nep-ifn New Economics Papers
on International Finance
Issue of 2005‒06‒19
three papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Europe Without Borders? The Effect of the EMU on Relative Prices By Hisham Foad
  2. Currency Unions, Options, and Foreign Direct Investment By Hisham Foad
  3. Inferential Expectations By Gordon Menzies; Daniel John Zizzo

  1. By: Hisham Foad
    Abstract: Has the formation of the European Monetary Union reduced the impact of national borders on cross-border market convergence? This paper extends Engel and Rogers (1996) well known work on border effects to cities across Western Europe over the period 1995 . 2002 and finds two key results. First, cross-border relative prices tend to be more volatile than prices between locations not separated by a border. This result is robust to a variety of potential explanations for border effects, such as uneven sampling bias, idiosyncratic price shocks, and incomplete exchange rate-pass through. Turning our attention to cross-border price volatility before and after the formation of the EMU, the effects vary by country size. Within the EMU, cross-border price volatility has not changed between the "small" countries, but has fallen significantly between the large EMU countries. Between the EMU and the UK, cross-border volatility has increased between the UK and the small EMU countries, but there has been no significant change between the UK and the large EMU countries. These results are consistent with the fact that exchange rates are more likely to adjust to price differentials between small countries than between large countries.
    Date: 2005–04
  2. By: Hisham Foad
    Abstract: A multinational deciding on where to locate a foreign production facility may not be indifferent to the choice of location. Numerous variables such as production costs, market access, and local tax treatments will influence the decision as to where the plant is located. Another key variable in this decision is uncertainty. Following the work of Dixit, a firm has an option to make a risky investment, and if this investment is at least partially irreversible, the option has some positive value. As the uncertainty in the investment project increases, so too does the value of the option. When comparing two investment projects that are identical in all respects except their underlying profit volatility, the one with the greater degree of uncertainty will require a higher trigger level of profits to be exercised. This paper examines the impact of uncertainty in exchange rates on a multinational.s decision to locate within or outside a currency union. The option values and trigger levels of investment within and outside the union are derived as a function of exchange rate variances and correlations, transport costs, and market size.
    Date: 2005–04
  3. By: Gordon Menzies (School of Finance and Economics, University of Technology, Sydney); Daniel John Zizzo (University of East Anglia)
    Abstract: We propose that the formation of beliefs be treated as statistical hypothesis tests, and we label such beliefs inferential expectations. If a belief is overturned through the build-up of evidence, agents are assumed to switch to the rational expectation. Rational expectations are shown to be a special (limiting) case of inferential expectations, with the test size a becoming a metric for rationality. When inferential expectations are built into a Dornbusch-style model of the exchange rate, regression tests of Uncovered Interest Parity and the rational expectations version of the term structure both display downward bias in the slope coefficient. We present the results of an experiment that supports inferential expectations.
    Keywords: expectations; macroeconomics; rationality; uncovered interest parity; term structure; exchange rate
    JEL: C91 D84 E50 F31
    Date: 2005–05–01

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