Explaining European Short-term Interest Rate Differentials: An Application of Tobin's Portfolio Theory

This paper seeks to identify potential determinants of short interest rate differentials across European countries. We rely on the portfolio theory of Tobin to choose our set of risk factors and then assess the ability of these macroeconomic variables to influence both the conditional mean and volatility of interest rate differentials. The macroeconomic variables employed in the analysis may be loosely considered to reflect both domestic government fiscal and monetary policy and international influences.We find significant ARCH-in-mean effects, implying that the conditional volatility of the interest rate differential exerts an important influence in the determination of its mean value. There are also significant short-run contagion effects whereby volatility in the macroeconomic factors is transmitted to the overall riskiness of the differential which in turn impacts upon the level of the differential.