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51
Towards a solution to the puzzles in exchange rate economics: where do we stand?, Canadian
 Journal of Economics
, 2005
"... This paper provides a selective overview of puzzles in exchange rate economics. We begin with the forward bias puzzle: high interest rate currencies appreciate when one might guess that investors would demand higher interest rates on currencies expected to fall in value. We then analyze the purchasi ..."
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Cited by 83 (2 self)
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This paper provides a selective overview of puzzles in exchange rate economics. We begin with the forward bias puzzle: high interest rate currencies appreciate when one might guess that investors would demand higher interest rates on currencies expected to fall in value. We then analyze the purchasing power parity puzzle: the real exchange rate displays no (strong) reversion to a stable longrun equilibrium level. Finally, we cover the exchange rate disconnect puzzle: the lack of a link between the nominal exchange rate and economic fundamentals. For each puzzle, we critically review the literature and speculate on potential solutions. JEL classification: F31.
Exchange Rates and Fundamentals: Footloose or Evolving Relationship?
, 2005
"... Using novel realtime data on a broad set of economic fundamentals for five major US dollar exchange rates over the recent float, we employ a predictive procedure that allows the relationship between exchange rates and fundamentals to evolve over time in a very general fashion. Our key findings are ..."
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Cited by 32 (4 self)
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Using novel realtime data on a broad set of economic fundamentals for five major US dollar exchange rates over the recent float, we employ a predictive procedure that allows the relationship between exchange rates and fundamentals to evolve over time in a very general fashion. Our key findings are that: (i) the welldocumented weak outofsample predictive ability of exchange rate models may be caused by poor performance of modelselection criteria, rather than lack of information content in the fundamentals; (ii) the difficulty of selecting the best predictive model is largely due to frequent shifts in the set of fundamentals driving exchange rates, reflecting swings in market expectations over time. However, the strength of the link between exchange rates and
fundamentals is different across currencies.
Properties of realized variance for a pure jump process: Calendar time sampling versus business time sampling
, 2004
"... Comments are welcome In this paper we study the impact of market microstructure effects on the properties of realized variance using a pure jump process for high frequency security prices. Closed form expressions for the bias and mean squared error of realized variance are derived under alternative ..."
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Cited by 31 (0 self)
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Comments are welcome In this paper we study the impact of market microstructure effects on the properties of realized variance using a pure jump process for high frequency security prices. Closed form expressions for the bias and mean squared error of realized variance are derived under alternative sampling schemes. Importantly, we show that business time sampling is generally superior to the common practice of calendar time sampling in that it leads to a reduction in mean squared error. Using IBM transaction data we estimate the model parameters and determine the optimal sampling frequency for each day in the data set. The empirical results reveal a downward trend in optimal sampling frequency over the last 4 years with considerable daytoday variation that is closely related to changes in market liquidity.
Using Copulas to Construct Bivariate Foreign Exchange Distributions with an Application to the Sterling Exchange Rate
"... Abstract: We model the joint risk neutral distribution of the eurosterling and the dollarsterling exchange rates using optionimplied marginal distributions that are connected via a copula function that satisfies the triangular noarbitrage condition. We then derive a univariate distribution for ..."
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Cited by 20 (3 self)
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Abstract: We model the joint risk neutral distribution of the eurosterling and the dollarsterling exchange rates using optionimplied marginal distributions that are connected via a copula function that satisfies the triangular noarbitrage condition. We then derive a univariate distribution for a simplified sterling effective exchange rate index (ERI). Our results indicate that standard parametric copula functions, such as the commonly used Normal and Frank copulas, fail to capture the degree of asymmetry observed in the data. We overcome this problem by using a nonparametric dependence function in the form of a Bernstein copula which is shown to produce a very close fit. We further give an example of how our approach can be used to price currency index options accounting for strikedependent implied volatilities. We would like to thank Michael Bennett, Andrew Patton and Alessio Sancetta, participants at the CEF 2005 in Washington and the GFC 2005 in Dublin, as well as seminar participants at the Bank of England for useful comments and discussion. Any remaining mistakes are our own. This paper represents the views of the authors and should not be thought to represent those of the Bank of England and members of the Monetary Policy Committee. 2
The monetary model strikes back: Evidence from the world
, 2010
"... We revisit the dramatic failure of monetary models in explaining exchange rate movements. Using the information content from 98 countries, we find strong evidence for cointegration between nominal exchange rates and monetary fundamentals. We also find fundamentalsbased models very successful in bea ..."
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Cited by 15 (0 self)
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We revisit the dramatic failure of monetary models in explaining exchange rate movements. Using the information content from 98 countries, we find strong evidence for cointegration between nominal exchange rates and monetary fundamentals. We also find fundamentalsbased models very successful in beating a random walk in outofsample prediction. The views expressed in this paper are those of the authors and do not necessarily represent the views or policies of the IMF or BIS. 2I.
Testing for OneFactor Models versus Stochastic Volatility Models Valentina Corradi and Walter DistasoTesting for OneFactor Models versus Stochastic Volatility Models ∗
, 2004
"... This paper proposes a testing procedure in order to distinguish between the case where the volatility of an asset price is a deterministic function of the price itself and the one where it is a function of one or more (possibly unobservable) factors, driven by not perfectly correlated Brownian motio ..."
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Cited by 14 (1 self)
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This paper proposes a testing procedure in order to distinguish between the case where the volatility of an asset price is a deterministic function of the price itself and the one where it is a function of one or more (possibly unobservable) factors, driven by not perfectly correlated Brownian motions. Broadly speaking, the objective of the paper is to distinguish between a generic onefactor model and a generic stochastic volatility model. In fact, no specific assumption on the functional form of the drift and variance terms is required. The proposed tests are based on the difference between two different nonparametric estimators of the integrated volatility process. Building on some recent work by Bandi and Phillips (2003) and BarndorffNielsen and Shephard (2004a), it is shown that the test statistics converge to a mixed normal distribution under the null hypothesis of a one factor diffusion process, while diverge in the case of multifactor models. The findings from a Monte Carlo experiment indicate that the suggested testing procedure has good finite sample properties.
Estimation of a microfounded herding model of German survey expectations”, Working
, 2007
"... The paper considers the dynamic adjustments of an average opinion index that can be derived from a microfounded framework where the individual agents switch between two kinds of sentiment with certain transition probabilities. The index can thus represent a general business climate, i.e., expectatio ..."
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Cited by 14 (6 self)
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The paper considers the dynamic adjustments of an average opinion index that can be derived from a microfounded framework where the individual agents switch between two kinds of sentiment with certain transition probabilities. The index can thus represent a general business climate, i.e., expectations about the future course of the economy. This approach is empirically tested with the survey expectations published by the ZEW and ifo institute. The estimated coefficients make economic sense and are highly significant. In particular, besides effects from fundamental data like the output gap in the recent past, one can identify a strong herding mechanism within both panels, such that metaphorically speaking the agents do not just join the crowd but follow each single motion of it. In addition, the transition probabilities of the ZEW agents are found to be influenced by the ifo climate but not the other way round.
Optimal design of early warning systems for sovereign debt crises
, 2007
"... This paper tackles the design of an optimal early warning system (EWS) for sovereign default from two distinct angles: the choice of the econometric methodology and the evaluation of the EWS itself. It compares Kmeans clustering of macrodata, a logit regression for macrodata, a logit regression for ..."
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Cited by 13 (0 self)
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This paper tackles the design of an optimal early warning system (EWS) for sovereign default from two distinct angles: the choice of the econometric methodology and the evaluation of the EWS itself. It compares Kmeans clustering of macrodata, a logit regression for macrodata, a logit regression for credit ratings, and the combined forecasts from all three methods. The optimal choice of forecast method is shown to depend on the desired tradeoff between missed defaults and false alarms. Hence, it is crucial to account for the decisionmaker's preferences which are characterized through a loss function and riskaversion parameter. Recursive forecast combining generally yields a better balance of type I and type II errors than any of the individual forecasting methods, and outperforms the naïve predictions.
A Simple Asymmetric Herding Model to Distinguish Between Stock and Foreign Exchange Markets
"... Drawing on previous work of one of the authors, the paper takes an asymmetric variant of Kirman’s ant model and combines it with an elementary asset pricing mechanism. The closedform solution of the equilibrium probability distribution allows the specification of a tractable likelihood function for ..."
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Cited by 12 (3 self)
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Drawing on previous work of one of the authors, the paper takes an asymmetric variant of Kirman’s ant model and combines it with an elementary asset pricing mechanism. The closedform solution of the equilibrium probability distribution allows the specification of a tractable likelihood function for daily returns, which is then employed to estimate the model’s behavioural parameters for a large pool of Japanese stocks. By way of Monte Carlo simulations it is found that most of these markets belong to the same class, which is characterized by a dominance of the stylized noise traders. In contrast, the model assigns a number of major foreign exchange markets to a different class, where on average the majority of agents follows the fundamentalist trading rule. Implications for the tail index are also worked out.
Transaction Taxes, Traders’ Behavior and Exchange Rate Risks
"... Abstract: We propose a new model of chartistfundamentalistinteraction in which both groups of traders are allowed to select endogenously between different forecasting models and different investment horizons. Stochastic interest rates in both countries and different behavioral assumptions for tren ..."
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Cited by 10 (1 self)
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Abstract: We propose a new model of chartistfundamentalistinteraction in which both groups of traders are allowed to select endogenously between different forecasting models and different investment horizons. Stochastic interest rates in both countries and different behavioral assumptions for trendextrapolating and fundamental based forecasts determine the agents’ market orders which drive the exchange rate. A numerical analysis of the model shows that it is able to replicate stylized facts of observed financial return time series like excess kurtosis and volatility clustering. Within this framework we study the effects of transaction taxes on exchange rate volatility and traders ’ behavior measured by their population fractions. Simulations yield the result that on the macroscopic level these taxes reduce the variance of exchange rate returns, but also increase their kurtosis. Moreover, on the microscopic level the tax harms shortterm speculation in favor of longterm investment, while it also harms trading rules based on economic