Financial Markets and Parity Conditions

Transcription

1 Lecture 1: Financial Markets and Parity Conditions Prof. Menzie Chinn Kiel Institute for World Economics March 7-11, 2005

2 Course Outline Introduction to financial markets; basic parity concepts Monetary models of exchange rates Bubbles, portfolio balance models Equilibrium Models; New open economy macroeconomics models Empirics, forecasting, policy

3 Lecture Outline Financial market structure and basic definitions Purchasing power parity Interest rate parity Real interest parity

4 I Financial Market Structure and Basic Definitions

5 Definitions Exchange rates: number of home currency units required to purchase one unit of foreign currency; also price of foreign currency. E.g., from EU resident perspective: /$, / E.g., from Chinese resident perspective: Ұ/$

6 Example: /$ /$ /EEU

7 Example: / / EJP/EEU

8 The Value of the Dollar (vs. Euro, Yen, and Trade Weighted basket) $ index (Fed broad) /$ /$

9 The institutional features of the forex market Average turnover in April 2004 = USD1.9 trillion per day Most trading volume between dealers, next most with financial institutions, next most with non-financials. USD, EUR, JPY, GBP, SFR most important in turnover. AUD moving up quickly.

10 Trends in FX Turnover

11 Definitions of Terms Spot transaction: single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery. Outright forward: transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery at some time in the future Foreign exchange swap: transaction which involves the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed at the time of the conclusion of the contract, and a reverse exchange of the same two currencies at a date further in the future at a rate agreed at the time of the contract.

12 Definition of Terms (cont d) Currency swap: contract which commits two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a previously agreed exchange rate at maturity. Currency option: Option contract that gives the right to buy or sell a currency with another currency at a specified exchange rate during a specified period. Forward rate agreement (FRA): interest rate forward contract in which the rate to be paid or received on a specific obligation for a set period of time, beginning at some time in the future, is determined at contract initiation.

13 Definition of Terms (cont d) Interest rate swap: agreement to exchange periodic payments related to interest rates on a single currency. Interest rate option: option contract that gives the right to pay or receive a specific interest rate on a predetermined principal for a set period of time.

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18 FX Trading Centers

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21 Time series: geographical dist n.5.4 London Eurozone country centers NY Tokyo.0 Zurich

22 Central bank holdings of reserve currencies USD DEM EUR.1.0 JPY GBP SFR

23 II Purchasing Power Parity

24 PPP: How exchange rates and prices are linked S = P / P S = P / P s= p p * i * i * Law of one price (LOOP) Absolute PPP in levels Absolute PPP in log levels q s p+ p * Def n: Log real exchange rate (constant at zero if PPP holds)

25 PPP (cont d) * s= p p + µ * s = p p + µ t t * t t s t = π t π * t Relative PPP in log levels Relative PPP in rates Restated, holding µ constant

26 Why do we care? If PPP holds, we have an explanation for what links these variables. If PPP holds instantaneously, unlikely that monetary policy will have a big effect on trade balance. If PPP only holds in the long run, bigger role for monetary and real shocks

27 Basic Empirics of PPP Testing Much confusing terminology, because everybody has a different definition of PPP. Early literature concluded yes for relative PPP in first differences (Germany during the 1920 s Frenkel). Most of the literature addresses relative PPP in log levels.

28 Testing for Relative PPP * s= p p + µ * q = s p+ p = µ Why? Because we rarely observe prices for identical bundle of goods Equivalently, test to see if the real exchange rate is constant Both are typically rejected, so Instantaneous/SR relative PPP rejected.

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31 Relative PPP Empirical literature in the mid-1980 s to 1990 s moved to testing for long run relative PPP Advent of unit root literature Subsequent cointegration literature If q reverts to its mean, then relative PPP holds in the long run.

32 Econometrics of PPP: I q q = ( ϕ 1) q + u t t 1 t 1 t q = φq + u ; φ < t t 1 t 1 q = βq + u ; β = ϕ t t 1 t 1

33 Econometrics of PPP: II Cointegration: Test whether s, p, p* exhibit a long run relationship, using: - Engle-Granger (many) - Johansen (many) - Horvath-Watson (Chinn, 1998) Panel unit root test (Frankel and Rose) Panel cointegration test (Pedroni) Threshold autoregression (Obstfeld & Taylor)

34 What s the consensus? There is mean reversion. It is faster than Rogoff s (1995) stylized fact of 3-5 years for half life. It can be even be faster w/tar But it is still slower than can be rationalized by sticky prices. Absolute PPP cannot be found except for country subgroups.

35 III Interest Rate Parity

36 Interest rate parity Any given interest differential can be decomposed arbitrarily into: * * e ( i i ) [ i i ( f s )] + ( f s ) + s e tk, tk, tk, tk, tt, + k t tt, + k t+ k t+ k Int.diff = polit. risk + exchange risk + exp. depr.

37 Testing for unbiasedness f t,t+k - s t = ( i t,k - i * t, k ). Political risk = 0 in dev. economies f e = s + η t, t+k t,t+k t,t+ k. Def n of risk premium s = ( i - i ) - e * t,k t, k η t, t+k t,t+ k, Combining

38 Testing for unbiasedness s t+k = s re t,t+k + ξ t,t+ k, Rational exp. Approach s t,t+k = ( i t,k - i * t,k ) -η t,t+k + ξ t,t+ k, Implied relationship s t,t+k = α + β ( i t,k - i * t, k )+ ε t,t+ k. UIP, or Fama regression

39 Recent estimates of β

40 Recent estimates over recent sub-periods 6 4 *** / \ Unbiasedness hypothesis / * ** *** *** *** / Can. Fr. Ger. Ita. Jap. UK Pooled *** ** *** *

41 Some competing explanations Risk premium (but the risk premium isn t correlated with anything). See Engel and Frankel. More exotic risk premia (consumption CAPM, w/ or w/o habit formation, keeping up with Joneses, loss aversion). See Bekaert, Hodrick and Marshall.

42 Some more competing explanations (econometric) Inappropriate coefficient restrictions induce size distortions. s = α + βf + ε t+ 1 t, 1 t+ 1 s s = α + βf s + ε t+ 1 t t, 1 t t+ 1 s s = α + β( f s ) + ε t+ 1 t t, 1 t t+ 1

43 Econometric issues (cont d) Hence Fama regression makes sense if β=1 exactly. However, if β 1 and the forward discount is highly serially correlated (or fractionally integrated) then may reject (McNown and Wallace; Zivot; Elliott; Baillie and Bollerslev). Solution: Estimate cointegrating relationship. (But why does β 1?)

44 Yet more econometrics Extreme support: examine only large deviations (Huisman, Kool and Nessen; Flood and Rose) Thresholds/bands of inaction: (Sarno and Taylor).

45 What about the long horizon? Ex Post Depreciation and 5-Year Government Bond Yields: ^ ^ Reject " $ H 0 : $ = 1 Adj-R 2 N DEM (0.010) (0.532) GBP (0.009) (0.311) CAD (0.005) (0.332) Constr Panel (0.404)

46 Long horizon (cont d) Ex Post Depreciation and 10-Year Government Bond Yields: ^ ^ Reject " $ H 0 : $ = 1 Adj-R 2 N DEM (0.005) (0.225) JPY *** (0.011) (0.202) GBP *** (0.003) (0.098) CAD *** (0.003) (0.138) Constr Panel (0.168)

47 $/DM, 1 year ( ).4.3 DM/$ 1 year depreciation One year interest differential GRDEP1Y GR1YDIFLAG4

48 $/DM, 10 year ( ) Ten year interest differential DM/$ 10 year depreciation GRDEP10Y GR10YDF1LAG40

49 What s the pattern? / Unbiasedness coefficient value mos. 6 mos. 1 year 3 years 5 years 10 years

50 Interpretation Monetary reaction function (McCallum; Anker; Kugler; Meredith and Chinn). Central bank reacts to exchange rate changes, using policy rate. Policy rate is closely linked to short term rates, less so to long term. Hence, LT rates less endogenous.

51 Econometric interpretation Monetary reaction function combined with CIP implies forward rate is more endogenous at short than long horizons. Long horizon regressions should provide less biased point estimates. Econometrically, forward rate is less endogenous at 5 year horizon.

52 Simulated data from Monetary Policy interpretation (Chinn-Meredith)

53 Expectations vs. Risk s t+k = s re t,t+k + ξ t,t+ k, Rat-x approach s t,t+k = α + β ( i t,k - i * t,k )+ ε t,t+ k. Fama regression e ˆ st, t + k = * α + β ( i t,k - i t, k )+ ~ ε t,t+ k. Alternative w/survey data

54 Empirics Use Currency Forecaster s Digest data FT Currency Forecaster /FXForecasts.com) Use survey sample mean What do the survey data look like?

55 $/ (as of Dec. 17) /- 1 s.e USD/Euro exchange rate (eop) Source: FX4casts

56 $/ /- 1 s.e USD/Yen Source: FX4casts

57 Consensus, IRP, historical correlations ($/ ) USD/Euro Consensus \ / IR P and interest rate implied

58 Consensus, IRP and historical correlations ($/ ) USD/Yen Consensus \ IRP implied \ / interest rate implied

59 UIP regressions: 3 mo. Constrained Unconstr. Unconstr., EMS OLS OLS SE (0.169) (0.209) (0.311) GMM SE (0.327) (0.382) (0.346) t: ß= *** 2.107*** 2.195** t: ß= t: ß= d.f _ R DW

60 UIP regressions: 1 year Constrained Unconstr. Unconstr., EMS OLS OLS SE (0.101) (0.140) (0.190) GMM SE (0.346) (0.410) (0.461) t: ß2= *** 2.715*** 3.484*** t: ß2= ** ** t: ß2= d.f _ R DW

61 What about the long horizon? Ex Ante Depreciation and 5-Year Government Bond Yields: ^ ^ Reject " $ H 0 : $ = 1 Adj-R 2 N DEM (0.010) (0.731) GBP (0.011) (0.570) CAD (0.005) (0.378) Constr Panel (0.384)

62 What about Emerging Markets? Dates N β (S. E.) t: β=0 t: β=1 DW F Prob Emerging and Newly Industrialized Economies 1. Czech Republic 12/96-4/ (0.6604) 2. Hong Kong 12/96-4/ (0.0376) 3. Hungary 10/97-4/ (1.2594) 4. India 10/97-4/ (0.8612) 5. Indonesia 12/96-12/ (0.2055) 6. Kuwait 12/96-4/ (0.9394) 7. Mexico 12/96-4/ (0.4079)

63 Emerging Markets (cont d) 1. Philippines 12/96-4/ (1.7128) 2. Saudi Arabia 12/96-4/ (0.0835) 3. Singapore 12/96-4/ (1.2898) 4. South Africa 12/96-4/ (1.8403) 5. Taiwan 12/96-4/ (0.5252) 6. Thailand 12/96-4/ (0.6853) 7. Turkey 12/96-4/ (0.0284)

64 Interpretation Unbiasedness is just as variable in emerging markets. What seems to matter is type of exchange rate regime. This is not so simple as one might think what determines exchange rate regimes might jointly determine whether unbiasedness holds.

65 IV Real Interest Parity

66 Implied by UIP and relative PPP i s t = π t π * t e e * e s tt, + k = πtt, + k πtt, + k e s = i i * tt, + k tk, tt, + k * e * i = π π e tk, tk, tt, + k tt, + k Relative PPP in rates of change Ex ante relative PPP UIP Set relative PPP equal to UIP

67 Real Interest Parity i e * π = i π * e tk, tt, + k tk, tt, + k Real interest rates equal or Subtract exp d infl. Diff. from UIP e e * e e * * e s π + π = ( i π ) ( i π ) tt, + k tt, + k tt, + k tk, tt, + k tk, tt, + k e e q = r r * e tt, + k tt, + k tt, + k

68 Does RIP hold?