The 2007-2009 Financial Crisis

296 Pages·2014·1.67 MB·English

by  Dr Aman Saggu

Saggu, Aman (2014) Asset prices and federal funds rate shocks: the
2007-2009 financial crisis. PhD thesis.

http://theses.gla.ac.uk/4916/

Copyright and moral rights for this thesis are retained by the author

A copy can be downloaded for personal non-commercial research or
study, without prior permission or charge

This thesis cannot be reproduced or quoted extensively from without first
obtaining permission in writing from the Author

The content must not be changed in any way or sold commercially in any
format or medium without the formal permission of the Author

When referring to this work, full bibliographic details including the
author, title, awarding institution and date of the thesis must be given

Glasgow Theses Service
http://theses.gla.ac.uk/
[email protected]
Mr Aman Saggu., B.S., M.S.,
Asset Prices and Federal Funds Rate Shocks:
The 2007-2009 Financial Crisis
Mr Aman Saggu., B.S., M.S.,
A Thesis Submitted in Fulfilment of the Requirements for the Degree of Doctor of Philosophy
The Adam Smith Business School
The University of Glasgow
February 2014
104,345 Words
Page 1 of 295
Mr Aman Saggu., B.S., M.S.,
Thesis Abstract
This empirically motivated doctoral thesis investigates the impact of Federal Funds
rate (FFR) surprises on asset prices between Jun-89 to Dec-12, with a focus on the effect of
the 2007-2009 financial crisis on this relationship. This is an important question to evaluate
because the Fed initially responded to the crisis by using conventional monetary policy (i.e.
target FFR cuts) to influence financial, monetary and economic conditions in the broader
macroeconomy. This was also the primary policy tool of the Fed throughout the majority of
the crisis period (Sep-07 to Dec-08) and non-conventional monetary policy measures were
only used when the target FFR approached the zero-lower bound. In Chapter 1 we outline the
thesis and in Chapter 2 we review empirical studies related to this thesis.
Chapter 3 is the first empirical chapter of this thesis in which we investigate the
impact of FFR surprises on US stock returns. We demonstrate that a structural shift occurred
during the recent crisis which significantly altered the US stock market response to FFR
shocks. In particular, stock returns were shown to be associated with non-positive or negative
responses to unexpected FFR cuts during the crisis. The lack of a positive stock response to
FFR shocks during the crisis implies that unexpected FFR cuts ceased to be seen as good
news by stock market investors, and were rather interpreted as signals from the Fed of
worsening macro-financial conditions.
We extend our empirical analysis to the US Treasury market and gold market in
Chapter 4. Our estimates show that very short-term maturity (3-Month), longer-term (5-Year,
10-Year and 30-Year) maturity Treasury yields and gold returns were associated with
significantly larger magnitude declines in response to unexpected FFR cuts during the crisis.
The stronger response of these securities to FFR shocks during the crisis implies that
unexpected FFR cuts signalled worsening future economic prospects and triggered a
rebalancing of investment portfolios away from falling equities and towards these safe-haven
assets. These cuts prompted significantly higher demand for highly liquid securities such as
3-Month T-Bills and gold. The stronger response of longer-term Treasuries implies that
investors anticipated a prolonged downturn and increased demand for longer-term, lower-risk,
safe-haven assets.
Finally in Chapter 5 we consider the international context, investigating the
transmission of FFR shocks to equity indices across 43 advanced and emerging market
countries. We find substantial cross country heterogeneity in the responses of foreign equity
index returns to FFR shocks outside the crisis, with positive stock responses to FFR shocks
where significant. However, we find even greater heterogeneity in the responses of foreign
equity indices to FFR shocks during the crisis, with an unexpected 1% FFR cut being
associated with significant 2.53%-7.50% decline across the equity indices of 12 countries,
and 2.79%-14.04% increases across the equity indices of 19 countries. Our estimates show
that cross country heterogeneity in equity market responses to FFR shocks during the crisis
period can only partly be explained in terms of real bilateral integration with the US economy,
and find that external borrowing from the rest of the world is also an important determinant.
Overall, our estimates in this thesis highlight the severity of the 2007-2009 crisis, reveal the
limits of conventional monetary policy at the zero lower bound and are consistent with the
Keynesian liquidity trap theory.
Page 2 of 295
Mr Aman Saggu., B.S., M.S.,
Table of Contents

Chapter 1: Outline
Thesis abstract 2
List of tables 8
List of figures 12
Acknowledgements 13
Author’s declaration 14
Introduction 15
References for Chapter 1 20

Chapter 2: A Review of Empirical Studies Relating to the Reaction of Asset Prices (US
Stocks, International Stocks and US Treasuries) to Monetary Policy Shocks
2.1 Introduction 21
2.2 US Stocks & Monetary Policy (Early Studies) 22
2.2.1 Early Studies from the 1960s and 1970s 22
2.3 US Stocks & Monetary Policy (Early Event-Studies) 24
2.3.1 Measured in terms of the discount rate 24
2.3.2 Measured in terms of the money supply 28
2.3.3 Measured in terms of the discount rate and money supply 29
2.4 US Stock Return Predictability & Monetary Policy 32
2.4.1 Measured using non-VAR models 32
2.4.2 Measured using VAR models 35
2.4.3 Critique of VAR & VAR related monetary policy measures 40
2.5 US Stocks & Monetary Policy (Alternative Measures) 41
2.5.1 Measured using heteroscedasticity based techniques 41
2.5.2 Measured using non-standard indicators 43
2.6 US Stocks & Monetary Policy (FFR Futures Implied Measures) 44
2.6.1 Measured using FFR futures 44
2.6.2 Measured using timing and level shocks, or target & path factors 49
2.6.3 State dependence 52
2.6.4 Asymmetries & volatility 56

Page 3 of 295
Mr Aman Saggu., B.S., M.S.,
2.7 US Stocks & Monetary Policy (The 2007-2009 Crisis) 59
2.7.1 Background & dating 59
2.7.2 Overview of pre-crisis studies 61
2.7.3 Conventional and non-conventional monetary policy 63
2.7.4 Overview 69
2.8 US Stocks & Monetary Policy (The International Transmission) 70
2.8.1 Early studies 71
2.8.2 Pre-crisis studies 72
2.8.3 Crisis studies 75
2.8.4 Overview 76
2.9 US Treasuries & Monetary Policy 78
2.9.1 Outline 78
2.9.2 Early studies 78
2.9.3 Measured using FFR futures 81
2.9.4 Structural instability 82
2.9.5 Measured using alternative approaches 84
2.9.6 Overview 85
2.10 US Treasuries & Monetary Policy (The 2007-2009 Crisis) 86
2.10.1 Outline 86
2.10.2 Conventional monetary policy 86
2.10.3 Non-conventional monetary policy: increasing use of 88
forward guidance
2.10.4 Non-conventional monetary policy: large-scale asset 91
purchase programmes
2.10.5 Overview 91
2.11 The Monetary Policy Transmission Mechanism Channels (Theory) 93
2.11.1 Traditional Interest Rate Channels 93
2.11.2 Exchange Rate Channels 94
2.11.3 Tobin’s Q & Wealth Effects Channels 95
2.11.4 Credit Channels (Balance Sheet & Bank Lending Channels) 96
2.11.5 Asset Pricing Channels 98
2.12 References 100

Page 4 of 295
Mr Aman Saggu., B.S., M.S.,
Chapter 3: The Stock Market Reaction to Federal Funds Rate Surprises: State-dependence
and the Financial Crisis (Empirical Analysis)
3.1 Abstract 111
3.2 Introduction 111
3.3 Data and sample period 115
3.3.1 Measuring conventional monetary policy shocks 115
3.3.2 Descriptive statistics 120
3.3.3 Preliminary graphical analysis 120
3.4 Econometric models and results 121
3.4.1 Preliminary estimates 121
3.4.2 Dating the 2007-2009 crisis (Exogenous) 123
3.4.3 Dating the 2007-2009 crisis (Endogenous) 124
3.4.4 Structural change during the 2007-2009 crisis 126
3.4.5 Robust MM-estimator weighted least squares 129
3.4.6 State-dependence and the financial crisis 131
3.4.7 Evidence from industrial sectors 135
3.4.8 Further robustness checks 138
3.5 Conclusions 140
3.6 References for Chapter 3 141

Chapter 4: The US Treasury & Gold Market Reaction to Federal Funds Rate Surprises:
Flight to Quality and the Financial Crisis (Empirical Analysis)
4.1 Abstract 175
4.2 Introduction 175
4.3 Data and sample period 180
4.3.1 Measuring conventional monetary policy shocks 180
4.3.2 Asset price data 180
4.3.3 Non-conventional monetary policy 181
4.3.4 Controlling for non-conventional monetary policy: forward 181
guidance
4.3.5 Controlling for non-conventional monetary policy: LSAP 185
programmes
4.3.6 Descriptive statistics 186
4.3.7 Preliminary graphical analysis 186
Page 5 of 295
Mr Aman Saggu., B.S., M.S.,
4.4 Econometric models and results 186
4.4.1 Preliminary estimates 186
4.4.2 Flight to quality during the 2007-2009 financial crisis 189
4.4.3 Controlling for non-conventional monetary policy: forward 194
guidance
4.4.4 Controlling for non-conventional monetary policy: LSAP 197
programmes
4.4.5 Flight to quality in the gold market 198
4.4.6 Further robustness checks 201
4.5 Conclusion 203
4.6 References for Chapter 4 204

Chapter 5: The International Stock Market Reaction to Federal Funds Rate Surprises:
Transmission during the Financial Crisis (Empirical Analysis)
5.1 Abstract 228
5.2 Introduction 228
5.3 Data and sample period 233
5.3.1 Measuring conventional monetary policy shocks 233
5.3.2 Asset price data and timing discrepancies 233
5.3.3 Proxies for real economic integration with the US economy, 236
financial linkages and macroeconomic factors
5.3.4 Descriptive statistics 237
5.4 Econometric models and results 237
5.4.1 Preliminary estimates 237
5.4.2 Structural change during the 2007-2009 financial crisis 241
5.4.3 Fixed-effects panel estimates 246
5.4.4 Determinants of international transmission of FFR shocks 248
5.4.5 Further robustness checks 256
5.5 Conclusion 258
5.6 References to Chapter 5 259

Page 6 of 295
Mr Aman Saggu., B.S., M.S.,
Chapter 6: Thesis Conclusion
6.1 Outline 284
6.2 Contribution of each chapter to the empirical literature 284
6.3 Implications of research 290
6.4 Avenues for future research 291
6.5 Publications 294
6.6 References 294

Page 7 of 295
Mr Aman Saggu., B.S., M.S.,
List of Tables
Chapter 3
Table 3.1 Descriptive statistics for target and unexpected FFR changes 146
Table 3.2 Response of US stock returns to unexpected FFR changes (sample 147
periods of pre-crisis studies), OLS estimates
Table 3.3 Response of US stock returns to unexpected FFR changes (sample 148
periods of crisis studies), OLS estimates
Table 3.4 Quandt-Andrews structural breakpoint tests 149
Table 3.5 Bai-Perron structural breakpoint tests 150
Table 3.6 Response of US stock returns to unexpected FFR changes, controlling 151
for the 2007-2009 crisis, OLS estimates
Table 3.7 Response of US stock returns to unexpected FFR changes, controlling 152
for the 2007-2009 crisis, robust MM-estimates
Table 3.8 Response of US stock returns to unexpected FFR changes, controlling 153
for state-dependence (pre-crisis sample), robust MM-estimates
Table 3.9 Response of US stock returns to unexpected FFR changes, controlling 154
for the 2007-2009 crisis and state-dependence, robust MM-estimates
Table 3.10 Response of US industry sector returns to unexpected FFR changes, 155
controlling for the 2007-2009 crisis, robust MM-estimates
Table 3.11 Response of US industry sector returns to unexpected FFR changes, 157
controlling for the 2007-2009 crisis and state-dependence (credit
market conditions), robust MM-estimates
Table 3.12 Response of US industry sector returns to unexpected FFR changes, 158
controlling for the 2007-2009 crisis and state-dependence (bear-
markets versus bull markets), robust MM-estimates

Chapter 3 Appendix
Table A3.1 Response of US stock returns to unexpected FFR changes, OLS 165
estimates
Table A3.2 List of unscheduled FOMC meetings with target FFR changes, 166
FOMC meetings with employment release reports and DFITS outlier
event-dates

Page 8 of 295
Mr Aman Saggu., B.S., M.S.,
Table A3.3 Response of US industry sector returns to unexpected FFR changes, 167
controlling for the 2007-2009 crisis and state-dependence (credit
market conditions), robust MM-estimates, excluding employment
Table A3.4 Response of US industry sector returns to unexpected FFR changes, 168
controlling for the 2007-2009 crisis and state-dependence (credit
market conditions), robust MM-estimates, excluding employment and
unscheduled
Table A3.5 Response of US industry sector returns to unexpected FFR changes, 169
controlling for the 2007-2009 crisis and state-dependence (bear-
markets versus bull markets), robust MM-estimates, excluding
employment
Table A3.6 Response of US industry sector returns to unexpected FFR changes, 170
controlling for the 2007-2009 crisis and state-dependence (bear-
markets versus bull markets), robust MM-estimates, excluding
employment and unscheduled
Table A3.7 Response of US stock returns to unexpected FFR changes, controlling 171
for the 2007-2009 crisis (Endogenous: Jan-08 to Mar-09) and state-
dependence, robust MM-estimates
Table A3.8 Response of US stock returns to unexpected FFR changes, controlling 172
for 2007-2009 crisis period, and state dependence (only outside the
crisis), robust MM-estimates
Table A3.9 Response of US stock returns to unexpected FFR changes, controlling 173
for state-dependence using the Pagan and Sossounov (2003) bear
dummy (pre-crisis sample), robust MM-estimates
Table A3.10 Response of US stock returns to unexpected FFR changes, controlling 174
for the 2007-2009 crisis and state-dependence using the Pagan and
Sossounov (2003) bear dummy robust MM-estimates

Chapter 4
Table 4.1 Dates of LSAP announcements 209
Table 4.2 Descriptive statistics for gold returns and US Treasury yield changes 210
Table 4.3 Response of US Treasuries to target FFR changes, OLS estimates 211

Page 9 of 295