Salem Witch Trials
Essay by review • December 17, 2010 • Research Paper • 7,437 Words (30 Pages) • 4,351 Views
The need to understand the mechanics of exchange rates and their developments has generated a
vast theoretical and empirical literature. The flexible price monetary model, which subsequently
gave way to the overshooting or sticky-price model, the equilibrium and liquidity models as well as
the portfolio balance approach have characterised three decades of research, from the 1960s to the
1980s. More recently, since the publication of Obstfeld and Rogoff's (1995) seminal "redux" paper,
the new open-economy macroeconomics has attempted to explain exchange rate developments in
the context of dynamic general equilibrium models that incorporate imperfect competition and
nominal rigidities. Empirically, these theoretical developments have fared poorly at explaining
exchange rate dynamics, at least over relatively short horizons, and several exchange rate puzzles
have been highlighted.
The increasing role played by international financial markets in developed economies
constitutes a persuasive argument to explore possible relationships between returns on risky assets
and exchange rates dynamics. Recently, a new strand of research has investigated the
interconnections between equity and bond returns, on one side, and exchange rate dynamics, on the
other side, with promising results (see Brandt et al., 2001; Pavlova and Rigobon, 2003; Hau and
Rey, 2004 and 2005).
In this paper, by employing the Lucas' (1982) consumption economy model, we introduce a
new framework explaining exchange rate dynamics. We propose an arbitrage relationship between
expected exchange rate changes and differentials in expected equity returns of two economies.
Specifically, if expected returns on a certain equity market are higher than those obtainable from
another market, the currency associated with the market that offers higher returns is expected to
depreciate. A resident in the market which offers higher expected returns suffers a loss when
investing abroad, and therefore she has to be compensated by the expected capital gain that occurs
when the foreign currency appreciates. This ensures that no sure opportunities for unbounded
profits exist and, therefore, the equilibrium is re-established. Due to the similarity with the
Uncovered Interest Parity (UIP) condition, the equilibrium hypothesis proposed and tested here is
baptised Uncovered Equity Return Parity condition (URP). There is, however, a key difference
between the two arbitrage relations. In the UIP return differentials are known ex ante, since they are
computed on risk-free assets, while in the URP are not.
Risk-averse agents investing in risky assets denominated in a foreign currency usually
require a market and a foreign exchange risk premium, which can be time varying. We begin our
study assuming that investors are risk-neutral, which implies that the URP does not include risk
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September 2005
premia. Next, we relax the risk-neutrality assumption and we enrich the URP by employing
additional financial variables, which are related to the business cycle. We use differentials in
corporate earnings' growth rates, short-term interest rate changes, and annual inflation rates, as well
as net equity flows. In line with previous studies (see, for instance, Fama and French, 1989; Chen,
1991; and Ferson and Harvey, 1991b), these variables can be thought of as proxies for the risk
premia. The URP with risk premia turns out to explain a large fraction of the variability of the
European currencies, particularly of the euro, the British pound and the Swiss franc.
We also test the forecasting ability of the URP with time-varying risk premia and find that it
beats the naïve random walk model with drift at two- and three-month ahead forecasts and always
predicts about two thirds of directional changes for the EUR/USD exchange rate. The forecasting
performances for the Swiss Franc are better in terms of mean square errors, but not in terms of the
sign tests. The specification for the British pound does not beat the naïve random walk model,
despite it predicts correctly more than 60% of its directional changes.
Similar specifications fail in explaining the evolution of the Japanese Yen and the Canadian
dollar against the US dollar, possibly due to the systematic intervention policy of these countries in
the foreign exchange market.
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Working Paper Series No. 529
September 2005
"My experience is that exchange markets have become so efficient that
virtually all relevant information is embedded almost instantaneously in
exchange rates to the point that anticipating movements in major currencies is
rarely possible..... To my knowledge, no model projecting directional
movements
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