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2003 Documento de Trabajo #153

Interest Rate Volatility and Nominalization

Most Latin American economies in the 1980’s and early 1990’s were burdened with extremely high inflation rates. Chile’s strategy to strengthen its financial market was to rely on inflation-linked securities. Indeed, indexation pervaded the whole economy for almost thirty years. However, the sharp decrease in the annual inflation rate over the last decade— from 26 percent in 1990 to 4 percent in 2001—led the Central Bank of Chile to set its monetary policy interest rate in nominal terms from August 2001 onwards. This paper analyzes the effect of nominalization on the behavior of nominal and inflation-linked interest rates. We find that nominalization has made nominal interest rates less volatile, while the opposite holds for inflation-linked interest rates. We use different volatility measures, and test the presence of structural breaks in unconditional variance by the Iterative Cumulative Sums of Squares (ICSS) algorithm. In addition, we model the co-movements of short and long maturity interest rates in the presence of volatility breakpoints. We also show that deposits in Chilean pesos have now a higher share of total deposits, and that trading of derivatives to hedge inflation risk has become much more active since nominalization took place. At the same time, the market of derivatives on interest rates also seems to have taken off.

Viviana Fernández