WENDY M.

JEFFUS
INTERNATIONAL FINANCIAL ENVIRONMENT
EXCHANGE RATE DETERMINATION
Exchange rates are prices that are determined by supply and demand. For some countries
the exchange rate is the single most important price in the economy because it determines
the international balance o payments. !"e#ich$ %&&'( )here is no general theory o
exchange rate determination$ but Eiteman et al !%&&'( di#ide the potential exchange rate
determinants into i#e areas* parity conditions$ inrastructure$ speculation$ cross+border
oreign direct in#estment and portolio in#estment$ and political ris,s. -lthough no
model has been consistent in predicting short+term oreign exchange rate beha#ior$ there
are se#eral ma.or concepts that play a role in determining the long+term beha#ior o
oreign exchange rates. )he irst concept is based on the idea that the current price o an
asset relects all a#ailable inormation/ and thereore$ only unexpected e#ents cause
exchange rates to luctuate. !"e#ich$ %&&'(
Exhibit 1: Factors that Affect Forei! Excha!e Rate Mo"e#e!ts
De#a!$ for C%rre!c&

'rice of C%rre!c&
National 0ncome

Demand or 1urrency
2eal 0nterest 2ates

Demand or 1urrency
0nlation 2ates

Demand or 1urrency
National Wealth ! 1urrent -ccount(

Demand or 1urrency
3reerred 1urrency Mix

Demand or 1urrency
Financial 2is,

Demand or 1urrency
3olitical 2is,

Demand or 1urrency
Supply o Domestic 4onds

Demand or 1urrency
Source: Levich (2001)
"e#ich !%&&'( points out that the character and the context o the change 5ill greatly
aect the nature o the change. )he nature o the change is the eect it has on the
exchange rate$ 5hether exchange rates mo#e immediately$ reach a ne5 e6uilibrium$
o#erreact$ or continue to ad.ust. For example$ 7character8 aects the nature o the
change depending on 5hether the change is unanticipated #ersus anticipated changes$
permanent #ersus temporary changes$ real #ersus nominal changes$ and single industry
#ersus economy+5ide changes. -dditionally$ the extent that an opinion is held on the
change and the le#el o the rate o change 5ill aect the nature o the change. "e#ich
!%&&'( also tal,s about the 7context8 o the change ha#ing an aect on exchange rate
mo#ement. For example$ regarding 7context8 he is reerring to ho5 monetary authorities
are percei#ed$ the demand or home country currency and securities$ the le#el o
liberali9ation$ and the source o the change.
0n the short term exchange rates seem to be aected by ne5s about undamental
economic e#ents$ although economic models still remain unreliable or short term
orecasting. 0n the last %: years economists ha#e adopted the asset approach to exchange
rates in an attempt to explain exchange rate mo#ements. )he asset approach emphasi9es
WENDY M. JEFFUS
the role o expectations. 0n the monetary approach the exchange rate establishes a
relati#e price bet5een t5o currencies. 0n the portolio+balance approach$ exchange rates
relect the relati#e ris, and return o t5o currencies. !"e#ich$ %&&'(
'ARIT( CONDITION)
3arity conditions are an explanation or the long+run #alue o exchange rates. )hey
include* relati#e inlation rates !purchasing po5er parity(, relati#e interest rates !Fisher
eect($ or5ard exchange rates$ exchange rate regimes$ and oicial monetary reser#es.
Interest Rate Parity
0nterest rate parity connects the or5ard rate to the spot rate and interest rates in the
domestic economy to those abroad. !Sercu+Uppal$ ';;:( )his relationship holds because
the or5ard rate
$ t T
F
is ,no5n. -dditionally$ the or5ard rate is not aected by in#estors
ris, a#ersion or uncertainty. 0nterest rate parity is the strongest relationship$ and through
arbitrage it is used to ensure that inancial prices relect a or5ard premium predicted by
interest rate parity. !Sercu+Uppal$ ';;:(
Purchasing Power Parity
3urchasing po5er parity
'
!333( states that o#er the long+run the exchange rate bet5een
t5o currencies ad.usts to relati#e price le#els. -s sho5n belo5$ the spot exchange rate at
the end o the period !S
'
( o#er the spot exchange rate at the beginning o the period !S
&
( is
e6ual to one plus the oreign inlation rate !' < 0
F
( o#er one plus the domestic inlation
rate !'< 0
D
(.
!'(
'
&
'
'
F
D
S I
S I
+
=
+
-n important ma.or determinant o long+run beha#ior o real exchange rates is economic
acti#ity such as a rise in producti#ity or gro5th in manuacturing. )hese actors aect
the o#erall 6uality and 6uantity o goods produced and consumed$ the 7national
consumption bas,et.8 While there is agreement that gro5th in economic acti#ity and
dierences in producti#ity inluence the long+term real exchange rate$ calculation o
these eects are still debated. !Solni,$ %&&&(
The International Fisher Effect
)he Fisher eect describes the long+run relationship bet5een inlation and interest rates.
)his theory states that nominal interest rates in each country are e6ual to the re6uired real
rate o return plus compensation or expected inlation. See e6uation %$ 5here i is the
nominal rate o interest$ r is the real rate o interest$ and = is the expected rate o inlation
o#er the period the unds are to be lent. -n approximation o the Fisher eect drops the
inal term. E6uation > is an example o the 0nternational Fisher eect$ 5here S
'
is the
spot rate at the beginning o the period and S
%
is the spot rate at the end o the period$ and
i represents the respecti#e national interest rates. )he 0nternational Fisher eect then
'
)he Economists 4ig Mac index stems rom the purchasing po5er parity theory.
WENDY M. JEFFUS
states that the spot exchange rate should change in an amount e6ual to$ but in the opposite
direction o the dierence in interest rates bet5een t5o countries.
!%(
i r r = + +
!>(
'
%
'&&
domestic forein s
S S
x i i
S

=
Exhibit *: The Fo%r I!ter!atio!a+ 'arit& Re+atio!shi,s
Source: Sercu !nd "pp!# (1$$%)
0n the abo#e diagram Sercu and Uppal !';;:( lin, three ormulas to imply the Fisher
open relationship !or the 0nternational Fisher Eect(. )he interest rate parity
%
relates to
the or5ard premium to the interest dierential. 3urchasing po5er parity lin,s the
expected exchange rate change to the inlation dierential. -s sho5n abo#e$ the
0nternational Fisher eect lin,s the interest rates to inlation. Sercu and Uppal !';;:(
also discuss the unbiased expectations hypothesis that lin,s the or5ard premium to the
expected change in the spot rate.
Unbiased Expectations Hypothesis
)he unbiased expectations hypothesis is the theory that or5ard exchange rates are
unbiased predictors o uture spot rates. )his hypothesis assumes that there is no
uncertainty about inlation. )his leads to 5hat is commonly called the Siegel 3aradox.
)he Siegel 3aradox is the obser#ation that i t5o in#estors rom dierent countries ha#e
%

$ '
$ ' ?
$ '
!' (
!' (
t t
t t t
t t
r
F S
r
+
+
+
+
=
+
For-ar$
're#i%#
I!terest
Differe!tia+
I!f+atio!
Differe!tia+
Rate of cha!e
of s,ot rate
Fisher @pen 2elationship
Unbiased Expectations
Aypothesis
0nterest 2ate 3arity 3urchasing 3o5er 3arity
WENDY M. JEFFUS
the same expectation o the probable distribution o uture exchange rates$ the expected
returns o the t5o currencies 5ill not actually oset one another. )he unbiased
expectations hypothesis also assumes that in#estors are ris, neutral and that exchange
rate can be ignored or the determination o the uture spot rate. !Sercu+Uppal$ ';;:(
.ALANCE OF 'A(MENT) AND THE A))ET MAR/ET
)here are t5o models to calculate exchange rates* the balance o payments approach and
the asset approach. 0n the balance o payments !4@3( approach the domestic price o a
oreign currency is determined by the intersection o the mar,et demand and supply
cur#es or that oreign currency. )he asset approach is based on the idea that exchange
rates are based on relati#e real interest rates and expectations or economic gro5th and
proitability. !Eiteman et al$ %&&'(
Balance of Payents !Flow "pproach#
-ccording to Solni, !%&&&( the balance o payments approach 5as the irst approach or
economic modeling o the exchange rate. )he balance o payments approach trac,s all o
the inancial lo5s across a countryBs borders during a gi#en period. -ll inancial
transactions are treated as a credit and the inal balance must be 9ero. )ypes o
international transactions include* international trade$ payment or ser#ice$ income
recei#ed$ oreign direct in#estment$ portolio in#estments$ short+ and long+term capital
lo5s$ and the sale o currency reser#es by the central ban,.
Fi%re 1: .a+a!ce of 'a&#e!ts Exa#,+e
4@3 C current account < capital account < oicial reser#e account C &
)he current account includes the trade balance$ balance o ser#ices$ net income recei#ed$
and unre6uited transers. - current account deicit !surplus( tends to be correlated 5ith
the depreciation !appreciation( o the exchange rate. )he capital account includes* direct
in#estment$ portolio in#estment$ other capital lo5s$ and net errors and omissions. -
capital account surplus !deicit( is correlated to the amount oreigners are 5illing to lend
!borro5(. )he third part o the e6uation$ the oicial reser#e account$ includes the net
changes in the go#ernmentBs international reser#es. )he 4@3 approach is also not as
accurate or short+term predictions.
"sset "pproach !$toc% "pproach#
)he asset approach is based on the ideas that mar,ets are eicient and that exchange rates
are assets traded in an eicient mar,et. )he asset approach predicts that the spot rate
beha#es li,e any other asset++the #alue o the spot rate changes 5hene#er rele#ant
inormation is released. )hereore$ prices are determined based on expectations about the
uture. )his approach ocuses on the relationship bet5een the capital account and
exchange rates.
WENDY M. JEFFUS
FORECA)TING
7Forecasting transorms chaos into error8
&E##iott Smith' (oston )o##ee
Exchange rate orecasting plays a undamental role in many aspects o international
inance$ such as the e#aluation o oreign borro5ing or in#estment opportunities$
orecasts o uture spot exchange rates$ short+term hedging$ operating and strategic
decisions$ and competiti#e analysis. !"e#ich$ %&&'( Exchange rate orecasting in#ol#es
the study o relati#e political$ social$ and economic conditions o rele#ant countries.
)here are t5o basic approaches to orecasting exchange rates* economic analysis and
technical analysis. Eco!o#ic a!a+&sis orecasts the present and uture 7air #alues8 o
oreign exchange rates$ based on the undamentals o the rele#ant countries. Tech!ica+
a!a+&sis uses 6uantitati#e models to estimate short+term luctuations in exchange rates.
)echnical analysis is based solely on price inormation. While there is considerable
disagreement on both the accuracy and appropriateness o orecasting$ it remains a
undamental aspect o 0nternational Finance. "e#ich !%&&'( points out the dierence
bet5een accurate and useul orecasts. -ccurate orecasts ha#e small error terms. Useul
orecasts help ma,e decisions that lead to proitable speculati#e positions and correct
hedging decisions.
&hallenges
Due to the competiti#e and dynamic nature o the currency mar,et$ both consumers and
producers o exchange rate orecasts ace special problems. For example$ choosing a
method has implications on the orecast. -dditionally$ there are numerous pro#iders o
analysis$ and subse6uent decisions on ho5 and 5here to implement analysis 5ill ha#e
large implications on the outcome o the analysis. )he orecast hori9on is also important
in any analysis. Forecast hori9ons can range rom minutes to decades. !"e#ich$ %&&'(
Success depends on the economic relationships that 5ill persist in the uture$ and
structural changes in the international economy 5ill continue to represent one o the
biggest challenges to orecasters. !"e#ich$ %&&'(
Efficient 'ar%et Hypothesis
Mar,et eiciency represents a .oint hypothesis regarding the e6uilibrium o prices !or
returns( in the mar,et and the ability o mar,ets to set actual prices. When mar,ets are
eicient then mar,et participants cannot earn abnormal returns. )he eicient mar,et
hypothesis !EMA( !Fama$ ';D&( states that a mar,et cannot be outperormed because all
a#ailable inormation is already built into all stoc, prices. 0n other 5ords$ no arbitrage
opportunities should exist in an eicient mar,et. !Wadh5ani$ ';;;( Empirical e#idence
supports mar,et eiciency 5hen transaction costs and other actors are ta,en into
account. !"e#ich$ %&&'( )his has been restated in terms o three degrees o eiciency.
)he *e!+ form o eiciency states the current prices relect all historic inormation. )he
semi&stron form o eiciency states that current prices relect all publicly a#ailable
inormation. Finally$ the strong orm o eiciency states that the current price o an asset
relects all a#ailable inormation including proprietary and insider inormation.
WENDY M. JEFFUS
)he eicient mar,et hypothesis is commonly tested under three methods* tests o return
predictability$ e#ent studies$ and tests or pri#ate inormation. !Fama$ ';;'( )ests or
return predictability are studies that examine 5hether returns can be predicted by historic
prices or historic inormation on undamental #ariables. E#ent studies are studies that
examine ho5 prices respond to public announcements. Finally$ tests or pri#ate
inormation indicate studies that examine 5hether speciic in#estors ha#e inormation
that is not in mar,et prices.
Policy Iplications
When policy ma,ers set interest rates$ they can be inluenced by their expectations or
uture interest rates. !Wadh5ani$ ';;;( 3ublic policy ma,ers are interested in the
eiciency o oreign exchange mar,ets$ because eicient mar,ets mean that the le#el o
exchange rates and #olatility is !on a#erage( a air relection o the underlying economic
undamentals. )hereore$ in an eicient mar,et the le#el and #olatility o exchange rates
are due to undamental actors rather than a misreading o these actors by pri#ate
in#estors. !"e#ich$ %&&'( Sources o mar,et ineiciencies are uncertain++they can relect
speculation$ insider trading$ corruption$ or poor decisions rom central ban,s and
go#ernments. 4ut 5hat is certain is that they create challenges or decision ma,ers.
Eployent Iplications
Forecasts o exchange rates are not straightor5ard. Many proessional economists earn
their li#ings based on the belie that exchange rates e#ol#e 5ith detectable trends.
Erossman !';;:( ma,es this point$ mar,ets cannot be perectly eicient 5hen
inormation is costly/ other5ise there 5ould be no incenti#e to de#ote signiicant
resources to collect inormation. Erossman !';;:( adds that or reasons unrelated to
uture expected payos$ prices mo#e by 7noise8 created by uninormed in#estors$
allo5ing inormed in#estors to earn a return or their data gathering eorts. !Wadh5ani$
';;;(
Economic modeling is used in currency orecasting$ and proessional economists .udge a
orecast by its ability to earn abnormal returns. 3roessionals also use technical analysis
to predict exchange rates. Structural changes in the international economy represent one
o the biggest challenges or proessional orecasters. !"e#ich$ %&&'( 4ecause there are
se#eral decisions to ma,e that re6uire insight not currently a#ailable by computer
analysis$ orecasters continue to be employed. Some o this insight is based on our
relationships. !Sercu+Uppal$ ';;:( First$ exchange rates should ne#er be considered in
isolation. )he inlation dierential is also important. Second$ interest rates 5ould ne#er
be compared in isolation. )he spot rate and associated ris, are important actors. )hird$
ris, needs to be considered 5hen calculating the expected uture #alue. Finally$ the
or5ard rate has not pro#en to be a good predictor o uture spot rates.
C0RRENC( '011LE)
)here are se#eral pu99les in exchange rate orecasting. Solni, !%&&&( lists some o the
common currency pu99les. )he irst is the for-ar$ ,re#i%# ,%22+e$ 5hich states that a
regression analysis bet5een the reali9ed exchange rate mo#ement and the or5ard
WENDY M. JEFFUS
premium !or discount( re#eals that the slope coeicient !F( is signiicantly smaller than '$
and sometimes negati#e. )his inding implies that a successul trading strategy 5ould be
to bet against the or5ard exchange rate$ in other 5ords$ expected exchange rates #ary
o#er time in a some5hat predictable manner as a unction o the interest rate dierential.
- second common pu99le is that exchange rates ollo5 trends.
-nother pu99le is that the implied dierence or the appropriate le#el o the interest rate
bet5een the exchange rate con#entions is substantial and that sometimes exchange rates
mo#e 5ithout any associated mo#e in the interest dierential. !Wadh5ani$ ';;;(
Wadh5ani !';;;( loo,s at this pu99le in the context o t5o classes o in#estors. )hose
that in#est in inormation and ma,e a decision on the uture o interest rates and those
that transact in currencies as a normal course o business 5ithout estimating uture
changes. -n example o the second type o in#estor is someone 5ho ma,es 7carry
trades8 5here the in#estor borro5s in the lo5 interest rate country and lends in the high
interest rate country. )hese dierent sets o in#estors trade or dierent reasons ma,ing
it diicult to examine strategies. Wadh5ani !';;:( concludes that it is 7hardly surprising
that 5e do not al5ays agree about the best 5ay to orecast exchange rates.8 - inal
currency pu99le is that inancial mar,et #olatility changes o#er time in a some5hat
predictable ashion$ and researchers ha#e ound e#idence o E-21A eects.
IT'EER
)he 0ntermediate+term model+based e6uilibrium exchange rate model !0)MEE2( 5as
created as a modiied unco#ered interest rate parity model. )he 0)MEE2 model suggests
that exchange rates mo#e to relect interest rate dierentials and an additional ris,
premium. )he ris, premium introduced in the model is inluenced by undamental
#ariables such as the current account$ unemployment rates$ net oreign assets$ relati#e
prices$ and yield dierentials on inancial assets. )he model or 0)MEE2 is sho5n
belo5. )he irst t5o terms are the estimated de#iations rom the e6uilibrium exchange
rate$ and G is a set o #ariables that helps predict the returns on other assets. )he
#ariables 1-DH UNED$ NF-D$ DY$ EI2$ and 30 are the dierentials o current account
o#er ED3$ unemployment rate$ net oreign assets$ lagged di#idend yield$ lagged e6uity
return$ and past inlation. 2W313 is the relati#e producti#ity and YS is the lagged yield
spreads.
!>(
?
! ( ! (
t t + t t t t +
E S S i i
+ +
= + +
! $ (
! $ $ $ (
! $ $ $ (
t + t t t
t t t t t
t
f ,
f )-D ".ED .F-D /0)1
, f D2 E3/ 2S 1I

+
=
=
=
)he model has three components$ the interest rate dierential$ the de#iation rom
e6uilibrium$ and the relati#e returns rom the #arious assets.
WENDY M. JEFFUS
"R&H()"R&H 'odels
)he -21AJE-21A models ha#e become standard tools or 6uestions about #olatility.
)he assumption o homos,edasticity$ that the s6uared expected #alues o all error terms
at any gi#en point are e6ual$ is the ocus o -21AJE-21A models. Aeteros,edasticity
is a problem 5here the #ariances o the error terms are not e6ual and thus are expected to
be larger or some ranges. -21AJE-21A models treat heteros,edicity as a #ariance to
be modeled. )he simplest speciication o the conditional #ariance is the -21A model$
in 5hich the conditional #ariance is simply the 5eighted a#erage o past s6uared orecast
errors. 0n the ollo5ing -21A e6uation !p( represents past s6uared orecast errors.
!K(
% % % %
' ' % ' '
...
t t t p t p
e e e
+
= + + + +

- generali9ation is to allo5 past conditional #ariance to enter the e6uation$ this brings us
to the Eenerali9ed -21A !E-21A( e6uation. )his generali9ation 5as introduced by
4ollersle# !';LM(. )his model used the 5eighted a#erage o past s6uared residuals$ but
has declining 5eights that ne#er go to 9ero. !Engle$ %&&'( 0n the ollo5ing E-21A
e6uation !p( represents the number lags or the s6uared error terms and !6( represents the
past #ariances.
!:(
% % % % % %
' ' % ' ' ' '
... ...
t t t p t p t 4 t 4
e e e
+
= + + + + + + +
)he most 5idely used E-21A speciication$ 7E-21A!'$'($8 states that the best
predictor o the #ariance in the next period is the 5eighted a#erage o the long+run
a#erage #ariance !the #ariance predictor or this period($ and ne5 inormation is captured
by the most recent s6uared residual. )he simpliied E-21A !'$'( model is sho5n
belo5.
!M(
% % %
' ' ' t t t
e
+
= + +
)he -21A+in+Mean model !-21A+M( 5as proposed by Engle$ "ilien$ and 2obins
!';LD(. )he -21A+M model allo5s the conditional #ariance to be a determinant o the
mean. )he )-21A model is a modiication o -21A and E-21A models. 0n a
)-21A process the past time increment aects the calculation in a dierent 5ay
depending on its sign. )-21A accounts or the act that traders react dierently to
positi#e and negati#e increments o a actor.
-dditional currency pu99les are brought orth by Sergio and Ser#Nn !%&&%(. First$ despite
the presumed rigidity o the peg underlying currency boards$ currency premiums tend to
be uniormly positi#e$ suggesting that mar,ets persistently anticipate a de#aluation o the
exchange rate. Sergio and Ser#Nn !%&&%( as, 5hether currency boards are really yielding
suicient credibility as to minimi9e currency ris,. Second$ according to Sergio and
WENDY M. JEFFUS
Ser#Nn !%&&%( political and economic e#ents seem to be important actors in the beha#ior
o currency premiums. )hird$ yield cur#es tend to slope up5ards but latten at the pea,
o a crisis leading to the implied possibility o arbitrage opportunities. Fourth$ currency
ris, seems to dier across mar,ets/ and inally$ domestic and oreign monetary and
inancial actors exert a systematic eect on the currency premium and its structure.
EXCHANGE RATE REGIME)
0n general a ixed exchange rate is preerred i monetary changes aect the general le#el
o prices. Examples o ixed exchange rate regimes are pegged exchange rates and
cra5ling pegs. - ,ee$ excha!e rate is 5here the country sets the #alue o its
national currency according to the #alue o a oreign currency li,e the U.S. dollar or the
French ranc$ or to a bas,et o currencies. 1entral ban,s inter#ene to ,eep the rate
bet5een narro5 bands through international reser#es. - pegged exchange rate may help
establish the credibility o a program to reduce inlation. -s the expectations o inlation
are reduced through the ,no5ledge that go#ernment policy must be subordinated to the
needs o maintaining the peg$ the threat o chronic inlation is reduced. For example$ the
go#ernment cannot increase borro5ing 5hile trying to maintain a pegged currency. With
cra5ling pegs the country sets its exchange rate according to a criterion such as the
relati#e change in inlation. 1ountries 5ith higher inlation rates than their trading
partners oten depreciate their currencies to pre#ent loss o competiti#eness. !1arama99a
and -9i9$ ';;L( - pegged exchange rate is not sustainable in the long run. !"e#ich$
%&&'( - f+oati! excha!e rate system is 5here the exchange rate is ree to ad.ust to
respond to changes in relati#e macroeconomic systems. Floating exchange rates relect
the speculati#e dynamics o the mar,et. !"e#ich$ %&&'(
Economic shoc,s such as a steep rise in international interest rates$ a slo5do5n o
gro5th in the industrial 5orld$ and the debt crisis oten re6uire currency depreciations
and the adoption o more lexible exchange rate regimes. )he increased capital mobility
and 5a#es o capital inlo5s and outlo5s ha#e heightened the potential or shoc,s and
the pressure or lexibility. !1arama99a and -9i9$ ';;L( 0n general a loating exchange
rate is preerred i real changes such as technology changes or shits in consumer
preerences aect the relati#e prices o domestic goods. Examples o loating exchange
rate regimes are managed loating or independently loating. - lexible exchange rate
enables go#ernments to allo5 inlation to rise !and eecti#ely increase tax re#enue(.
Many de#eloping countries ha#e thin inancial mar,ets 5here a e5 large transactions
can cause extreme #olatility.
C0RRENC( CRI)E)
-ccording to Solni, !%&&&( most currency crises ha#e the ollo5ing pattern. First$ the
country runs a gro5ing current account deicit. )hus$ the currency is regarded as
o#er#alued by 333 standards. 0n instances 5here oreigners 5ere in#esting in a
7booming8 economy and lending to local irms at attracti#e interest rates this capital
account surplus is co#ered up by the current account deicit. Ao5e#er$ once prospects
WENDY M. JEFFUS
or economic gro5th 5ea,en and uncertainty builds$ these oreign in#estors begin to exit
the mar,et. -s in#estors exit$ the current account deicit is re#ealed$ and go#ernments
are orced to raise interest rates to attract capital. )hese high interest rates slo5 the
economy and hurt economic prospects urthering the need or capital control measures.
-t this instance the 0MF oten steps in to pro#ide additional reser#es/ and since mar,ets
begin to become highly speculati#e the country is orced to de#alue its currency or let the
exchange rate loat. )his process can create a #icious cycle 5here currency depreciation
leads to increased inlation 5hich leads to urther depreciation o the currency.
CONTAGION
1ontagion is a signiicant increase in cross+mar,et lin,ages ater a shoc, to an indi#idual
country !or a group o countries(. !Forbes and 2igobon$ %&&'( )here are t5o main
channels o contagion++through trade lin,s and through the inancial system. !Economist$
%&&'( Forbes and 2igobon !%&&'( go on to speciy that 7shit+contagion8 reers to a
signiicant increase in cross+mar,et lin,ages ater a shoc,$ such as the correlation in asset
returns$ the probability o a speculati#e attac,$ or the transmission o shoc,s or #olatility.
)he theoretical literature on contagion can be di#ided into t5o groups* crisis+contingent
and non+crisis+contingent theories. Forbes and 2igobon !%&&'( deine crisis+contingent
theories as those that explain 5hy transmission mechanisms change during a crisis and$
thereore$ 5hy cross+mar,et lin,ages increase ater a shoc,. Non+crisis+contingent
theories are those that assume transmission mechanisms are the same during a crisis as
during more stable periods and$ thereore$ cross+mar,et lin,ages do not increase ater a
shoc,.
)he irst group o theories can be di#ided into three groups* multiple e6uilibria$
endogenous li6uidity$ and political economy. Multiple e6uilibria is based on in#estor
psychology and occurs 5hen a crisis in one country coordinates in#estorsB expectations
or another economy. Endogenous li6uidity causes portolio re+composition 5hen a
crisis in one country reduces the li6uidity o mar,et participants. 3olitical contagion
aects exchange rate regimes 5hen the political pressure to maintain a ixed exchange
rate is reduced by the actions o another mar,et participant.
)he second group o theories can be di#ided into our broad channels* trade$ policy
coordination$ country ree#aluation$ and random aggregate shoc,s. )rade 5or,s through
de#aluation o currency or the reduction o exports o competing products. 3olicy
coordination occurs as one country responds to another countryBs economic shoc,.
1ountry ree#aluation or learning$ is the idea that in#estors apply lessons learned ater a
shoc, to other countries 5ith similar macroeconomic policies. 2andom aggregate shoc,s
or global shoc,s$ such as international interest rates$ international supply o capital or a
decline in international demand aect the undamentals o se#eral countries.
)he ollo5ing is a typical example o an exogenous li6uidity shoc,. Sets x
t
and y
t
are
t5o stoc, mar,et indices$ 9
t
is a li6uidity shoc,$ and O
t
and n
t
are idiosyncratic and
independent shoc,s. )he model o an endogenous li6uidity shoc, assumes that shoc,s
WENDY M. JEFFUS
are transmitted rom country x
t
to country y
t
through the #ariable F$ and that the li6uidity
shoc, has dierent eects on t5o countries$ 9
t
is independent o O
t
and n
t
. - li6uidity
shoc, 5ould ha#e a negati#e impact on both x
t
and y
t
.
314
t t t t
t t t
5 x 6
x 6

= + +
= +

@n the other hand$ an endogenous li6uidity shoc, is a case 5ith t5o regimes. When the
reali9ation o xt is positi#e$ the spread o shoc,s rom x
t
to y
t
is F/ but 5hen the
reali9ation is negati#e$ then the propagation o shoc,s is F < PQ. )his 5ould continue to
increase the #ariance o both mar,ets.
3*4
&
& &
t t
t
t
!x x
6
x
<
=

>

)here are our dierent approaches to measure the transmission o shoc,s and test or
contagion* analysis o cross+mar,et correlation coeicients$ E-21A rame5or,s$ co+
integration$ and probit models. -nalysis o cross+mar,et correlation coeicients test the
correlation in returns bet5een t5o mar,ets during stable periods and then test or a
signiicant increase in the correlation coeicient ater the shoc,. )he E-21A !or
-21A( rame5or, estimates the #ariance+co#ariance transmission mechanism across
countries. 1o+integration tests or changes in the long+run relationship bet5een mar,ets
rather than short+run changes ater a shoc,. 3robit models such as #ariance matrices use
simpliying assumptions and exogenous e#ents to identiy a model and directly measure
changes in the spread.
Suliman !%&&%( gi#es an example o a typical -21AJE-21A model o international
reser#es 5here 2 is international reser#es and RBs are #ariables that aect changes in the
international reser#es$ Os are inno#ations to international reser#e changes 5ith 9ero mean
and conditional #ariance S%t$ Yt+. are #ariables other than past s6uared inno#ations or
lagged orecast #ariance that may explain international reser#esB #olatility.
354
t 7 t 7 7
/ 8

= + +
364
% %
' t t t 7
2

= + +
Some economists argue that it is impossible to deine contagion based on simple tests o
changes in cross+mar,et relationships. !Forbes and 2igobon$ %&&'( Se#eral models ha#e
been created to predict 5hich country is most li,ely to incur problems. !Economist$ %&&'(
WENDY M. JEFFUS
Foreign debt is the le#el o debt and its gro5th rate. Debt that is %&&T o exports is
typically a 5arning signal. Aigh budget deicits and excessi#e short+term borro5ing is
also concerning to in#estors. @ther models include current+account deicits that continue
to rise and exchange rates. !Economist$ %&&'( 1arama99a and -9i9 !';;L( argue that
misalignments and currency 7crashes8 are e6ually li,ely under pegged and lexible
exchange rate regimes. )his is based on the statistics that hal o the recent crashes
occurred under ixed exchange rate regimes 5hile the other hal occurred under loating
exchange rate regimes/ although$ they admit that this may relect the act that relati#ely
e5 de#eloping mar,ets ha#e truly loating exchange rates.
WENDY M. JEFFUS
REFERENCE)
4ollersle#$ )im. !';LM( 7Eenerali9ed -utoregressi#e 1onditional Aeteros,edasticity.8
9ourn!# of Econometrics$ -pril$ >'*>$ pp. >&D+>%D.
1arama99a$ Francesco and -9i9$ Jahangir$ !';;L($ Fixed or Flexible* Eetting the
Exchange 2ate 2ight in the ';;&s. Economic 0ssues 0nternational Monetary Fund.
!%&&'( Ao5 the bug can spread$ Economist$ July ';.
Eiteman$ Da#id U.$ Stonehill$ -rthur 0.$ and Moett$ Michael A. !%&&'( Multinational
4usiness Finance ;
th
edition$ published by -ddison+Wesley "ongman$ 0nc.
Engle$ 2obert !%&&'( E-21A '&'* )he Use o -21AJE-21A Models in -pplied
Econometrics$ 9ourn!# of Economic 1erspectives$ Vol. ':$ Numer K$ p. ':D+'ML.
Engle$ 2obert$ "ilien$ Da#id$ and 2obins$ 2ussell$ !';LD( WEstimation o )ime Varying
2is, 3remia in the )erm Structure* the -21A+M Model$W Econometric! ::* >;'+K&D
Fama$ Eugene. !';D&( WEicient capital mar,ets* - re#ie5 o theory and empirical
5or,$W Journal o Finance %:$ >L>+K'D.
Fama$ Eugene !';;'( WEicient capital mar,ets* 00W$ Journal o Finance KM$ ':D:+'M'D.
Forbes$ Uristin and 2igobon$ 2oberto$ !%&&'( Measuring 1ontagion* 1onceptual and
Emperical 0ssues$ Editor Sti.n 1laessens 0nternational Financial 1ontagion$ Ulu5er
-cademic 3ublishers p. K>+MM.
Erossman$ Stanord J !';;:( 7Dynamic -sset -llocation and the 0normational
Eiciency o Mar,ets$8 Journal o Finance$ Vol "$ No >$ July$ pp DD>+DLD.
"e#ich$ 2ichard M. !%&&'( 0nternational Financial Mar,ets$ %
nd
edition$ published by
McEra5+Aill.
Mar,o5it9$ Aarry !';:%( 73ortolio Selection$8 9ourn!# of Fin!nce D$ No. ' !March
';:%($ pp. DD+;'
2oc,eeller$ 4arbara$ !%&&'($ 1N41 %DJD )rading* -round the cloc,$ around the 5orld
3ublished by John Wiley X Sons$ 0nc.$ 1opyright 14N1
Schmu,ler$ Sergio ". and Ser#Nn$ !%&&%( 73ricing 1urrency 2is,* Facts and 3u99les rom
1urrency 4oards8 N4E2 Wor,ing 3aper
Sercu$ 3iet and Uppal$ 2aman$ !';;:( 0nternational Financial Mar,ets and the Firm$
published by SouthWestern.
WENDY M. JEFFUS
Solni,$ 4runo$ !%&&&( 0nternational 0n#estments K
th
edition 3ublished by -ddison+Wesley
1opyright -ddison Wesley "ongman
Suliman$ @sman$ !%&&%( 1ontagion in Eul 1ountries
Wadh5ani$ Sushil 4.$ !';;;( 71urrency 3u99les8 Speech deli#ered at "ondon School o
Economics$ September 'M.