How to Exploit Central Bank Spending: A Theoretical Approach

Nils Alexander Bredegaard & Maximillian Frederik Gylling Andersen

Student thesis: Master thesis

Abstract

As central banks roll out quantitative easing programs across the world, many financial assets are purchased not because they exhibit great value or are thought to increase in value, but because they need to be purchased for an inflationary target. This paper will deal with purchases done by central banks by focusing on the European Central Bank and their Asset Purchase Program. This paper will try to exploit the purchases and see if mispricing from the quantitative easing program is introduced to the economy. In order to do so, a great understanding of where and how the asset purchases occur must be had as well as of how the effects of the purchases distributes over the assets while maintaining a view of how the different assets are treated by all market participants. This paper tries to highlight the influential factors within assets in order to exploit only specific components of the assets. The first part of the paper deals with an investigation of the ECB’s quantitative easing program’s effect on Euro-zone government bond yields and expected inflation. This part seeks to uncover whether expected inflation throughout the sample period has had an effect on government bond yields. This will be done through the use of single factor OLS models. Afterwards, the process will consist of a methodical dissection of bond yields which are then analyzed before and during QE with respect to their separate yield components. The components will afterwards be analyzed as if, QE had ceased and combined to find so-called shadow yields. Findings vary between countries as the effect of QE is found to be significant both with respect government bond yields and expected inflation throughout the Eurozone. This is most significant in central EU-member countries including Germany, France and Italy as well as long maturity bond yields especially. In the second part of the paper the findings of the first part are used to develop a theoretical relative value strategy, which concludes into a hedged portfolio of specific government bonds. The findings uncover a significant mispricing of bonds, given the termination of QE. This presents an investment opportunity with an expected return of 10.664% with an additional annual yield component of 0.299%.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2018
Number of pages150