesobonos premium is generally positive. In particular, there was a significant
spike in the Tesobonos premium at the time of the Colosio assassination in March
1994, whereas the Cetes premium actually became more negative at that time.

We also computed the correlation coefficients between the currency and
country term and risk premia for both levels and changes in these variables. In-
terestingly, although the levels of country and currency risk premia are positively
correlated, changes in the two premia are negatively correlated. For example, the

^This argument is articulated in Barr and Campbell (1995) in the context of expected inflation and
a comparison of nominal and indexed notes. Campa and Chang (1995) also examine the validity ofthe
expectations hypothesis with respect to the term structure of volatilities in foreign exchange options.

”One alternative would be to employ U.S. Treasury bills as proxies for risk-firee rates, but it is
difficult to believe that six-month Treasury bills are viewed as truly risk-free by the investing public
because of the inflation risk that they contain. As a result, the term structure of Treasury bill rates
would contribute to our country risk measure and could actually introduce more noise than it removes.
Moreover, as shown below, under the expectations hypothesis, the term premium should be constant
over time.

198 Journal of Financial and Quantitative Analysis

<5
0)

O

o

(0
B
CD

o

Domowitz, Glen, and Madhavan 199

correlation between the currency ("peso") premium and the country risk premium
is 0.66 for the 91-day notes, but is -0.34 for changes in these variables. Antic-
ipating evidence presented in Section IV with respect to cointegration, we note
that the levels of the premia contain a unit root. Nevertheless, the level corre-
lations are consistent estimates (Stock (1987)). The proper interpretation is that
the level correlations represent long-run association, while the estimates using
the differences are short-run correlations. The findings also are reflected in the
negative correlation in both levels and changes in the currency and country term
premia. For example, the correlation between the changes in the country and cur-
rency term premia is —0.65. These results suggest that the two risk components
identified do indeed reflect exposures to different economic factors. We turn now
to a more formal investigation of these issues.

C. The Expectations Hypothesis

Under rational expectations, the slope of the term structure (and its priced
components) reflects investors' beliefs about future movements in interest rates
and risk premia. In particular, the expectations hypothesis states that current long-
term rates reflect optimal forecasts of future short-term rates.^ For pure discount
notes with maturities / andj (where i is some integer multiple ofj), Campbell and
Shiller (1991)—henceforth CS—show that under the expectations hypothesis,

/-Q ij — J T^ij Z7 D'~J ni
(°) ^l = '. 1-* ( — ^»"(+7 "" " ( I

where F'/ is a term premium as previously defined, and R is the /-period rate
of return (or premium) used in the definition of T,̂ . Equation (8) states that the
term premium is proportional to the expected difference between today's long-
term rate and the future short-term rate. Assuming that expectations are rational,
equation (8) provides our first test of the expectations hypothesis: a regression
of the realized value of the right-hand side of the equation on a constant and its
predicted value, s'j, provided that the underlying rates are integrated of order one.
In the case of the risk premia defined here, the latter requirement translates into a
cointegration restriction.

This first test leads to the following four regression equations,

(9a) ipilj-ipt = a + l3s%-i-c,,

(9b) I'ni.ij-lL = a + ds'L + t,,

(9c) C~j – c ; = Q + /35'̂ , -I- e,,

(9d) C 7 – ^ ' = a + psl, + e,,

where, in each case, the null hypothesis under the expectations hypothesis is that
a = 0 and /3 = 1. Essentially, these equations try to predict the change in yield on
a bill as its maturity declines.

*'The expectations hypothesis has a long history and has been the subject of considerable empirical
investigation (Campbell and Shiller (1991)). A theoretical discussion of the expectations hypothesis
is presented in Cox, Ingersoll, and Ross (1981). The model has many variants including both linear
and non-linear forms. We focus upon the linear approximation.

200 Journal of Financiai and Quantitative Analysis

D. The Perfect-Foresight Spread

A second method for testing the expectations hypothesis discussed by CS
(1991) uses the perfect-foresight spread, i.e., the spread that would obtain under
the expectations hypothesis, if there were perfect foresight about future inter-
est rates. Our second test of the expectations hypothesis involves regressing the
perfect-foresight spreads onto their respective actual spreads, r'/-', yielding.

(10a)

(10b)

(10c) 1^1 (y^,+,-y«,j = a+p I

(lOd) (1](J J) = a + ph–i,,]+e,.

These regressions can be thought of as predicting the change in yield holding
maturity constant. Under the expectations hypothesis, the slope will be unity in
regressions (lOa)-(lOd).

E. The Theoretical Spread

Regression-based tests involve overlapping data that limit the number of in-
dependent observations, and do not tell us how similar are the movements in the
actual spread to those implied by the expectations hypothesis. CS (1987) pro-
pose an alternative vector-autoregressive (VAR) approach for evaluating present
value models. From the VAR coefficients, one can compute the optimal forecast
of 7-period interest rate changes. The long-run behavior of interest rates is then
inferred from their short-run behavior in the sample period, rather than being esti-
mated directly. The theoretical term structure spread can then be calculated from
the model and compared with the actual spread.

Application of the VAR methodology …

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