International Bond Market Cointegration Using Regime Switching Techniques

Abstract

This article uses MSCI bond index data to assess the degree of international bond market integration using modern cointegration techniques. Using daily data over a sample period from January 1994 to August 2006 the analysis shows that bond markets are indeed governed by a common long run relation that is subject to periodic structural change. The existence of such a common trend has important implications for both market efficiency and portfolio diversification arguments in favor of international diversification. The analysis adds to the existing literature by employing regime switching techniques to allow for structural change in the long run equilibrium. By allowing for occasional breaks in the central long run relation the analysis provides compelling evidence in favor of international bond market integration. The article shows that the prepayment-default model has significant explanatory power. Using the mortgage loan prices at origination, the model shows that OAS and duration depend on the FICO score, original loan-to-value ratio, the loan size and the recovery ratio. Lastly, a model of the economic value of a loan default guarantee is specified and the model shows that the price elasticities of the guarantee with respect to the loan size and the borrower's FICO score are −0.46 and −11.89 respectively.