Showing papers on "Forward exchange rate published in 2001"

Expectations Hypotheses Tests

Abstract: We investigate the expectations hypotheses of the term structure of interest rates and of the foreign exchange market using vector autoregressive methods for U.S. dollar, Deutsche mark, and British pound interest rates and exchange rates. We examine Wald, Lagrange multiplier, and distance metric tests by iterating on approximate solutions that require only matrix inversions. Bias-corrected, constrained VARs provide Monte Carlo simulations. Wald tests grossly overreject the null, Lagrange multiplier tests slightly underreject, and distance metric tests overreject. A common interpretation emerges from the small sample statistics. The evidence against the expectations hypotheses is much less strong than under asymptotic inference. ACCORDING TO THE EXPECTATIONS HYPOTHESIS, information in current interest rates provides the conditional expectation of future asset prices. The expectations hypothesis of the term structure of interest rates ~EH-TS! states that the current term spread between a long-term interest rate and a short-term interest rate is the expected value of a weighted average of the expected future changes in the short-term interest rate. This theory, popularized in the writings of Fisher ~1930!, Keynes ~1930!, and Hicks ~1953!, continues to be a way that many economists think about the determination of long-term interest rates. Fisher ~1930! and Keynes ~1930! also discuss the expectations hypothesis in the foreign exchange market ~EH-FX!, which states that the interest-rate differential between two currencies is the conditional expected value of the rate of depreciation of the high interest-rate currency relative to the low interest-rate currency. Because of covered interest arbitrage, the interest differential equals the forward premium, which is the percentage difference between the forward exchange rate and the spot rate. Hence, the EH-FX is equivalent to the unbiasedness hypothesis, which is the proposition that the logarithm of the forward exchange rate is an unbiased predic* Bekaert and Hodrick are from Columbia University and are Research Associates of the National Bureau of Economic Research. Our research benefitted from the comments of Federico

Time-Variation and Structural Change in the Forward Discount: Implications for the Forward Rate Unbiasedness Hypothesis

Abstract: It is a well accepted empirical result that forward exchange rate unbiasedness is rejected in tests using the “differences regression” of the change in the logarithm of the spot exchange rate on the forward discount. The result is referred to in the International Finance literature as the forward discount puzzle. Competing explanations of the negative bias of the forward discount coefficient include the possibilities of a time-varying risk premium or the existence of “peso problems.” We offer an alternative explanation for this anomaly. One of the stylized facts about the forward discount is that it is highly persistent. We model the forward discount as an AR(1) process and argue that its persistence is exaggerated due to the presence of structural breaks. We document the temporal variation in persistence, using a time-varying parameter specification for the AR(1) model, with Markov-switching disturbances. We also show, using a stochastic multiple break model, suggested recently by Bai and Perron (1998), that for the G-7 countries, with the exception of Japan, the forward discount persistence is substantially less, if one allows for multiple structural breaks in the mean of the process. These breaks could be identified as monetary shocks to the central bank’s reaction function, as discussed in Eichenbaum and Evans (1995). Using Monte Carlo simulations we show that if we do not account for structural breaks which are present in the forward discount process, the forward discount coefficient in the “differences regression” is severely biased downward, away from its true value of 1.

Currency Hedging For Export-Flexible Firms *

Abstract: This paper examines the production and hedging decisions of a competitive exporting firm under exchange rate uncertainty. The firm possesses export flexibility in that it can distribute its output to either the domestic market or a foreign market, after observing the true realization of the exchange rate. It is shown that the separation theorem does not hold under export flexibility, i.e., the firm's optimal output depends on the firm's preference and on the underlying exchange rate uncertainty. Furthermore, the export- flexible firm underhedges its exchange rate risk exposure in a currency forward market where in the forward exchange rate contains a non-positive risk premium. [D21, F31]

Self-Generating Variables in a Cointegrated VAR Framework

Abstract: A variable is defined to be self-generating if it can be forecast efficiently from its own past only. Conditions are derived for certain linear combinations to be self-generating in error correction models. Interestingly, there are only two candidates for self-generation in an error correction model. They are cointegrating relationships and common stochastic trends defined by Gonzalo and Granger (1995). The usefulness of self-generation as a multivariate-modelling tool is investigated. A simple testing procedure is also presented. Some interesting economic hypothesis can be easily tested in the self-generation framework. For example, for forward exchange rate to have forecasting power for the future movements in spot rate, the latter should not be self-generating. Given that they are cointegrated, the spot exchange rate should not be a common stochastic trend, which can be easily tested. We also provide additional examples.

Modelling the Currency Forward Risk Premium: A New Perspective

Abstract: In this paper we seek to develop a new approach to the time series analysis of foreign exchange risk premia. We do so by assuming a geometric Brownian process for the spot exchange rate and expressing the no-arbitrage spot-forward price relationship under the historical probability measure. We are thereby able to obtain a stochastic differential equation system linking the spot exchange rate, the forward exchange rate and the risk premium (modelled directly as a mean-reverting diffusion process) which we estimate using Kalman filtering techniques. We are able to use observations at a range of frequencies since the framework we set up does not involve overlapping observations. The model is then applied to the French Franc/USD, DEM/USD, GBP/USD, and Japanese Yen/USD exchange rates from 1 January 1990 to 31 December 1998. For all currencies we find evidence that the forward risk premium is stationary and exhibits substantial positive time variation.

Self-Generating Variables in a Cointegrated VAR Framework - eScholarship

Abstract: A variable is defined to be self-generating if it can be forecast efficiently from its own past only. Conditions are derived for certain linear combinations to be self-generating in error correction models. Interestingly, there are only two candidates for self-generation in an error correction model. They are cointegrating relationships and common stochastic trends defined by Gonzalo and Granger (1995). The usefulness of self-generation as a multivariate-modelling tool is investigated. A simple testing procedure is also presented. Some interesting economic hypothesis can be easily tested in the self-generation framework. For example, for forward exchange rate to have forecasting power for the future movements in spot rate, the latter should not be self-generating. Given that they are cointegrated, the spot exchange rate should not be a common stochastic trend, which can be easily tested. We also provide additional examples.

Efficiency and News in Exchange Rate Market. The Euro/Dollar Case

Abstract: The aim of the paper is twofold: the first one is to examine the theoretical points that constitute literature on exchange rate market efficiency. We give a quick look to the long run, in which high or low efficiency results from the adjustment velocity of prices and production in goods market. We then go to examine literature conclusions about the short run. The second aim is to test the efficiency for the US dollar against the Euro foreign exchange market with anews' exchange rate model using daily data over a period of 19 months. In the model we use, as proxies of 'news', variables generated by the residuals from a VAR model. Our results are consistent with the hypothesis that the forward exchange rate is not an unbiased predictor of the future spot rate. That is, we reject the hypothesis of efficiency and we show the importance of the 'news' in determining short-run movements in the exchange rate markets. The general conclusion we reach is that the euro dollar exchange rate market, from its birth to august 2000, is not efficient because expectations could not be rational, i.e. operators cannot predict risks coming from stock exchange and from uncertainty on future values of economic variables.

Self-generating variables in a cointegrated var framework

Abstract: A variable is defined to be self-generating if it can be forecast efficiently from its own past only. Conditions are derived for certain linear combinations to be self-generating in error correction models. Interestingly, there are only two candidates for self-generation in an error correction model. They are cointegrating relationships and common stochastic trends defined by Gonzalo and Granger (1995). The usefulness of self-generation as a multivariate-modelling tool is investigated. A simple testing procedure is also presented. Some interesting economic hypothesis can be easily tested in the self-generation framework. For example, for forward exchange rate to have forecasting power for the future movements in spot rate, the latter should not be self-generating. Given that they are cointegrated, the spot exchange rate should not be a common stochastic trend, which can be easily tested. We also provide additional examples.

Modelling exchange rates returns using a nested design model.

Abstract: This paper examines cross-country currency variations regarding using a “nested design model“. It attempts to address the following three fundamental questions frequently asked by market practitioners. Is the market efficientŒ How significant is the variation of currencies volatility across countriesŒ How significant is the risk premium in the currency marketŒ The logic of these questions is that, if countries have similar trade policies, then they are likely to share common market risk factors. These factors could include, among others, a common risk shared by the various currencies. The study here compares the prediction power of two models. The first is by Levich (1978) and Frankel (1982). Wilkinson and Rogers (1973) motivated the second in the experimental design framework. In the model due to Wilkinson and Rogers (!973), we incorporated a time component into the model structure to yield what we term the nested design model (or nested exchange rate model). This model is then compared with a traditional exchange rate model. The daily spot and forward exchange rate data (in US dollar equivalence) from six developed countries were used in the study. The speculative returns and forward premium of both models were calculated. Evidence here suggests that the nested exchange rate model appears to be a better model.

Effects of Current Forward Market Intervention in the Korean Currency Crisis

Abstract: This paper investigates the effect of the exchange market interventions of the Bank of Korea on the exchange rate of Korean won vis-a-vis US dollar during the 1997 currency crisis. In particular, this paper tests the effects of spot and forward market interventions, using daily intervention data of the Bank of Korea. During the 1997 period, Korea faced two series of crisis in January-March and September-November. It turns out that the spot market intervention was effective in stabilizing the spot market exchange rate at least during the first crisis period. In contrast, there seemed no effect of the forward market intervention. Forward market intervention was rather destabilizing through forward exchange rate during the second crisis period. This implies that even though the forward and sterilized spot market interventions are equivalent in their effect on exchange rate, these two instruments can widely diverge from each other under the circumstances of exchange rate volatility and speculation.