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

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CD

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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 …