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

temporal aggregation of an estar process some implications for purchasing power parity adjustment nonlinear models of deviations from ppp have recently provided an important theoretically well motivated contribution to the ppp puzzle most of these studies use temporally aggregated data to empirically estimate the nonlinear models as noted by taylor 2001 if the true dgp is nonlinear the temporally aggregated data could exhibit misleading properties regarding the adjustment speeds we examine the effects of different levels of temporal aggregation on estimates of estar models of real exchange rates our monte carlo results show that temporal aggregation does not imply the disappearance of nonlinearity and that adjustment speeds are significantly slower in temporally aggregated data than in the true dgp furthermore the autoregressive structure of some monthly estar estimates found in the literature is suggestive that adjustment speeds are even faster than implied by the monthly estimates

parity reversion in real exchange rates during the post bretton woods period abstract a common view among recent studies on purchasing power parity is that the post bretton woods period is far too short to reveal any significant parity reversion in individual series of real exchange rates is this really so the answer this study shows depends very much on the statistical test being used two efficient univariate unit root tests are applied to uncover parity reversion these tests require much shorter sample sizes than conventional tests to attain the same statistical power empirical results show that parity reversion can be unveiled over the modern float if an efficient unit root test is applied

quantifying the uncertainty about the half life of deviations from ppp we propose a bayesian framework in which the uncertainty about the half life of deviations from purchasing power parity can be quantified based on the responses to a survey study we propose a prior probability distribution for the half life under the recent float intended to capture widely held views among economists we derive the posterior probability distribution of the half life under this consensus prior and confirm the presence of substantial uncertainty about the half life we provide for the first time a comprehensive formal evaluation of several nonnested hypotheses of economic interest including rogoff s 1996 claim that the half life is contained in the range of 3 to 5 years we find that no hypothesis receives strong support from the data copyright 2002 john wiley sons ltd

factor models and time varying parameter framework for forecasting exchange rates and inflation a survey a survey of models used for forecasting exchange rates and inflation reveals that the factor based and time varying parameter or state space models generate superior forecasts relative to all other models this survey also finds that models based on taylor rule and portfolio balance theory have moderate predictive power for forecasting exchange rates the evidence on the use of bayesian model averaging approach in forecasting exchange rates reveals limited predictive power but strong support for forecasting inflation overall the evidence overwhelmingly points to the context of the forecasts relevance of the historical data data transformation choice of the benchmark selected time horizons sample period and forecast evaluation methods as the crucial elements in selecting forecasting models for exchange rate and inflation

are real exchange rates nonstationary evidence from a panel data test it is well documented that real exchange rates between the united states and many industrialized countries in the post bretton woods period are integrated this result implies that purchasing power parity ppp does not hold even as a long run relationship this paper demonstrates that the failure to reject the unit root hypothesis may result from the low power of existing univariate test procedures i test for unit roots in real exchange rates by employing a more powerful panel based procedure using both cpi and wpi real dollar exchange rate data i strongly reject the null hypothesis of a unit root my results provide overwhelming support for the long run ppp under the current float copyright 1996 by ohio state university press

using survey data to test standard propositions regarding exchange rate expectations survey data provide a measure of exchange rate expectations superior to the forward rate in that no risk premium interferes we estimate extrapolative adaptive and regressive models of expectations static or random walk expectations and bandwagon expectations are rejected current appreciation generates the expectation of future depreciation because variables other than the contemporaneous spot rate receive weight in comparing expectations to the process governing the spot rate we find statistically significant bias no variable is as ubiquitous in international financial theory and yet as elusive empirically as investors expectations regarding exchange rates in the past expectations have been modeled in an ad hoc way often by using the forward exchange rate there is however a serious problem with using the forward discount as the measure of the expected change in the exchange rate in that the two may not be equal the gap that may separate the forward discount and expected depreciation is generally interpreted as a risk premium most of the large empirical literature testing the unbiasedness of the forward exchange rate for example has found it necessary either arbitrarily to assume away the existence of the risk premium if the aim

the purchasing power parity persistence paradigm abstract rogoff journal of economic literature 1996 34 647 668 describes the remarkable consensus of 3 5 year half lives of purchasing power parity deviations among studies using long horizon data these studies however focus on rejections of unit roots in real exchange rates and do not use appropriate techniques to measure persistence our half life estimates explicitly account for serial correlation sampling uncertainty and most importantly small sample bias calculating confidence intervals as well as point estimates for long horizon and post 1973 data we find that even though most of the point estimates lie within the 3 5 year range univariate methods provide virtually no information regarding the size of the half lives

median unbiased estimation in df gls regressions and the ppp puzzle using median unbiased estimation recent research has questioned the validity of rogoff s remarkable consensus of 3 5 year half lives of deviations from ppp these half life estimates however are based on estimates from regressions where the resulting unit root test has low power we extend median unbiased estimation to the df gls regression of elliott rothenberg and stock 1996 we find that median unbiased estimation based on this regression has the potential to tighten confidence intervals for half lives using long horizon real exchange rate data we find that the typical lower bound of the confidence intervals for median unbiased half lives is just under 3 years thus while previous confidence intervals for half lives are consistent with virtually anything our tighter confidence intervals now rule out economic models with nominal rigidities as candidates for explaining the observed behavior of real exchange rates therefore while we obtain more information using efficient unit root tests on longer term data this information moves us away from solving the ppp puzzle

ppp strikes back aggregation and the real exchange rate we show the importance of a dynamic aggregation bias in accounting for the ppp puzzle we prove that the aggregate real exchange rate is persistent because its components have heterogeneous dynamics established time series and panel methods fail to control for this using eurostat data we find that when heterogeneity is taken into account the estimated persistence of real exchange rates falls dramatically its half life for instance may fall to as low as eleven months significantly below the consensus view of three to five years

a note on an interest rate immunization strategy abstract the mechanisms for insuring investments in stocks and bonds against depreciation have grown rapidly in the last decade insuring a portfolio entails managing it in such a way that the left hand tail of the return distribution is truncated the present paper demonstrates how this may be achieved for fixed interest securities discrete time hedging procedures are derived with the inclusion of transaction costs

real exchange rate behavior the recent float from the perspective of the past two centuries using annual data spanning two centuries for dollar sterling and franc sterling real exchange rates we find strong evidence of mean reverting real exchange rate behavior using simple stationary autoregressive models estimated on prefloat data we easily outperform nonstationary real exchange rate models in dynamic forecasting exercises over the recent float such stationary univariate equations explain 60 80 percent of the in sample variation in real exchange rates although the degree of short run persistence may be high the econometric estimates imply a half life of shocks to the real exchange rate of about 6 years for dollar sterling and a little under 3 years for franc sterling

why panel tests of purchasing power parity should allow for heterogeneous mean reversion recent studies of purchasing power parity ppp use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates in contrast to several other severe restrictions of panel models and tests of ppp the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored this paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies using monte carlo simulation we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing more specifically power functions are low and assume irregular shapes furthermore homogeneous estimates of the mean reversion parameters exhibit potentially large biases these properties can lead to misleading inferences on the validity of ppp our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates

on cross country differences in the persistence of real exchange rates abstract previous findings of long run purchasing power parity come mainly from data for industrial countries raising the issue of whether the results suffer sample selection bias and exaggerate the general relevance of parity reversion this study uncovers substantial cross country heterogeneity in the persistence of deviations from parity the results show that it is more likely rather than less likely to find parity reversion for developing countries than industrial countries although some persistence variations may partly reflect country differences in structural characteristics such as inflation experience and government spending a considerable portion of those variations seems unaccounted for

the long run volatility puzzle of the real exchange rate abstract this paper documents large cross country differences in the long run volatility of the real exchange rate it shows that the real exchange rate of developing countries is approximately three times more volatile than the real exchange rate in industrial countries the paper shows that this difference in volatility cannot be explained by the fact that developing countries face larger shocks both real and nominal recurrent currency crises or by different elasticities to these shocks arch estimations find a much higher persistence of deviations of the variance of the rer from its long run value when the economy suffers shocks of various kinds

increasing evidence of purchasing power parity over the current float we conduct unit root tests of real exchange rates with the united states dollar and the german mark as base currencies using samples of data which begin in 1973 and end between 1982 and 1996 we find that as the sample is extended the evidence of ppp strengthens with panel but not univariate methods because of the sharp rise and fall of the dollar in the early 1980s rejections of the unit root null do not monotonically increase with the sample size the evidence of ppp is uniformly stronger when the mark is used as the base currency

the re emergence of ppp in the 1990s abstract in this paper we investigate purchasing power parity ppp in a panel with 17 countries for the period 1972 through 1996 the novel feature of our panel methodology is that results are invariant to the choice of a benchmark on numeraire currency in the panel we allow individual country effects in the relation between prices and exchange rates in this way we can identify the currency pairs for which ppp holds or does not hold we conclude that there is substantive evidence for ppp although not to the same extent for every currency evidence in favor of ppp is strongest for many exchange rates relative to the dmark and weakest for the japanese yen for this currency a trend like variable like productivity growth is missing

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

bond price dynamics and options this paper provides a closed form preference free means of valuing a european call option written on a default free pure discount bond investors may not agree upon a theory of the term structure but they will necessarily agree on equilibrium option values further these equilibrium option values may be obtained without recourse to numerical approximation default free pure discount bond prices were posited to follow a non standardized transformed brownian bridge process this specification implicitly incorporates the terminal constraint that the price of a default free pure discount bond equal its face value at maturity contingent claim valuation necessarily involves consideration of terminal constraints on the value of financial securities the brownian bridge specification permits an appropriate means of incorporating a number of such constraints therefore while this paper has considered only the application of the brownian bridge process to the valuation of debt options the introduction of this process may provide for many further financial applications

purchasing power parity and aggregation bias for a developing country the case of mexico abstract this paper investigates long run purchasing power parity ppp between the us and mexico we use a panel of disaggregated price data between the us and mexico with a long time series to look at two types of aggregation bias the first is examined in imbs et al which we refer to as estimator aggregation bias and the second is put forth by broda and weinstein hereafter data aggregation bias the findings indicate substantial estimator aggregation bias and data aggregation bias although estimates using aggregate data and imposing homogeneous coefficients provide little evidence of ppp findings with disaggregated data and heterogeneous coefficient estimators offer strong support the results also suggest the presence of small sample bias as examined in chen and engel but with little effect on the qualitative results tradable goods and non tradable goods show little distinction in convergence rates estimated half lives are lower under flexible than fixed exchange rates and indicate rapid convergence during the mexican peso crisis

real exchange rates under the gold standard purchasing power parity is one of the most important equilibrium conditions in international macroeconomics empirically it is also one of the most hotly contested numerous recent studies for example have sought to determine the validity of purchasing power parity using data from the post bretton woods float and have reached different conclusions we assert that most such studies are flawed for two reasons first the post 1973 data contain by definition only a very limited amount of the low frequency information relevant for examination of long run parity second the dynamic econometric techniques used to model deviations from parity are typically quite crude with respect to admissible low frequency dynamics both deficiencies are rectified in the present paper with dramatic results we construct a new data set of 16 real exchange rates covering more than a century of the classic gold standard period and we study deviations from parity using long memory models that allow for subtle forms of mean

a nonparametric measure of convergence towards purchasing power parity it has been claimed that the deviations from purchasing power parity are highly persistent and have quite long half lives under the assumption of a linear adjustment of real exchange rates however inspired by trade cost models nonlinear adjustment has been widely employed in recent empirical studies this paper proposes a simple nonparametric procedure for evaluating the speed of adjustment in the presence of nonlinearity using the largest lyapunov exponent of the time series the empirical result suggests that the speed of convergence to a long run price level is indeed faster than what was found in previous studies with linear restrictions copyright 2006 john wiley sons ltd

dynamic asset pricing with non redundant forwards abstract in an incomplete market in which non redundant forward contracts contribute to span the uncertainty some standard results of portfolio theory must be amended when the investment opportunity set is driven by k state variables a k 3 mutual fund separation theorem is obtained in lieu of merton s k 2 fund separation result the additional fund is a portfolio that hedges the interest rate risk brought about by the optimal portfolio strategy itself second the mean variance efficiency of the market portfolio of cash assets is neither a necessary nor a sufficient condition for the linear relationship between expected return and beta to hold third the pricing equation for a forward contract is shown to contain an extra term relative to that for a cash asset term we name strategy risk premium

option pricing and replication with transactions costs transactions costs invalidate the black scholes arbitrage argument for option pricing since continuous revision implies infinite trading discrete revision using black scholes deltas generates errors which are correlated with the market and do not approach zero with more frequent revision when transactions costs are included this paper develops a modified option replicating strategy which depends on the size of transactions costs and the frequency of revision hedging errors are uncorrelated with the market and approach zero with more frequent revision the technique permits calculation of the transactions costs of option replication and provides bounds on option prices

an exact bond option formula this paper derives a closed form solution for european options on pure discount bonds assuming a mean reverting gaussian interest rate model as in vasicek 8 the formula is extended to european options on discount bond portfolios

bayesian methods for dynamic multivariate models if dynamic multivariate models are to be used to guide decisionmaking it is important that probability assessments of forecasts or policy projections be provided when identified bayesian vector autoregression var models are presented with error bands in the existing literature both conceptual and numerical problems have not been dealt with in an internally consistent way in this paper the authors develop methods to introduce prior information in both reduced form and structural var models without introducing substantial new computational burdens their approach makes it feasible to use a single large dynamic framework for example twenty variable models for tasks of policy projections copyright 1998 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association

searching for stationarity purchasing power parity under the current float abstract using panel data methods we investigate long run purchasing power parity by testing for unit roots in real exchange rates of industrial countries under the current float the evidence against the unit root hypothesis is stronger for larger than for smaller panels for monthly than for quarterly data and when the german mark rather than the united states dollar is used as the base currency while we find that accounting for serial correlation considerably weakens the evidence against the unit root null the results as a whole are consistent with long run purchasing power parity

understanding the empirical literature on purchasing power parity the post bretton woods era abstract this paper argues that the empirical failure of statistical tests of ppp in post bretton woods data is largely due to the low power of the tests employed this result is demonstrated using monte carlo experiments on the size and power of different testing procedures a new procedure based on horvath and watson econometric theory 11 pp 984 1014 1995 has greater power than previous approaches using the horvath watson procedure we find moderate evidence in favor of ppp in the post bretton woods era

aggregate real exchange rate persistence through the lens of sectoral data a novel approach to analyzing real exchange rate rer persistence and its sources is presented using highly disaggregated data for a group of eu 15 countries it is shown that the distribution of sectoral persistence is highly heterogeneous and skewed to the right so that a limited number of sectors are responsible for the high levels of persistence observed at the aggregate level quantile regression has been employed to investigate whether traditional theories such as the lack of arbitrage due to nontradability or imperfect competition combined with price stickiness are able to account for the slow reversion to parity of rers