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International Finance Exchange Assessment Notes

Uncovered Interest Parity From the Lecture: – If an investor has the option between investing domestically and investing internationally in a risk free asset (bond) then there will be an equilibrium determined by the exchange rate. – The return on the domestic bond will be 1+i – The return on the international bond will be 1/St (1+i*); hence in the future when convereted back to domestic currency this will be (Et (St+k)/St) (1+i*) – Now, because if 1+I >(Et (St+k)/St) (1+i*), the domestic bond is better value, the market will invest in the domestic bond increasing the price (lowering the return), and if (Et (St+k)/St) (1+i*)>1+I then the market will invest in the international bond. – As a result, this creates an equilibrium where 1+I = (Et (St+k)/St) (1+i*) ○ Note however that this is not arbitrage (but rather based on speculation of the future exchange rate – This is the uncovered interest rate parity – Also, (Et (St+k)/St) (1+i*) = 1 + (Et (St+k)-St)/ St = 1 + Δ St+k – So in equilibrium (1+i) = (1 + Δ St+k)(1+i*) ○ Using approximations (see lecture slide on approximations – will need to include in assignment!) this means that Δ St+k = i-i* – The assumptions that underlie this theory are: ○ Risk neutral investors with rational expectations ○ Can invest in the domestic interest rate of i for k periods, or in the international interest rate of i* for k periods ○ The exchange rate is quoted using the direct method ○ More? Covered Interest Parity From the lecture: – The covered interest rate parity assumes that investors know exactly what Et (St+k) is because they use the futures markets. – That is Ft,t+k = Et (St+k). – This would make the equation of (Ft-St)/St = it-it* ○ Note, this (unlike the uncovered interest parity) creates an arbitrage opportunity because there is an exact value for the expectations of the future – the futures price – Assumptions: ○ Same assumptions from uncovered interest rate parity

That the covered interest rate parity assumes that investors know exactly what Et (St+k) is because they use the futures markets ○ That the futures markets only reflect the expectation of future spot prices. ○ More? Also note that due to the Siegel Paradox (will need to explain in assignment), this is expressed using logarithms ○

FRUH From the Lecture: – The FRUH says that the future/forward’s price will fully reflect future expectations of the spot rate (i.e. it is efficient) – This means that Et (St+k) = Ft,t+k – And hence St+k = Ft,t+k + ut+k ○ Where Et(ut+k)= 0 ○ ut+k is uncorrelated with other information  although, it need not be uncorrelated From Engel (1996): – Hodrick, Robert J., 1987, The empirical evidence on the efficiency of forward and futures foreign exchange markets (Harwood, Char), first discovered that there was a large conditional bias if the forward rate was used to predict the future spot rate of exchange. – Findings of a beta not equal to 1 and negative is a “robust finding.” This is demonstrated by many sources of empirical evidence: ○ Backus, David, Allan Gregory and Chris Telmer, 1993, Accounting for forward rates in markets for foreign currency, Journal of Finance 48, 1887-1908 → Found that for one month forward rates on corresponding spot rates on the Canadian dollar, French franc, DM, Yen and pound between 1974 and 1990 that the beta is significantly less than one and negative. They further state that this is consistent for the Lira, the Belgium Franc, guilder and Swiss franc and even true when non US dollar cross rates are used. ○ Mark, Nelson, Yangru Wu and Weike Hai, 1993, Understanding spot and forward exchange rate regressions (Ohio State University, Columbus, OH) confirm this finding with evidence on the Franc, Yen and Pound between 1976 to 1988. ○ Froot, Kenneth A. and Jeffrey A. Frankel, 1989, Forward discount bias: Is it an exchange risk premium?, Quarterly Journal of Economics 104, 139-161 find that beta is significantly less than zero for the pound, yen, swiss franc and mark between 1976 and 1985. ○ Baillie, Richard T., 1989, Tests of rational expectations and market efficiency, Econometric Reviews 8, 151-186 suggests bivariate VARs for St - St-1 and Ft - St and finds that the forward rate is not an unbiased predictor of the spot rate for mark/dollar between 1973 and 1980.

Bekaert, Geert, 1992, The time-variation of expected returns and volatility in foreign exchange markets, Journal of Business and Economics Statistics, forthcoming, confirms Baillie (1989) for the Mark, Pound and Yen to the dollar between 1975 and 1991. McCallum, Bennett T., 1994, A reconsideration of the uncovered interest parity relationship, Journal of Monetary Economics 33, 105-132 finds a beta of -4 for the yen, mark and pound against the dollar between 1978 and 1990. Byers, J.D. and D.A. Peel, 1991, Some evidence on the efficiency of the sterling-dollar and sterling-franc forward exchange rates in the interwar period, Economics Letters 35, 317-322; and MacDonald, Ronald and Mark P. Taylor, 1990, The term structure of forward foreign exchange premia: The inter-war experience, The Manchester School of Economics and Social Studies 58, 54-65; MacDonald, Ronald and Mark P. Taylor, 1991, Risk, efficiency and speculation in the 1920s foreign exchange market: An overlapping data analysis, Weltwirtschaftliches Archiv 127, 500-523 find that the beta is negative in the 1920s between the pound/ French franc and the dollar. McFarland, James W., Patrick C. McMahon, and Yerima Ngama, 1994, Forward exchange rates and expectations during the 1920s: A reexamination of the evidence, Journal of International Finance 13, 627636 find that the beta is less than 1 but not negative (and hence reject the null hypothesis) for the pound, French frank, dollar, Belgian franc and lira in the 1920s. Flood, Robert P. and Andrew K. Rose, 1994, Fixes: Of the forward discount puzzle, Working paper no. 4928 (National Bureau of Economic Research, Cambridge, MA) find a negative beta for floating exchange rates for the AUD, CAD,French Franc, Mark, Yen, Swiss Franc and Pound between 1981 ad 1984. However, when they conduct the same analysis of Belgian Franc, Krone, Punt, Lira and guilder against the mark (which are fixed exchange rates) for the same period, they estimate a beta of 0.58…although when they re-estimate it by omitting the dates when exchange rate realignments occur they get a beta of 0.25. Others include:  Choi, Seugmook and Benjamin J.C. Kim, 1991, Monetary policy regime changes and the risk premium in foreign exchange markets: A GARCH application, Economics Letters 37, 447-452.  Chrystal, K. Alec and Daniel L. Thornton, 1988, On the information content of spot and forward exchange rates, Journal of International Money and Finance 7, 321-330.  Kearney, Colm and Ronald MacDonald, 1991, Efficiency in the forward foreign exchange market: Weekly tests of the Australian/U.S. dollar exchange rate, January 1984-March 1987, Economic Record 67, 237-242.  Marston, Richard C., 1993, Interest differentials under fixed and flexible exchange rates: The effects of capital controls and exchange risk, In: Michael D. Bordo and Barry Eichengreen, eds., A retrospective on the Bretton Woods system: Lessons for

international monetary reform (University of Chicago Press, Chicago, IL).  Pittis, Nikitas, 1992, Causes of the forward bias: Non-rational expectations versus risk premia, Applied Economics 24, 317325.  Bekaert, Geert and Robert J. Hodrick, 1993, On biases in the measurement of foreign exchange risk premiums, Journal of International Money and Finance 12, 115-138. Arguments against: ○ Mayfield, E. Scott and Robert G. Murphy, 1992, Interest rate parity and the exchange risk premium: Evidence from panel data, Economics Letters 40, 319-324, however do a regression and include a common time varying intercept and find that they can no longer reject the null hypothesis. ○ Taylor (1989) – see bellow ○ Cornell, Bradford, 1989, The impact of data errors on measurement of the foreign exchange risk premium, Journal of International Money and Finance 8, 147-157 suggests that studies have been misaligned by not including transaction costs (they usually just take averages of bid and ask values) and they don’t correctly align the forward dates with the spot rates. As a result, he reivenstigates the Fama (1984) data set and finds that you cannot reject the null hypothesis for CAD/USD however you can for French Franc, Pound, Yen, guilder relative to the USD.  Fama, Eugene, 1984, Forward and spot exchange rates, Journal of Monetary Economics 14, 319-338. ○ The example the lecturer did in class With a risk premium: ○ Bekaert, Geert, 1992, The time-variation of expected returns and volatility in foreign exchange markets, Journal of Business and Economics Statistics, forthcoming. ○ Canova, Fabio and Takatoshi ito, 1991, The time-series properties of the risk premium in the yen/dollar exchange market, Journal of Applied Econometrics 6, 125-142. ○ Canova, Fabio and Jane Marrinan, 1993, Profits, risk and uncertainty in foreign exchange markets, Journal of Monetary Economics 32, 259-286. ○ Cheung, Yin-Wong, 1993, Exchange rate risk premiums, Journal of International Money and Finance 12, 182-194. ○ Mark, Nelson, Yangru Wu and Weike Hai, 1993, Understanding spot and forward exchange rate regressions (Ohio State University, Columbus, OH).  These studies conduct a regression with a risk premium of rpt however they all find that the risk preimium varies a lot, indicating that dollar assets swing from periods in which they regard the domestic currency as safe to periods where they regard the domestic currency unsafe!  Main problem with rpt is that it still relies on ‘rational investors’ and can suffer from sampling errors in small samples

From Taylor (1995): – The uncovered interest rate parity: ○ Is the corner stone parity condition for testing foreign exchange market efficiency ○ It says that if the risk neutral hypothesis holds, then it assumes that the expected foreign exchange gain from holding one currency must exactly offset the expected opportunity cost of holding another currency. That is: Δ St+k = i-i* – Testing for efficiency: ○ Early tests such as POOLE, WILLIAM. "Speculative Prices as Random Walks: An Analysis of Ten Time Series of Flex- ible Exchange Rates," Southern Econ. J., Apr. 1967, 33(2), pp. 468-78, tested efficiency by testing for ‘randomness’ or ‘random walks.’ However, generally the random walk principle is inconsistent with the interest parity principle as random walks only occur when the nominal interest rate differential is identical to a constant and there are rational expectations.  This was proved by OBSTFELD, MAURICE. "Exchange Rates, Inflation, and the Sterilization Problem: Germany 1975- 1981," Europ. Econ. Rev., Mar./Apr. 1983, 21(1/2), pp. 161-89. ○ Another way to test for efficiency is to test for the profitability of filter rules or trading rules (e.g. buying a currency whenever it rises j percent above its most recent trough and selling the currency whenever it falls j percent below its most re- cent peak). A number of studies do however prove that simple filter rules have been profitable, although it is not always clear of the filter rule size to be chose ex ante:  DOOLEY, MICHAEL P. AND SHAFER, JEFFREY R. "Analysis of Shortrun Exchange Rate Behavior: Mar. 1973 to 1981," in Exchange rate and trade instability. Eds.: David Bigman and Teizo Taya. Cambridge, MA: Ballinger, 1983, pp. 43-69.  LEVICH, RICHARD M. AND THOMAS, LEE R. "The Significance of Technical Trading-Rule Profits in the Foreign Exchange Market: A Bootstrap Approach," J. Int. Money Finance, Oct. 1993, 12(5), pp. 451-74.  ENGEL, CHARLES AND HAMILTON, JAMES D. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?" Amer. Econ. Rev., Sept. 1990, 80(4), pp. 689-713. ○ The most common way to test efficiency (of exchange rates) is through regression based analysis of spot and forward exchange rates…hence the covered interest rate parity. ○ The uncovered interest rate parity can be tested by estimating the regression of:

When you run the regression you should get a beta of 1.  Initially evidence proved to find a beta of close to 1 - FRENKEL, JACOB A. "A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empiri- cal Evidence," Scand. J. Econ., Mar. 1976, 78(2), pp. 200-24. However, this was realised to be wrong because it didn’t take into account the non-stationarity (i.e. the ordinary method of the sum of least squares will drive beta towards unity) – as a result, regression tests have become more sophisticated…  However, this new evidence has been unfavourable - Fama, Eugene, 1984, Forward and spot exchange rates, Journal of Monetary Economics 14, 319-338.  Infact – they are usually closer to minus unity! This is referred to as the forward discount bais - FROOT, KENNETH A. AND THALER, RICHARD H. "Anomalies: Foreign Exchange," J. Econ. Perspectives, Summer 1990, 4(2), pp. 179-92 • This means that the more the forward currency is at a premium, the less the home currency is expected to depreciate.  Further adjustments to the regression included considering a risk premium (i.e. assuming risk aversion rather than risk neutral behaviour). This is usually done by taking the risk premium as a function of the variance of the forecast errors or exchange rate movements: • FRANKEL, JEFFREY A. "In Search of the Exchange Risk Premium: A Six-Currency Test Assuming Mean- Variance Optimization," J. Int. Money Finance, Dec. 1982b, 1(3), pp. 255-74; reprinted in JEF- FREY FRANKEL 1993a, pp. 21934. • DOMOWITZ, IAN AND HAKKIO, CRAIG S. "Condi- tional Variance and the Risk Premium in the Foreign Exchange Market," J. Int. Econ., Aug. 1985, 19(1/2), pp. 47-66. • GIOVANNINI, ALBERTO AND JORION, PHILIPPE. "The Time Variation of Risk and Return in the Foreign Exchange and Stock Markets," J. Fi- nance, June 1989, 44(2), pp. 307-25. • HANSEN, LARS P. AND HODRICK, ROBERT J. "Risk-Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models," in JACOB FRENKEL, ed. 1983, pp. 113-42. however used a ‘latent variable formulation’ of the risk premium. ○ All of these have shown mixed (but not promising) results when applied to data sets.  A further adjustment is to assume the error is in the ‘rational expectations’ assumption made by the uncovered interest rate

parity. This is within the field of bahavioural finance (which has come into popularity with the recent credit crunch crisis). Some examples include: • The peso problem (where agents attach a small probability to a large change in the economic fundamentals, which causes a skew in the distribution of forecast errors even if agents' expectations are rational) – ROGOFF, KENNETH. "Expectations and Exchange Rate Volatility." Unpublished Ph.D. thesis, Massachusetts Institute of Technology, 1979. • Rational Bubbles – LEWIS, KAREN K. "Changing Beliefs and Systematic Ra- tional Forecast Errors with Evidence from Foreign Exchange," Amer. Econ. Rev., Sept. 1989, 79(4), pp. 621-36. • Learning about regime shifts – LEWIS, KAREN K. "Changing Beliefs and Systematic Ra- tional Forecast Errors with Evidence from Foreign Exchange," Amer. Econ. Rev., Sept. 1989, 79(4), pp. 621-36. • Inefficient information processing – BILSON, JOHN F. 0. "The 'Speculative Efficiency' Hypothesis," J. Bus., July 1981, 54(3), pp. 435-51.  The main problem with empirical tests is however that it relies on the assumption ceteris paribus (i.e. that the other components are correct). However, the generally accepted conclusion is that both risk aversion and a lack of rational expectations affect the uncovered interest rate parity • MCCALLUM, BENNETT T. "A Reconsideration of the Uncovered Interest Rate Parity Relation- ship," J. Monet. Econ., Feb. 1994, 33(1), pp. 105-32. • Taylor (1995) The covered interest rate Parity: ○ Says that if there are no barriers to arbitrage across international markets, then the interest differential on similar assets should be zero (adjusted for the covering in the forward currency exchange market at the maturity of the underlying assets), so that: (it-it*) - (Ft-St) = 0 ○ Evidence is however quite supportive of the covered interest rate parity:  FRENKEL, JACOB A. AND LEVICH, RICHARD M. "Covered Interest Arbitrage: Unexploited Prof- its?" J. Polit. Econ., Apr. 1975, 83(2), pp. 325- 38; FRENKEL, JACOB A. AND LEVICH, RICHARD M. "Transaction Costs and Interest Arbitrage: Tranquil versus Turbulent Periods," J. PoUit. Econ., Dec. 1977, 85(6), pp. 1207-

24. – find that it is consistent for Euro-deposit rates, but not so much for treasury bills CLINTON, KEVIN. "Transactions Costs and Cov- ered Interest Arbitrage: Theory and Evidence, J. Polit. Econ., Apr. 1988, 96(2), pp. 358-70. TAYLOR, MARK P. "Covered Interest Parity: A High-Frequency, High-Quality Data Study," Economica, Nov. 1987, 54(216), pp. 429-38. TAYLOR, MARK P. "Covered Interest Arbitrage and Market Turbulence," Econ. J., June 1989, 99(396), pp. 376-91.

Does the FRUH hold? From the lecture: – To test if the FRUH holds, you form the regression: St+k = α + β Ft,t+k + ut+k ○ And then test for α = 0 and β = 1 – Early evidence by Cornell (1977), Levich (1979) and Frenkel (1980) do this and generally find support for the FRUH ○ However, is testing the above equation the best thing to do? – A better way is to form the regression: ΔSt+k = α + β (Ft,t+k - St) + ut+k ○ And then test for α = 0 and β = 1 – The textbooks, Engel (1996) and Taylor (1995) give an overview of this and the evidence and find no support for the FRUH → use these sources a lot! ○ The evidence finds that the estimates of β are closer to minus unity rather than unity! – Other evidence: ○ However, Cointegration tests to favour the model a bit more – although Zivot (2000) discusses some of the problems with cointegration tests ○ Huisman et al (1998) find support during periods where the forward premium is large. – Perhaps the reason is because we have made something wrong with the assumptions. Lets now assume investors are risk averse (and not risk neutral). This makes: Et (St+k) + rpt = Ft,t+k ○ Where rpt is a risk premium – Hence, with rational expectations, we get: Ft,t+k = St+k + rpt + ut+k ○ Now, we assume that the risk premium is a function of the forward rate and spot rate: rpt = α + β (Ft - St) ○ And then, when this is subbed into the original formula: Ft,t+k - St+k = α1 + β1 (Ft - St) + ut+k ○ Notice the similarities with the familiar:

○ Fama ○ ○ ○ ○ ○

ΔSt+k = α2 + β2 (Ft,t+k - St) + ut+k This shows us why β2 doesn’t equal zero! (1984) explains this: We know that Ft,t+k - St+k equals the risk premium plus the error We also know that Ft,t+k - St+k is a function of the of the forward premium So, if β1 doesn’t equal zero, the risk premium is present in Ft,t+k - St+k An if β2 doesn’t equal zero the forward rate contains predictive information about the future spot rate We know that:

Now, if the covariance is zero, we know that β1+ β2 =1. However, if the covariance doesn’t equal zero, simple interpretation is lost. As a result, under rational expectations, the FRUH could fail because of a highly time-varying risk premium…however this seems unlikely. Even if we assume that investors value the FRUH in real terms ○ This makes: ○

Now, assuming that the variables are log normally distributed, this can be written as:

These last two terms are Jensen’s inequalities and implies that:

However, unfortunately this is not enough to explain the failure of the FRUH.

Other Journal Articles – Recommended: Dwyer (1992): – Demonstrates that contrary to the assertions of the following, asset prices determined in an efficient market can be co-integrated: ○ GRANGER, C.W., ‘Developments in the Study of Cointegrated Variables,’ Oxford Bulletin of Economics and Statistics, August 1986, 48: 213-228 at 218.

BAILLIE,R ICHARDT ., ANDT IM BOLLERSLEV‘C, ommon Stochastic Trends in a System of Exchange Rates,’ Journal of Finance, March 1989, 44: 167- 181. ○ HAKKIO, CRAIG S., AND MARK RUSH, ‘Market Efficiency and Cointegration: An Application to the Sterling and Deutschemark Exchange Markets,’ Journal of International Money and Finance, 1989,8: 75-88. ○ MACDONALD, RONALD, and MARK P. TAYLOR, ‘Foreign Exchange Market Efficiency and Cointegration: Some Evidence from the Recent Float,‘Economic Letters, 1989,29: 63-68. ○ COLEMAN, MARK, ‘Cointegration-Based Tests of Daily Foreign Exchange Market Efficiency,’ Economic Letters, 1990, 32: 53-59. ○ BOOTH, GEOFFREYG ., AND CHOWDHURYM USTAFA, ‘Long-Run Dynamics of Black and Official Exchange Rates,’ Journal of Internationul Money and Finance, September 1991, 10:392-405. ○ COPELAND, LAURENCE S., ‘Cointegration Tests with Daily Exchange Rate Data,’ Oxford Bulletin of Economics and Statistics, May 1991: 185-198. They specifically demonstrate how this can apply to exchange rates and forward exchange rates. ○

Elliot (1999): – The FRUH states that the forward rate is an unbiased estimator of the spot rate in the future. – The usual way to test this is to see whether the forward premium in logs (Ft, k - St) is an unbiased estimator of the ex-post depreciator (St+ k - St). – Because evidence tends to frequently reject this, it is referred to as a ‘puzzle’ – This puzzle suggests the opportunity of unexploited profits (arbitrage). ○ This idea is confirmed in:  FROOT, KENNETH A. AND THALER, RICHARD H. "Anomalies: Foreign Exchange," J. Econ. Per- spectives, Summer 1990, 4(2), pp. 179-92  Lewis, K.K., 1995. Puzzles in international Þnance markets. In: Grossman, G., Rogo¤, K. (Eds.), Handbook of International Economics, North Holland, Amsterdam, pp. 1913Ð1971. – Most sources have blamed the risk premium for this puzzle, although regression tends to require risk premiums that seem way too high - Bekaert, G., 1995. The time variation of expected returns and volatility in foreignexchange markets. Journal of Business and Economic Statistics 13, 397Ð408. – As a result, this study ignores the regression and takes the data set from Ito, T., 1990. Foreign exchange rate expectations: Micro survey data. American Economic Review 80, 434-449. Instead, its goes straight to the arbitrage profits that would be available from this puzzle. – Elliot finds that although the survey data does create a puzzle, the profits are mostly small profits from trading rules. Furthermore, these profits are highly variable, so there is significant risk in using one of these trading strategies. – However, he concludes that the evidence indicates that there is more going on in the models of exchange rates than simply static expectations with random noise.

Fama (1984): – They restate everything that has been said so far about the FRUH. – They create a model to test it – in particular how the premium of the forward rate relates to the spot rate. – The discover large positive autocorrelations of the difference between the forward rate and the spot rate, indicating a variation in either the premium (F – S) or in the assessment of the expected changes in the spot rate. – They also discover negative slope coefficients in the regressions of St+k – St or Ft – St and as a result conclude that the variance of the premium is much larger than the variance of the expected value of the spot change. Hakkio (1989): – After lots of evidence to discover whether exchange markets are efficient, they decide to test it again using a new method (at the time) which involves cointegration. – States that there are generally 2 ways of testing market efficiency: ○ Method 1 - involves regressing the future spot rate on the forward rate so that; – St+1 = a + bFt + e  They then hope that a = 0 and b = 1  Used by FRENKEL, JACOB A. "A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empiri- cal Evidence," Scand. J. Econ., Mar. 1976, 78(2), pp. 200-24; FRENKEL, JACOB A. AND LEVICH, RICHARD M. "Transaction Costs and Interest Arbitrage: Tranquil versus Turbulent Periods," J. PoUit. Econ., Dec. 1977, 85(6), pp. 1207-24 ○ Method 2 – involves regressing the rate of depreciation on the forward premium so that: St+1 - St= a + b(Ft – St) + e  And hope that a = 0 and b = 1  Used by: BILSON, JOHN, ‘The Speculative Efficiency Hypothesis,‘Journulof Business, July 1981, 54: 435-432.; CUMBY, ROBERT E., AND MAURICE OBSTFELD, ‘Exchange Rate Expectations and Sominal Interest Rate Differentials: A Test of the Fisher Hypothesis,‘JournalofFinance, June 1981,36: 697-703; GE~%;E, JOHN F., AND EDGAR L. FEIGE, ‘Some Joint Tests of the Efficiency of Markets for Foreign Exchange,’ Review of Economics and Statistics, August 1979, 61: 334-341; H.ANSEN, LARS P., AND ROBERT J. HODRICK;, ‘Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis,’ Journal of Political Economy, October 1980, 88:829853; H~ASG, ROGER, ‘Some Alternative Tests of Forward Exchange Rates as Predictors of Future Spot Rates,’ Journal of International Money ond Finance, August 1984, 3: 153-168. – The second method is usually preferred because the spot and forward rates in the first are non stationary (hence there can be trend), however results have shown that beta is generally -1! – However a 3rd method has evolved. – ENGLE, ROBERT, AND CLIVE W.J. GR.INGER, ‘Cointegration and Error Correction: Representation, Estimation, and Testing,’ Econometrica, March

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1987, 55: 251-276.and GRAXER, CLIVE W.J., ‘Developments in the Study of Cointegrated Economic Variables,’ Ox-rd Bulletin of Economics and Statistics, August 1986, 48: 213-228 showed that 2 prices from a pair of efficient markets cannot be cointegrated. Hakkio hence applies this to German and UK spot rates, aswell as between spot rates and future rates within those countries. Their results are that the German and UK spot rates are not cointegrated (suggesting efficiency), The Uk future spot and forward rates are not cointegrated (efficient). However they then adjust their results for error correction equations and suddenly there is cointegration and hence markets are inefficient.

Huisman (1998): – The uncovered interest rate parity says that the return on a domestic currency deposit equals the expected return from converting the domestic currency into the foreign currency, investing it in a foreign deposit and then converting the proceeds back into the domestic currency at the future expected exchange rate. – This implies that the forward premium is an unbiased predictor of the change in the spot exchange rate. – However, after many investigations, data shows that the UIP doesn’t hold – This paper uses a ‘panel model’ to test the UIP/FRUH and finds that beta is not -1, but only about 0.5 – so not unity, but not as bad as minus unity – Then they distinguish between normal and abnormal observations where normal observations are determined by the average size of the forward premiums over all exchange rates. ○ Bilson, J.F.O., 1981. The speculative efficiency hypothesis. J. Bus. 54, 435-451; Flood, R.P., Rose, A.K., 1994. Fixes: of the forward discount puzzle. NBER Working Paper, 4928, and Flood, R.P., Taylor, M.P., 1996. Exchange rate economics: what’s wrong with the conventional macro approach. In: Frankel, J.A., Galli, G., Giovannini, A. (Eds.), The Microstructure of Foreign Exchange Markets. NBER, pp. 261-294. Were the first to suggest to distinguish between normal and abnormal observations – however bilson discovers that abnormal observations are actually more inkeeping with the UIP! – When they do this, they find that the UIP almost perfectly holds in periods where the average cross-sectional forward premium is large. But no success for small premiums. ○ This suggests the peso problem (see above), as suggested by Baldwin, R.E., 1990. Re-interpreting the failure of foreign exchange market efficiency tests: small transaction costs, big hysteresis bands. CEPR Discussion Paper, 407. Mark (1998): – Tries to explain the Forward Premium Bias using the standard representative agent intertemporal asset pricing model and a model of noise trading. ○ The standard representative agent intertemporal asset pricing model is the normal model we have been using with a risk premium ○ The noise trader model is taken from De Long et al (1990). This model combines rational investors with noise traders. The model shows that

the more noise traders there are, the more risky it is for rational arbitrageurs to offset this position so there is a tendancy for the market to be pushed away from its efficient level. There analysis finds that the standard representative agent intertemporal asset pricing model has very little empirical evidence, despite its intuitive attractions. Hence the move towards the Behavioural finance explanations – but there is much conjecture about these theories in general, so they cannot yet explain the Forward premium bias.

Taylor (1989): – Defines UIP and CIP – They then investigate the UIP and the CIP during periods of ‘turbulance’ or introduced news that is known to significantly effect the market. They also make explicit allowances for costs such as brokerage, bid-offer spread and the formulae used by market participants. – They discover that: ○ Small (but potentially exploitable) arbitrage opportunies to emerge during periods of turbulence, however during relatively calm periods (the control) there are no exploitable arbitrage opportunities ○ The degree of efficiency of the markets appears to have increased over the 20 year period they examined (1967-1987) ○ That few (if anyP arbitrage opportunies arise in shorter maturities, whilst small but significant profitable opportunities arise in longer maturities during turbulent periods.  This suggests that this is due to credit limits and liquidity constraints. – Their results therefore support the CIP! Zivot (2000): – Discusses the large amount of literature of the FRUH – Says that since Hakkio and Rush (1989) that efficiency has to be tested by cointegrating St+1 and ft using a cointegration vector of (1,-1). – However, the paper explains some pitfalls in modeling the cointegarted behaviour of spot and forward rates. My own articles (may not be that relevant): Bekeart (2007): – Notes that although there is a lot of evidence against the UIP, that recent evidence has found that this is not by as much as first calculated. For example: ○ Bekaert, G., Hodrick, R.J., 2001. Expectations hypotheses tests. Journal of Finance 56 (4), 1357e1394; and Baillie, R.T., Bollerslev, T., 2000. The forward premium anomaly is not as bad as you think. Journal of International Money and Finance 19 (4), 471e488. – argue that doubtful statistical inference was the problem ○ Chinn, M.D., Meredith, G., 2004. Monetary policy and long-horizon uncovered interest parity. IMF staff papers 51 (3), 409e430. – argue that the UIP holds better at long horizons ○ Chaboud, A.P., Wright, J.H., 2005. Uncovered interest parity: it works, but not for long. Journal of International Economics 66 (2), 349e362. –

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finds that there is support for the UIP for overnight exchange rate movements and interest-rate differentials. He also notes that people have long ignored this puzzle (i.e. they usually assume the UIP holds!) As all of this evidence is totally conflicting, Bekaert thinks it is necessary to reinvestigate the UIP. He does this by examining the UIP at both long and short intervals using a vector autoregression (VAR). He discovers that: ○ Evidence is totally mixed – it depends on which currency you use ○ That it is not time dependant – long and short term deviate the same amount This evidence is largely consistent with that of Bekaert, G., Hodrick, R.J., 2001. Expectations hypotheses tests. Journal of Finance 56 (4), 1357e1394; and Baillie, R.T., Bollerslev, T., 2000. The forward premium anomaly is not as bad as you think. Journal of International Money and Finance 19 (4), 471e488.

Chinn 2008: – Investigates exchange rate movements in general. – Evaluates the key exchange rate prediction models of: ○ The random walk model formulated by Frankel JA. 1979. On the mark: a theory of floating exchange rates based on real interest differentials. American Economic Review 69: 610–622, of the Dornbusch R. 1976. Expectations and exchange rate dynamics. Journal of Political Economy 84: 1161–1176 model. ○ The UIP ○ The Gourinchas P-O, Rey H. 2005. International financial adjustment. NBER Working Paper No. 11155 - a log-linearize model based on net exports to net foreign assets variable around its steady-state value  For the purposes of this we will focus on the 2nd one – Find that evidence doesn’t prove correct and hence suggest a new model. Felmingham (2005): – This paper tests whether the UIP and the CIP hold between the Aus and Us dollar between 1985 and 2000 in the 90 day and 180 day forward markets. ○ To overcome the problem of nonstationarity data, comparatively recent estimation techniques are introduced and applied. The UIP model is modified to allow for the presence of a time-varying risk premium in the foreign exchange market. – States that the CIP asserts that the forward premium on foreign exchange must equal the difference between domestic and foreign interest rates on securities of the same term to maturity provided that domestic and foreign bonds are both free of default risk. A second requirement for CIP is that speculative trading should bring the forward premium (discount) into equality with expected depreciation (appreciation) of the domestic currency. – States that the UIP underpins a number of models of the balance of payments and the exchange rate and in terms of policy implication if the UIP condition holds sterilised foreign exchange market intervention is ineffective. The failure of UIP does mean that sterilised intervention can have real effects and that the portfolio balance model of exchange rate intervention may be preferred to the monetary models of the balance of payments.

Results: ○ That the CIP holds for both 90 and 180 day forwards ○ That the UIP doesn’t hold between 1985 and 1991, however holds between 1992 and 2000. Perhaps this success in because the Australian economy is a small open economy and yet hthe currency is the 5th most traded currency in the world

Kavussanos (2004): – Applies the FRUH theory to freight OTC market. – The results show that Forward Freight Agreements (FFA) for 1 and 2 month are unbiased estimators of the spot rate, whilst 3 months Pacific routes are unbiased predictors. However, for panamax atlantic routes there are biased. – As a result – they conclude it totally depends on the product and market Moosa (2004): -Post Keynesian view of Interest rate parity Nikolaou (2006): – States the usual on UIP – Takes a new approach by using the option market instead of the futures market – that is they use options to create a synthetic forward position. – The results confirm (replicate) the previous bias – that is, there is a synthetic option bias puzzle aswell! – This suggests that forward and options provide optimal exchange rate predictions consistent with the notion of unbiasedness. Razzak (2002); – Same old stuff – finds that different markets and different maturities produce different results Widjaja (2004) and Shank (2002): – Examine FRUH in emerging market of asia – Find that: ○ There is still a bias Sarantis (2006): – Once again tests the UIP using traded volatility, a time varying risk premium and hetrogenous expectations. – Results: ○ There is support for an extended nonlinear UIP model ○ That high currency volatility causes unstable exchange rate paths…less like for UIP to hold?