-15-

With regard to point 2, it is interesting to consider a
portfolio balance model that explicitly includes opportunities to
invest in individual econamies through purchases of equities. Such a
model could potentially be developed to Gescribe the effects of a
change in the attractiveness of one country's equities (perhaps
reflecting an election outcome or policy change) on the spectrum of
market clearing asset prices and exchange rates. To the extent that
equities in U.S. firms are denominated in dollars, the expected real
return on U.S. equities might be held roughly in line with the expected
real return on dollar-denominated bonds, recognizing that actual
returns on stocks and bonds could diverge in different states of the
world. The extent to which the mark value of the dollar should
appreciate in response to revisions in expectations about relative
returns on U.S. and German equities might still be judged roughly on
the basis of changes in expected real interest differentials on dollar
and mark-denominated bonds. The interesting consequence of introducing
equities, however, is that it allows the risk premium to be formulated
by modelling the link between the perceived variance of real returns on
equities and perceptions about the effectiveness of macroeconamic
policies in particular, or country-specific exogenous variables in
general .22/

With regard to the third shortcoming of portfolio balance
models, the limited attention to microeconomic foundations is
particularly striking when contrasted with the numerous and careful
econametric studies of whether time series data on exchange rates and
interest rates support the joint hypothesis of market efficiency and
risk neutrality (recall footnote 8). It seems difficult to avoid
concluding that the microeconomic evidence challenges both parts of the

joint hypothesis.


-32-

23/ Dooley and Isard (1983b) take a similar approach in modelling
international lending and exchange rate determination in the con-
text of default risk.

24/ Goodman (1981, 1982), Levich (1981, 1982) and Rosenberg (1981)
Provide interesting evaluations.

25/ The latter is a suggestion that it may take several hours or days
for markets to readjust to old information following a large
“exogenous” currency flow.

26/ Rodriguez (1980) presents data from surveys of corporate foreign
exchange management practices in 1974 and 1977, although her
analysis of corporate behavior leans heavily on a questionable
classification of particular currencies into those that were
expected to appreciate and those that were expected to depreciate.
Adler and Dumas (1981, 1982) provide more recent perspectives.

27/ The choice of the currency composition of a multinational
corporation's net financial assets may take the form of a choice of
how much net worth to allow each overseas facility to hold in
local-currency assets and how much to convert back into hame-
currency denaminated investments.

28/ Such "inefficiency" at the microeconomic level has presumably been
reduced over time as experience has made firms more sophisticated
at integrating the objective of responding quickly to new
information with the objective of using top management's time in a
cost-effective manner.

29/ Meese and Rogoff do find that the superiority of the randam walk
over the structural models diminishes as the forecast horizon is
extended. A search over grids of theoretically-plausible

coefficient values discovers coefficients with which structural


-llb-
Notes to Table 1

a/ The data on S-year U.S. inflation expectations were collected by
Richard B. Hoey, Vice President and Chief Economist at Warburg Paribus/
A.G. Becker. Hoey surveyed the 5 and 10-year inflation expectations of
several hundred financial decision makers at 12 "points in time" between Jine
1980 and March 1983. The polls were completed over periods of several days.
The survey dates listed in the table are approximate midpoints of these
periods.

b/ I have constructed 5-year German inflation expectations by taking
Federal Reserve Board forecasts for horizons of 1-1/2 to 2 years and assuming
that inflation beyond the Federal Reserve's forecast horizon was expected to
continue at the rate forecast for the last 4 quarters of the horizon. The
tabulated 5-year inflation expectations do not represent the forecasts of the
Federal Reserve Board or anyone else on its staff.

c/ The data on Eurocurrency rates are brokers indications of bid rates for
fixed-term 5-year Eurodollar and Euromark deposits, as collected by the Bank
of America and made available through Data Resources Inc.

@/ The 5-year forward nominal exchange rates are constructed from spot
exchange rates and Eurocurrency interest rates.

e/ The 5-year forward real exchange rates are constructed as the products
of 5-year forward nominal exchange rates multiplied by the ratios of the U.S.
and German price levels that are assumed to have been expected at S-year
horizons. The expected future price-level ratios have been constructed from
current ratios of consumer price indexes and the expected 5-year inflation
rates.


-19-
accurate measures of the news. The Meese-Rogoff results may basically
reflect a lack of attention to, or success at, capturing the difference
between ex ante expectations about explanatory variables and their actual
realizations (or capturing changes in expectations between successive
points in time). Consistently, the basic structural features of exchange
rate models — namely, the covered interest rate parity condition and the
notion that movements in nominal exchange rates are correlated with
revisions in expectations about inflation differentials, other things
equal —- may provide an extremely profitable forecasting framework for
anyone who is relatively accurate in predicting changes in nominal
interest rates and (expected) inflation rates. Foreign exchange markets
are analagous to stock markets in offering profit opportunities to
forecasters who can accurately predict the Girections in which investors
as a group will revise their expectations about interest rates,
inflation rates and other market "fundamentals."

The view that "news" explains a major portion of exchange rate
variation has now become widely accepted .22/ Most of the initial
efforts to isolate the effects of news have quantified the news either
as differences between ex post realizations and autoregressive measures
of ex ante expectations, or as first differences of autoregressive
measures of ex ante expectations 2)/ The definition of “news” as
revisions in expectations is appropriate for a risk-neutral world. A
broader definition of news would be more appropriate in principle to the
extent that investors are concerned with more than just the means of the
probability distributions that describe the future values of explanatory
variables. In a risk averse world, the realization of an expected
outcome can be “news” in the sense that it can influence the exchange

rate by resolving uncertainty.


-4-
which classifies exchange rate models on the basis of their
assumptions about parity conditions.

The first basis on which exchange rate models have been
classified is their assumption about whether the interest bearing
assets denominated in the two currencies are perfect substitutes, such
that portfolio arbitrage drives the nominal interest rate differential
into equality with the expected rate of change in the exchange rate.
This uncovered interest rate parity condition can be written as

(10) Ra- Rpes-s
It implies, fram (1) and (2), that the forward rate equals the
expected future spot rate, or that risk® = 0. Models that adopt the
assumption of uncovered interest parity or perfect asset
substitutability have been labeled monetary models, while models that
do not have been classified as portfolio balance modeis.4/

Monetary models have been subclassified on the basis of
whether purchasing power parity (PPP) is assumed to hold continuously
— or more precisely, whether sreal is assumed to fluctuate unsystem
atically around a time-invariant PPP level. Monetary models that
assume continuous PPP have been called flexible price monetary
models 2/ Monetary models that instead allow the real exchange
rate to deviate systematically in the short run fron its long run
equilibrium level, equivalently allow real interest rates to differ
across countries in the short run, with systematic differences between
nominal interest differentials and expected inflation differen-
tials.€/ These models have generally imposed direct assumptions
on the adjustment paths followed by price levels or the exchange rate
in the short run, and have been classified as sticky price monetary

models.2/


- 30-
the set of asset-market Clearing conditions to those for the two
moneys: hence, the term "monetary model",

5/ Examples include Frenkel (1976) and Bilson (1978).

&/ This is readily seen fram condition (9) under the monetary model
assumption that risk® = 9,

2/ Examples include Dornbusch (1976) and Frankel (1979).

8/ The large and growing "market efficiency literature” includes Geweke
and Feige (1979), Tryon (1979), Hansen and Hodrick (1980, 1983),
Haakio (1981), Longworth (1981), Cumby and Obst feld (1981), Meese and
Singleton (1982), Dooley and Shafer (1983) and Loopesko (1983).

9/ See Rogoff (1983) and Tryon (1983). Attempts to estimate structural
models of the risk premium include Dooley and Isard (1982, 1983a),
Frankel (1982b, 1982c), Rogoff (1983) and Danker, Haas, Symansky and
Tryon (1983).

10/ See Edison (1983).

i1/ This argument is spelled out in Dooley and Isard (19835). The notion
that the long-run PPP level should solve a goods-market or balance-
of~payments equilibrium condition can also be found in the important
contributions by Kouri (1976) and Branson (1977).

12/ See Fellner (1979), Isard (1980, 1983), Shafer and Loopesko (1983),
Hooper (1983) and the 1983 Economic Report of the President.

13/ For a somewhat dated reference see Eckstein (1972).
14/ See Shafer and Loopesko (1983) and Hooper (1983).
‘15/ The behavior of mark/dollar exchange rates during 1980-8] has been

considered at greater length in Isard (1983).


-16-

With regard to efficiency in the use of information, some
exchange rate forecasters will admit to biasing their forecasts toward
the forward rate. These forecasters perceive that the major element
in their payoff or loss function is whether they have correctly
advised their clients that covering exposures in the forward market
will prove profitable or unprofitable, and not how accurately they have
predicted how much the future spot rate will differ fram the forward
rate. Although this perception alone does not make it rational to bias
their forecasts, it is apparently also perceived that clients are
suspicious of predictions that differ considerably from what other
forecasters are predicting. There seems to be a cost attached to
being too extreme, or perhaps a risk-averse response by the forecaster
to the prospect that an extreme prediction may reflect an incorrect
forecasting model.

A second anecdotal fact that bears on market efficiency is
that neither forecasters nor their clients review their full
information sets every day. A typical multinational corporation may
undertake an extensive review of its foreign currency exposure once a
month, and relatively few exchange rate forecasters revise their
predictions more frequently than once-a-month or once-a-week. This
suggests a lagged response to new information on the part of many
large market participants. Of course, it may only take a “margin” of
fully-informed quickly-responding market participants to make
market-clearing exchange rates efficient. Perhaps the tail can wag
the dog. But it seems constructive to address the efficiency question
by posing it with a time dimension. How many minutes, hours or days
does it take for markets to respond fully to new information — or as
a weak-form definition of market efficiency, for exchange rates to

respond fully to the information content of their own history? The


-22-
References
Adler, Michael and Bernard Dumas, “Should Exposure Management Depend
on Translation Accounting Methods," Euromoney, June 1981.

+ “International Portfolio Choice and Corporation

Finance: A Survey,” manuscript, November 1982.

Artus, Jacques R. “Exchange Rate Stability and Managed Floating: The
Experience of the Federal Republic of Germany", IMF Staff
Papers 23, 1976: 312-33.

Bilson, John F.O. “The Monetary Approach to the Exchange Rate: Some
Empirical Evidence", IMF Staff Papers 25, 1978: 48-75.

Branson, William H. “Asset Markets and Relative Prices in Exchange

Rate Determination” Sozialwissenschaftliche Annalen 1,

1977: 69-89.

Branson, William H., Hanna Halttunen and Paul Masson. “Exchange Rates
in the Short Run: The Dollar Deutschemark Rate", European
Economic Review 10, 1977: 303-24.

ee. + "Exchange Rates in the Short Run: Some Further
Evidence", European Economic Review 12, 1979: 395-402.

Cumby, Robert E. and Maurice Obstfeld, “A Note on Exchange—Rate
Expectations and Nominal Interest Differentials: A Test
of the Fisher Hypothesis", slournal of Finance 36, 1981:
697-704.

Danker, Deborah, Richard Haas, Steven Symansky and Ralph Tryon, "Small
Empricial Models of Exchange Market Intervention:
Applications to Canada, Germany and Japan," Federal Reserve

Board Staff Study, forthcoming, 1983.


-18-
to limit the foreign currency exposure that results from the projected
Operations of the corporation reveals little about how top corporate
Management choses the currency composition of the firm's net financial
assets.2// What is presumably true, however, is that upper-level
decisions about portfolio ‘Stocks are normally reviewed only periodically,
reflecting the costs of top management's time, so that the
stock-adjustment response to new information may be gradual. In
addition, to the extent that the discretionary authority of corporate
foreign exchange managers is essentially restricted to deciding how
extensively to hedge the transactions exposures associated with the
Payables and receivables that can be projected over near-term horizons,
Corporate hedging operations may put pressures on exchange rates that are
directly related to prospective near-term balances of international trade
flows, other things equal. In any case, these considerations Suggest
that many of the large participants in foreign exchange markets (banks
and corporations) consider it rational to structure their internal
decision processes and authority in a way that is inconsistent at the
microeconomic level with the traditional instantaneous-adjust-
ment paradigm of portfolio balance models .28/

v. Interpreting the Poor Forecasting Performance of Structural Models

Meese and Rogoff (1983a, 1983b) and others have searched
extensively and unsuccessfully for evidence that structural exchange
rate models can outperform the forward rate or a random walk in
forecasting post sample. The structural models don't even outperform
the random walk when purged of all errors in forecasting the
explanatory variables.2°/ One interpretation is that the
Structural models are not "fit to survive."

An alternative interpretation is that the structural models

have not been tested properly in a "news" framework with sufficiently


16/

ly

18/

-31-

One possible source of measurement error in survey or forecast data
on inflation expectations is that some respondents or forecasters may
report modes rather than means when their subjective probability
distributions are not symmetric.

10-year U.S. inflation expectations are available from the same
source as the 5-year expectations (see Table 1). 10-year Euro-
dollar and Euromark interest rates, however, are not available

for constructing 10-year nominal forward exchange rates, and

the construction of 10-year German inflation expectations would
require extrapolating 2-year inflation forecasts over 8 years
rather than 3. It thus seems evident, a priori, that constructed
data on 10-year forward real DM/$ rates would be subject to
considerably greater measurement error than the data on the 5-year
forward real DM/S rates.

From the 1982 Annual Report of the Bundesbank, p. 68.

(19/ Prom “Treasury and Federal Reserve Foreign Exchange Operations",

2/

Federal Reserve Bulletin, September 1981, pp. 697-8.

The Economic Report of the President, February 1983, p. 64.

See Wihlborg (1978) or Dornbusch (1982) for relatively simple
expositions.

Frankel (1982c) estimates a variance-covariance matrix of nominal
rates of return, treating the elements of this matrix as
parameters that are constant throughout his sample period.

Dooley and Isard (1982, 1983a), Frankel (1982b) and Rogoff (1983)
essentially absorb the variance of the exchange rate into the para-

meters of asset demand functions.


-13-

official estimates of the prospective size of U.S. budget deficits, as
well as public statements made by Congressional leaders upon returning
from their Labor Day recess.

A second major swing in FREAL® (as shown in Figure 2) has
occurred since the middle of 1982, coinciding with the intensification
of concerns over international debt problems and the emerging indica-
tions of a U.S. economic recovery. In analyzing exchange market
behavior during that period, the Counci] of Economic Advisers reported:
"Many observers believe that other factors besides real interest rates
help explain the dollar's strength. In particular, the unsettled state
of the world economy ... may have created a desire on the part of
investors for a safe haven for their funds. The United States,
according to this argument, is still regarded as the most politically
and economically stable of the market econamies and has become a
financial refuge in troubled times .»20/ In addition, since
mid-1982 most forecasts of U.S. real activity growth have been raised
relative to forecasts of German activity growth: the U.S. economic
outlook has improved and perhaps become less uncertain relative to the
economic outlook for Germany.

The official explanations of the behavior of dollar exchange
rates during the first eight months of 1981 and since the middle of
1982 closely reflect the market commentary of financial portfolio
managers. The explanations suggest that alternative portfolio assets
are not perfect substitutes, but emphasize substitutability consid-
erations that are not stressed by portfolio balance models as they have
traditionally been formulated and estimated. The next section
discusses ways that portfolio balance models might be reformulated to

capture better the messages of market commentary.


-9-

ratios of national price levels. Thus, changes in nominal exchange
rates are critically linked to changes in the ratios of national price
levels, or to relative inflation rates.

Reflecting this link, structural models of exchange rate
determination have generally supplemented their assumptions about
parity conditions with behavioral assumptions about price level
determination. Many models, including each of the three structural
models tested by Meese and Rogoff (1983a, 1983b), have assumed that
price levels clear money markets in which money demand functions have
the popular Cagan form

(11) m= Pj * ays aQRj for j = A,B.

Here mj and ¥5 denote the logrithms of the nominal money stock and
real income in country j. Meese and Rogoff have conjectured that the
instability of parameter estimates for this money demand specification
may be a principal factor underlying the poor out-of-sample perform
ance of the structural exchange rate models they tested. Hopes of
using the money demand function to obtain a stable price equation are
dimmed a priori by recognition that the set of close substitutes for
money (however defined) is continuously changing, as are the
"coefficients" that might best describe the extent to which central
bankers attempt to adjust supplies of money in reaction to information
about the economic variables and political developments that concern
them. Hopes of combining a money demand function and the assumption
of rational expectations to obtain a stable structural model of how
market participants form expectations about future price levels,
moreover, are dimmed further a priori by the fact that economists and
other market participants disagree on the question of which model of
prices is "rational". In practice, major econometric forecasting

services rely on different classes of price equations, which in many


7 28 -
Rosenberg, Michael R., "Is Technica] Analysis Right For Currency
Forecasting?", Euromoney, June 1981.
Shafer, Jeffrey R. and Bonnie E. Loopesko, "Floating Exchange Rates

After Ten Years", Brookings Papers on Economic Activity,

1983: forthcoming.

Tryon, Ralph, "Testing for Rational Expectations in Foreign Exchange
Markets", International Finance Discussion Paper No. 139,
Federal Reserve Board, 1979.

+ "Small Empirical Models of Exchange Market

Intervention: A Review of the Literature," Federal Reserve
Board Staff Study, forthcoming, 1983.
Wihlborg, Clas, "Currency Risks in International Financial Markets,"

Princeton Studies in International Finance No. 44, 1978.


-25-
Goodman, Stephen, “Technical Analysis Still Beats Econometrics,"
Euromoney, August 1981.

+ "Two Technical Analysts Are Even Better Than

One," Euromoney, August 1982.
Haas, Richard and William Alexander, "A Model of Exchange Rates and

Capital Flows," Journal of Money and Credit and Banking ll,

1979: 467-82.
Haakio, Craig S. "Expectations and the Forward Exchange Rate,”

International Economic. Review 22, 1981: 663-78.

Hanson, Lars Peter and Robert J. Hodrick, “Forward Exchange Rates
as Optimal Predictors of Future Spot Rates: An

Econometric Analysis", Journal of Political Economy 88,

1980: 829-53.

, “Risk Averse Speculation in the Forward Foreign

Exchange Market: An Econometric Analysis", in J.A. Frenkel,

ed., Exchange Rates and International Macroeconomics (U.

of Chicago Press: Chicago, Ill.) forthcoming 1983.
Herring, Richard J. and Richard C. Marston, "The Forward Market and

Interest Rates in the Eurocurrency and National Money

Markets", in C.H. Stem, J.H. Makin and D.E. Logue, eds.,

Eurocurrencies and the International Monetary System

(American Enterprise Institute: Washington, D.C.) 1976.
Hoffman, Dennis L. and Don E. Schlagenhauf, "Rational Expectations,
the Role of 'News,' and Exchange Market Efficiency,"
manuscript, 1982.
Hooper, Peter, “Movements in the Dollar's Real Exchange Rate over the
Ten Years of Floating: A Structural Analysis," manuscript,

1983.


-6-

values of explanatory variables that enter those models, the poor
forecasting performance of structural models may largely reflect
inaccurate assumed measures of ex ante expectations and does not
necessarily imply that the structural approach to modelling exchange
rates should be abandoned.

Same additional points about modelling strategy are evident
from condition (9). Among the terms on the right side of (9), the
expected real interest differential and the expected premium for
bearing exchange risk are generally regarded to have small orders of
magnituje, at least in comparison with the expected future real
exchange rate. Thus, although changes in nominal interest rate
differentials and expected inflation differentials may be regarded as
largely accounting for changes in observed exchange rates, an
explanation of the real or price-adjusted levels of observed exchange
rates must be linked to an explanation of the level of the real
exchange rate that is expected to prevail at some future horizon. In
this context, the notion of long run equilibrium provides the most
appealing foundation for anchoring expectations of future real
exchange rates. Same empirical exchange rate models have assumed that
the real exchange rate is expected to converge to a long-run
purchasing power parity level that can be either measured as an
historical average or treated as a constant parameter to be estimated
in regression analysis. However, the strong assumption that expec-
tations about the long-run purchasing power parity level are time
invariant (or insensitive to "real shocks") has been challenged,
and there is sune evidence that it is rejected by data for the United
Kingdom. 20/

To deny the strong PPP assumption that the real exchange

rate is always expected to converge to some exogenous time-invariant


-5-

One issue that has been resolved convincingly in the
literature is that the assumption of continuous PPP is not supported
by the data; the flexible price monetary model can be rejected.
Differences of opinion remain, however, on whether the data show
evidence of a time varying risk premium, which would reject the
sticky-price monetary model in favor of the portfolio balance model.

A number of studies of the time series properties of exchange rates
and interest differentials have been interpreted as rejecting the
joint hypothesis that market participants form rational expectations
and that the risk premium is zero (or constant) 2/ Many

economists, however, remain skeptical of these results, and nobody has
yet found significant evidence that the behavior of exchange rates
lends support to a structural model of the risk prenium2/
Section III presents some evidence that casts doubt on the sticky
price monetary model, but that also suggests the portfolio balance
model has been poorly specified.

The issues of modelling strategy that are discussed in
sections III to V can be put into perspective by returning to
condition (5). As noted above, this condition is merely a manipulated
form of the covered interest rate parity assumption, and in general,
the structural exchange rate models that have been tested empirically
over the past decade can be derived by substituting behavioral models
or assumed measures for the expectational terms in (5), or in some
variant of (5). Sections III and IV respectively suggest directions
for attempting to improve the way that price expectations are captured
and the way that the portfolio balance framework and risk premium are
formulated. Section V argues that regardless of whether the
expectational terms in (5) are quantified directly or replaced by

behavioral models together with assumed measures of the expected


-14-

Iv. Same Shortcanings of Portfolio Balance Models

Traditionally, portfolio balance models have distinguished
between stocks of outside assets denominated in different currencies,
and attempts to test the empirical validity of these models have
looked for significant correlations between the relative stocks of
these assets and the relative yields they were expected to offer,
taking account of expected exchange rate movements. Several short-
comings in the formulation and estimation of such models seem
particularly severe: (1) the degree of uncertainty about exchange rates
has generally been treated empirically as an exogenous parameter rather
than an endogenous variable; (2) portfolio assets have been distin-
guished mainly by currency and not adequately by the countries on whose
macroeconomic policies, productivity performances, creditworthiness,
taxes and capital controls their yields depend; and (3) the micro-
economic foundations of the literature do not adequately reflect the
way that major exchange market participants perceive their portfolio—
management objectives and structure their portfolio-adjustment
decisions.

With regard to point 1, the degree of uncertainty about
future exchange rates has been linked in conceptual models of the
exchange risk premium to perceived degrees of uncertainty about
relative inflation rates, output levels, etc., which in turn reflect
uncertainties about macroeconomic policies.2/ Although it seems
difficult to construct quantitative time series data on the degrees of
uncertainty attached to exogenous variables, it can also be argued
that the attempts that have been made to verify the portfolio balance
approach by seeking structural evidence of asset substitutability or
exchange risk premiums have been primitive in their treatment of the

degree of exchange risk as a constant parameter or matrix of parameters .22/


-B-
the expected instantaneous real interest differential (which must
converge to the expected instantaneous premium for bearing exchange
risk if the real exchange rate is expected to converge to a constant).
Alternatively, the expected real interest differential can be viewed
approximately as an expected long-term real interest differential,
measured in percent per annum, multiplied by the number of years to
maturity of the long-term assets to which the interest rates corre-
spond. Moderate percentage-point per annum changes in expected
long-term real interest differentials can thus give rise: to much
greater percentage changes in observed exchange rates, as discussions
of exchange rate volatility have emphasized increasingly in recent
years 22/ Crude data on expected long-term inflation
differentials suggest that more than half of the dollar's 40 percent
appreciation against the mark between mid-1980 and mid-1982 was
associated with observed changes in long-term nominal interest
differentials relative to revisions in expectations about long-term
inflation differentials (see Figure 2 in Section III below). These
considerations suggest that models or measures of long-term inflation
expectations are a critical ingredient for understanding the behavior
of exchange rates.

III. Methods for Capturing Inflation Expectations

The argument that models or measures of inflation
expectations are critical for "explaining" nominal exchange rates
(given observations of nominal interest rates) need not be linked
explicitly to conditions (5) or (6). A deeply-rooted notion in
economic analysis is that general equilibrium models can be solved for
relative price levels but typically not for absolute price levels.
This suggests that real exchange rates may have equilibrium values,

but that nominal exchange rates can only be explained relative to


-20-

The view that exchange rate movements Predominantly reflect
responses to news has different implications for forecasting ex ante
than for explaining exchange rates ex Post. Economists without accurate
foresight of the news can test Structural models in a news framework if
they have accurate ex post measures of what market participants expected
ex ante. A notable feature and criticism of the Strategies that have
been used to date for quantifying expectations in exchange rate models
is that they have pursued unbiasedness with little concern for efficiency.
This limitation deserves considerable attention, particularly if one
accepts the view that the mileage in making structural exchange rate models
more useful lies in constructing more accurate measures of expectations.

Two directions for increasing the efficiency of expectations
measures can be suggested. One suggestion is to impose the hypothesized
Structure of the exchange rate equation completely in order to construct
measures of exchange rate expectations "rationally" from (or simulta-
neously with) constructed measures of the expected values of the
explanatory variables that enter the exchange rate equat ion.22/ On
efficiency grounds such an approach would generally dominate regressing
the realized (perfect foresight) value of the exchange rate on a set of
relevant variables, since the former approach would generally exploit more
information on the relevant set of variables and how they fit together.
Similarly, structural information should be exploited as much as possible
in constructing measures of the expected values of the explanatory
variables that enter the exchange rate equation. A second Suggestion,
which is particularly relevant for constructing efficient measures of the
expected values of those explanatory variables that are treated as exoge—
nous, is to pool data on different indicators within each class of variable.
Market participants in fact revise their expectations continuously in

response to data announcements for many different types of Price indexes,


International Finance Discussion Papers
Number 226
August 1983

WHAT'S WRONG WITH EMPIRICAL E¥CHANGE RATE MODELS:
SOME CRITICAL ISSUES AND NEW DIRECTIONS

by

Peter Isard

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished material)
should be cleared with the author or authors.


-ll-
(5), it is appropriate to construct an index of the long term forward
rate adjusted for expected future relative price levels

(12) freal® = 5 - (Ry-R,) + (P®p-P®a)

=f + (p°p-p®,)
Condition (5) can then be transformed into

(13) freal® = sreal® - risk®
ignoring the potentially large measurement error in (PEPE)
and hence freal®. It is then straightforward to test the joint
hypothesis that sreal® and risk® are constant (as implied by the
sticky-price monetary model). In addition, structural models of the
risk premium might be retested under the assumption of time-invariant
expectations about the long-run real exchange rate.

Some survey data are now available on the 5-year U.S.
inflation expectations of financial decision makers, sampled at 12
“points in time" since June 1980. These are shown in Table 1, along
with some constructed measures of 5-year German inflation expectations
(see the notes to Table 1). Figure 1 shows the week-to-week behavior
of the spot (S) and S-year forward (F) mark/dollar exchange rates
since June 1980 (expressed as index levels, and not logrithmic), and
Figure 2 compares movements in S and F with movements the 5-year
forward real exchange rate (FREAL®), as constructed fram F and the
data sho in Table 1.22/

The question of whether the long-term forward real exchange rate
has been constant, as predicted by the sticky price monetary model under
the strong form of the purchasing power parity assumption, can be
considered visually with the help of Figure 2. The figure shows that the
5-year forward real DM/$ rate has varied over a 25 percent range, or by
about 12-1/2 percent on each side of its sample mean. This could
conceivably be explained by measurement errors of up to 2-1/2 percentage

points per annum in the expected inflation differential 26/


-10-

cases do not appear to be closely linked to a simple form of the money
demand function.13/ These considerations raise questions about

the prospective payoffs from incorporating structural models of
inflation or price-level expectations into models of exchange rate
determination. On the other hand, approaches to modelling exchange
rates that do not require structural models of inflation expectations
may also have serious limitations. In particular: autoregressive
techniques seem poorly designed for capturing the important revisions
in inflation expectations that may accompany elections or other
changes in policy regimes (the Thatcher, Reagan and Mitterand
effects); there is hardly any survey data available on long-term
inflation expectations; and the use of long-term nominal interest
rates as proxy measures for long-term inflation expectations (as in
Frankel (1979) and Hooper and Morton (1982)) is incompatable with the
widespread view that long-term dollar interest rates have not moved
closely in parallel with U.S. inflation expectations during recent
years. One response to this measurement dilemma has been the use of
centered moving averages of actual inflation rates to proxy expected
inflation rates, blending the assumptions of regressive expectations
and accurate foresight L4/ Potentially, the establishment of
options markets in long-dated CPI futures might provide an ideal
source of daily information on participants’ long-term inflation
expectations.

It is worth emphasizing, nevertheless, that conditions (5)
and (6) provide a starting point for considering how empirical
exchange rate modelling might proceed with direct or proxy data on
long-term inflation expectations, however obtained. Given the
endogeneity of interest rates and inflation expectations and the a-

priori knowledge of the coefficients attached to them in condition


-27-
McKinnon, Ronald I., "Floating Exchange Rates 1973-74: The Emperor's
New Clothes," in K. Brunner and A. Meltzer, eds.,

Institutional Arrangements in the Inflation Problem (North

Holland: Amsterdam) 1976.
Meese, Richard M. and Kenneth S. Rogoff, “Empirical Exchange Rate
Models of the Seventies: Do They Fit Out of Sample?",

Journal of International Economics 14, 1983a: 3-24.

ee » “The Out-Of-Sample Failure of Empirical Exchange

Rate Models: Sampling Error or Misspecification?", in

J. A. Frenkel, ed., Exchange Rates and International

Macroeconomics (U. of Chicago Press: Chicago, Ill.)
forthcoming 1963b.

Meese, Richard and Kenneth Singleton, "On Unit Roots and the
Empirical Modelling of Exchange Rates” Journal of Finance,
37, 1982: 1029-36.

Massa, Michael, "Empirical Regularities in the Behavior of Exchange

tes and Theories of the Foreign Exchange Market", in

K. Brunner and A.H. Meltzer, eds., Policies for Employment

Prices and Exchange Rates, Carnegie-Rochester Conference

Series on Public Policy, Vol. 11, Supplementary series to

Journal of Monetary Economics, 1979.

Obstfeld, Maurice, "Exchange Rates, Inflation and the Sterilization
Problem: Germany, 1975-1981," manuscript, 1982.

Rodriguez, Rita M., Foreign-Exchange Management_in U.S.

Multinationals, (Lexington, Mass.: Lexington Books) 1980.
Rogoff, Kenneth, "On the Effects of Sterilized Intervention: An

Analysis of Weekly Data," manuscript, 1983.


- 26 -
Hooper, Peter and John Morton, “Fluctuations in the Dollar: A Model
of Nominal and Real Exchange Rate Determination", Journal

of International Money and Finance 1, 1982: 39-56.

Isard, Peter, "Factors Determining Exchange Rates: The Roles of
Relative Price Levels, Balances of Payments, Interest Rates
and Risk", International Finance Discussion Paper No 171,
Federal Reserve Board, 1980.

+ "An Accounting Framework and Some Issues for

Modelling How Exchange Rates Respond to the News", in

J.A. Frenkel, ed., Exchange Rates and International

Macroeconomics (U. of Chicago Press: Chicago, Ill.)
forthcoming 1983.

Kouri, Pentti J.K. "The Exchange Rate and the Balance of Payments in
the Short Run and in the Long Run", Scandinavian Journal
of Economics 78, 1976: 280-304.

Levich, Richard M., "How to Compare Chance With Forecasting
Expertise,” Euromoney, August 1981.

+ "How the Rise of the Dollar Took Forecasters by

Surprise,” Euromoney, August 1982.
Longworth, David, "An Empirical Efficient-Markets Model of Exchange Rate
Determination,” manuscript, 1980.

__+ “Testing the Efficiency of the Canandian-U.S.

Exchange Market Under the Assumption of No Risk Premium,"
Journal of Finance 36, 1981: 43-9.

Loopesko, Bonnie, "A Time Series Study of the Relationship Between
Exchange Rates, Intervention and Other Variables: Enpirical
Evidence Fram Daily Data," Federal Reserve Board Staff Study,

forthcoming, 1983.


-7-

level is not to deny the weak PPP assumption that the real exchange
rate may always be expected to converge to some endogenous equilibrium
level, the perceived value of which may vary over time in response to
"shocks" or new information. A key conceptual issue is how to model
the long-run equilibrium level of the real exchange rate. In the
Dornbusch (1976) model the long-run real exchange rate is constrained
by a goods-market clearing condition, and it is a fairly short step
from the Dornbusch specification to the popular notion that the real
exchange rate must satisfy a balance-of-payments equilibrium condition
in the long run. Rational expectations about the long run real
exchange rate, accordingly, should be sensitive to changes in factors
that influence production or absorption in the long run. Consistently,
from a credit-market perspective, simple two-country comparative
static analysis suggests that the expected long-run PPP level will be
altered by any shocks that change the expected long-run stock of one
country's (real) net claims on the other, assuming that the change in
the debtor country's trade surplus consistent with meeting interest
payments on the long-run stock of (real) debt requires a greater-than-
infinitesimal adjustment of the real exchange rate L/

The presumption that observed levels of real and nominal
exchange rates are anchored by expectations about the long-run real
exchange rate, however imprecisely defined, implies that observed
nominal exchange rates discount nominal interest differentials and
expected inflation differentials over long horizons. This is apparent
from condition (6), in which fluctuations in nominal spot exchange
rates relative to expected long-run real exchange rates reflect changes
in expected long-term real interest differentials, appropriately
compounded. In conditions (6) and (9) the expected real interest
differential can be viewed as the integral over a long-term horizon of


-17-
Dooley-Shafer (1983) findings and some evaluations of the profit-
ability of technical forecasting services*4/ suggest that there

is money to be made (on average over time) by taking positions in
exchange markets on the basis of filter rules or various turning-
point indicators. There is additional anecdotal evidence, however,
that a large part of the profits from following technical rules is
obtained during the few days following the signals to change
positions; those who do not act fairly quickly may not profit. Thus,
the suggestion may be that markets take up to several days to adjust
fully to new information, which is consistent with contentions that
sterilized intervention or large “exogenous” private foreign exchange
flows can sometimes influence exchange rates for a few hours or
days .22/

To be respectable, such a view requires that market
participants are risk averse and/or find it costly to re-evaluate
their currency positions continuously. The proposition that it is
difficult to find large market participants who are not risk averse
was advanced early in the floating-rate period by McKinnon (1976) and
has not been seriously disputed. Both banks and nonbank corporations
generally instruct their foreign exchange managers to avoid exposing
the value of their firms to large risks through open foreign currency
positions.

Apart from the conclusion that foreign exchange managers are
not delegated the authority to take large foreign exchange risks,
however, it is difficult to know what to infer fram the literature on
corporate foreign exchange practices.29/ There is an important
distinction between the overall objectives of the firm and the
objectives that foreign exchange managers are given instructions or

incentives to pursue. The fact that foreign exchange managers may act


-23-
Dooley, Michael P. and Peter Isard, "2B Portfolio Balance Rational-Ex-
pectations Model of the Dollar-Mark Rate”, Journal of
International Economics 12, 1982:257-76.

"The Portfolio-Balance Model of Exchange Rates

and Some Structural Estimates of the Risk Premium", manu-
script (IMF DM/83/20), 1983a.

"Country Risk, International Lending and Exchange

Rate Determination”, International Finance Discussion Paper
No. 22], Federal Reserve Board, 1983b.

Dooley, Michael P. and Jeffrey R. Shafer, "Analysis of Short-Run
Exchange Rate Behavior: March 1973 to November 1981",
in David Bignan and Teizo Taya, eds., Exchange Rate and
Trade Instability (Ballinger: Cambridge, Mass.), forth-
coming 1983.

Dornbusch, Rudiger, "Expectations and Exchange Rate Dynanics, Journal
of Political Economy 84, 1976: 1161-76.

"Exchange Rate Economics: Where Do We Stand?"

Brookings Papers on Economic Activity 10, 1980: 143-85.
“Exchange Risk and the Macroeconamics of Exchange

Rate Determination", in R. Hawkins, R. Levich and

C. Wihlborg, eds., The Internationalization of Financial

Markets and National Economic Policy, (JAI Press: Greenwich,

Conn.), 1982.

Eckstein, Otto, ed., The Econometrics of Price Determination (Board

of Governors of the Federal Reserve System: Washington,
D.C.) 1972.
Edison, Hali, “The Rise and Fall of Sterling: Testing Alternative
Models of Exchange Rate Determination,” manuscript, 1983.
Edwards, Sebastian, “Exchange Rates and 'News': A Multi-Currency

Approach", Journal of International Money and Finance 1,

1982: 211-24.


-3-

(5) s* (RR-R,) - (PE i) + sreal® - risk®

In first-differenced form, condition (5) separates changes
in the spot exchange rate into components reflecting changes in the
nominal interest differential, revisions in expectations about future
relative price levels (or the inflation differential), revisions in
expectations about the future real exchange rate and changes in the
risk premium. By adding and subtracting p, - pg on the right-hand
side, condition (5) can be converted into

(6) $= (P,- B) + (rE n) + sreal® - risk®

where tS and Th denote “expected real interest rates" defined as
(7) ie RO (Pe Px)

(8) az Re (Pao Py)
Thus, from conditions (6) and (3)

(9) sreal = (rE th) + sreal®- risk®

Conditions (5), (6) and (9) represent no more nor less than the
covered interest rate parity condition manipulated into alternative forms
through the use of definitions (2), (4),(7) and (8). Since covered interest
parity is assumed by virtually all exchange rate models that have been
proposed over the past decade, conditions (5), (6) and (9) provide a general
framework for discussing some key issues that arise in modelling exchange
rate behavior. The behavioral assumptions that have been embodied in
exchange rate models can be divided into assumptions about parity conditions
between variables that are generally regarded as endogenous, and additional
assumptions to explain the behavior of endogenous variables other than

the dependent exchange-rate variable. A nomenclature has developed


- lle -

Figure 1
NOMINAL EXCHANGE RATES

(Weekly data)

Marks/dollar
— TM72.70
a
Nv
= i Spot Ae \ \ 72.50
iv \ not awantnd
a} \ A? Vd \l ‘
} y / Vv
1 At nd 2.30
! ve
i
A hy
= I 4
n VY 2.10
5-Year Forward
“1.90
“1.70
—1.50
poser der p rrr s tit ith 3
J s M J s D M J s D M

D
1980 1981 1982 1983

J


-12-
It is also conceivable that the sticky price monetary model is correct but
that it takes longer than 5 years for real exchange rates to adjust to
their purchasing power parity levels. Consistently, the range of
variation might be considerably narrower for the 10-year forward real
Dé/$ rate, which I have not attempted to construct 2//

The case against dismissing the visual impression of wide
variation in the S-year forward real DM/$ rate as measurement error Or
as uncharacteristic of movements in even longer-term forward real DM/$
rates is that the large changes shown in Figure 2 were contemporaneous
with some informative market commentary. During the period. from
January through August 1961, financial portfolio managers commented
frequently that they were impressed by the Reagan Administration's
ability to formulate rapidly and then implement almost all of the
econamic programs it sought, in contrast with the situation in
Germany, where the lack of a strong political consensus was paralyzing
econamic policy. According to the Bundesbank's analysis, the dollar
"rose steeply on a strong wave of confidence ... [reflecting] the
expectation that the new Administration would radically change the
@irection of econamic policy in the United states. "28/ A similar
view was expressed by the Federal Reserve Bank of New York: “Market
participants focussed on the policy challenges facing many governments
abroad and were concerned that policies would not be adopted to deal
with these problems effectively . . . Moreover, as the administration's
economic proposals gained congressional approval, market participants
compared the breadth of support for the new policy directions in the
United States with the continuing debates on a full range of mlicies
in many countries abroad. *22/ Consistently, the decline in
FREAL® between August and October 1981 coincided with perceptions
that Congressional support for the Reagan Administration's programs was

eroding, following the revelation in mid-August of new and larger


-2-
of explanatory variables, which are critical for testing structural
models in a "news" framework.

II, An Overview of Models and Issues in the Literature

The exchange rate literature that has developed over the
past decade has emphasized equilibrium conditions in asset markets as

well as goods markets 2/ The covered interest rate parity condi-

tion is generally assumed to hold continuously, such that2/

(1) s=f+RR-R
Here and below the notation is as follows:
s,f,s° denote the logrithms of the naminal values
of spot, forward and expected future spot
rates, in units of currency A per unit of
currency B
ParPp denote lograrithms of the price levels in
countries A and B
RyRy denote nominal own rates of interest on
assets denaninated in currencies A and B
e denotes the expected future value of the
variable to which it is superscripted
References are also made to the premium expected for bearing exchange
risk and the real exchange rate, respectively defined as
(2) risk® = s& - £
and
(3) sreal = 5 + Py - Pa
Definition (3) also applies to expected future values of the

variables
(4) sreal® «s+ PE - Bh

Together, conditions (1), (2) and (4) imply


-33-
models can sometimes out perform the random walk at forecast
horizons longer than 12 months, but in an unstable fashion that is
not consistent across different forecast horizons.

30/ See Mussa (1979) for striking evidence of how little of the
variation of spot exchange rates is predicted ex ante by forward
premiums.

31/ Efforts to model the news explicitly include Dornbusch (1989),
Isard (1980), Longworth (1980), Frenkel (1981), Edwards (1982) and
Hoffman and Schlagenhauf (1982). Dornbusch (1980) relies on OECD
current account forecasts rather than autoregressive measures of ex
ante expectations.

32/ To my knowledge only Dooley and Isard (1982) have attempted to
incorporate the structure of the exchange rate equation into the
process that is assumed to generate exchange rate expectations.
They did not, however, attempt to exploit much information in
generating expectations of asset stocks and other exogenous

variables, for which they relied on simple autoregressions.


-2-
activity indicators, monetary variables, etc. Observing pools of

indicators enables them both to filter out noise and to obtain more

rs)

frequent observations, and econametric techniques that did likewise m.
generate more accurate measures of market expectations.
VI. Conclusions

This paper has listed a number of criticisms of empirical
exchange rate models, with the intent of suggesting directions for
improvement, and without regard for the obvious difficulties of pursuing
many of these directions. After characterizing the literature in section
II, the paper has argued three broad themes in sections III-V. The thene
of section III is that models of nominal exchange rates are bound to be at
least as poor as models or measures of expected inflation differentisls,
and that the literature should diversify away from imposing a simple money
demand structure to capture inflation or price-level expectations. The
theme of section IV is that the portfolio—balance framework needs
renovation: (a) to describe more adequately the link between prospective
yields on assets and country-specific variables such as macroeconomic
policies and outlooks, taxes, capital controls, etc.; and (b) to draw on
microeconomic evidence on how large exchange market participants (banks
and corporations) perceive their portfolio-management objectives and
structure their portfolio-adjustment decision processes. Section V ends,
however, on an upbeat theme for structural exchange rate models: their
poor forecasting performance to date cannot unsettle the major structural
foundations provided by the covered interest parity condition and the
notion that movements in naminal exchange rates are correlated with
revisions in expectations about inflation differentials, other things
equal. Instead, the poor forecasting performance can be interpreted as
indicating the importance of estimating structural models in a “news"
franework, and of developing more accurate (efficient) measures or models

of expectations.


T'S WRONG WITH EMPIRICAL EXCHANGE RTE MODELS:
SOME CRITICAL ISSUES AND NEW DIRECTIONS

Peter Isarat/
August 1983

I. Introduction

A number of recent statistical studies have found that
“representative” structural exchange rate models are no more accurate
than forward rates or random walks in forecasting out-of-sample, even
when purged of errors in forecasting explanatory variables./
This paper discusses some deficiencies in the specification and
estimation of structural exchange rate models. The criticisn is
organized into three basic themes, which are developed in sections
IlI-v after section Il provides a brief review of some major issues and
classes of models in the literature. Section III suggests that
empirical exchange rate models have essentially put a lot of eggs into
one basket in their attempts to capture the behavior of inflation
expectations, and that new directions for modelling or measuring
inflation expectations should be pursued. Section IV argues that
portfolio balance models have been oversimplified: insufficient
attention has been paid to microeconomic evidence on how large exchange
market participants (banks and corporations) perceive their portfolio-
management objectives and structure their portfolio-adjustment decision
processes; and conceptual models have distinguished portfolio assets
mainly by currency, without adequately linking the prospective yields
on assets to country-specific variables such as stabilization policies
and macroeconomic outlooks, taxes, capital controls, creditworthiness,
etc. Section V argues, however, that despite the deficiencies in the
specifications of structural exchange rate models, the poor empirical
performance of these models may stem much less from structural short-

comings than from deficiencies in quantifying ex ante expectations


- 29 -

Footnotes

* This paper represents the views of the author and should not be
interpreted as reflecting the views of the Board of Governors of
the Federal Reserve System or other members of its staff. I am
particularly grateful to Michael P. Dooley and Ralph W. Smith for
discussions of some of the issues addressed in this paper.

l/ The careful and extensive studies by Meese and Rogoff (1983a,
1983b) are pathbreaking examples.

(2/ See Frankel (1982a) for a recent review of the literature of
empirical exchange rate models and Rogoff (1983) and Tryon (1983) for
reviews of portfolio balance models. See Shafer and Loopesxo (1983)
for a perspective of the history and policy issues that have
influenced how the exchange rate literature has developed over
the past decade.

3/ In reality the covered parity condition holds closely when Rp and
R, are represented by Eurocurrency deposit rates; see Herring
and Marston (1976, footnote 3). Reserve requirements and other
taxes or capital controls can lead to significant covered dispari-
ties between the domestic deposit rates of different countries.

4/ Examples of the wide variety of different specifications of small-
scale empirical portfolio balance models include Artus (1976),
Branson, Haltunnen and Masson (1977, 1979), Dooley and Isard (1982,
1983a), Haas and Alexander (1979), Hooper and Morton (1982) and
Obstfeld (1982). See Rogoff (1983) and Tryon (1983) for recent
surveys. For the traditional simple two-country portfolio balance
model with two moneys and two bonds, the assumption that the bonds are

perfect substitutes makes it sufficient via Walras' Law to restrict


- 24-
Fellner, William, "The Bearing of Rise Aversion on Movements of Spot
and Forward Exchange Relative to the Dollar." In John R.

Chipman and Charles P. Kindleberger, eds., Flexible Exchange

Rates and the Balance of Payments, (Amsterdam: North

Holland) 1979,
Frankel, Jeffrey A. "On the Mark: A Theory of Floating Exchange
Rates Based on Real Interest Differentials", American
Economic Review 69, 1979: 610-22.
—_ "Monetary and Portfolio-Balance Models of Exchange
Rate Determination", in J. Bhandari, ed., Economic Inter-

dependence and Flexible Exchange Rates (MIT Press:

Cambridge, Mass.), 1982a.

, “A Test of Perfect Substitutability in the Foreign
Exchange Market", Southern Economic Journal 48, 1982b:
406-16.

, "In Search of the Exchange Risk Premium: A Six-
Currency Test Assuming Mean-Variance Optimization",

Journal of International Money and Finance 1, 1982c: 255-74.

Frenkel, Jacob A. “A Monetary Approach to the Exchange Rate:
Doctrinal Aspects and Empirical Evidence",

Scandinavian Journal of Economics 78, 1976: 200-24.

,"Flexible Exchange Rates, Prices and the Role of

'News': Lessons from the 1970s", Journal of Political
Economy 89, 1981: 665-705.

Geweke, John F. and Edgar L. Feige, "Some Joint Tests of the
Efficiency of Markets for Forward Foreign Exchange",

Review of Economics and Statistics 61, 1979: 334-41.



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