Regime Switches In Exchange Rate Volatility And Uncovered Interest Parity

In this paper, we examine in which periods uncovered interest rate parity was likely to hold. Empirical research has shown mixed evidence on UIP. The main finding is that it doesn't hold, although some researchers were not able to reject UIP in periods with large interest differentials or high volatility. In this paper, we introduce a switching regime framework in which we assume that the exchange rate can switch between a UIP regime and a random walk regime. Our empirical results provide evidence that exchange rate movements were consistent with UIP over some periods, but not all. Consistent with the existing literature we also show that in periods with large interest differentials or increased exchange rate volatility, the exchange rate is more likely to follow UIP.

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.

In the context of a flexible-price monetary exchange rate model and the assumption of uncovered interest parity, we obtain a measure of the fundamental determinant of exchange rates. Daily data for the European Monetary System are used to explore the importance of nonlinearities in the relationship between the exchange rates and fundamentals. Many implications of existing “target-zone” exchange rate models are tested; little support is found for existing nonlinear models of limited exchange rate flexibility.

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.

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.

In this paper, we analyze several proposals for reducing the volatility and/or misalignment of key-currency exchange rates. The proposals examined are a system of target zones, the imposition of controls or taxes on international capital flows, and a strengthening of international coordination over economic policies. We also review key characteristics of the behavior of major-currency exchange rates over the period of floating rates and examine the various criteria or standards for drawing inferences about excess volatility and misalignment. In evaluating exchange rate volatility, attention is directed toward the influence of the exchange rate regime, to the behavior of fundamentals, to the volatility of both goods prices and other asset prices, to the costs of exchange rate volatility, and to the nature of shocks facing the economy. Turning to misalignment, we examine the strengths and weaknesses of the purchasing-power-parity approach, of the underlying balance approach, and of the sustainability approach. We argue that inferences about excess exchange rate volatility and misalignment are subject to wide margins of error and that the exchange rate experience of the past 15 years is subject to multiple interpretations.

The authors apply regime-switching methods to a monetarist model of exchange rates and identify well-defined intervention policy cycles. The policy response indices include a standard exchange market pressure-based index and a model-based volatility ratio that is endogenized relative to Japan, assumed to be a "benchmark" floater. The authors find strong evidence that balance sheet effects, proxied by the stock ratio of external liabilities to assets, and economic performance, as measured by GDP and stock market indices, determine the cost of the regime shift. They use a panel of quarterly data from 1985 to 2004 for a sample of 15 countries, mostly in East Asia and Latin America.