nep-ifn New Economics Papers
on International Finance
Issue of 2008‒06‒27
ten papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Arbitrage in the Foreign Exchange Market: Turning on the Microscope By Akram, Qaisar Farooq; Rime, Dagfinn; Sarno, Lucio
  2. Market Microstructure Approach to the Exchange Rate Determination Puzzle By Thabo Mokoena; Rangan Gupta; Renee Van Eyden
  3. Exchange Rate Regimes and Capital Mobility: How Much of the Swoboda Thesis Survives? By Barry Eichengreen
  4. Do Peso Problems Explain the Returns to the Carry Trade? By Burnside, A Craig; Eichenbaum, Martin; Kleshchelski, Isaac; Rebelo, Sérgio
  5. Short-run Exchange-Rate Dynamics: Theory and Evidence By John A Carlson; Christian M. Dahl; Carol L. Osler
  6. Testing hypotheses in an I(2) model with applications to the persistent long swings in the Dmk/$ rate By Søren Johansen; Katarina Juselius; Roman Frydberg; Michael Goldberg
  7. Real Exchange Rate Dynamics under Staggered Loan Contracts By Ippei Fujiwara; Yuki Teranishi
  8. Testing for Fractional Integration in SADC Real Exchange Rates By Thabo Mokoena; Rangan Gupta; Renee Van Eyden
  9. Deconstructing Shocks and Persistence in OECD Real Exchange Rates By Syed A. Basher; Josep Lluis Carrión-i-Silvestre
  10. Real-Time Price Discovery in Global Stock, Bond and Foreign Exchange Markets By Torben G. Andersen; Tim Bollerslev; Francis X. Diebold; Clara Vega

  1. By: Akram, Qaisar Farooq; Rime, Dagfinn; Sarno, Lucio
    Abstract: This paper provides real-time evidence on the frequency, size, duration and economic significance of arbitrage opportunities in the foreign exchange market. We investigate deviations from the covered interest rate parity (CIP) condition using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency. The analysis unveils that: i) short-lived violations of CIP arise; ii) the size of CIP violations can be economically significant; iii) their duration is, on average, high enough to allow agents to exploit them, but low enough to explain why such opportunities have gone undetected in much previous research using data at lower frequency.
    Keywords: arbitrage; covered interest rate parity; exchange rates; foreign exchange microstructure
    JEL: F31 F41 G14 G15
    Date: 2008–06
  2. By: Thabo Mokoena (South African Reserve Bank, Pretoria); Rangan Gupta (Department of Economics, University of Pretoria); Renee Van Eyden (Department of Economics, University of Pretoria)
    Abstract: The market microstructure approach has been applied to the three major puzzles of exchange rate economics: the forward bias puzzle, the excess volatility puzzle, and the exchange rate determination puzzle. It claims that the imbalances between ‘buyer-initiated and seller-initiated trades’ in foreign exchange markets are indicative of the transmission link between exchange rates and fundamental determinants of exchange rates. In the context of the exchange rate determination puzzle, this paper discusses the market microstructure approach from the stand point of hybrid models that integrate order flow, fundamentals and non-fundamental variables to establish the determinants of the rand-dollar exchange rate. Among the non-fundamentals considered is the Economist commodity price index, the relevance of which is based on Chen and Rogoff (2002). Another non-fundamental variable included is a proxy for country risk—the differential between the Global Emerging Market Bond Index and the South African long-term bond. The paper relies on the autoregressive distributed lag (ARDL) model of Persaran, Shin and Smith (2001) and as explained in Persaran and Persaran (1997). The ARDL approach to cointegration does not require pre-testing for the integration properties of the individual series used in the empirical analysis. Instead, it relies on a bounds testing procedure. In this setting, inference is based on an F-test on the significance of lagged levels of variables in the error correction form. The results, based on the Schwarz Bayesian Criterion for choosing a model’s lag length, show that the there is a long-run relationship between the rand-dollar real exchange rate, nonfundamentals, the fundamentals and the proxy for order flow, which is the dollar-denominated daily net turnover on the South African markets.
    Keywords: Market Microstructure, Real Exchange Rates, ARDL
    JEL: C32
    Date: 2008–06
  3. By: Barry Eichengreen
    Abstract: Alexander Swoboda is one of the originators of the bipolar view that capital mobility creates pressure for countries to abandon intermediate exchange rate arrangements in favor of greater flexibility and harder pegs. This paper takes another look at the evidence for this hypothesis using two popular de facto classifications of exchange rate regimes. That evidence supports the bipolar view for the advanced countries, the sample for which it was originally developed, but not obviously for emerging markets and other developing countries. One interpretation of the contrast is that there is a tendency to move away from intermediate regimes in the course of economic and financial development, implying that emerging markets and other developing countries will eventually abandon intermediate regimes as well. Another interpretation is that the advanced countries have been faster to abandon soft pegs because they have been faster to develop attractive alternatives, notably Europe's monetary union. In this view, other countries are unlikely to abandon soft pegs because of the absence of the distinctive political conditions that have made the European alternative feasible. A final interpretation is that the advanced countries have been able to abandon soft peg because of their success in substituting inflation targeting for exchange rate targeting as the anchor for monetary policy. The paper presents some evidence for this view, which suggests the feasibility of further movement by emerging markets and developing countries in the direct of greater exchange rate flexibility.
    JEL: F31
    Date: 2008–06
  4. By: Burnside, A Craig; Eichenbaum, Martin; Kleshchelski, Isaac; Rebelo, Sérgio
    Abstract: Currencies that are at a forward premium tend to depreciate. This `forward-premium puzzle' is an egregious deviation from uncovered interest parity. We document the properties of the carry trade, a currency speculation strategy that exploits this anomaly. This strategy consists of borrowing low-interest-rate currencies and lending high-interest-rate currencies. We first show that the carry trade yields a high Sharpe ratio that is not a compensation for risk. We then consider a hedged version of the carry trade, which protects the investor against large, adverse currency movements. This strategy, implemented with currency options, yields average payoffs that are statistically indistinguishable from the average payoffs to the standard carry trade. We argue that this finding implies that the peso problem cannot be a major determinant of the payoff to the carry trade.
    Keywords: carry trade; exchange rates; Uncovered interest parity
    JEL: F31
    Date: 2008–06
  5. By: John A Carlson; Christian M. Dahl; Carol L. Osler (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: Recent research has revealed a wealth of information about the microeconomics of currency markets and thus the determination of exchange rates at short horizons. This information is valuable to us as scientists since, like evidence of macroeconomic regularities, it can provide critical guidance for designing exchange-rate models. This paper presents an optimizing model of short-run exchange-rate dynamics consistent with both the micro evidence and the macro evidence, the first such model of which we are aware. With respect to microeconomics, the model is consistent with the institutional structure of currency markets, it accurately reflects the constraints and objectives faced by the major participants, and it fits key stylized facts concerning returns and order flow. With respect to macroeconomics, the model is consistent with most of the major puzzles that have emerged under floating rates.
    Keywords: Exchange-rate dynamics, currency market microstructure
    JEL: F31 G12 G15
    Date: 2008–01–07
  6. By: Søren Johansen; Katarina Juselius; Roman Frydberg; Michael Goldberg (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: This paper discusses a number of likelihood ratio tests on long-run relations and common trends in the I(2) model and provide new results on the test of overidentifying restrictions on beta’xt and the asymptotic variance for the stochas- tic trends parameters, alpha 1: How to specify deterministic components in the I(2) model is discussed at some length. Model specification and tests are illustrated with an empirical analysis of long and persistent swings in the foreign exchange market between Germany and USA. The data analyzed consist of nominal exchange rates, relative prices, US in.ation rate, two long-term interest rates and two short-term interest rates over the 1975-1999 period. One important aim of the paper is to demonstrate that by structuring the data with the help of the I(2) model one can achieve a better understanding of the empirical regularities underlying the persistent swings in nominal exchange rates, typical in periods of floating exchange rates.
    Keywords: PPP puzzle, Forward premium puzzle, cointegrated VAR, likelihood inference
    JEL: C32 C52 F41
    Date: 2008–01–15
  7. By: Ippei Fujiwara (Director, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: ippei.fujiwara; Yuki Teranishi (Associate Director, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: yuuki.teranishi
    Abstract: In this paper, we investigate the relationship between real exchange rate dynamics and financial market imperfections. For this purpose, we first construct a New Open Economy Macroeconomics (NOEM) model that incorporates international staggered loan contracts as a simple form of the financial market imperfections. Recent empirical studies show that such staggered loan contracts are prevalent in the US, UK, and Japan and direct shocks to the bank lending interest rate (risk premium shocks) are major drivers of business cycle dynamics. Simulation results only with such a financial market friction and a risk premium shock can generate persistent, volatile, and realistic hump-shaped responses of real exchange rates, which have been thought very difficult to reproduce in standard NOEM models. This implies that these financial market developments can possibly be a major source of real exchange rate fluctuations.
    Keywords: Financial Market Imperfections, Real Exchange Rates, Staggered Loan Contracts
    JEL: F31 E41
    Date: 2008–06
  8. By: Thabo Mokoena (South African Reserve Bank, Pretoria); Rangan Gupta (Department of Economics, University of Pretoria); Renee Van Eyden (Department of Economics, University of Pretoria)
    Abstract: This paper utilises “a class test for fractional integration” associated with the seminal contribution of Hinich and Chong (2007) to appraise the possibility that South African Development Community (SADC) real exchange rates can be treated as long memory processes. The justification for considering fractional integration is that the general failure to reject the unit-root hypothesis in real exchange rates is caused by the restrictiveness of standard unit-root tests regarding admissible low-frequency dynamic behaviour. The paper presents evidence that a majority of SADC real exchange rates are fractionally integrated and therefore mean-reverting.
    Keywords: Long Memory Processes, Real Exchange Rates, Mean-Reversion
    JEL: F31
    Date: 2008–06
  9. By: Syed A. Basher (Department of Economic Policies, Qatar Central Bank, Doha, Qatar.); Josep Lluis Carrión-i-Silvestre (AQR-IREA, University of Barcelona.)
    Abstract: This paper analyzes the persistence of shocks that affect the real exchange rates for a panel of seventeen OECD developed countries during the post-Bretton Woods era. The adoption of a panel data framework allows us to distinguish two different sources of shocks, i.e. the idiosyncratic and the common shocks, each of which may have di¤erent persistence patterns on the real exchange rates. We first investigate the stochastic properties of the panel data set using panel stationarity tests that simultaneously consider both the presence of cross-section dependence and multiple structural breaks that have not received much attention in previous persistence analyses. Empirical results indicate that real exchange rates are non-stationary when the analysis does not account for structural breaks, although this conclusion is reversed when they are modeled. Consequently, misspecification errors due to the non-consideration of structural breaks leads to upward biased shocks' persistence measures. The persistence measures for the idiosyncratic and common shocks have been estimated in this paper always turn out to be less than one year.
    Date: 2008–06
  10. By: Torben G. Andersen; Tim Bollerslev; Francis X. Diebold; Clara Vega (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: Using a unique high-frequency futures dataset, we characterize the response of U.S., German and British stock, bond and foreign exchange markets to real-time U.S. macroeconomic news. We find that news produces conditional mean jumps, hence high-frequency stock, bond and exchange rate dynamics are linked to fundamentals. Equity markets, moreover, react differently to news depending on the stage of the business cycle, which explains the low correlation between stock and bond returns when averaged over the cycle. Hence our results qualify earlier work suggesting that bond markets react most strongly to macroeconomic news, in particular, when conditioning on the state of the economy, the equity and foreign exchange markets appear equally responsive. Finally, we also document important contemporaneous links across all markets and countries, even after controlling for the effects of macroeconomic news.
    Keywords: Asset Pricing, Macroeconomic News Announcements, Financial Market Linkages, Market Microstructure, High-Frequency Data, Survey Data, Asset Return Volatility, Forecasting
    JEL: F3 F4 G1 C5
    Date: 2007–08–16

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