expectations the exchange rate and the current account abstract a critical examination is undertaken of the relationship between the exchange rate and the current account in a small open economy theoretically the correlation between the exchange rate and the current account seems to be ambiguous in particular the association between movements in the exchange rate and the current account is likely to depend in an essential manner on the nature of exogenous disturbances affecting the two variables simultaneously lastly the question of the role of an optimal monetary policy and the choice of an exchange rate regime in an uncertain environment is raised

the determinants of realignment expectations under the ems some empirical regularities abstract the stability of the ems depends crucially on realignment expectations of the market participants in this paper we discuss how to measure such expectations and how to relate them to economic fundamentals central bank reputation and institutional arrangements of the ems we find the following empirical regularities for ff dm and il dm exchange rates 1 1 expected devaluations are positively related to the current exchange rate deviation from the central parity 2 2 expected devaluations are negatively related to the length of time since last realignment in the short and medium run 3 3 the basle nyborg agreements seem to have a stabilizing effect for both currencies examined albeit through different channels

convergence to the law of one price without trade barriers or currency fluctuations using a panel of 51 prices from 48 cities in the united states we provide an upper bound estimate of the rate of convergence to purchasing power parity we find convergence rates substantially higher than typically found in cross country data we investigate some potentially serious biases induced by i i d measurement errors in the data and find our estimates to be robust to these potential biases we also present evidence that convergence occurs faster for larger price differences finally we find that rates of convergence are slower for cities farther apart however our estimates suggest that distance alone can only account for a small portion of the much slower convergence rates across national borders

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

the purchasing power of money and nominal interest rates a re examination while it has been known for some time that under uncertainty the original version of the fisher hypothesis is not precisely correct empirical researchers have largely ignored this fact such an omission has possibly resulted in erroneous conclusions concerning other hypotheses most notably the impact of prices on the real economy this paper clarifies some of the previous interpretations of the existing empirical literature and provides a theoretical version of the relation between prices and interest rates empirical tests based on both the livingston survey data and data from time series forecasting models provide support for the fisher effect and the hypothesis that only covariance risk is priced in the treasury bill market one of the basic hypotheses concerning rationality in financial markets is based on statements generally attributed to fisher 18 fisher argued that the nominal or money rate of return on an asset should compensate an investor for his or her required real rate of return and changes in the purchasing power of money for the uncertainty case fisher replaced known purchasing power changes with the expected inflation rate whereas the fisher relationship under certainty is well defined his basic theorem under uncertainty is not precise as fama 15 has argued it is changes in the purchasing power of money not the inflation rate that should concern investors under uncertainty the expected value of one is not by jensen s inequality the inverse of the expected value of the other moreover fama and farber 16 grauer and litzenberger 20 and benninga and protopapadakis 3 have shown that when investors are risk averse the fisher relationship will generally not hold even after adjustment has been made for the distinction between purchasing power changes and the inflation rate in particular these authors show that an adjustment must be made for the fact that the real rate of return on nominal bonds is random while these issues have been discussed in the theoretical literature they have largely been ignored in the empirical work on this topic given the fact that nominal rates do not seem to adjust as rapidly to price changes as fisher hypothesized numerous empirical researchers have expanded the basic fisher model in an attempt to explain this empirical anomaly these extensions include the incorporation of a inflation rate variability and the growth in real output

efficient adaptation in long term contracts take or pay provisions for natural gas to mitigate the inflexibility of long term contracting for natural gas parties will look for terms that minimize the need for costly adjudication while maintaining incentives for appropriate adaptation the authors examine the incident of take or pay provisions in contracts between natural gas producers and pipelines from this perspective they argue that take obligations can be viewed as a mechanism for effecting appropriate incentives for contractual performance and show that efficient breach considerations define an optimal take percentage as a function of characteristics of the transaction these incentives are distorted by regulated price ceilings which cause the adoption of take obligations in excess of optimal levels the findings refute the common perception that take or pay provisions are just an artifact of wellhead price regulation and serve no useful purpose in the absence of regulation 20 references 1 figure 1 table

a model of international asset pricing under imperfect commodity arbitrage abstract this paper examines the effect of imperfect international commodity arbitrage i e violation of the law of one price modeled as the existence of non traded goods on the structure of purchasing power risk optimal portfolio rules of the risk averse investors and the equilibrium yield relationship among assets the major results of the paper include i there are two separate sources of purchasing power risk i e relative price risk and inflation risk relative price risk is specific to the country in which the investor resides ii in a world of n countries investors may hold n 1 hedge portfolios as vehicles to hedge against purchasing power risk facing different relative prices investors residing in different countries display divergent portfolio behavior iii in equilibrium investors are compensated in terms of excess return for bearing not only the systematic world market risk but also the systematic inflation and relative price risks

exchange rate variability and asset trade in popular discussion about the merits of different international monetary arrangements it is often maintained that increased exchange rate variability has a negative influence on international tra

the expectations management approach to stabilization in argentina during 1976 1982 abstract the main goals of the economic authorities in argentina during 1976 1982 were to open the economy to foreign trade and to reduce inflation the stabilization plan relied first on the control of money and wages later on a preannounced schedule of a declining future exchange rate actions that were supposed to be accompanied by a fiscal policy to reduce the public sector deficit the stabilization plan was abandoned in the first quarter of 1981 for two reasons an important financial crisis during the second quarter of 1980 and a deterioration of fiscal discipline that could no longer assure coherence between the deficit and the preannouncement schedule the paper also argues that the political situation in argentina undermined the credibility of the reforms and particularly the stabilization attempts with the abandonment of the stabilization schedule new commercial and exchange rate measures were gradually introduced reversing the policy of opening the economy to foreign trade the financial reform was reversed in 1982 with the virtual nationalization of deposits the experience of argentina suggests that capital inflows responding to interest rate arbitrage play a fundamental role in the short run dynamics of real exchange rates they can promote the adjustment or they can precipitate a run on the foreign exchange market the lesson is that a stabilization plan based on the preannouncement of future exchange rates is highly risky for an economy like argentina s

the effects of inflation on real interest rates one of the most obvious facts of recent monetary history is that high inflation is associated with high nominal interest rates this association has been interpreted by many as supporting a superneutrality hypothesis that an increase in inflation will not affect real interest rates in the long run however the bulk of the evidence contradicts superneutrality beginning with irving fisher 1896 1930 most empirical investigations have found that fully anticipated inflation has less than a unit effect on nominal interest rates and thus reduces real interest rates even in the longest of runs this has been shown under the assumption that expectations are formed rationally douglas pearce 1979 that they take the form of an arbitrary distributed lag on past inflation rates fisher 1930 william gibson 1970 or that they are accurately represented by the livingstone expectations data pearce kajal lahiri 1976 lawrence summers 1983 attempted to measure the long run effect without an explicit theory of expectations regressing long swings in various nominal interest rates against long swings in inflation over various subintervals from 1860 to 1979 he found coefficients consistently less than unity for the post world war ii era as a whole the coefficients were in the range of 0 5 to 0 75 with standard deviations of 0 08 to 0 33 a few studies have found coefficients close to unity william yohe and denis karnosky 1969 martin feldstein and otto eckstein 1970 gibson 1972 lucas but as several authors have observed thomas sargent 1976 robert shiller 1980 john wood 1981 summers these findings are limited to a particular period of u s history approximately 1953 71 furthermore even a unitcoefficient would contradict superneutrality of the after tax real interest rate which would require a coefficient substantially greater than unity even taking into account the other inflation distortions in the tax system summers calculated that the coefficient ought to lie in the range of 1 3 to 1 5 far higher than observed these empirical findings pose a challenge to traditional monetary theory much of which implies that superneutrality should hold at least approximately for example the model of miguel sidrauski 1967 implies that the real interest rate should equal the marginal product of capital which in the long run should equal the representative household s marginal rate of time preference if this rate of time preference is a constant then in particular it will be independent of the rate of inflation if it is positively related to the household s wealth or utility then inflation can reduce the marginal product of capital somewhat through what are commonly called mundell tobin effects that is higher inflation can reduce the demand for real balances which reduces real wealth which lowers the rate of time preference and leads to further capital accumulation 2 but this real balance effect on saving is commonly recognized to be too small to make department of economics social science centre university of western ontario london canada n6a 5c2 we are grateful to charles adams norman cameron john chilton jacob frenkel david laidler ben mccallum baldev raj brad reid jack weldon john whalley ron winrck and two anonymous referees for helpful discussions and comments on earlier drafts all errors are attributable to transaction costs robert lucas 1980 finds empirical support for the hypothesis which he calls one of the central implications of the quantity theory of money it has also been adopted by a wide range of more eclectic economists as evidenced by its endorsement in two of the most popular macroeconomics textbooks rudiger dornbusch and stanley fischer 1981 pp 454 58 robert j gordon 1978 pp 289 91 2these implications of variable time preference can be drawn almost immediately from the work of hirofumi uzawa 1968 a graphical analysis is presented by david laidler 1969b who focuses on the logically equivalent question of the effects of paying interest on money

renegotiation design with unverifiable information this paper considers a buyer seller relationship with observable but unverifiable investments and or random utility parameters in such situations it is known that contract renegotiation may prevent the implementation of first best outcomes in this paper we show however that efficient investments and optimal risk sharing can typically be achieved provided the initial contract is able to monitor the ex post renegotiation process specifically we focus on the following two features of renegotiation design first default options in case renegotiation breaks down second the allocation of all bargaining power to either contracting party moreover we show that these two features can be obtained in standard rubinstein bargaining games through contractual provisions such as specific performance clauses and penalties for delay or equivalently financial hostages refundable without interest

effects of monetary disturbances on exchange rates with risk averse speculation abstract this paper develops a macroeconomic model in which domestic and foreign bonds are perfect substitutes on a covered basis but in which speculators are assumed to be risk averse we analyze the effects of various transitory and permanent disturbances on the economy and show how the existence of the risk premium known to exist under such conditions has important implications for macroeconomic behavior most of our attention is devoted to how the economy responds to temporary and permanent changes in the money and bond supplies and in the central bank s forward market position the effects of disturbances in the foreign price level and interest rate are also briefly discussed

co specific investments hold up and self enforcing contracts abstract this paper offers a general model of the hold up problem when investments are co specific agents are risk neutral and there are no information asymmetries nash bargaining with outside options determines the division of the surplus arising from exchange the model formally demonstrates that reciprocal exposure to specific assets achieved via the partial redistribution of specific investment costs to the potentially opportunistic party serves as a credible commitment to mutually advantageous exchange

price index convergence among united states cities we study the dynamics of price indices for major u s cities using panel econometric methods and find that relative price levels among cities mean revert at an exceptionally slow rate in a panel of 19 cities from 1918 to 1995 we estimate the half life of convergence to be approximately nine years the surprisingly slow rate of convergence can be explained by a combination of the presence of transportation costs differential speeds of adjustment to small and large shocks and the inclusion of nontraded goods prices in the overall price index do price indices in major u s cities share a common trend and if so how quickly do they revert to that trend following a local shock to the price index to answer this question we study the dynamics of consumer price indices for 19 major u s cities over the period from 1918 to 1995 the panel time series methods we employ are now commonly used for studying real output growth rates and levels of real exchange rates across countries we estimate that price index divergences across u s cities are temporary but surprisingly persistent with a half life of nearly nine years our research has two primary motivations first we hope to gain a better understanding of the sources of persistence in the deviations from purchasing power parity ppp found in studies of national price indices and exchange rate data second and more importantly we see the european monetary union as having many similarities to the united states and believe that studying the behavior of prices across u s cities will help us in understanding the likely nature of inflation convergence in the euro area the european central bank s stated inflation objective is a year on year change in the harmonized index of consumer prices hicp of not more than 2 but how large might we expect regional deviations from this euro area wide average to be and how long are they likely to persist the lack of data prevents us from answering this question directly using european prices under monetary union instead we look to the united states a mature common currency area of similar regional diversity size and industrial development

the persistence of the peso problem when policy is noisy abstract the peso problem the market s belief that a discrete event may occur has frequently been blamed for the persistence of on average mistaken forecasts of macroeconomic variables this paper demonstrates how beliefs that a policy process may have switched can induce apparent ex post biased forecasts of exchange rates even after the switch has occurred furthermore during this peso problem period exchange rates may appear to contain a speculative bubble component since they will systematically deviate from the levels implied by observing fundamentals ex post and the conditional variance of exchange rates will exceed the variance implied by observing fundamentals

contract duration and relationship specific investments empirical evidence from coal markets this paper examines the importance of specific relationship investments in determining the duration of coal contracts negotiated between coal suppliers and electric utilities data for 277 coal contracts are used to perform the analysis the results provide strong support for the view that buyers and sellers make longer commitments to the terms of future trade at the contract execution stage and rely less on repeated bargaining when relationship specific investments are more important

money bonds and foreign exchange in the theory of finance capital markets provide securities which allow the ownership of productive assets to be allocated among investors according to their willingness to bear risk in exchange for return and independently of their tastes for the productive services provided by the assets this paper uses the theory of finance to study the role of money as a productive asset and the transformation of money into a portfolio asset true to its purpose the capital market provides securities nominal bonds that allow an allocation of the current services of the money supply according to its current productivity and without regard for its future purchasing power risk and an allocation of the future purchasing power risk of the money supply according to the willingness of investors to bear this risk in exchange for return and without regard for investor needs for the future transactions services of money in open

supplier performance in vertical alliances the effects of self enforcing agreements and enforceable contracts the paper examines the significance of enforceability and adaptability in governing vertical alliances and their performance ramifications for suppliers literature on supplier relations suggests that suppliers are skeptical of close ties with their buyers helper 1991 helper and sako 1995 such skepticism persists in spite of the fact that buyers are writing longer enforceable contracts with fewer suppliers in this context the paper develops a transaction cost economics tce based model that distinguishes between the verifiable and nonverifiable aspects of governance attributes of safeguards incentive intensity and adaptability in explaining supplier performance variations the paper argues that the following factors prove valuable for suppliers 1 the adaptive and collaborative orientation fostered by the original equipment manufacturer s oem s credible commitment to the exchange and by information sharing on the part of the supplier 2 the presence of certain nonverifiable safeguards and 3 the incentives inherent in target pricing these assertions have been tested using data from the home appliance industry results indicate that information sharing together with 1 oem dependence and 2 target pricing does indeed enhance supplier performance also results suggest that while nonverifiable safeguards can help verifiable safeguards do not have a positive association with supplier interests under certain conditions then suppliers can venture into closer relationships with buyers and benefit

price uncertainty and the exchange rate risk premium abstract this paper develops a simple two country portfolio model of the exchange rate risk premium which incorporates price uncertainty in both countries it is shown how the risk premium depends on the world shares of outside assets and wealth as well as on the variance covariance matrix of prices and the exchange rate in particular when purchasing power parity holds the distribution of world wealth has no effect on equilibrium asset prices

measuring regional cost of living accurate measures of regional cost of living are vital to businesses and individuals we compare a commonly used regional cost of living index produced by the american chamber of commerce research association accra to an index we calculate using consumer price index data and research from kokoski cardiff and moulton we find significant differences between the accra and the new indexes that are likely due to theoretical design data collection and sampling design the comparison of these indexes highlights sources of differences in regional cost of living measures and suggests caution in the use of accra indexes

pricing capital assets in an international setting an introduction this paper shows how differences across countries of 1 inflation rates 2 consumption baskets of investors and 3 investment opportunity sets of investors matter when one applies capital asset pricing models in an international setting in particular the fact that countries differ is shown to affect the portfolio held by investors the equilibrium expected returns of risky assets and the financial policies of firms

mitigating contractual hazards unilateral options and contract length in this article we consider the ways in which the desire for efficient low cost adaptation to change influences the tradeoff between the design and duration of long term contractual relationships we examine the distortions in contract terms occasioned by nonprice competition for natural gas in the presence of wellhead price regulation deviations from optimal contract incentives significantly raise the cost of being bound to long term agreements and shorten the duration of contracts the approach we adopt suggests a method for empirically assessing the efficiency of alternative contracting practices and legal standards

commodity own rates real interest rates and money supply announcements abstract this paper develops a measure of the real interest rate that is based on commodity own rates the rate at which one can contract to exchange units of a commodity today for units of the commodity in the future we use this measure to study the impact of money supply announcements on the real interest rate we find that money shocks have little effect on one and three month real interest rates however there is a strong positive relation between money shocks and six and twelve month real interest rates

optimum consumption and portfolio rules with money as an asset this article generalizes merton s optimum consumption and portfolio rules in continuous time by introducing money as a capital asset and allowing for uncertain inflation assuming that prices are log normally distributed a three funds theorem is derived and the introduction of money is shown not to change the form of the standard inflation adjusted capm but to change the market price of risk the individual s consumption portfolio problem is completely solved under uncertain inflation if his utility function is iso elastic in its arguments comparative statics are used to assess the influence of changes in exogenous parameters on the individual s optimal rules

international asset pricing with time varying risk premia abstract recent empirical evidence that forward exchange rates are biased predictors of future spot rates can also be interpreted as evidence against the hypothesis of a constant risk premium consequently reconciliation of this evidence with efficient international capital markets requires the existence of time varying risk premia this paper modifies kouri s 1977 asset pricing model to allow time varying exected returns on assets eliminates the assumption of a risk free real asset and derives the characteristics of the risk premia in the forward market as well as the equilibrium yield relationships among the equities and riskless nominal bonds of all countries

what can us city price data tell us about purchasing power parity abstract we study the dispersion of absolute price levels for us cities since 1918 by absolute price levels we mean price indices that measure the cost of a given consumption basket at each point in time we find strong evidence that city price levels converge over time and that the dispersion of price levels is lower for us cities than between oecd countries we argue that price level convergence for us cities will produce bilateral real exchange rate nonstationarity in this case however nonstationarity is not evidence against purchasing power parity ppp rather it is the consequence of improved market integration

unbiased estimation of the half life to price index convergence among u s cities estimates of the half life to convergence of prices across a panel of cities are subject to bias from three potential sources inappropriate cross sectional aggregation of heterogeneous coefficients presence of lagged dependent variables in a model with individual fixed effects and time aggregation of commodity prices this paper finds no evidence of heterogeneity bias in annual cpi data for 17 u s cities from 1918 to 2006 but correcting for the nickell bias and time aggregation bias produces a half life of 7 5 years shorter than estimates from previous studies

real interest rate parity new measures and tests abstract international financial theory implies that for international comparisons the appropriate measure of the real interest rate is one defined in terms of traded goods prices alone new measures of the real interest rate are constructed using changes in price indexes for traded goods as deflators these new measures are tested for international real rate equality and the results are compared to those of similar tests using measures based on the change in the cpi and the wpi there are important differences between the traded goods real rate measures and those based on either the cpi or the wpi however in general the tests support the hypothesis that the real interest rate is approximately measured in terms of traded goods jel f30

diversification of macroeconomic risk and international integration of capital markets the case of mexico this article tests the arbitrage pricing theory in the context of the unstable macroeconomic years in mexico 1977 87 using information on returns on assets available to domestic investors primarily stocks traded at the local stock exchange an attempt is made to ascertain the extent to which these assets have offered premia for a set of proposed sources of risk the pervasive factors that play an important role in asset pricing in mexico are unexpected inflation unexpected money growth innovations in the standard poor s 500 price series and innovations in the dollar oil price a residual market factor is obtained using the mcelroy and burmeister model given that these risks get premia over and above the riskless rate expected rates of return in mexico have been higher during the years of erratic macroeconomic conditions mexico is not considered to be well integrated with the international capital markets because local sources of risk such as inflation are not priced in the united states whereas international sources of uncertainty such as oil price shocks are priced locally but not in the united states capital markets are becoming increasingly important in developing countries because of the international debt problem it seems unlikely that semi industrial nations will be able to raise substantial amounts of funds in the international financial markets the development and growth of modern domestic capital markets will allow these economies to tap additional savings and to improve the allocation of scarce funds organized and liquid capital markets are a vital factor in promoting overall development they provide a means of allocating capital to alternative private and public projects and they furnish essential information for evaluating investment undertakings ross 1978 black 1988

a model of uk real effective exchange rate behaviour an integrated model of the uk real effective exchange rate is examined which links purchasing power parity with trade flow and asset market mechanisms furthermore time series and econometric analysis using quarterly data from 1972 to 1987 are applied the results obtained are broadly consistent with this model and imply that the uk real effective exchange rate index is constant in the long run

forward foreign exchange rates expected spot rates and premia a signal extraction approach in this paper we implement a methodology to identify and measure premia in the pricing of forward foreign exchange that involves application of signal extraction techniques from the engineering literature diagnostic tests indicate that these methods are quite successful in capturing the essence of the time series properties of premium terms the estimated premium models indicate that premia show a certain degree of persistence over time and that more than half the variance in the forecast error that results from the use of current forward rates as predictors of future spot rates is accounted for by variation in premium terms the methodology can be applied straightforwardly to the measurement of unobservables in other financial markets there exists a growing body of empirical research on premia in the pricing of forward foreign exchange conditional on the hypothesis that the foreign exchange market is efficient or rational the existence of time varying premia has been documented in the literature by fama 6 hansen and hodrick 10 11 hodrick and srivastava 15 16 hsieh 171 and korajczyk 20 frankel 9 fails to identify such premia and domowitz and hakkio 51 obtain different results for different currencies

collapsing exchange rate regimes abstract the paper develops models of speculative runs and collapse of fixed exchange rate regimes which result from credit policies that are ultimately inconsistent with a fixed exchange rate while no substantially new results are offered the formulation itself is of interest in highlighting the important ideas that have emerged in this area we modify the flood garber model to make the analysis more comparable with the deterministic case specifically we assume that the money growth process is specified in terms of growth rates rather than absolute increments and as a uniform rather than exponential distribution the modified analysis lends itself to a simple geometric interpretation of the krugman and flood garber models highlighting the important difference between the deterministic and stochastic models in the former the speculative attack run is concentrated in the latter the transition to floating is diffuse reserve losses exceed increases in domestic credit because of a rising probability of transition and reserve depletion accelerates on the way to the regime change

the forward exchange rate and macroeconomics abstract this paper discusses the conditions under which a risk premium is incorporated in the forward exchange rate a new condition for the existence of a risk premium is proposed we show that earlier models of the risk premium which emphasize either the role of net foreign investment or of the relative supplies of outside assets are not suited for assessing the effects of changes in macroeconomic policy

signalling and renegotiation in contractual relationships this paper examines how the possibility of renegotiation affects contractual outcomes in signaling games when an infinite number of rounds of renegotiations are allowed before contracts are executed the main results of the paper are 1 contracts may still contain distortions 2 the popular efficient separating equilibrium outcome is never an equilibrium outcome with renegotiation 3 incentive compatibility constraints can be generalized to incorporate renegotiation 4 equilibrium outcomes can be separating and nevertheless depend on the uninformed player s prior and 5 renegotiation in signaling games may lead to outcomes similar to equilibrium outcomes of screening games in which multiple contract purchases are allowed copyright 1993 by the econometric society

financial policy and speculative runs with a crawling peg argentina 1979 1981 abstract in this paper we present a model of a balance of payments crisis and examine the argentine experiment with a crawling peg between december 1978 and february 1981 the approach taken allows us to examine the evolution of a crisis when a collapse is not perfectly foreseen and yields plausible estimates of one month ahead probabilities of a collapse of the crawling peg the results suggest that the viability of an exchange rate regime depends on the consistency of exchange rate policy with domestic credit policy if the two are not consistent confidence in exchange rate policy is undermined

rational and self fulfilling balance of payments crises speculative attacks on a pegged exchange rate must sometimes occur ifasset price paths are to be free of abnormal profit opportunities suchattacks are fully rational as they reflect the market s response to aregime breakdown that is inevitable the authors shows that under someexpectations about policy balance of payments crises can also be purely self fulfilling events in such cases even a permanently viableregime may collapse and the economy will possess multiple equilibriacorresponding to different subjective assessments of the probability ofa crisis the behavior of the domestic interest rate will naturally reflect the possibility of a speculative attack copyright 1986 by american economic association

on the effects of sterilized intervention an analysis of weekly data abstract as the recent empirical studies surveyed here illustrate it is very difficult to demonstrate that the exchange rate risk premium depends through a portfolio balance channel on the currency composition of outside assets the existence of a portfolio balance effect is a necessary condition for sterilized intervention to be a genuinely independent tool of monetary policy this paper studies u s canadian data and attempts to improve on earlier studies by using higher frequency weekly data and by implementing an appropriate instrumental variables technique 2s2sls however we still fail to detect evidence of a portfolio balance effect

international portfolio diversification with estimation risk international portfolio diversification has long been advocated as a way of enhancing average returns while reducing portfolio risk for the investor who considers diversifying into foreign securities this proposition however relies on the assumption that the required inputs to the classical mean variance analysis are known with certainty typically expected returns variances and covariances are simply replaced by their ex post sample values and the optimal portfolio is derived without mentioning the uncertainty inherent in these parameter values but the rational investor should take this uncertainty into account when forming expectations and probably will consider estimators that are less subject to estimation error than the classical sample mean this paper investigates alternative estimators of expected returns and their implications for the alleged gains from diversification an important observation is the crucial influence that errors in estimating expected returns have on portfolio analysis a closer examiprevious studies of international portfolio diversification have relied on ex post meanvariance analysis without considering the problem of estimation risk typically past averages are substituted for expected returns and no allowance is made for the uncertainty inherent in these parameter values first i demonstrate the shortcomings of such an approach and second i investigate another method of estimating expected returns initially proposed by stein by shrinking the sample averages toward a common mean i find that the out of sample performance of the optimal portfolio is substantially increased one of the implications of this method is that the classical conclusions vastly overestimate the possible gains in average returns instead benefits from diversification are more likely to accrue from a reduction in risk this paper draws on part of my dissertation at the university of chicago i am grateful to arnold zellner michael mussa george constantinides and especially john bilson for useful discussions and comments numerous improvements were also suggested by the referee this research received the generous financial support of the college interuniversitaire d etudes doctorales dans les sciences du management

nominal rigidity and monetary uncertainty in a small open economy temporary nominal rigidity is introduced into a dynamic stochastic general equilibrium model of a small open economy the foreign country is also modelled and is the closed economy counterpart of the domestic country we examine whether a small open economy is more vulnerable than a closed economy to uncertainty over its monetary policy a signal of an increase in future variability which was not previously foreseen as a risk by agents is shown to weaken the current exchange rate and boost current output in the small open economy in the equivalent closed economy it has no effect on current variables

trade in nominal assets monetary policy and price level and exchange rate risk in a previous paper trade in risky assets i have analyzed the pattern of international trade in risky real assets between barter economies relying on the law of comparative advantage and using autarky asset price differences to predict the pattern of asset trade in this paper the analysis is extended to international trade in nominal assets assets with returns paid in currencies between monetary economies the risk chracteristics of real returns on nominal assets depend on price level and exchange rate risk and therefore on monetary policy it is examined how different combinations of monetary policies and exchange rate regimes affect nominal assets return risk characteristics their autarky perices and hence their trade pattern when countries differ with respect to their outputs or their attitudes towards risk when world asset markets are incomplete different monetary policies and exchange rate regimes have dramatic effects on risk characteristics of home and foreign currency bonds and on the trade pattern in these assets as well as on aggregate capital and current accounts

an analysis of intertemporal pricing for forward foreign exchange contracts an asset pricing model with an unobservable time varying risk premium is used to price forward foreign exchange contracts specifically the term spectrum of forward foreign exchange contracts is examined in order to focus on country specific and maturityspecific information the testable restrictions imposed by the model are consistent with both cross country and cross maturity forward contracts except at the short end of the maturity spectrum for cross country forward exchange rates this indicates that the intertemporal model is relatively robust in valuing forward contracts of different maturities and for different exchange rates but that it may fail when there are significant short term country specific shocks theoretical and empirical studies have demonstrated that the forward exchange rate incorporates a time varying risk premium in addition to an expected future spot exchange rate recent works by fama 9 and hodrick and srivastava 21 reveal the importance of the risk premium by showing that the variability in risk premiums exceeds the variability in expected change in spot exchange rates these results are very general in that they are based on the definition that equates the forward exchange rate to the expected future spot exchange rate and a risk premium term a logical but more demanding next step is to model and conduct specification tests of the risk premium itself the purpose of this paper is to use an intertemporal latent variable assetpricing model ilvm to examine the risk return characteristics of the term structure of forward foreign exchange contracts more specifically the ilvm is used to price various bilateral dollar forward exchange contracts for each maturity as well as the different maturities for each bilateral forward exchange contract the ilvm was first utilized by hansen and hodrick 16 and hodrick and srivastava 20 to examine forward exchange risk premiums the two studies are however confined to just one month forward exchange contracts in addition the studies yield conflicting results the application of the ilvm to other

foreign exchange futures prices under fixed exchange rates abstract this paper develops three models for the determination of foreign exchange futures prices under fixed exchange rates and expectations of devaluation these models show that certain characteristics of futures prices behavior that have been used as proof of inefficiency may be present even if the market is efficient they also have several implications that are consistent with the observed behavior of mexican pesos futures prices

unbiased estimation of the half life to ppp convergence in panel data three potential sources of bias introduce complications for panel data estimation of the half life of purchasing power parity deviations they are bias induced by inappropriate cross sectional aggregation of heterogeneous coefficients small sample estimation bias of dynamic lag coefficients and bias induced by time aggregation of commodity prices all of these biases have been addressed individually in the literature in this paper we address all three biases in arriving at our estimates using an annual panel data set of cpi based real exchange rates for 21 oecd countries from 1973 to 1998 we obtain a point estimate of the unbiased half life of 3 0 years with a 95 confidence interval of 2 3 4 2 years

currency preferences purchasing power risks and the determination of exchange rates in an optimizing model most recent research on the theory of exchange rate determination treats the exchange rate as the relative price of two assets domestic money and foreign money the value of an asset depends on the distribution of its return however most of the research has dealt with models in which there is no uncertainty the present paper focuses on questions that cannot be addressed in a world of certainty because in such a world an asset is never risky it investigates how purchasing power risks affect the determination of exchange rates this investigation is pursued in a fairly general optimizing model the present research is related to some recent work in international economics and in financial economics it follows the approach of obstfeld 1981 and stockman 1980 in that it uses an optimizing model and takes into account the role of government transfers in the flow budget constraint of individuals as in calvo and rodriguez 1977 stockman 1980 and others the fact that holdings of foreign monies are useful to domestic individuals is taken into account finally the paper uses techniques developed in papers in the finance literature which build on merton s 1973 asset pricing model and use a concept of equilibrium developed in

management of foreign exchange risk a review article this paper reviews the literature on foreign exchange risk management ferm which has burgeoned during the last decade scholars and practioners emerging interest in foreign exchange risk management was spurred by the advent of fluctuating exchange rates in the early seventies as well as by the pronouncement of the infamous fasb statement no 8 in 1976 which laid down unambiguous guidelines for consolidating financial statements of multinational corporations a normative rather than a market view of foreign exchange risk management is taken and accordingly the author reviews first the two key informational inputs necessary for any foreign exchange risk management program forecasting exchange rates and measuring exposure to exchange risk available decision models for handling transaction and translation exposures are reviewed next a concluding section identifies gaps in the existing literature and suggests directions for future research

evidence on the purchasing power parity in a panel of cities evidence is provided on the ppp hypothesis using a sample of 50 spanish cities for a long time period through the application of panel data unit root tests although results suggest non rejection of the ppp short run deviations as measured by half lives indicate that real factors might be causing a slow rate of convergence to a common price index even in highly integrated economies

frequency bias in consumers perceptions of inflation an experimental study we investigate whether the perception of economy wide inflation is affected by the frequency with which various goods prices are observed we provide novel experimental evidence that consumers perceptions of aggregate inflation are systematically biased toward the perceived inflation rates of the frequently purchased items this frequency bias may affect consumers consumption and investment decisions and thus have important macroeconomic consequences it may also explain why consumers typically over estimate inflation in surveys during periods where frequently purchased non durable goods are inflating faster than durables