currency and credit markets abstract in this paper we focus on two aspects of the relationship between exchange rates and interest rates which have not been widely discussed first the extent to which the forward premia discount in one market can be used to predict the speculative return in the other second the extent to which unanticipated changes in the speculative returns are correlated across markets so that positions in one market can be hedged using positions in the other our results demonstrate that these two linkages are also important factors behind the time variation in speculative risk premia

education spillovers in farm productivity revisiting the evidence this paper exploits the social organization of india to revisit the question of education spillovers in farm productivity the fact that social interactions mainly occur within castes in rural india provides tools to show that the observed correlation between farm productivity and neighbors education is likely to be a spillover effect in particular there are no cross caste and no cross occupation effects which underlines that under specific assumptions which are stated and explored in the paper the education of neighbors does not capture the effect of group unobservables this evidence is complemented by separate estimations by crops which show results that are consistent with education spillovers the strategy used in this paper helps understand and interpret previous findings from the literature

measuring noise in exchange rate models abstract this paper conducts a race between models in terms of their ability to explain observed violations of uncovered interest parity this is done by comparing the empirical performance of the simple efficiency hypothesis and the models which assume the existence of risk premiums my analysis uses noise ratios which complement specification tests by showing the relative degree to which each model reconciles with the data the empirical results imply that the risk premiums introduced by the latent variable model could significantly explain the deviation of forward exhange rates from the expected future spot rates

predictable and profitable price patterns evidence from us interest rates abstract this paper detects a predictable response of short term eurodollar interest rate futures to us employment data during 1988 1993 a simulation with a trading rule derived from this predictable response generates systematic profits thus violating the efficient markets hypothesis

noisy signals in target zone regimes theory and monte carlo experiments abstract previous empirical evidence indicates that uncovered interest parity uip does not hold for target zone exchange rates like those in the european monetary system and in the nordic countries we explore a target zone model where the market infers the probability of a realignment of the band on the basis of a noisy signal we show theoretically and through monte carlo simulations that if the market overrates the information content in the signal then this may explain the empirical results obtained from testing uip for target zone exchange rates

the speculative efficiency hypothesis the hypothesis that forward prices are the best unbiased forecast of future spot prices is often presented in the economic and financial analysis of futures markets this paper considers the hypothesis independently of its implications for rational expectations or market efficiency and in order to stress this fact the term speculative efficiency is used to characterize the state envisaged under the hypothesis if a market is subject to efficient speculation the supply of speculative funds is infinitely elastic at the forward price that is equal to the expected future spot price the expected future spot price is a market price determined as the solution to the underlying rational expectations macroeconomic model although the paper is primarily concerned with testing this hypothesis in the foreign exchange market the methodology introduced in the paper is of general application to all futures markets this abstract was borrowed from another version of this item

continuous time model of uncovered interest parity with regulated jump diffusion interest differential this study investigates to what extent can an exchange rate model built on uncovered interest parity uip match the empirical features of the exchange rate and the interest differential data this article presents a continuous time model of uip in which the interest differential evolves following regulated jump diffusion simulation experiments show that the model is capable of matching several important features of the data inclusion of jumps improves the model to capture persistent dynamics of interest differential and fat tails in exchange rate returns compared to simple diffusion processes

predictability in financial markets what do survey expectations tell us abstract there is widespread evidence of excess return predictability in financial markets for the foreign exchange market a number of studies have documented that the predictability of excess returns is closely related to the predictability of expectational errors of excess returns in this paper we investigate the link between the predictability of excess returns and expectational errors in a much broader set of financial markets using data on survey expectations of market participants in the stock market the foreign exchange market the bond market and money markets in various countries the results are striking first in markets where there is significant excess return predictability expectational errors of excess returns are predictable as well with the same sign and often even with similar magnitude this is the case for foreign exchange stock and bond markets second in the only market where excess returns are generally not predictable the money market expectational errors are not predictable either these findings suggest that an explanation for the predictability of excess returns must be closely linked to an explanation for the predictability of expectational errors

the effects of surprise and anticipated technology changes on international relative prices and trade abstract this paper argues that it is important to distinguish surprise and anticipated components of total factor productivity tfp when we study the international transmission of tfp shocks we document that surprise and anticipated shocks to us tfp induce distinct dynamics for international relative prices the real exchange rate and the terms of trade and international trade real exports real imports and the trade balance our empirical findings can reconcile some conflicting empirical results in the literature and hence lead to a better understanding of the international transmission of tfp shocks in addition we evaluate a standard international macroeconomic model and discuss the mechanisms that may help to replicate our empirical findings

carry trades order flow and the forward bias puzzle we investigate the relation between foreign exchange fx order flow and the forward bias we outline a decomposition of the forward bias according to which a negative correlation between interest rate differentials and order flow creates a time varying risk premium consistent with that bias using 10 years of data on fx order flow we find that more than half of the forward bias is accounted for by order flow with the rest being explained by expectational errors we also find that carry trading increases currency crash risk in that order flow generates negative skewness in fx returns

assessing target zone credibility mean reversion and devaluation expectations in the erm 1979 1992 abstract the paper presents estimates of devaluation expectations for six erm currencies relative to the deutsche mark for the period march 1979 april 1992 both the simplest test and the drift adjustment method are used the simplest test adjusts interest rate differentials for the maximum and minimum expected rate of depreciation within the exchange rate band the drift adjustment method adjusts interest rate differentials by the estimated expected rate of depreciation within the band the latter method gives more precise estimates especially for short horizons and allows statistical inference and hypothesis testing expected rates of devaluation have generally fallen during the period still some devaluation expectations relative to the deutsche mark remain in 1992 except for the belgian luxembourg franc and the netherlands guilder expected rates of devaluation have fluctuated more than interest rate differentials

do momentum based strategies still work in foreign currency markets this paper examines the performance of momentum trading strategies in foreign exchange markets we find the well documented profitability of momentum strategies during the 1970s and the 1980s has continued throughout the 1990s our approach and findings are insensitive to the specification of the trading rule and the base currency for analysis finally we show that the performance is not due to a time varying risk premium but rather depends on the underlying autocorrelation structure of the currency returns in sum the results lend further support to prior momentum studies on equities the profitability to momentum based strategies holds for currencies as well

new evidence on the forward premium puzzle the forward premium anomaly exchange rate changes are negatively related to interest rate differentials is one of the most robust puzzles in financial economics we recast the underlying parity relation in terms of lagged forward interest rate differentials documenting a reversal of the anomalous sign on the coefficient in the traditional specification we show that this novel evidence is consistent with recent empirical models of exchange rates that imply exchange rate changes depend on two key variables the interest rate differential and the magnitude of the deviation of the current exchange rate from that implied by purchasing power parity

currency fluctuations in the post bretton woods era the international monetary landscape that has emerged since the felling of bretton woods is characterized by a hybrid exchange rate system that lies somewhere between the textbook polar cases of a gold standard and a pure float this system has relatively flexible exchange rates between major countries active central bank intervention in the market for the major currencies and predominantly fixed exchange rates relative to the dollar or to some basket of currencies for less developed countries and newly industrializing nations the majority of research on currency markets since the early 1970s has focused on the characteristics of flexible exchange rates under this hybrid regime my thesis is that this research has been unsuccessful the proportion of monthly or quarterly exchange rate changes that current models can explain is essentially zero even after the fact forecasts that use actual values instead of forecasted values of the explanatory variables cannot explain major currency movements over the post bretton woods era this result is quite surprising since exchange rate changes would be entirely unpredictable only in very special cases of the theoretical models discussed as the discussion below will argue it is not a general implication of market efficiency that exchange rates follow a random walk process 1

anticipated versus unanticipated terms of trade shocks and the j curve phenomenon abstract using a dynamic stochastic general equilibrium dsge model we examine the impact of anticipated and unanticipated terms of trade tot shocks on aggregate output inflation and the trade balance tb this allows us to offer an alternative explanation of the j curve phenomenon we find that an unanticipated tot shock increases real output as well as inflation but the j curve phenomenon may not exist under a certain condition however under the same condition an anticipated tot shock leads to the j curve effect we find that our main result concerning the j curve phenomenon continues to hold even if the assumption of rational expectations about the tot is relaxed further analysis reveals that the presence of a cost channel of monetary policy increases the intensity of the j curve effect assuming plausible parameter values while using a more general model calibration results support our theoretical predictions

the carry trade and fundamentals nothing to fear but feer itself the carry trade is the investment strategy of going long in high yield target currencies and short in low yield funding currencies recently this nave trade has seen very high returns for long periods followed by large crash losses after large depreciations of the target currencies based on low sharpe ratios and negative skew these trades could appear unattractive even when diversied across many currencies but more sophisticated conditional trading strategies exhibit more favorable payos we apply novel within economics binary outcome classication tests to show that our directional trading forecasts are informa tive and out of sample loss function analysis to examine trading performance the critical conditioning variable we argue is the fundamental equilibrium exchange rate feer expected returns are lower all else equal when the target currency is overvalued like traders researchers should incorporate this information when evaluating trading strategies when we do so some questions are resolved negative skewness is purged and market volatility vix is uncorrelated with returns other puzzles remain the more sophisticated strategy has a very high sharpe ratio suggesting market ineciency

can cross country portfolio rebalancing give rise to forward bias in fx markets abstract this paper develops a model of exchange rate dynamics that takes into account positions in foreign and domestic equities in addition to standard short term riskless securities the modeling of cross country stock holdings is motivated by evidence that a large and ever increasing proportion of currency flows has been directed toward national stock markets to the extent that there is not perfect risk sharing investors tend to hold currency risk and international equity risk as a bundle this paper examines the impact of such cross country covariance risk on the relationship between exchange rate returns and interest rate differentials in particular we show that the sign and magnitude of the coefficient on the lagged interest differential is governed by a type of time varying beta risk that reflects the conditional covariance between exchange rate returns and the return differential between foreign and domestic equities as this cross country beta is predominantly negative our results have direct implications on the empirical failure of the uncovered interest parity uip hypothesis suggesting that the traditional uip regression equation is confounded in a non standard nonlinear way by the presence of cross country equity flows simulation experiments show that accounting for such portfolio rebalancing activities may in part help to explain the anomalous slope coefficient associated with the forward premium

affine models of the joint dynamics of exchange rates and interest rates this paper extends the affine class of term structure models to describe the joint dynamics of exchange rates and interest rates in particular the issue of how to reconcile the low volatility of interest rates with the high volatility of exchange rates is addressed the in complete market approach of introducing exchange rate volatility that is orthogonal to both interest rates and the pricing kernels is shown to be infeasible in the affine setting models in which excess exchange rate volatility is orthogonal to interest rates but not orthogonal to the pricing kernels are proposed and validated via kalman filter estimation of maximal 5 factor models for 6 country pairs

the time variation of risk and return in the foreign exchange and stock markets this paper attempts to determine whether the fluctuations of conditional first and second moments which are observed for many assets are consistent with the sharpelintner mossin capital asset pricing model we test the mean variance model under several different assumptions about the time variation of conditional second moments of returns using weekly data from july 1974 to december 1986 that include returns on a portfolio composed of dollar deutsche mark sterling and swiss franc assets together with the u s stock market the results indicate that estimated conditional variances cannot explain the observed time variation of risk premia rates of return on international financial assets are characterized by statistical properties that are quite common to all financial markets they are highly volatile and largely unpredictable these properties make it very difficult to extract statistically reliable estimates of systematic exchange rate and assetprice movements and are at the root of the generally poor empirical performance of international asset pricing models nevertheless two important results have been uncovered by empirical researchers and can be considered a fair characterization of the data a expected returns on foreign assets vary over time cumby and obstfeld 1981 and the numerous articles that followed recently surveyed by frankel and meese 1987 b the volatility of returns of foreign assets also changes over time cumby and obstfeld 1984 hodrick and srivastava 1984 and hsieh 1988 among others as giovannini and jorion 1987 suggest the

a reexamination of the uncovered interest rate parity hypothesis abstract it is now widely known that the uncovered interest rate parity uip hypothesis which states that forward exchange rates are unbiased predictors of future spot exchange rates is generally rejected by empirical evidence we show in this paper by means of a cox et al 1985 model extended to a two country economy that a careful examination of the no arbitrage principle leads to a different formulation for this hypothesis roughly speaking this new formulation states that the expected future spot exchange rate is equal to the forward exchange rate multiplied by a term premium whose closed form expression can be derived moreover this multiplicative term premium reduces to 1 i e the standard uip hypothesis holds if and only if conditional variances are deterministic in short we show that rejection of the standard uip hypothesis is not surprising as long as arch effects have been evidenced in exchange rate data as a by product we provide a parametric and tractable specification for the so called risk premium i e the component of the expected exchange rate in excess of the forward exchange rate

efficiency testing revisited a foreign exchange market with bayesian learning abstract the paper re examines the efficiency hypothesis in the foreign exchange market the traditional efficiency testing equations are reviewed and a more general model is developed that incorporates bayesian revisions of devaluation expectations a number of properties regarding the pattern of the coefficients in efficiency testing equations are established the empirical estimation of the model by using data from the emerging foreign exchange market in greece confirms the properties of the theoretical model

tests of international capm with time varying covariances we perform maximum likelihood estimation of a model of international asset pricing based on capm we test the restrictions imposed by capm against a more general asset pricing model the betas in our capm vary over time as the supplies of assets change and as the conditional covariances or returns on those assets change we let the covariances change over time as a function of macroeconomic data and an alternative model allows the covariances to follow a multivariate arch process we also can identify a modified capm model with measurement error we find that the estimated capm performs much better when variances are not constant over time nonetheless capm is rejected in favour of the lessrestricted model of asset pricing

the forward bias in the ecu peso risks vs fads and fashions abstract forward rates of european currencies against the private and official ecu exhibit a bias similar to the one found in other data the cumby obstfeld fama cof regression coefficients are systematically below unity and two thirds of them are negative we use the discount of the private ecu relative to the official ecu as a measure of market scepticism or mistrust in one view this sentiment is based on peso risk fears of realignments and possibly also the risk of a meltdown of the private ecu relative to the official one alternatively the discount just reflects fads and fashions dichotomizing the data on the basis of the size of the discount in the private ecu we find that the cof beta strongly depends on the degree of mistrust and that the negative cof coefficients are generated by typically less than 20 of the data but the pattern fits the fads and fashion view better than the peso theory if the sentiment factor contains a conventional risk premium at all then this risk premium is definitely not the one predicted by bansal bansal r 1997 an exploration of the forward premium puzzle in currency markets review of financial studies 10 369 403 nor is the sentiment factor proxying for huisman et al s huisman r koedijk k kool c nissen f 1998 extreme support for uncovered interest parity journal of international money and finance 17 211 228 transaction cost effects

intertemporal substitution in imported durables abstract this paper analyzes the hitherto unexplored relation between expected exchange rates and import prices of durable goods the distinguishing feature of durable goods is their asset like quality implying that their current and future sales are substitutable durability induces intertemporal substitution hence expected exchange rates affect the current price of imported durables although the sign of the effect cannot be determined by theory only the evidence shows that an expected appreciation raises the current import price of durables

cross currency cross maturity forward exchange premiums as predictors of spot rate changes theory and evidence abstract this paper shows that in predicting the spot rate of a currency the term structures of forward premiums of other currencies have incremental information content in addition to the term structure of the currency s own forward premiums the theoretical model motivating the analysis hinges on the abundant evidence on the co movements of excess returns from investing in different currencies the empirical results are obtained through fiml estimation of a vector error correction model for weekly data on three bilateral us dollar exchange rates

foreign banks and foreign currency lending in emerging europe based on survey data from 193 banks in 20 countries we provide the first bank level analysis of the relationship between bank ownership bank funding and foreign currency fx lending across emerging europe our results contradict the widespread view that foreign banks have been driving fx lending to retail clients as a result of easier access to foreign wholesale funding our cross sectional analysis shows that foreign banks do lend more in fx to corporate clients but not to households moreover we find no evidence that wholesale funding had a strong causal effect on fx lending for either foreign or domestic banks panel estimations show that the foreign acquisition of a domestic bank does lead to faster growth in fx lending to households however this is driven by faster growth in household lending in general not by a shift towards fx lending

testing for market timing ability abstract in this paper we examine the henriksson merton test of market timing and its potential usefulness in evaluating investment advice the paper proposes a natural extension of the test that is valid under more general assumptions about the distribution of asset returns we show that the henriksson merton test and its more general counterpart are special cases of standard tests of market rationality and efficiency both tests are applied to a group of foreign exchange advisory services

an equilibrium model of exchange rate determination and asset pricing with nontraded goods and imperfect information this paper presents a two country model with maximizing households stochastic production stochastic money growth and perfect capital mobility because of the presence of nontraded goods households in different countries consume different goods analytic solutions are presented for the nominal exchange rate the real exchange rate nominal interest rates and real interest rates it is shown that the model is compatible with some important features of the real world behavior of exchange rates when households are imperfectly informed about the distribution of money growth the exchange rate exhibits patterns of overshooting and is more volatile than the ratio of the money stocks copyright 1987 by university of chicago press

the risk adjusted uncovered equity parity abstract this paper explores the risk adjusted uncovered equity parity model to investigate a degree of market integration for four asian emerging markets relative to the u s japan and the u k from january 1994 to july 2008 the uncovered equity parity is revised to take into account of market risk in a framework of a portfolio rebalancing model evidence was found to strongly support our hypotheses market risk is significant in international capital flows between the asian emerging markets and the developed economies and it can help explain the failure of a traditional uncovered equity or interest parity model the relationship between returns and an appreciation of the exchange rate are divided between the asian emerging markets and the developed economies depending on the direction of capital flows

beating the foreign exchange market filter rule profits found in foreign exchange markets in the early days of the current managed float persist in later periods as shown by statistical tests developed and implemented here the test is consistent with but independent of a wide variety of asset pricing models the profits found cannot be explained by risk if risk premia are constant over time inclusion of the home foreign interest rate differential in computing profits has little effect on the comparison of filter returns to those of buy and hold in the early years of the generalized managed floating that began in march 1973 filter rule profits in excess of buy and hold were found for many countries logue sweeney and willett 18 dooley and shafer 6 cornell and dietrich 5 it was unclear however whether such profits indicated inefficiencies first it was not clear that risk was adequately handled in such tests and often risk was ignored second there was no evidence such profits would be available postsample and third there was no statistical test of the significance of these profits this paper uses the logic of risk return tradeoffs to analyze the role of risk in such tests and illustrates the logic in a discussion using the sharpe lintner capital asset pricing model capm although a breeden consumption based capm a merton intertemporal capm or an arbitrage pricing model apm could easily be used the paper develops a test of statistical significance appropriate to foreign exchange markets section i analyzing the rate of return on foreign exchange speculation less the foreign domestic interest rate differential the test explicitly assumes that risk premia are constant over the sample the excess rates of return observable in using filters in going from a risk free dollar asset to a risk free deutsche mark dm asset persist into the 1980 s section ii and this is true even when taking account of transactions costs it turns out that these results for the dm case do not depend very much on the interestrate differential but primarily on exchange rate behavior this is useful to know because it is often quite difficult to find matching interest rate data of high quality for a sample of nine other currencies using only exchange rates section iii shows that the excess returns made in the first 610 days of the float persist in the next 1 220 days into the 1980 s dooley and shafer 7 find similar persistence in experiments that do not use buy and hold and have no significance tests when filter rule profits have been found in spot exchange markets it has often been argued that the profits are due to risk this paper uses the capm to analyze rates of return both to buy and hold and to filter strategies it turns out that the claremont mckenna college and claremont graduate school arthur d warga douglas joines and thomas d willett offered helpful comments and ning ning koo provided research assistance

bank funding securitization and loan terms evidence from foreign currency lending we examine how bank funding structure and securitization activities affect the currency denomination of business loans we analyze a unique data set that includes information on the requested and granted loan currency for 99 490 loans granted to 57 464 firms by a bulgarian bank our findings document that foreign currency lending is at least partially driven by bank eagerness to match the currency structure of assets with that of liabilities our results also show that loan currency as well as loan amount and maturity are adjusted to make loans eligible for securitization

were the returns from stocks and bonds of different countries really different in the 1980 s we analyzed the total equity returns of indexes from australia canada germany japan the uk and the us and total fixed income returns of indexes from all but australia excluded due to lack of data to see if the returns of stocks and bonds were statistically different across markets during the 1980s at the end of 1989 these countries represented over 87 of the market capitalization of the morgan stanley capital international msci world equity index and over 88 of the salomon brothers world bond index this study used monthly observations from january 1980 through december 1989 and examined returns based in local currency and hedged and unhedged us dollars we found that sample mean stock and bond returns during the 1980s were statistically indistinguishable across countries however because the sample variances were so large relative to the sample means it would have been difficult to detect differences in population means by any test we found evidence of variance heterogeneity which may be

do asset demand functions optimize over the mean and variance of real returns a six currency test abstract international asset demands are functions of expected returns optimal portfolio theory tells us that the coefficients in this relationship depend on the variance covariance matrix of real returns but previous estimates of the optimal portfolio 1 assume expected returns constant and 2 are not set up to test the hypothesis of mean variance optimization we use maximum likelihood estimation to impose a constraint between the coefficients and the error variance covariance matrix for a portfolio of six currencies we are able statistically to reject the constraint evidently investors are either not sophisticated enough to maximize a function of the mean and variance of end of period wealth or else are too sophisticated to do so

changing beliefs and systematic rational forecast errors with evidence from foreign exchange this paper addresses a new interpretation to the appearance in the early 1980s of systematic errors in forecasting the dollar exchange rate following a change in the process of a fundamental variable market participants revise their beliefs about the process using bayes rule since the market does not immediately recognize the change forecast errors are on average wrong during a period when the market is rationally learning for conservative parameter values the learning behavior of the dollar exchange rate in the early 1980s appears consistent with about half of the dollar s underprediction implied by the forward market copyright 1989 by american economic association

a stochastic dominance analysis of yen carry trades abstract yen carry trades have made headline news for over a decade we examine the profitability of such trades for the period 2001 2009 yen carry trades generated high mean returns and sharpe ratios prior to the recent financial crisis they continued to outperform major stock markets for the full sample period given the non normality of carry trade returns we apply non parametric tests based on stochastic dominance sd to evaluate whether the high returns of yen carry trades are compatible with risk as reflected in returns on us and global stock market indices we apply a general test for sd developed recently by linton maasoumi and whang 2005 to six currencies as well as portfolios of these currencies for a large class of risk averse investors profits from yen carry trades cannot be attributed to risks

delayed overshooting is it an 80s puzzle we reinvestigate the delayed overshooting puzzle using a method of sign restrictions we find that delayed overshooting is primarily a phenomenon of the 1980s when the fed was under the chairmanship of paul volcker related findings are as follows 1 uncovered interest parity fails to hold during the volcker era and tends to hold during the post volcker era 2 us monetary policy shocks have substantial impacts on exchange rate variations but misleadingly appear to have small impacts when monetary policy regimes are pooled in brief we confirm dornbusch s overshooting hypothesis

the cyclical behaviour of wages and profits under imperfect competition the authors build a dynamic model of the business cycle with monopolistically competitive firms with simple assumptions concerning firm entry and exit the model can explain some stylized facts of the business cycle that standard real business cycle models cannot predict they include the cyclical behavior of the shares of capital and labor income in total income and the pattern of net firm creation these predictions are robust to whether the main source of the business cycle is aggregate supply shocks or aggregate demand shocks

exchange rate predictability the main goal of this article is to provide an answer to the question does anything forecast exchange rates and if so which variables it is well known that exchange rate fluctuations are very difficult to predict using economic models and that a random walk forecasts exchange rates better than any economic model the meese and rogoff puzzle however the recent literature has identified a series of fundamentals methodologies that claim to have resolved the puzzle this article provides a critical review of the recent literature on exchange rate forecasting and illustrates the new methodologies and fundamentals that have been recently proposed in an up to date thorough empirical analysis overall our analysis of the literature and the data suggests that the answer to the question are exchange rates predictable is it depends on the choice of predictor forecast horizon sample period model and forecast evaluation method predictability is most apparent when one or more of the following hold the predictors are taylor rule or net foreign assets the model is linear and a small number of parameters are estimated the toughest benchmark is the random walk without drift

anomalies foreign exchange most all behavior can be explained by assuming that agents have stable well defined preferences and make rational choices consistent with those preferences in markets that eventually clear an empirical result qualifies as an anomaly if it is difficult to rationalize or if implausible assumptions are necessary to explain it within the paradigm this column will present a series of such anomalies readers are invited to suggest topics for future columns by sending a note with some reference to or better yet copies of the relevant research comments on anomalies printed here are also welcome the address

accounting for forward rates in markets for foreign currency absteract forward and spot exchange rates between major currencies imply large standard deviations of both predictable returns from currency speculation and of the equilibrium price measure the intertemporal marginal rate of substitution representative agent theory with time additive preferences cannot account for either of these properties we show that the theory does considerably better along these dimensions when the representative agent s preferences exhibit habit persistence but that the theory fails to reproduce some of the other properties of the data in particular the strong autocorrelation of forward premiums since the advent of flexible exchange rates in the early 1970s a large body of statistical work has established that forward rates for major currencies are not optimal predictors of future spot rates relevant evidence is reported in studies by baillie lippens and mcmahon 1983 bekaert 1991 bilson 1981 boothe and longworth 1984 cumby 1988 cumby and obstfeld 1984 fama 1984 gregory and mccurdy 1984 hansen and hodrick 1983 hodrick and srivastava 1984 and korajczyk and viallet 1990 a more complete list of references is provided by hodrick 1987 these papers indicate that returns from speculation in forward and spot currency markets are predictable and that the predictable components vary considerably over time a number of alternative explanations have been offered for the predictable variation in foreign currency market excess returns kaminsky 1988 korajczyk 1985 and krasker 1980 suggest that infrequent extreme events may make returns appear predictable in small samples the so called peso problem lewis 1989 argues that rational learning following infrequent changes in the process governing equilibrium prices can explain part of the ex post predictability of currency returns froot and frankel 1989 and froot and thaler 1990 examine the hypothesis that market forecasts of future spot

risk aversion foreign exchange speculation and gambler s ruin the apparent persistence of unexploited opportunities for expected profits in foreign exchange markets suggests highly risk averse market participants financial institutions put tight limits on the foreign exchange positions they may have at risk at any time despite beliefs that the odds are favourable that the positions will be profitable this safety first practice is consistent with keeping the probability of ruin low enough to be of no practical concern the setting of a very low probability of ruin for prudential reasons provides a rationale for traders behaving as if they have a degree of risk aversion that might otherwise seem implausibly high

the forward bias is it a money tree abstract this paper examines the forward discount anomaly i e the fact that the forward exchange rate is a biased predictor of the future spot rate we run a series of rolling regressions which we use to predict the value of the future spot rate based upon this bias we show that the average return from an investment strategy based on the bias in forward exchange rates is in many cases insignificantly different from zero in other cases however the return is significantly positive hence the in sample bias does not necessarily lead to a money making strategy for all currencies

a test for speculative bubbles in the sterling dollar exchange rate 1981 84 the u s dollar price of the u k pound sterling is tested for a speculative bubble defined as a period with a nonzero median in excessreturns a nonparametric procedure is developed which controls for data mining over the period of flexible exchange rates and finds a negative bubble in the excess return to holding sterling rather than dollar assets during the period 1981 84 possible interpretations arebootstrap equilibria rational bubbles nonsym metric fundamentals and nonrational expectations copyright 1986 by american economic association

on biases in the measurement of foreign exchange risk premiums abstract the hypothesis that the forward rate is an unbiased predictor of the future spot rate has been consistently rejected in recent empirical studies this paper examines several sources of measurement error and misspecification that might induce biases in such studies although previous inferences are shown to be robust to a failure to construct true returns and to omitted variable bias arising from conditional heteroskedasticity in spot rates we show that the parameters were not stable over the 1975 89 sample period estimation that allows for endogenous regime shifts in the parameters demonstrates that deviations from unbiasedness were more severe in the 1980s jel f31

exchange rate risk premiums abstract a state space model which allows for the covariation of risk premiums and unexpected rates of depreciation is used to study exchange rate risk premiums we find that exchange rate risk premiums have a high degree of persistence and the covariance of risk premiums and unexpected rates of depreciation is negative regressions of the estimated risk premium on its determinants implied by the equilibrium model of lucas 1982 show limited support for the model jel f31

towards a loanable funds amended liquidity preference theory of the exchange rate and interest rate abstract the objective is to develop a unified theory of the exchange rate and interest rate using a loanable funds amended liquidity preference approach in order to provide a new perspective on many puzzling facts associated with the post bretton woods international economy it is shown that i a monetary expansion can initially raise the interest rate but depreciate the home currency ii real demand shocks can cause interest rate and exchange rate overshooting iii an infinite interest elasticity for capital flows cannot cause exchange rate overshooting if an extended marshall lerner condition holds iv the home currency can appreciate when the current account is negative if the extended marshall lerner condition is not satisfied and v changes in the disequilibrium regime will cause instability in the estimates of reduced form coefficients

a test of perfect substitutability in the foreign exchange market i motivations for the test the question of whether or not domestic bonds are perfect substitutes for foreign bonds in investors portfolios implying that the expected rates of returns must be equalized across currencies is an important one for two reasons the question is crucial first for choosing among various asset market models of exchange rate determination and second for evaluating tests of efficiency in the forward exchange market to illuminate the first motivation a brief discussion of models of exchange rate determination is necessary all asset market models share the assumption that there are no significant transactions costs capital controls or other impediments to the international flow of capital thus actual portfolios adjust instantaneously to equal desired portfolios this implies for example covered interest parity the domestic interest rate should differ from the foreign interest rate by an amount exactly equal to the forward discount rate perfect substitutability between domestic and foreign bonds is the stronger assumption that market participants are indifferent as to the currency composition of their portfolio it implies uncovered interest parity the domestic interest rate must differ from the foreign interest rate by an amount exactly equal to the expected rate of depreciation the perfect substitutability assumption is far from standard in fact exchange rate models within the asset market view can be classified into those that belong to the monetary approach defined by the assumption of perfect substitutability and those that belong to the portfolio balance approach defined by the assumption of imperfect substitutability in the portfolio balance approach investors hold well defined proportions of their wealth in the form of each country s assets with the proportions depending on the expected rates of return as in equation 1

a re examination of the unbiased forward rate hypothesis in the presence of multiple unknown structural breaks we test the unbiased forward rate ufr hypothesis using new tests for cointegration developed by hatemi j 2008a that allows for multiple unknown structural breaks we analyse the australian dollar aud euro eur british pound gbp and japanese yen jpy versus the us dollar usd spot rates and forward rates relationship during the period 5 january 1999 to 28 december 2006 we find that the ufr does hold when the effects of the unknown structural breaks are taken into account the parameters that we obtained were close to unity hence taking into account transaction cost and the existence of a risk premium earning arbitrage profits may still not be possible thus the markets for these currencies may still be considered as efficient

do multinationals operate flexibly theory and evidence do multinational enterprises operate flexibly i e do they shift production in response to currency changes three theoretical perspectives are developed flexibility optimism premised on information and sunk cost advantages takes a macro efficiency perspective and predicts sizable responses flexibility pessimism premised on inertia and internal opportunism takes an organizational perspective and predicts sticky responses flexibility realism premised on the view that to be flexible in the current period multinational enterprises need to have planned and invested accordingly in previous periods predicts positive but relatively modest responses empirical analysis spanning the period 1977 1993 finds that multinational enterprises systematically exploit currency shifts but even in the face of large exchange rate changes their operational responses are relatively modest the results appear most consistent with flexibility realism and this hypothesis is selected over the alternatives considered

the term structure of forward exchange premiums and the forecastability of spot exchange rates correcting the errors we develop a framework to extract information regarding subsequent spot rate movements from the term structure of forward exchange premiums while admitting possible deviations from rationality and

the euroization of bank deposits in eastern europe in central eastern and southeastern europe a substantial share of bank deposits are denominated in foreign currency deposit euroization poses key challenges for monetary policy and financial sector supervision on the one hand it limits the effectiveness of monetary policy interventions on the other hand it increases financial sector fragility by exposing banks to currency risk or currency induced credit risk policymakers disagree on whether countries in the region should tackle deposit euroization with dedollarization policies or should rather strive to adopt the euro as their legal tender assessing the potential effectiveness of dedollarization policies requires a clear understanding of which households hold foreign currency deposits and why they do so on the basis of survey data covering 16 375 households in ten countries in 2011 and 2012 we provide a comprehensive household level analysis of deposit euroization in central eastern and southeastern europe we examine how households preferences for and holding of foreign currency deposits are related to individual expectations about monetary conditions and network effects we also examine to what extent monetary expectations and deposit euroization are the legacy of past financial crises or the outflow of current policies and institutions in the region our findings suggest that deposit euroization in central eastern and southeastern europe can be partly tackled by prudent monetary and economic decisions by today s policymakers the preferences of households for euro deposits are partly driven by their distrust in the stability of their domestic currency which in turn is related to their assessment of current policies and institutions however our findings also suggest that a stable monetary policy may not be sufficient to deal with the hysteresis of deposit euroization across the region first we confirm that the holding of foreign currency deposits has become a habit in the region second we find that deposit euroization is still strongly influenced by households experiences of financial crises in the 1990s our findings question the effectiveness of supply side interventions e g bank regulation or demand side interventions e g local currency capital market development in de euroizing household savings first we show that deposit euroization is largely demand driven second we show that households already have access to a broad range of savings products in local currency

further evidence on exchange rate expectations abstract this paper considers a previously unexploited survey data set of exchange rate expectations which allows us to focus on differences between ems and dollar exchange rates we corroborate the earlier finding in the literature that exchange rate forecasts are not rational and that agents do not use all available information efficiently although extrapolative and adaptive expectations formation mechanisms describe non ems exchange rate expectations to a certain extent ems exchange rates forecasts seem to follow long run fundamentals more closely and would suggest that agents believe that ems exchange rate expectations undershoot their long run equilibrium values jel f31

the long run uncovered interest rate parity in view of a trading strategy uncovered interest rate parity uip states that bonds in different denomination should produce the same returns if the maturities of the bonds are the same given this if a foreign bond produces a lower holding period return than a home bond of the same maturity for their remaining lives the same foreign bond ought to produce a return higher than the home bond a test is designed according to this relationship with 1 to 6 year interest rate data of u s britain and germany from 1979 to 2005 our test shows that this relationship is more reliable for 6 year interest rates than the shorter rates in general this result lends support to the long run uip a trading strategy is developed by utilizing this idea we show that positive returns can be achieved by the strategy for bonds of longer horizons this result also serves as indirect evidence of the long run uip

uncovered interest parity it works but not for long abstract if an investor borrows in a low interest currency and invests in a high interest currency the interest differential accrues in a lumpy manner formally just like the dividend payments on a stock the investor will receive the interest differential discretely at the point when a position is rolled over from one day to the next a position that is not held open overnight receives no interest differential because intradaily interest rates are zero using a large data set of intradaily exchange rate data we run uncovered interest parity uip regressions over different short time intervals taking careful account of the settlement rules in the spot foreign exchange market we find results that are supportive of the uncovered interest parity hypothesis over very short windows of data that span the time of the discrete interest payment however adding even a few hours to the span of the window destroys the positive uncovered interest parity results

testing the hypothesis of market efficiency in the taiwan us forward exchange market since 1990 this article examines the applicability of the hypothesis of market efficiency in taiwan s foreign exchange market using daily data instead of linear regression based models we consider the possibility that the true data generating process may come from two different distributions and we employ the markov switching approach to analyse this from the results of the two state markov switching model we define state 1 as the efficient state and state 2 as the inefficient one only the 30 day forward rate is able to differentiate between the two states based on the unconditional probabilities from the markov switching model we also find that the 30 day forward rate has a 70 probability in the efficient state which indicates that 70 of all speculators fully extract information when predicting future spot rates while 30 of all investors do not

the road less travelled institutional aspects of data and their influence on empirical estimates with an application to tests of forward rate unbiasedness the difference between data used in empirical studies and that envisioned in the theory can influence empirical estimates sometimes by enough that the direction of future research is altered this paper illustrates how in the context of tests of forward rate unbiasedness a lack of articulation about the mechanics underlying foreign exchange market speculation and about the institutional aspects governing spot and forward rate contracts leads to sampling of the data in a way that is not consistent with the theory the authors find that the sampling problems account for some but not all of the bias in the coefficient on the forward premium copyright 1996 by royal economic society

a reconsideration of the uncovered interest parity relationship abstract this paper argues that the uncovered interest parity uip relationship is distinct from and more important than the unbiasedness of forward exchange rates as predictors of future spot rates the standard finding that the slope estimate b is roughly 3 in regressions of s t on t 1 s t 1 implies rejection of unbiasedness but not necessarily uip the hypothesis that monetary authorities manage interest rates so as to smooth their movements while also resisting changes in exchange rates is attractive conceptually and is capable of explaining not only the b 3 finding but also several other notable features of the data

where s the risk the forward premium bias the carry trade premium and risk reversals in general equilibrium abstract this paper builds a two country dynamic stochastic general equilibrium macro model to understand three empirical facts about international currency returns they are the downward forward premium bias the carry trade return and the long run risk reversal cross country heterogeneity in unit root productivity levels generates the systematic risk priced into currency returns the risk can be magnified through monetary policy both a complete markets and an incomplete markets model are qualitatively consistent with these facts quantitatively the incomplete markets model performs better

foreign exchange market efficiency tests implications of recent empirical findings abstract the recent empirical literature on the efficiency of the foreign exchange market has been characterized by strikingly contradictory conclusions drawn from similar empirical evidence these contradictions result because 1 different maintained hypotheses are held and 2 different criteria e g micro versus macroeconomic are used to judge the evidence in this survey we organize the empirical literature under several headings the presence of risk premiums empirical regularities in regression tests profitable trading rules and advanced econometric techniques in integrating this material we consider the implications of the current evidence for investors forecasters policy makers and theorists

risk premia carry trade dynamics and economic value of currency speculation in this paper we derive the dynamics and assess the economic value of currency speculation by formalizing the concept of a trader inaction range we show that exchange rate returns comprise a time varying risk premium and that uncovered interest parity uip holds in a speculative sense the often cited forward bias puzzle originates from the omission of the risk premium in standard uip tests consistent with its popularity among market professionals the carry trade strategy can be rationalized as it systematically collects risk premia and generates economic value when applied in multi currency portfolios

a cardan s discriminant approach to predicting currency crashes abstract this paper models large swings in exchange rates by introducing nonlinearity via the generalized normal gen distribution lye j n martin v l 1993 robust estimation nonnormalities and generalized exponential distributions journal of the american statistical association 88 261 267 as the distribution allows for bimodality a switch between modes may give rise to currency crashes a statistic known as cardan s discriminant based on the shape parameters of the gen is used to detect bimodality the cardan s discriminant is found to reliably predict currency crashes for eight emerging countries and generate relatively low false signals for stable currencies

exchange rate expectations and the pricing of chinese cross listed stocks abstract i show that the price discounts of chinese cross listed stocks american depositary receipts adrs and h shares to their underlying a shares indicate the expected yuan us dollar exchange rate the forecasting models reveal that adr and h share discounts predict exchange rate changes more accurately than the random walk and forward exchange rates particularly at long forecast horizons using panel estimations i find that adr and h share investors form their exchange rate expectations according to standard exchange rate theories such as the harrod balassa samuelson effect the risk of competitive devaluations relative purchasing power parity uncovered interest rate parity and the risk of currency crisis

liquidity premia and interest rate parity abstract due to the us dollar s dominant role for international trade and finance risk free assets denominated in us currency not only offer a pecuniary return but also provide transaction services both nationally and internationally accordingly the responses of bilateral us dollar exchange rates to interest rate shocks should differ substantially with respect to the us or foreign origin of the shock we demonstrate this empirically and apply a model of liquidity premia on us treasuries originating from monetary policy implementation the liquidity premium leads to a modification of uncovered interest rate parity uip which enables the model to explain an appreciation of the dollar subsequent to an increase in us interest rates if foreign interest rates follow the us monetary policy rate

investor overconfidence and the forward premium puzzle we offer an explanation for the forward premium puzzle in foreign exchange markets based upon investor overconfidence in the model overconfident individuals overreact to their information about future inflation which causes greater overshooting in the forward rate than in the spot rate thus when agents observe a signal of higher future inflation the consequent rise in the forward premium predicts a subsequent downward correction of the spot rate the model can explain the magnitude of the forward premium bias and several other stylized facts related to the joint behaviour of forward and spot exchange rates our approach is also consistent with the availability of profitable carry trade strategies

tests of three parity conditions distinguishing risk premia and systematic forecast errors abstract this study provides evidence that uncovered interest differentials between currencies cannot be attributed to either risk premia or systematic forecast errors alone the evidence is based on developing joint tests of three parity conditions uncovered interest parity purchasing power parity and real interest parity the study tests parameter restrictions based on knowing that risk premiums only affect nominal and real interest differentials but not inflation differentials while systematic errors in forecasting exchange rates only affect nominal interest differentials and inflation differentials but not real interest differentials the study finds a variety of cases where deviations from some or all of the parity conditions can be systematically related to variables currently known to investors and borrowers the most intriguing evidence is that for some currencies these deviations from parity are perfectly correlated as if they were driven by a common factor

conditional variance and the risk premium in the foreign exchange market abstract we investigate the existence of a risk premium in the foreign exchange market based on the conditional variance of market forecast errors the forecast errors are assumed to follow the arch process introduced by engle 1982 estimation and diagnostic testing of the model are discussed and results are presented for the currencies of the united kingdom france germany japan and switzerland