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Richard Conway 07534043 EC4051 Hilary Term Empirical Research Project 2011
Abstract A common ﬁnding in the literature on international ﬁnancial economics is that, contrary to theoretical predictions, countries with high nominal interest rates tend to experience currency appreciation. This “forward discount puzzle” has been shown to be pervasive across all markets and maturities, and aﬀects not just the spot market, but also the forward market through the interest rate diﬀerential. Our article aims to uncover recent trends in strict interest parity and the changing nature of forward market eﬃciency, and investigate the changing strength with which these complementary hypotheses hold. We use pre and post ﬁnancial crisis data to examine the possibility of a structural break in 2007, and to examine whether exchange market eﬃciency has declined in the wake of the crash. As Milton Friedman once said,“The only relevant test of the validity of a hypothesis is comparison of prediction with experience.”
1 Introduction 1.1 Background & Related Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 The Model 2.1 The Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Empirical Results 3.1 Uncovered Interest Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Unbiased Forward Rate Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Conclusions & Possible Extensions 2 2 4 5 6 6 11 14
Uncovered interest rate parity (UIP) predicts that high interest rate currencies will depreciate relative to their low interest rate counterparts. This relationship between interest rate diﬀerentials and spot exchange rate depreciation is at the heart of many theoretical models in ﬁnance. A simple example can illustrate these dynamics. Suppose foreign interest rates were higher over a one week horizon than their domestic counterparts. Risk neutral investors with rational expectations (two key assumptions of the model) would buy the foreign currency to invest abroad at the one week maturity and capture these excess returns. This would continue up to the point that the foreign currency depreciates suﬃciently to account for the initial interest rate diﬀerential. This simple uncovered arbitrage argument dictates that in equilibrium, there are zero attainable excess returns from such a strategy. If we are to believe that such a process holds for all currency pairs over all time horizons, UIP will hold. Given the depth of liquidity in markets for foreign exchange, eﬃciency of this type is not an unreasonable assumption. However, it has been shown empirically (Froot & Thaler (1990), Hodrick (1987) and Flood and Rose (1994)) that instead of depreciating - in line with the model’s predictions - high interest rate currencies in fact display a systematic tendency to appreciate. This anomalous forward discount bias seems to be persistent across all the major currency pairs and time horizons. Systematic deviations from UIP warrant further attention for a number of reasons. For one, UIP forms the basis of many ﬁnancial and open-economy general equilibrium models. The better we understand deviations from this parity condition, the better we can build these models in the future, and reduce policy and investment errors grounded in model misspeciﬁcation. Secondly, the growing size of the carry trade and the large proﬁts attainable are based on the breakdown of UIP. Given the size of ﬂows and the scope of this strategy (the number of currency pairs involved), we would expect the room for proﬁt to disappear as money aims to exploit interest rate diﬀerentials - however, it doesn’t. Further analysis of UIP should shed light on the potential proﬁtability of such strategies over time. This paper will aim to provide a pre and post crisis comparison of UIP in order to identify changing levels of foreign exchange market eﬃciency, both in the spot and forward market.
Background & Related Literature
UIP has been widely tested over many diﬀerent time periods, and all of the major FX currency pairs. The most comprehensive reviews are given by Froot & Thaler (1990), Hodrick (1987) and Flood and Rose (1996). In most cases, positive interest rate diﬀerentials are accompanied by 2
exchange rate appreciation, rather than the depreciation that UIP dictates should occur. This would lead to a compounding of potential proﬁts to such strategy - proﬁts from the favorable exchange rate diﬀerential would be increased through favorable exchange rate appreciation. Most tests of UIP have tested an equation of the form,
st+∆ − st = α + β(ih − if ) + εt+k t t
Estimates of β have been shown to not just to deviate from the correct UIP value of unity, but in fact to be regularly and signiﬁcantly negative. Froot (1990) reports a consensus estimate for β in academic literature of -0.88, along with nontrivial estimates for α. Thus, uncovered interest parity predicts an outcome almost exactly opposite to what the data tells us. Several explanations have been put forward for these large and systematic deviations from UIP. Marey (2004) describes how the above test is essentially a test of the joint hypothesis that investors exhibit rational expectations [E(St+∆ ) = St+∆ ] and have constant risk premia. It follows that in the presence of time-varying risk premia, or expectational error (e.g. adaptive expectations instead of RE), the above will not hold as UIP predicts. Other explanations utilize monetary policy rules to explain the forward discount bias, through their sensitivity to and eﬀects on short term interest rates and diﬀerentials (Backus et al, 2010), or model UIP heterogeneity through exchange rate regime choice and incidence of exchange rate crises and “crash risk” (Flood & Rose, 2001). Of all these, the most robust explanation is the presence of expectational error, followed by time-varying risk premia, although recent studies are showing a closer ﬁt to UIP predictions over longer time periods. The expectational error theory generally characterizes expectation formation as either adaptive expectations, regressive expectations, or extrapolative expectations (Marey, 2004). Lewis’ (1989) paper concerns modeling learning in expectations formation, and shows that slow learning on the part of market participants can explain almost half of the observed short-run deviation in many studies. Another common explanation is the persistence of the ’peso problem’ for many currencies. Mussa (1980) notes that inﬂation rate distributions are skewed, and although normally conﬁned to a restricted range, can from time to time suﬀer bouts of hyperinﬂation. Overestimation of the magnitude of inﬂation risk then leads investors to attribute higher values for expected future inﬂation than are rational. Through monetary policy rules (e.g. a Taylor Rule), this should have the eﬀect of raising interest rates and lowering expected depreciation, pushing estimates of β below unity. The risk premia argument departs from risk neutrality to a world where investors are risk
averse. This could either be of the constant or non constant ﬂavor. Constant risk premia may be applied to similar oﬀshore assets with comparable default attributes - such as government bonds of stable, developed economies, or blue chip multinationals. Non-constant risk premia can be thought of in the sense that risk averse investors will demand premia on speciﬁc interest-bearing assets due to higher levels idiosyncratic risk. For example, in this situation risk premia could be positive due to the presence of exchange risk in holding foreign currency denominated assets. Default risk and counterparty risk could also feature, dependent obviously on the nature of interest bearing instrument used in the foreign currency (e.g. government bonds or commercial paper). Modeling this is important, because depending on the interest-bearing foreign assets used for testing, diﬀerential risk proﬁles can skew results (even if we try to account for risk, but misspecify the type we’re dealing with). In general, measurement of the risk premium is diﬃcult to reconcile with the economic theory, and mainly results from purely statistical methods, with little in the way of economic description. Due to diﬃculty in modeling the risk premium for investors, we shall restrict the analysis to more classical tests of UIP.
To test for UIP, we initially use an approach similar to Flood & Rose (1994),
(1 + ih )/(1 + if ) = Et (St+∆ )/St t t
with ih and if representing risk-free returns available domestically and in the foreign country t t respectively at time t (over the maturity ∆), St the spot rate at time t, and Et (St+∆ ) the expected spot rate at time t + ∆. Note Et is assumed orthogonal to the information set at time t, Ωt , which includes the interest diﬀerential, (ih − if ) . Taking logs of the above allows us to extract t t an equilibrium relationship, from which we may then form into our main regression equation for testing UIP:
Et (st+∆ − st ) ≈ (ih − if ) t t
It should be noted that this ﬁrst order taylor approximation is not exact, but considering the relatively small magnitude of interest rate diﬀerentials, and therefore of the cross terms, it is an appropriate simpliﬁcation. We can then test the above using the following conﬁguration,
(st+∆,k − st,k ) = αk + βk (ih − if ) + εk,t t t 4
with the subscript k denoting the intercept, slope coeﬃcient, and error term for each country. If UIP holds, we would expect the interest rate diﬀerential to be an unbiased predictor of the change in the spot rate over the relevant period. For this to be true, we would need the joint null to hold, H0 : α = 0, β = 1. If UIP holds and investors use rational expectations, we arrive at the ‘Risk Neutral Eﬃcient Markets Hypothesis’, or RNEMH (Bui, 2010). We also assume that the error is stationary (no heteroscedasticity), and orthogonal to the information set at time t with zero expected mean, E|Ωt (ε) = 0. This allows us to use OLS estimators on our time series. If all this holds, positive interest rate diﬀerentials for the foreign currency should lead to an exchange rate depreciation (and vice-versa), implying a value of β = 1. The above regression will be run over periods of 1 week, 1 month, and 3 months, for all of the ﬁve currencies. This will be repeated for both time periods - pre and post-crisis. We then extend our analysis to the related problem of the unbiased forward rate hypothesis (UFRH) by using a regression similar to the one used in Taketoshi It¯’s (1990) paper: o
st+∆ − ft,∆ = α + βk,t (st − ft−∆ ) + ut
This regression looks at the predictive power of previous spot-forward diﬀerentials for future diﬀerentials. For UFRH to hold, we would need to conﬁrm the joint null, H0 : α = 0, βk = 0. In the case that the null is rejected, past diﬀerentials could be used to forecast future diﬀerentials. Therefore, the FX market in that particular currency pair would be shown to systematically violate market eﬃciency, and opportunities for proﬁtable arbitrage would exist. In order to get a feel for the structure of ineﬃciencies (if they exist), we can add more lags on the right to obtain a more precise speciﬁcation of the eﬀect of previous diﬀerentials. We will be using two lags for each currency pair, at the one week and one month horizons.
The dataset covers the 5 major currency pairs with the USD (our centre, or anchor, currency for the purposes of this analysis):
1. Australian Dollar (AUD) 2. British Pound Sterling (GBP) 3. Canadian Dollar (CAD) 4. Japanese Yen (JPY) 5. Swiss Franc (CHF) 5
We will then run the aforementioned regressions to test UIP and URFH over the ﬁve currency pairs and over two distinct periods - pre and post ﬁnancial crisis. The date for the start of the ﬁnancial crisis is chosen as the announcement of the liquidity shortages by the French bank BNP Paribas, on September 9th 2007. We could use other notable ﬁnancial events - such as the Lehmann collapse - as our starting point, but it was BNP’s liquidity crisis that ﬁrst indicated widespread market disruption. The period from the start of the ﬁnancial crisis to the present is deﬁned as September 10th 2007 until 14th March 2011. The data frequency is daily, which leads to a maximum of 910 observations for our regressions (accounting for lags and leads). The pre-ﬁnancial crisis data uses a sample period of the same length, in order to produce comparable results. This is deﬁned as 3rd December 2004 through September 9th 2007. The dataset consists of daily LIBOR closing rates at 1 week, 1 month and 3 month maturities from the British Bankers’ Association, along with bilateral spot and forward exchange rates for each maturity from Thomson Reuters. These three diﬀerent rates are used to gauge the sensitivity of the UIP condition to interest rate maturities. All data was obtained from Datastream, and testing was carried out using Stata.
Uncovered Interest Parity
Firstly, we set out to test the uncovered interest parity hypothesis using the aforementioned regression, (4), over three diﬀerent horizons - one week, one month, and three months - with a view to examining the eﬃciency of the UIP argument over three relatively short (and important) maturities. Longer-dated tests were eschewed in favor of short for the purposes of this paper - the analysis of recent trends - although long term studies have strongly conﬁrmed UIP in historical data (Chinn & Merideth, 2005). Using (4), the UIP regressions speciﬁed were,
f (st+1week − st ) = α + β(ih t(1week) − it(1week) ) + εt
f (st+1month − st ) = α + β(ih t(1month) − it(1month) ) + εt
f (st+3months − st ) = α + β(ih t(3months) − it(3months) ) + εt
Due to the presence of both autocorrelation and heteroscedasticity, standard OLS could not be used. In line with the literature (Alexius, 2001) we opted for HAC estimators, which produce heteroskedasticity-autocorrelation robust standard errors. It should be noted that these have their own unique problems, such as over-rejecting the null in certain cases. However, as economic theory behind strict tests of UIP dictated the form above, changing the model speciﬁcation (e.g. by adding lags or diﬀerencing) was not preferable. Newey-West estimators were chosen, with leg length determined by L = #obs 4 which yielded an appropriate lag length of 5 for our regressions (sampling periods were roughly the same for all regressions). Structural breaks were a worry, and testing over longer periods pre-2007 yielded conclusions with little statistical signiﬁcance over any of the countries in question, or any of the maturities tested. However properly estimating these breaks was beyond the scope of this paper. These could be more rigorously tested using visual inspection followed by Chow tests to conﬁrm, as described in Brooks (2008). Possible breaks in the data were avoided by using two distinct sampling periods that straddled the ﬁnancial turmoil starting in September 2007. Table 1 shows the results of the pre-crisis regressions for each currency against our USD base.
Table 1: Pre-Crisis UIP Tests (st+∆ − st ) = α + β(ih + if ) + εt ∆ ∆ ∆ Australia 1 Week 1 Month 3 Months Canada 1 Week 1 Month 3 Months Japan 1 Week 1 Month 3 Months Switzerland 1 Week 1 Month 3 Months UK 1 Week 1 Month 3 Months α -.0017[.0018] -.0086[.0038] .0171[.0208] -.0017[.0009] -.0030[.0121] -.0188[.0034] -.0038[.0041] .0046[.0089] .0217[.0094] -.0055[.0043] -.0213[.0106] -.0493[.0145] -.0018[.0011] -.0059[.0024] -.0117[.0027] β -.0025[.0041] -.0126[.0090] .0262[.0149] -.0005[.0045] -.0030[.0121] .0148[.0163] .00301[.0041] .0046[.0089] .0217[.0095] .0064[.0053] .0239[.0128] .0564[.0177] -.0018[.0026] -.0093[.0060] -.0144[.0071] F 0.39 (0.5319) 1.97(0.1610) 2.10(0.1473) 0.01(0.9084) 0.06(0.8041) 0.82(0.3663) 0.56(0.4552) 0.27(0.6002) *5.27(0.0220) 1.42(0.2332) **3.50(0.0615) *10.06(0.0016) 0.45(0.5039) 2.43(0.1194) **4.04(0.0447) R2 0.0025 0.0178 0.0221 0.0001 0.0005 0.0059 0.0040 0.0023 0.0328 0.0064 0.0203 0.0656 0.0021 0.0147 0.0229
Results are mixed, and show a large degree of heterogeneity in UIP conditions across the sample. From our 15 regressions, just over half (8/15) have a positive slope coeﬃcient, β, and most results are quite close to zero - far from the hypothesized value of unity. This is at odds with many previous ﬁndings that β is signiﬁcant, negative, and close to -1. Values for α are positive and roughly equal in size (marginally lower) to estimates for β. Some in the literature have argued that non-zero estimates of α are consistent with UIP due to Jensen’s inequality (Meese, 1990), although Engel (1996) rejects the idea on the basis that constants resulting from this will be small in practice (Chinn & Merideth, 2005). Of note is the fact that the regressions seem to tend towards signiﬁcance and hypothesized coeﬃcients for β for longer periods of observation. We consider the 5% & 10% levels of signiﬁcance to check the null hypothesis, H0 : β = 0. For the majority of the sample, we cannot reject the null that β = 0, and interest rates diﬀerentials have no eﬀect on the expected future spot price appreciation/depreciation . This in itself is a
Standard Errors are in square brackets. are in parentheses. 3 *Signiﬁcant at the 5% level; ** signiﬁcant at the 10% level
2 P -values 1 Newey-West
rejection of UIP - and a strong one, as the UIP condition states that these are the only factor driving spot price changes. Inclusion of more estimators, and augmenting the model to account for risk would hopefully increase computed F statistics to a reasonable level of signiﬁcance for more of our regressions. β is signiﬁcant for Japan, Switzerland, and the UK at 5% over 3 months, and at 10% for Switzerland over the one month horizon (Australia comes close at 1 & 3 months, and UK at 1, but the rest of the sample yield high enough p-values for us not to worry about Type-I errors). These signiﬁcant estimators tend away from the hypothesized value of 1 as timeto-maturity increases, and in 3 of the 4 cases are actually negative. In one sense, these data tell us that for Switzerland, Japan, and the UK (at least at long maturities), the eﬀect of risk and (and other possible omitted variables) on the future spot price changes is not great enough to make our strict tests of UIP insigniﬁcant. This is puzzling, as this is the group that would be expected to validate UIP more strongly, being the main traded currency pairs against the USD with deeper and more liquid markets. Furthermore, in the case that our model lacks a signiﬁcant risk component, we would expect this to have more of an eﬀect on these percieved “safe haven” currencies (perhaps this inductive eﬀect will become evident in the post-crisis period). Newey West estimators are high, and in some cases larger than the estimated coeﬃcients, which greatly reduces the predictive power of estimates. The fact that many of the estimates are so close to zero, with such large (NW) standard errors, means that reported signs could easily be due to error, and predictions therefore aren’t very strong (even given signiﬁcance at high levels of conﬁdence). The post-crisis results show a slightly diﬀerent story, and are summarized in table 2 below. βs are now for the most part negative (in 11/15 cases), and larger in magnitude, |β|, than our previous ﬁndings. Estimates for α are now orders of magnitude below those for β, which is comforting given our confusing results over the pre-crisis sample, and is expected from the theory. These results are much more in line with previous longer-term studies (at these same maturities), with negative slope coeﬃcients. At one level, it is better that our results are broadly in line with other published literature. However, they still refute parity, and UIP appears to hold less well over long periods - with estimates becoming more negative as we move towards the three month maturity - which is in line with our ﬁndings over the pre-crisis period. One would think that markets work less eﬃciently over periods of crisis, when volumes drop and risk increases. From these results, this indeed seems to be the case, although it can not be conﬁrmed with a great degree of statistical rigor due to the poor F tests from the pre-crisis regressions.
Table 2: Post-Crisis UIP Tests (st+∆ − st ) = α + β(ih + if ) + εt ∆ ∆ ∆ Australia 1 Week 1 Month 3 Months Canada 1 Week 1 Month 3 Months Japan 1 Week 1 Month 3 Months Switzerland 1 Week 1 Month 3 Months UK 1 Week 1 Month 3 Months α .0036 [-.0071] .0217[.0158] .0171[.0208] -.0009[.0026] -.0003[.0048] -.0003[.0071] -.0009[.0016] -.00345[.0036] -.0066[.0047] .0018[.0019] .0066[.0047] .0172[.0048] -.0047[.0029] -.0145[.0060] -.0581[.0117] β .0046 [.0055] .0245[.0119] .0262[.0149] -.0024[.0080] .0014[.0128] -.0055[.0239] -.0045[.0032] -.0227[.0066] -.0436[.0096] -.0220[.0105] -.0843[.0193] -.1892[.0209] -.0196[.0092] -.0687[.0159] -.2364[.0375] F 0.68 (0.4106) *4.26(0.0394) **3.1(0.0788) 0.09(0.7662) 0.01(0.9121) 0.05(0.8183) 2.07(0.1510) *12.03(0.0005) *20.64(0.0000) 4.39(0.0364) *19.09(0.0000) *81.52(0.0000) *4.46(0.0350) *18.76(0.0000) *39.70(0.0000) R2 0.0035 0.0206 0.0091 0.0004 0.0000 0.0002 0.0102 0.0645 0.0911 0.0250 0.0772 0.3521 0.0283 0.0726 0.2484
Also, if we think that risk is an omitted variable, as before, we could think of it as having relatively less sway on the spot price diﬀerential when viewed in the light of interest rate gaps. Newey West HAC errors show a similar picture to pre-crisis values, but larger coeﬃcient estimates in this case mean they pose less of a worry for inference(they don’t imply as much of a chance of positive observations). We can thus view the mainly negative βs here with a greater degree of certainty, and thus inferences are more robust. Overall the results lend creedence to the “forward discount bias” and prove that spot rates systematically violate UIP for three of the main short-run interest rates and matching spot diﬀerentials. The degree to which this occurs is seen to be increasing in time to maturity, and is more pronounced in recent data. As one of the purposes of this paper is cross period comparison, we should consider how the slope (β) coeﬃcient estimates for our set of 15 regressions change over the two periods. Pre-crisis estimates are less signiﬁcant than their post-crisis counterparts
Standard Errors are in square brackets. are in parentheses. 3 *Signiﬁcant at the 5% level; ** signiﬁcant at the 10% level
2 P -values 1 Newey-West
across the board. While Switzerland and UK three month money rates signiﬁcantly exhibit negative βs in the post-crisis period, the rest of our results deliver conclusions that the eﬀect of interest rate diﬀerentials is not signiﬁcantly diﬃcult from zero, or signiﬁcantly close enough to zero to matter little (with levels of conﬁdence high enough to not worry about Type-I errors).
Unbiased Forward Rate Hypothesis
As discussed previously, the unbiased forward rate hypothesis (UFRH) and eﬃciency of the forward market for foreign exchange is tested by looking at the predictive power of appropriate past forward-spot diﬀerentials on future diﬀerentials. This can be thought of as an alternative formulation of UIP using forward rates. In theory, we should obtain the same predictions as our interest rate studies. This will be tested using one-week and one-month forward contracts, with two lags each. Logs of the forward and spot rate values are used. The equations we estimated are shown below.
(st+1week − ft,1week ) = α + β1,k (st − ft−1week ) + β2,k (st−1week − ft−2weeks ) + ut,k
(st+1month − ft,1month ) = α + β1,k (st − ft−1month ) + β2,k (st−1month − ft−2month ) + ut,k (10)
Estimation was carried out using a similar procedure to our interest rate tests, employing Newey West heteroscedasticity-autocorrelation-consistent estimators with a maximum of 5 lags. Results of the regressions are presented below. If markets are eﬃcient, UFRH states that the forward settlement rate, Ft+∆ should be and unbiased predictor of the future spot rate ∆ periods ahead, St+∆ (Elliott & It¯, 1999). Essentially, the diﬀerence between the spot and forward o rate for the period t + ∆ should be on average zero, (α = 0) and should be orthogonal to the information set available at time t, (β1 = 0, β2 = 0). If markets are not eﬃcient, and past forecast errors have predictive power for the diﬀerence between spot rates at t and the rate predicted by an appropriate forward contract, then we would expect one or all of the aforementioned terms to be signiﬁcantly diﬀerent from zero. This will be judged by the results of the joint F -test (the p-values for which are given in parentheses).
Table 3: Pre-Crisis UFRH Test (st+∆ − ft,∆ ) = α + β1,k (st − ft−∆ ) + β2,k (st−∆ − ft−2∆ ) + ut,k ∆ Australia 1 Week 1 Month Canada 1 Week 1 Month Japan 1 Week 1 Month Switzerland 1 Week 1 Month UK 1 Week 1 Month α -.0015[.0021] -.0064[.0057] -.0002[.0016] -.0010[.0032] -.0025[.0012] -.0121[.0029] -.0015[.0013] -.0061[.0039] .00145[.0013] .0037[.0035] β1 -.0145[.0778] .2317[.1054] -.1159[.1137] .0561[.0758] -.0226[.0659] .0792[.0678] .1335[.0591] -.1628[.0888] -.0713[.0646] .1686[.0684] β2 .0735[.0693] .0424[.0795] -.0536[.0924] .1200[.0660] -.0165[.0626] -.2237[.0768] -.0571[.0682] .1763[.0780] .1966[.0887] .2199[.0719] F 0.57(0.5664) *3.01(0.0499) 0.52(0.5940) 1.92(0.1476) 0.08(0.9244) *5.19(0.0057) **2.92(0.0545) *6.51(0.0016) *4.51(0.0113) *9.22(0.0001) R2 0.2635 0.0016 0.3546 0.3011 0.2480 0.3746 0.2897 0.3628 0.3330 0.2983
From the pre-crisis results we can see that the UFRH condition breaks over most of the sample, with the notable exception of Canada, where it holds over all maturities. When it falls down, most of the predictive power is at the second lag, which impacts the diﬀerence between prevailing spot rates and forward predictions both positively and negatively (depending on the country). This tells us that, for instance, the diﬀerential from two weeks ago can be used to predict the diﬀerential in a week, and that from two months ago can be used to predict the diﬀerential in a month’s time. This seems to hold particularly well for the USD-GBP pair, with strongly signiﬁcant β-coeﬃcients - showing an impact even at the certainty of the 2% level. Results for Switzerland are roughly signiﬁcant at the 5% level (signiﬁcance is all relative, and 0.0545 is close enough to consider it as this level). For those estimates with high F values, the magnitude of the coeﬃcients is large enough to have a qualitative eﬀect - with the impact of β2 for the UK coming in at 21%. The R2 stat is also reasonably high, at 29%, although this is noted mainly for illustrative purposes (as it’s not as applicable here as in standard OLS). The values for the F test are much more relevant.
Standard Errors are in square brackets. are in parentheses. 3 *Signiﬁcant at the 5% level; ** signiﬁcant at the 10% level
2 P -values
Table 3: Post-Crisis UFRH Test (st+∆ − ft,∆ ) = α + β1,k (st − ft−∆ ) + β2,k (st−∆ − ft−2∆ ) + ut,k ∆ Australia 1 Week 1 Month Canada 1 Week 1 Month Japan 1 Week 1 Month Switzerland 1 Week 1 Month UK 1 Week 1 Month α -.0012[.0011] -.0102[.0022] -.0016[.0007] -.0085[.0020] .0014[.0009] .0086[.0022] .0000[.0009] .0012[.0023] -.0010[.0009] -.0063[.0023] β1 -.0325[.0560] -.3583[.0799] -.0224[.0567] -.0614[.0632] -.0128[.0528] -.2667[.0775] -.0524[.0598] -.2249[.0759] .0182[.0567] -.2810[.0803] β2 -.1134[.0711] .0876[.0525] .0154[.0616] .0579[.0783] -.0001[.0649] -.1399[.05926] .0081[.0547] -.1719[.0679] -.0807[.0435] -.1284[.0724] F 1.27(0.2806) *11.82(0.0000) 0.12(0.8835) 0.86(0.4240) 0.03(0.9707) *6.63(0.0014) 0.46(0.6344) *5.92(0.0028) 1.82(0.1632) *6.63(0.0014) R2 0.2830 0.0015 0.3032 0.3211 0.3168 0.3080 0.3587 0.3104 0.3114 0.3061
The post crisis results tell quite a diﬀerent story, now with strong signiﬁcance only occurring at the 1 month maturity. We can extrapolate from this that UFRH holds in a much stronger sense over short maturities (F -test p-values are very high for the majority of the sample), and breaks with a great degree of signiﬁcance (1% level) at long maturities for all but the still problematic Canada. This could be rationalized through greater importance of omitted risk measures diﬀerent horizons (or indeed some other signiﬁcant explanatory variable). We could even think of economic agents having a tiered expectations structure, thus applying diﬀerent expectation generating procedures to short and long maturities. If the idea of the same agent with diﬀerent structures is too much, we could think of two markets governed by populations of agents with mutually distinct expectations generating mechanisms. While unlikely to be occur in the strictest sense, a degree of heterogeneity could be seen to reﬂect mainly speculative short term market participants trading in the 1 week contracts enforcing tight market eﬃciency, while 1 month participants operate with a diﬀerent modus operandi. The fact that signiﬁcant results impact future diﬀerentials negatively in the post crisis period and positively in the pre crisis one (for the most part), could imply some more structural change in investor behavior. For the UK and Switzerland, these changes are not only statistically signiﬁcant, but also large in the context (turnarounds of 0.4496 & 0.3483 for the β2 of the USD-UK pair for example).
Conclusions & Possible Extensions
Foreign exchange markets come as close as any to the ideal of perfect competition. Trading on a near continuous basis, spread across the globe, and with huge volumes and depth, we would expect this to be closest to idealized theoretical models of eﬃciency. However, in light of our results, we can conclude that the market not only simply deviates from eﬃciency on a transitory basis, but in fact contradicts the theory in a regular and systematic fashion. For these reasons, currency trading, and in particular carry strategies, have become machines for the generation of phenomenal excess returns oﬀ the back of predictable market ineﬃciencies. However, even as this study shows, turnarounds in risk characteristics between periods (pre and post ﬁnancial crisis) can lead to risks in the longer term. Also, the contrasting results from UIP and UFRH tests lead to a notable degree of uncertainty with relation to the nature of ineﬃciencies, possibly reducing attainable risk-adjusted returns from many common currency strategies. To explain this further, we would have to augment our model by specifying the return-generating process and the nature of risk, alongside some assumptions on investor preferences in a world where risk neutrality is no longer the status quo. One obvious possible extension is the inclusion of a risk premium term to account for realworld investor behavior (as their decisions are surely weighted by risk). Short of modeling risk aversion - which can be fraught with diﬃculty outside of the realm of hypothetical monte carlo models - we could include a market based measure of risk. An ideal candidate would be a variable risk measure such as the CBOE Volatility Index, the VIX. This is derived from the implied volatility if a bundle of constant maturity options on the S&P 500, but we could construct our own version for each of the currencies and across each of the maturities. Using futures of appropriate maturity for each of the pairs, we could compute weighted indices of the implied volatility (over the range of strike prices). This could be used as a proxy measure of risk. Inclusion of this variable in our classic UIP and UFRH regressions would then account for a market-derived measure of risk, and hopefully ﬁx the omitted variable issue that seems to be aﬀecting our results. Furthermore, some of the conditions by which we judged our regressions (Fama, 1984) are contentious. For instance, although we rejected the impact of Jensen’s inequality on our theoretical coeﬃcient estimates, some have argued that this not only exists, but can in fact be signiﬁcant and large enough in magnitude that it plays a greater role in pulling F and Et (St+1 ) apart (Sibert, 1989). Continued pressure on scholars of the risk aversion and expectations hypothesis to produce results robust to maturity and currency pair choice have spawned a miscellany of new
measures to try and solve the puzzle. Modiﬁed risk procedures, using innovative OLS methods such as those employed by Goodhart (1997), and continued application of such tests to longerterm data seems to be getting more towards solving the vexing uncovered interest parity puzzle. As is often the case, the puzzle is simply a product of oversimpliﬁed analysis. Further advances in econometrics, along with behavioral models such as DeLong’s “noise trader risk” ( and their adaptation to the puzzle should hopefully soon provide us with answers. In expectation of this conclusion, we have shown, through historical analysis, the changing nature of UIP breaks and forward discount biases, hopefully helping to improve whatever degree of intuition currently plays substitute to a full solution.
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