Topic IIC:

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International Fixed Income

• Topic IIC
• Empirical Analysis How Well Do the Parity
  Relations Hold?

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OUTLINE

• Review of Evidence on PPP
• Alternative Exchange Rate Approaches
• Forecasting
• Forward Premium Puzzle

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I. Recall the Evidence on PPP

• Deviations from purchasing power parity can be
  substantial in the short run.
• Real exchange rates can take several years to
  return to equilibrium.
• Real exchange rates are autoregressive (that is,
  they depend on previous levels).

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The empirical Record of RPPP in the long run
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Evidence on RPPP Deviations
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RXRs Over the (Very) Long Run 1900-1990
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Implementation Issues

• A few problems/questions arise
• The choice of a price index
• choices include CPI, PPI, GDP
• The choice of a base year/reference level
• chose an equilibrium period
• ...but (I) how do we know?, and (II) what does
  disequm mean?
• some fundamental structural changes might have
  occurred
• Relative prices might have changed
• hence PPP is not expected to hold

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PPP an Exchange Rate Determination Theory

• Causality is
• Goods market gt Currency Market
• The adjustment mechanism
• real is weak and domestic prices are low
• gt export will rise import will fall
• gt a trade surplus will generate a real and
  nominal appreciation
• We completely ignore
• the role of financial transactions
• the forward-looking nature of exchange rates
• the stickiness of prices

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Recall the Evidence on the Fisher Relation
Difference in realized quarterly inflation (p-p)
Difference in 3-month Eurocurrency interest rates
(i-i)
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II. Alternative Approaches to Modeling XR
Determination

• Main challenge is to relate
• Macro variables
• consumption, savings, taxes, investments, export,
  import, gvt deficit
• gt supply and demand of FX
• THE FUNDAMENTALS APPROACH TO XRs DETERMINATION
• Financial variables
• interest rates, asset flows, volatility, risk
  premiums, stockmarket behavior
• central bank policy and intervention
• THE ASSET APPROACH TO XRs DETERMINATION
• ...and to provide theory(ies) which explain and
  reconcile
• short, medium and long term behavior of XRs and
  RXRs
• puzzles

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The Balance of Payments Approach

• Current Account (sales and purchases of goods
  and services)
• CA X - M
• X - export of goods and services
• M - import of goods and services
• As the RXR rises (real appreciation) X__, M__ gt
  CA__
• In Equm Y C I G CA
• GNP consumptioninvestmentgvtspend
• Open economy add CA surplus(deficit)
• RXR ltgt CA(RXR) Y - C - I - G
• ...in order to (improve CA) ltgt (reduce RXR)
• we need to increase Y and/or reduce C and/or
  reduce I and/or reduce G
• Causality is the big leap of faith

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The Asset Approach

• The traditional approach
• XRs adjust to eliminate trade imbalances
• gt Countries with CA surplus will experience an
  appreciating currency
• Empirical evidence is counterfactual to this
  theory
• consider especially the US during 1980-85
  (deficit appreciation)
• The asset approach treats XRs as a financial
  asset
• attribute a FORWARD LOOKING role to XRs,
  consistent w/ other financial theories
• explain large moves relative to fundamental

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III. FORECASTING

• What do we (think we) know ?
• Higher interest rates gt strengthening currency
• Inflation rises gt currency weakens
• but for given real rates, high inflation ltgt
  high interest rates
• Trade deficit gt weaker currency
• but recall the experience in the US in the
  early 80s and recent opposite experience in FE
  countries

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Merrills March98 3mon Forecasts

• 3 out of 5 forecasts in the right direction
• Mean change is 3.364
• Mean absolute error of forecast 4.102
• HOW DO THESE FORECASTS COMPARE TO
  MARKET-WIDE AVAILABLE FORECASTS ?
• (e.g., CURRENT XRs and FORWARD rates)

Source March 5th, 1998 Currency and Bond
Market Trends biweekly review
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Exchange Rate Forecasting

• Market-Based Exchange Rate Forecasts
• EStd/f S0d/f - The random walk hypothesis
• EStd/f Ftd/f - The expectations hypothesis
• EStd/f S0d/f (1pd)/(1pf)t - RPPP
• Model-Based Exchange Rate Forecasts
• Technical analysis - uses the past history of
  exchange rates to predict future exchange rates
• Fundamental analysis - uses macroeconomic data to
  predict future exchange rate changes

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March98 3mon Forward Forecasts

• 3 out of 5 forecasts in the right direction
• Mean change is 3.364
• Mean absolute error of forecast 3.337

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Forward vs. Merrill

• 3 out of 5 forecasts in the right direction in
  both
• Forward forecast outperforms

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Merrill vs. Random Walk

• Random Walk MAE is 3.170
• Outperforms both Forward and Merrills
  forecasts...

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1-month forward rates as spot rate
predictorsYen per dollar exchange rates
1970-1995
Actual change in the spot rate

Forward premium or discount
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The Forward Premium Puzzle

• The Expectations hypothesis
• Ft1/ St EtSt1 / St
• Consider the regression
• St1/ St a b (Ft1 / St) errt
• Random walk gt a___, b___
• Exp Hypothesis gt a___, b___

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The Forward Premium Puzzle
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The Forward Premium PuzzleLong Horizon Evidence
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Implications and Interpretations

• With a beta-1.8, on average when igti by 1,
  then the XR appreciates by 0.88 instead of
  depreciating by 1
• gt Sell a currency trading at a premium(UIP
  predicts it should appreciate, but empirically
  the reverse happens), and buy a currency at a
  discount