nep-ifn New Economics Papers
on International Finance
Issue of 2006‒08‒05
27 papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Uncovered Interest Parity By Peter Isard
  2. Can Firms’ Location Decisions Counteract the Balassa-Samuelson Effect? By Isabelle Mejean
  3. Determinants of Venezuela's Equilibrium Real Exchange Rate By Juan Zalduendo
  4. An Empirical Investigation of the Exchange Rate Pass-Through to Inflation in Tanzania By Nkunde Mwase
  5. Merging the Purchasing Power: Parity and the Phillips Curve Literatures: Regional Evidence from Italy By Andrea Vaona
  6. Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle By Lucio Sarno; Giorgio Valente; H. L. Leon
  7. Monetary disequilibria and the Euro/Dollar exchange rate By Nautz, Dieter; Ruth, Karsten
  8. Sudden Stops and Currency Drops: A Historical Look By Luis Catão
  9. The renminbi equilibrium exchange rate: an agnostic view By Antoine Bouveret; Sana Mestiri; Henri Sterdyniak
  10. Determinants of current account developments in the central and east European EU member states – consequences for the enlargement of the euro area By Herrmann, Sabine; Jochem, Axel
  11. The Role of IMF Support in Crisis Prevention By Juan Zalduendo; Uma Ramakrishnan
  12. U.S. Dollar Risk Premiums and Capital Flows By Ravi Balakrishnan; Volodymyr Tulin
  13. Exchange Rate Misalignment: An Application of the Behavioral Equilibrium Exchange Rate (BEER) to Botswana By Atsushi Iimi
  14. Fiscal Discipline and Exchange Rate Regimes: Evidence from the Caribbean By Guillermo Tolosa; Rupa Duttagupta
  15. The coordination channel of foreign exchange intervention: a nonlinear microstructural analysis By Reitz, Stefan; Taylor, Mark P.
  16. Real Exchange Rate Volatility and the Price of Nontradables in Sudden-Stop-Prone Economies By Enrique G. Mendoza
  17. Can Affine Term Structure Models Help Us Predict Exchange Rates? By Antonio Diez de los Rios
  18. Authorities' beliefs about foreign exchange intervention: getting back under the hood By Christopher J. Neely
  19. How costly is exchange rate stabilisation for an inflation targeter? The case of Australia By Mark Crosby; Tim Kam; Kirdan Lees
  20. What drives volatility persistence in the foreign exchange market? By David Berger; Alain Chaboud; Erik Hjalmarsson; Edward Howorka
  21. Transmission of volatility and trading activity in the global interdealer foreign exchange market: evidence from electronic broking services (EBS) data By Fang Cai; Edward Howorka; Jon Wongswan
  22. The Euro's Challenge to the Dollar: Different Views from Economists and Evidence from COFER (Currency Composition of Foreign Exchange Reserves) and Other Data By Ewe-Ghee Lim
  23. Forecasting and Combining Competing Models of Exchange Rate Determination By Carlo Altavilla; Paul De Grauwe
  24. The Introduction of the Euro and its Effects on Investment Decisions By Haselmann, Rainer; Helmut, Herwartz
  25. The forecast ability of risk-neutral densities of foreign exchange By Craig, Ben; Keller, Joachim
  26. The dynamic relationship between the Euro overnight rate, the ECB´s policy rate and the term spread By Nautz, Dieter; Offermanns, Christian J.
  27. Exchange rate risk and economic reform: the case of endogenous institutional change in China By Veit, Wolfgang

  1. By: Peter Isard
    Abstract: This paper provides an overview of the uncovered interest parity assumption. It traces the history of the interest parity concept, summarizes evidence on the empirical validity of uncovered interest parity, and discusses different interpretations of the evidence and the implications for macroeconomic analysis. The uncovered interest parity assumption has been an important building block in multiperiod models of open economies, and although its validity is strongly challenged by the empirical evidence, at least at short time horizons, its retention in macroeconomic models is supported on pragmatic grounds by the lack of much empirical support for existing models of the exchange risk premium.
    Date: 2006–04–24
  2. By: Isabelle Mejean
    Abstract: This paper studies determinants of relative price levels in a New Trade framework. The model combines a Balassa-Samuelson mechanism, explaining Purchasing Power Parity (PPP) deviations in the non-traded good sector, and an endogenous location of firms leading to PPP deviations in the traded good sector. Calibrating the model with OECD data, I show that PPP deviations in the traded good sector can either lessen or strengthen the Balassa-Samuelson effect, depending on the share of traded goods in consumption. Moreover, in general equilibrium, the real exchange rate also depends on the relative size of countries, through the Home Market Effect.
    Keywords: Long-Run Real Exchange Rate; PPP deviations; Balassa-Samuelson effect; location decisions; relocation; international trade; new trade theory
    JEL: F1 F2 F4
    Date: 2006–07
  3. By: Juan Zalduendo
    Abstract: The Venezuelan Bolivar is pegged to the U.S. dollar and supported by foreign exchange restrictions. To assess the appropriateness of the peg during the current period of high oil export earnings and the likely consequences of a liberalization, this paper attempts to disentangle the effects of oil prices from other factors underlying the equilibrium real exchange rate, and examines the role of foreign exchange controls by extending the application of a vector error correction (VEC) model to parallel market exchange rates. Several findings are worth noting. First, oil prices have indeed played a significant role in determining a time-varying equilibrium real exchange rate path. Second, oil prices are not the only important determinant of the real effective exchange rate: declining productivity is also a key factor. Third, appreciation pressures are rising. Finally, the speed of convergence of a VEC model using parallel rather than official rates is higher, suggesting that the government has been able to maintain sharp deviations between the official and equilibrium rates because of Venezuela's oil dependency and the concentration of oil income in government hands.
    Keywords: Real effective exchange rates , Venezuela, Republica Bolivariana de , Oil prices , Foreign exchange , Exchange control measures , Exchange markets ,
    Date: 2006–03–31
  4. By: Nkunde Mwase
    Abstract: The paper examines the effect of exchange rate changes on consumer prices in Tanzania using structural vector autoregression (VAR) models. Using a data set covering the period 1990-2005, we find that the exchange rate pass-through to inflation declined in the late 1990s despite the depreciation of the currency. This could be partly attributed to the macroeconomic and structural reforms that were implemented during this period. The decline in the pass-through does not necessarily imply that exchange rate fluctuations are less significant in explaining macroeconomic fluctuations. The recent increase in the share of imports in the economy suggests that the pass-through could rise over the medium term. The findings imply that the authorities should remain vigilant in assessing the potential impact of foreign prices on the dynamics of inflation in Tanzania. In this regard, the authorities should seek to maintain low and stable inflation and continue the ongoing structural reforms designed to improve efficiency and increase competition.
    Date: 2006–06–26
  5. By: Andrea Vaona
    Abstract: The main purpose of this paper is to merge together two strands of the literature regarding, either directly or indirectly, inflation: the PPP and the Phillips curve ones. In order to accomplish this task, this contribution applies the tools of the Empirical Growth Literature and of Dynamic Panel Data estimation on a sample of 81 Italian provinces from the year 1986 to the year 1998, exploiting cross-sectional variation to avoid to use instruments not directly connected with the inflation generating process. This research strategy allows to conclude that inflation is characterized by a low degree of persistence and by conditional b-convergence across provinces. Its most suitable driving variable is the unemployment rate and there are long-term non neutralities at the regional level.
    Date: 2006–07
  6. By: Lucio Sarno; Giorgio Valente; H. L. Leon
    Abstract: We provide empirical evidence that deviations from uncovered interest rate parity (UIP) display significant nonlinearities, consistent with theories based on transaction costs or limits to speculation. This evidence suggests that the forward bias documented in the literature may be less indicative of major market inefficiencies than previously thought. Monte Carlo experiments allow us to reconcile these results with the large empirical literature on the forward bias puzzle since we show that, if the true process of UIP deviations were of the nonlinear form we consider, estimation of conventional spot-forward regressions would generate the anomalies documented in previous research.
    Date: 2006–06–12
  7. By: Nautz, Dieter; Ruth, Karsten
    Abstract: Although stable money demand functions are crucial for the monetary model of the exchange rate, empirical research on exchange rates and money demand is more or less disconnected. This paper tries to fill the gap for the Euro/Dollar exchange rate. We investigate whether monetary disequilibria provided by the empirical literature on U.S. and European money demand functions contain useful information about exchange rate movements. Our results suggest that the empirical performance of the monetary exchange rate model improves when insights from the money demand literature are explicitly taken into account.
    Keywords: Euro/Dollar Exchange Rate, Monetary Model, Money Demand Functions
    JEL: E41 F31
    Date: 2005
  8. By: Luis Catão
    Abstract: This paper shows that recent manifestations of sudden stops (SSs) in international capital flows have striking parallels in the early financial globalization era preceding World War I. All main capital-importing countries then faced episodic capital flow reversals averaging some 5 percent of GDP and with a median duration of four years. Most SSs also displayed striking crosscountry synchronization, being immediately preceded by rising world interest rates. Both fixed and floating exchange rate regimes were hit, with no significant differences between them. Yet, not all SSs resulted in currency drops: while some countries experienced currency collapses, others managed to preserve exchange rate stability. These different responses are related to domestic "frictions" that heightened the procyclicality of absorption and hindered precautionary reserve accumulation in some countries relative to others.
    Keywords: Financial crisis , Capital flows , Exchange rate regimes ,
    Date: 2006–06–06
  9. By: Antoine Bouveret; Sana Mestiri; Henri Sterdyniak (Observatoire Français des Conjonctures Économiques)
    Date: 2006
  10. By: Herrmann, Sabine; Jochem, Axel
    Abstract: The current accounts of most EU member states in central and eastern Europe have been showing growing deficits in recent years. According to panel estimates the deficits can be attributed primarily to factors characteristic for the stage of development, ie the relative income level and high capital building. The positive impact of a closing income gap, however, is largely compensated by real appreciation. The net effect of government budget deficits is rather small, since they are mostly financed by private saving. Further integration of the financial sector is likely to improve the current accounts. Although the current account positions do not require fundamental policy reversals, there are clear risks of exchange rate adjustments that should be reduced before entering the euro area.
    Keywords: current account, new EU member countries, catching-up process
    JEL: F15 F32
    Date: 2005
  11. By: Juan Zalduendo; Uma Ramakrishnan
    Abstract: This paper examines the role of IMF-supported programs in crisis prevention; specifically, whether, conditional on an episode of intense market pressures, IMF financial support helps prevent a capital account crisis from developing and, if so, through what channels. In doing so, the paper distinguishes between the seal of approval inherent in IMF support and its financing, evaluates the interaction of IMF support with economic policies, and assesses whether IMF financing has a different impact on the likelihood of a crisis than other forms of liquidity. The main result is that IMF financing helps prevent crises through the liquidity provided (i.e., money matters). However, since the effect holds even after controlling for (gross) foreign exchange reserves, stronger policies and the seal of approval under an IMFsupported program must also play a role. Finally, the results suggest that IMF financing as a crisis prevention tool is most effective for an intermediate range of economic fundamentals.
    Keywords: Fund-supported adjustment programs , Balance of payments assistance , Crisis prevention , Capital account , Financial crisis ,
    Date: 2006–03–31
  12. By: Ravi Balakrishnan; Volodymyr Tulin
    Abstract: This paper sheds light on the attractiveness of U.S. assets by studying dollar risk premiums, calculated using Consensus exchange rate forecasts, and linking them to bilateral capital flows. The paper finds that the presence of negative dollar risk premiums (i.e. expectations of a dollar depreciation net of interest rate effects) amid record capital inflows could suggest that investors may favor U.S. assets for structural reasons. One possible explanation could be that the Asian crisis created a large pool of savings searching for relatively riskless investment opportunities, which were provided by deep, liquid, and innovative U.S. financial markets with robust investor protection. Moreover, the continued attractiveness of U.S. financial markets to European investors suggests that they offer a large array of assets, with different risk/return characteristics, that facilitate the structuring of diversified investment portfolios. Looking forward, this suggests that the allocative efficiency of U.S. financial markets could mitigate risks of a disorderly unwinding of global current account imbalances.
    Date: 2006–07–11
  13. By: Atsushi Iimi
    Abstract: Botswana's successive currency devaluations and recent move from a fixed to a crawling peg exchange rate regime raise the question of whether the exchange rate might be misaligned with economic fundamentals. This paper, applying the behavioral equilibrium exchange rate (BEER) approach, analyzes the behavior of the real exchange rate for the period 1985-2004. It finds that the pula was undervalued in the later 1980s but overvalued in recent years. Some policy lessons from experiences in other countries with crawling peg arrangements are therefore considered in the context of Botswana.
    Keywords: Exchange rates , Botswana , Devaluation , Crawling peg , Exchange rate regimes ,
    Date: 2006–06–13
  14. By: Guillermo Tolosa; Rupa Duttagupta
    Abstract: This paper assesses the nature of fiscal discipline under alternative exchange rate regimes. First, it shows in a simple theoretical framework that fiscal agencies under a currency union with a fixed exchange rate can have the largest incentive to overspend or "free-ride" (compared to those under other exchange rate regimes) owing to their ability to spread the costs of overspending in terms of the inflation tax across both time-given the fixed exchange rate-and space-given the currency union. In contrast, such free-riding behavior does not arise under flexible regimes owing to the immediate inflationary impact of spending. Next, empirically, it shows that fiscal stances in countries with fixed pegs and currency unions regime demonstrate greater free-riding behavior than countries with more flexible regimes in 15 Caribbean countries during 1983-2004.
    Keywords: Fiscal policy , Caribbean , Monetary unions , Exchange rate regimes , Flexible exchange rates , Currency pegs ,
    Date: 2006–05–12
  15. By: Reitz, Stefan; Taylor, Mark P.
    Abstract: The coordination channel has been proposed as a means by which foreign exchange market intervention may be effective, in addition to the traditional portfolio balance and signaling channels. If strong and persistent misalignments of the exchange rate are caused by non-fundamental influences, such that a return to equilibrium is hampered by a coordination failure among fundamentals-based traders, then central bank intervention may act as a coordinating signal, encouraging stabilizing speculators to re-enter the market at the same time. We develop this idea in the framework of a simple microstructural model of exchange rate movements, which we then estimate using daily data on the dollar-mark exchange rate and on Federal Reserve and Bundesbank intervention operations. The results are supportive of the existence of a coordination channel of intervention effectiveness.
    Keywords: foreign exchange intervention, coordination channel, market microstructure, nonli mean reversion
    JEL: C10 F31 F41
    Date: 2006
  16. By: Enrique G. Mendoza
    Abstract: This paper shows that the dominant view that the high variability of real exchange rates is due to movements in exchange rate-adjusted prices of tradable goods does not hold for Mexican data for periods with a managed exchange rate. The relative price of nontradables accounts for up to 70 percent of real exchange rate variability during these periods. The paper also proposes a model in which this fact, and the sudden stops that accompanied the collapse of Mexico's managed exchange rates, could result from a Fisherian debt-deflation mechanism operating via nontradables prices in economies with dollarized liabilities.
    Keywords: Real effective exchange rates , Mexico , Dollarization , Price adjustments ,
    Date: 2006–04–11
  17. By: Antonio Diez de los Rios
    Abstract: The author proposes an arbitrage-free model of the joint behaviour of interest and exchange rates whose exchange rate forecasts outperform those produced by a random-walk model, a vector autoregression on the forward premiums and the rate of depreciation, and the standard forward premium regression. In addition, the model is able to reproduce the forward premium puzzle.
    Keywords: Exchange rates; Interest rates; Econometric and statistical methods
    JEL: E43 F31 G12 G15
    Date: 2006
  18. By: Christopher J. Neely
    Abstract: This paper presents the results of a survey of monetary authorities with respect to their beliefs about foreign exchange intervention. The survey provides evidence on new intervention issues that would be difficult to investigate otherwise, such as conditional response times, non-foreign exchange factors in intervention and beliefs about profitability. At the same time, the survey provides new evidence on issues that have been investigated with other methods, such as channels of effectiveness, effect on currency components, profitability, and motivations for secrecy. Respondents disagreed with the predominant views on intervention*s effect on volatility and common arguments against intervention. The exchange rate regime of a central bank explains its beliefs about several important aspects of intervention, including factors in a successful intervention and the potential profitability of intervention.
    Keywords: Foreign exchange ; Banks and banking, Central
    Date: 2006
  19. By: Mark Crosby; Tim Kam; Kirdan Lees (Reserve Bank of New Zealand)
    Abstract: This paper quantifies the costs of mitigating exchange rate volatility within the context of a flexible inflation targeting central bank. Within a standard linearquadratic formulation of inflation targeting, we append a term that penalises deviations in the exchange rate to the central bank’s loss function. For a simple forward-looking New Keynesian model, we show that the central bank can reduce volatility in the exchange rate relatively costlessly by aggressively responding to the real exchange rate. However, when we append correlated shocks – to better match summary statistics of the Australian data – we find that the costs associated with reducing exchange rate volatility are larger: output volatility increases substantially. Finally, we apply our method to a variant of a small backward-looking New Keynesian model of the Australian economy. Under this model, large increases in inflation and output volatility accrue if the central bank attempts to mitigate exchange rate volatility.
    JEL: C51 E52 F41
    Date: 2006–06
  20. By: David Berger; Alain Chaboud; Erik Hjalmarsson; Edward Howorka
    Abstract: We analyze the factors driving the widely-noted persistence in asset return volatility using a unique dataset on global euro-dollar exchange rate trading. We propose a new simple empirical specification of volatility, based on the Kyle-model, which links volatility to the information flow, measured as the order flow in the market, and the price sensitivity to that information. Through the use of high-frequency data, we are able to estimate the time-varying market sensitivity to information, and movements in volatility can therefore be directly related to movements in two observable variables, the order flow and the market sensitivity. The empirical results are very strong and show that the model is able to explain almost all of the long-run variation in volatility. Our results also show that the variation over time of the market's sensitivity to information plays at least as important a role in explaining the persistence of volatility as does the rate of information arrival itself. The econometric analysis is conducted using novel estimation techniques which explicitly take into account the persistent nature of the variables and allow us to properly test for long-run relationships in the data.
    Keywords: Foreign exchange rates ; Foreign exchange market
    Date: 2006
  21. By: Fang Cai; Edward Howorka; Jon Wongswan
    Abstract: This paper studies the transmission of volatility and trading activity in the foreign exchange market across trading regions for the euro-dollar and dollar-yen currency pairs, using high-frequency intraday data from Electronic Broking Services (EBS). In contrast with previous studies that use indicative quote frequency to proxy for trading activity, we use actual regional trading volume to identify five distinct trading regions in the foreign exchange market: Asia Pacific, the Asia-Europe overlap, Europe, the Europe-America overlap, and America. Based on realized volatility computed from high-frequency data and a regional volatility model, we find statistically significant evidence for volatility spillovers at both the own-region and the inter-region levels, but the economic significance of own-region spillovers is much more important than that of inter-region spillovers. We also examine the transmission of trading activity (trading volume and number of transactions) across the five trading regions and find similar results to those for volatility, but the economic significance of own-region spillovers is even more dominant.
    Keywords: Foreign exchange rates ; International finance
    Date: 2006
  22. By: Ewe-Ghee Lim
    Abstract: This paper examines opposing views on the euro's challenge to the dollar as an international currency. One view emphasizes Europe's large economy and diversification effects as undergirding a vigorous challenge. The other emphasizes "network externalities," particularly undergirding continued dollar dominance. The data to date support the second view but also show the euro has significantly overtaken the legacy currencies as a reserve currency. Generally, large economic size alone is insufficient to challenge the network externalities supporting vehicle currencies, but scope exists for the euro to advance as an international store of value. The paper discusses the euro's medium-term prospects.
    Date: 2006–06–27
  23. By: Carlo Altavilla; Paul De Grauwe
    Abstract: This paper investigates the out-of-sample forecast performance of a set of competing models of exchange rate determination. We compare standard linear models with models that characterize the relationship between exchange rate and its underlying fundamentals by nonlinear dynamics. Linear models tend to outperform at short forecast horizons especially when deviations from long-term equilibrium are small. In contrast, nonlinear models with more elaborate mean-reverting components dominate at longer horizons especially when deviations from long-term equilibrium are large. The results also suggest that combining different forecasting procedures generally produces more accurate forecasts than can be attained from a single model.
    Keywords: non-linearity, exchange rate modelling, forecasting
    JEL: C53 F31
    Date: 2006
  24. By: Haselmann, Rainer; Helmut, Herwartz
    Abstract: In this paper we examine changes on investment decisions induced by the introduction of the Euro. There are two potential sources of portfolio reallocation. First, the introduction of the Euro diminished exchange rate risks within the EMU region, which relieved European investors from currency risk associated with intra-EMU investments. Second, monetary policy has been bundled within one single institution, which increased the correlation of different national stock and bond market returns. We test for structural breaks in the portfolio holdings of German investors and estimate a market model in the latter in order to account for the two described effects. We observe a significant decrease in national and an significant increase in intra-EMU as well as US investments. Therefore, the establishment of the EMU led to a decrease of investment home bias.
    Keywords: investment home bias, realized volatility, Euro introduction
    JEL: F21 F33 F36 G15
    Date: 2005
  25. By: Craig, Ben; Keller, Joachim
    Abstract: We estimate the process underlying the pricing of American options by using higher-order lattices combined with a multigrid method. This paper also tests whether the risk-neutral densities given from American options provide a good forecasting tool. We use a nonparametric test of the densities that is based on the inverse probability functions and is modified to account for correlation across time between our random variables, which are uniform under the null hypothesis. We find that the densities based on the Americanoption markets for foreign exchange do quite well for the forecasting period over which the options are thickly traded. Further, simple models that fit the densities do about as well as more sophisticated models. Keywords: Risk-neutral densities from option prices, American exchange rate options, Evaluating Density Forecasts, Pentionominal tree, Density evaluation, Overlapping data problem
    Keywords: Risk-neutral densities from option prices, American exchange rate options, Evaluating Density Forecasts, Pentionominal tree, Density evaluation
    JEL: C52 C63 F31 F47
    Date: 2005
  26. By: Nautz, Dieter; Offermanns, Christian J.
    Abstract: This paper investigates how the dynamic adjustment of the European overnight rate Eonia to the term spread and the ECB’s policy rate has been affected by rate expectations and the operational framework of the ECB. In line with recent evidence found for the US and Japan, the reaction of the Eonia to the term spread is non-symmetric. Moreover, the response of the Eonia to the policy rate depends on both, the repo auction format and the position of the Eonia in the ECB’s interest rate corridor.
    Keywords: Monetary Policy Impleme ion, Term Structure of Interest Rates, Nonli Cointegration
    JEL: E43 E52
    Date: 2006
  27. By: Veit, Wolfgang
    Abstract: Over the past 15 years the mutual importance of institutional economics and development economics have grown strongly. This paper attempts to apply institutional analysis to issues of economic development by analysing China’s reform process after her accession to the WTO on the background of the hypothesis of vertically dependent institutions. It will be shown that institutions on a lower level (e.g. a fixed exchange rate regime) are dominated by higher level institutions like (e.g. laws governing firms, financial and labour markets). The latter are dominated by institutions on a higher level, for example by regulations governing the economic and political system. Consequently, economic policy options like a change in the exchange rate regime will depend on adjustments in areas ranging from constitutional to company law. In the second chapter, the concept of hierarchical institutions is introduced. In the third chapter, the general results of China’s recent trade liberalisation under WTO rules and the issue of a fixed exchange rate to the US Dollar are recounted. In the fourth chapter, reforms necessitated by China’s accession to the WTO, and reflected by the present exchange rate regime, are identified. This is followed by the analysis of institutions that are conducive to successful implementation of those reforms in China.
    Date: 2005

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