Official Interventions and Occasional Violations of Uncovered Interest Parity in the Dollar-DM Market (original) (raw)
Related papers
Official interventions and the forward premium anomaly
Journal of Empirical Finance, 2007
This paper presents a model of exchange rate determination in which the forward premium anomaly emerges as the result of unanticipated central bank interventions in the foreign exchange market. Deviations from uncovered interest parity (UIP) therefore represent neither unexploited profit opportunities nor compensation for bearing risk. In simulations, the model generates a forward premium anomaly and matches several other notable features of US-German data. Additional empirical support is obtained from an analysis of Fed and Bundesbank interventions in the dollar-DM market where it is found that the forward premium anomaly intensifies during those times when a central bank intervenes.
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.”
The Failure of Uncovered Interest Parity: Is it Near-rationality in the Foreign Exchange Market?
1991
A risk-averse US investor ad-justs the shares of a portfolio of short-term nominal domestic and foreign assets to maximize expected utility. The optimal strategy is to respond immediately to all new information which arrives weekly. We calculate the expected utility foregone when the investor abandons the optimal strategy and instead optimizes less frequently. We also consider the cases where the investor ignores the covariance between returns sourced in different countries, and where the investor makes unsystematic mistakes when forming expectations of exchange rate changes.
1986
L,ZIP ENCE the late l970s, theoretical explanations of exchange rate deternunation have emphasized the asset approach rather tItan the expenditure approach.' Most of the empirical research applying the asset models of exchange rate detern malion also subsume the efficient market hypothesis. In this article, we test three efficient niarke I hypotheses bearing on forward exchange rates: Fl rst, are forward rates unbiased forecasts of future spot exchange rates? Second, does ''news'' in particular iinanti ci pated changes in nominal or real interest differentialsexplain for-Mack Ott is a senioreconomist atthe Federal Reserve BankofSt. Louis and Paul T W. M. Veugelers, formerly a professor in the Department of Monetary Economics, Erasmus University, is a private consultant in the Netherlands. This article is the result of research undertaken in 1985 during an exchange of visits -Mr. Veugelers to this Bank and Mr. Ott to Erasmus University. The authors acknowledge the research assistance ofJames C. Polefti and the helpful comments of Clemens Kool, 'One rationale tor this shin is the observation that the interest rate parity (IRP) postulate of the asset view has held up substantially better than the purchasing power parity (PPP) postulate or the expenditure view; see Frenkel (1981b). The former reters to the equality ot asset yields across currencies, while the latter refers to the equality ot purchasing power across currencies. PPP frequently, and for protracted periods, has been violated by exchange rates; see Frenkel (1981 b). Thus, analysts have been faced with either modifying the PPP assumption and diluting its relevance, or accepting the evidence and developing theories to explain it, Indeed, some authors, and , argue that changing real exchange rates vitiate the relevance of PPP. ward rate forecast errors?~tiiird, are forward rate forecast errors affected by change in the U.S. monetary policy regime? These hypotheses are tested by examining the forecast errors the difference between the forward rate arid the subsequently observed spot rate) for the U.S. dollar forward rate against the currencies of eight industrialized countries over the latest floating-rate era . ' •~r'T he forward exchange rate in an efficient market reflects all the information possessed by individuals active in that market. i'hus, iti an open market, the forward rate should he. an unbiased predictor' of the future spot rate Henc e,are.gression of the observed spot rate at time t on the forward rate at time t -I where exchange rates are measured by natural logarithms of the dollar pr ces of foreign exchangei, lii 5, =~b t~_,+ t~, should result in an estimated constant not signiticantlv different from zero, an estimated coeflicient on 2See Dornbusch (1976), , and Edwards (1983b).
Is the forward bias economically small? Evidence from European rates
Journal of International Money and Finance, 2008
For the purpose of testing uncovered interest parity (UIP), rates of European currencies against the Mark offer a distinct advantage: the admissible band of the Exchange Rate Mechanism (ERM) induces statistically significant mean-reversion in weekly rates. Thus, unlike for freely floating rates, there is an expectation signal that has nontrivial variation and is sufficiently traceable for research purposes. When running the standard regression tests of the unbiasedexpectations hypothesis at the one-week horizon, we nevertheless obtain essentially zero coefficients for intra-EMS exchange rates (and the familiar negative coefficients for extra-EMS rates). Even more puzzlingly, lagged exchange-rate changes remain significant when added to the regression, a feature that seems hard to explain as a missing-variable effect. The deviation from UIP is significant not just statistically but also economically: trading-rule tests reveal that for sufficiently large filters the average profit per trade exceeds transaction costs, and that cumulative gains can be quite impressive. The size of the profits and the patterns from buy versus sell decisions also allow us to reject the hypotheses of either a risk premium or peso issues about realignments as sufficient explanations.
This paper shows than when there are significant costs for private agents to change their positions in foreign bonds, an incomplete markets two-country general equilib- rium monetary model with sticky prices can reproduce a "forward premium anomaly", an upward sloping term structure of uncovered interest parity (UIP) regression slope coefficients, Sharpe ratios for carry-trade strategies close to the data, and predicts a 2.3 basis-point decrease in the short-term foreign interest rate after an unexpected one standard deviation central bank purchase of foreign bonds. A crucial element of the analysis is the interaction between the central bank balance sheet, the private agents budget constraints, and market clearing conditions in both bond markets.
2005
The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of crosscountry differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in-and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of short-term interest rates, not to a breakdown of the link between fundamentals and exchange rates.
Determinants of Currency Risk Premiums
SSRN Electronic Journal, 2000
This paper presents a theoretical model of exchange-rate determination intended to address the forward premium puzzle. It also explains the empirical observation that risk premiums depend on interest differentials. The model's closed-form solution indicates that currency risk premiums depend on two factors: interest differentials and the current deviation of the exchange rate from its long-run equilibrium. If speculators have an alternative to exchange-rate speculation, then there is no presumption that uncovered interest parity holds even approximately in long-run equilibrium. The model is consistent with existing evidence suggesting that forward premiums are negatively related to rationally expected future exchange rate changes. New empirical evidence is provided in support of the model.