A Regime Switching Approach To Uncovered Interest Parity

This paper reviews the empirical evidence on violations of uncovered interest parity and explores whether the evidence is consistent with the behaviour of speculative bubbles. The problem of testing for bubbles in exchange rates, without an accepted model of fundamentals, are then examined and a variety of tests are suggested. Extensive tests are run using weekly forward rate and survey data for seven major exchange rates. Results are presented.

"This paper presents techniques for modelling and estimating the behavior of financial market price or return differentials that follow non-linear regime-switching behaviour. The methodology to be used here is estimation of variants of threshold autoregression (TAR) models. In the basic model the differentials are random within a band defined by transactions costs and contract risk; they occasionally jump outside the band, and then follow an autoregressive path back towards the band. The principal reference is Tchernykh (1998). The application here is to deviations from covered interest parity (CIP) between forward foreign exchange (FX) markets in Hong Kong and the Philippines. We have observed that these deviations from the band follow irregular steps, rather than single jumps. Therefore a Modified TAR model (MTAR) that allows for this behaviour is also estimated. The estimation methodology is a regime-switching maximum likelihood procedure. The estimates can provide indicators for policy-makers of the market's expectation of crisis, and could also provide indicators for the private sector of convergence of deviations to their usual bands. The TAR model has the potential to be applied to differentials between linked pairs of financial market prices more generally"--NBER website

This dissertation consists of introductory chapter and an additional three papers. There are three common aspects in these three papers. First, the main topic of each paper is the nominal exchange rate regime. Second, the entire three papers use a Markov Switching Regime model as the empirical approach of the analysis. Third, the region covered by the study is Middle East and North Africa (MENA). The first paper is entitled "Identifying De Facto Exchange Rate Regimes: An Alternative Markov Switching Approach." In this paper, a new alternative methodology is applied to classify de facto exchange regimes. The proposed approach is based on a Markov Switching Model (MSM). The paper introduces current methodologies available and their cons and pros. The proposed MSM provides several advantages over existing methodologies and gives additional insightful information for policy makers. The second paper is entitled "Exchange Rate Misalignment Across De Facto Exchange Rate Regimes: A Markov Switching Model Analysis." In this paper, I estimate equilibrium exchange rates for 8 selected countries of MENA region using a panel cointegration technique. The difference between equilibrium and actual exchange rates is identified as exchange rate misalignment. Misalignment, then, is analyzed with a de facto exchange rate regime index using a Markov Switching Model. The main objective of this paper is to determine empirically, which regime is associated with lower misalignment. This result is of interest to policy maker so as to avoid currency crises. The third paper is entitled "Excess Returns Across Exchange Rate Regimes: A Markov Switching Model Analysis." In this paper, a MSM is used to analyze the excess returns over what uncovered interest rate parity predicts for four MENA countries: Egypt, Jordan, Morocco and Tunisia. The main purpose of this paper is to examine the effects of liberalization - signified by applying more flexible exchange rate regimes - on the degree of integration into international financial markets measured as the magnitude of the excess return over what uncovered interest rate parity predicts.

This note provides an overview of the uncovered interest parity assumption. It traces the history of the interest parity concept, summarizes evidence on the empirical validity of uncovered interest parity, and discusses the implications for macroeconomic analysis. The uncovered interest parity assumption has been an important building block in multiperiod and continuous time models of open economies, and although its validity is strongly challenged by the empirical evidence, its retention in macroeconomic models is supported on pragmatic grounds, at least for the time being, by the lack of much empirical support for existing models of the exchange risk premium.

The main drawback however is that it is the more complicated to implement. A Markov chain technique is used as an estimation method. By imposing interest rate parity, the relationship between exchange rate and foreign and domestic interest rate difference is also simultaneously examined. The results indicate that interest rate difference does not affect the level and the volatility of exchange rates. This finding supports the random walk theory of exchange rates. On the other hand two different regimes, a high-volatility regime and a low-volatility regime, are discovered and well modeled. The development of a forecasting model will be the subject for future studies.

''In summary, the book is valuable as a textbook both at the advanced undergraduate level and at the graduate level. It is also very useful for the economist who wants to be brought up-to-date on theoretical and empirical research on exchange rate behaviour.'' ""Journal of International Economics""