A test of purchasing power parity for emerging economies

The concept of purchasing power parity (PPP) is examined here for its applicability to the soft currencies of a large group of emerging/developing economies. PPP is tested through the use of the technique of cointegration. Based on data covering the period of 1975–1997, cointegration tests of price indices and exchange rates are conducted for 27 countries (against the U. S.). The results provide relatively strong evidence (for 14 countries) in favor of the long-term applicability of PPP as a cointegration concept. Further tests on real exchange rates indicate that the symmetry and proportionality conditions implied by PPP are rejected in all but one case. The latter tests also show that departures from long-term exchange values can last for several years and that a priori restrictions imposed on the cointegrating vector can lead to a false rejection of the PPP concept.     

Nonlinear trends in real exchange rates: A panel unit root test approach

We analyze the possibility of nonlinear trend stationarity as the alternative to unit roots in 23 OECD real exchange rates, 1974–1998, by adding nonlinear time terms to the CIPS panel unit root test of Pesaran (2007). We follow a thorough bootstrapping approach and propose a technique to adjust statistical significance for the use of multiple tests over several time trend orders. The unit root null that all real exchange rates have unit roots is rejected at better than the 0.05 level. Bootstrapped results from a procedure of Chortareas and Kapetanios (2009) suggest that the hypothesis that all are stationary is reasonable. We argue that nonlinear trend stationarity is the most likely alternative hypothesis for at least some of the real exchange rates because: (1) the strongest CIPS rejection occurs when quadratic trends are specified; (2) nonlinear time terms are statistically significant at the 0.10 level; (3) the actual CIPS statistics are more consistent with CIPS sampling distributions from bootstrapped nonlinear trend stationary processes than from linear trend or mean stationary processes.     

Beyond the purchasing power parity: testing for cointegration and causality between exchange rates, prices, and interest rates

This paper reexamines the causality between the dollar and the yen in a multivariate framework with the aid of cointegration and error-correcting modeling for the 1951–94 period. The Phillips-Perron tests and Johansen's tests are performed. While causality from interest rates to exchange rates is found in the short run, no causality between prices and exchange rates is found in the short run. However, causality is found running from relative prices to exchange rates along with interest rates between the U.S. and Japan in the long run, which supports the long-run PPP hypothesis.     

A century of purchasing power parity confirmed: The role of nonlinearity

Taylor (2002) claims that Purchasing Power Parity (PPP) has held over the 20th century based on strong evidence of stationary for century-long real exchange rates for 20 countries. Lopez et al. (2005), however, found much weaker evidence of PPP with alternative lag selection methods. We reevaluate Taylor’s claim by implementing a recently developed nonlinear unit root test by Park and Shintani (2005). We find strong evidence of nonlinear mean-reversion in real exchange rates that confirms Taylor’s claim. We also find a possible misspecification problem in using the ESTAR model that may not be detected with Taylor-approximation based tests.     

Why panel tests of purchasing power parity should allow for heterogeneous mean reversion

Recent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.     

National price levels, purchasing power parity, and cointegration: a test of four high inflation economies

The time series properties of exchange rates and wholesale prices from four high inflation countries show some evidence in support of purchasing power parity. Tests for stationarity of real exchange rates and cointegration among price and exchange rate variables are presented for Argentina, Brazil, Chile, and Israel during the 1970s and 1980s. Error correction models describe the mechanism of adjustment to long-run equilibrium.     

Cross‐sectional Restrictions on the Spot and Forward Term Structures of Interest Rates and Panel Unit Root Tests

In this paper we examine the stationarity of all the rates comprising the USD, GBP, DM and JPY spot and forward term structures. Instead of focussing on short maturity interest rates, as most other papers do, we perform a detailed analysis of the whole range of spot and forward interest rates of the 4 main currencies. We investigate the issue of stationarity within the framework of an equilibrium interest rate model such as Vasicek (1977), that defines the cross-sectional and time series properties that interest rates of various maturities must satisfy. We show that within a one-factor interest rate model, such as Vasicek, all interest rates are restricted to exhibit the same mean reverting behaviour. This restriction allows us to apply more powerful panel unit root tests. This methodology increases considerably the number of observations available and as a result the power of the unit root tests. The higher power of these tests allows us to demonstrate that there does exist mean reversion on the spot and forward US interest rates and the forward DM and GBP interest rates.     

Financial factors in foreign direct investments: A dynamic analysis of international data

In contrast to existing empirical foreign direct investment (FDI) studies that examine the static effects of strategic or real economic variables, this paper focuses on the impacts of financial variables on FDI outflows for four largest industrial countries using dynamic time series methods. The results show that FDI outflows are non-stationary but have a long-run cointegrating relationship with real exchange rates. In addition, there are causal effects of exchange rates on direct investments in the short run. Multivariate cointegration analysis shows the significance of financial channels such as cost of capital and real wealth through which the real exchange rate effects operate. The effects of financial channels are comparable to those of the real wage rate channel. Overall, the present paper provides significant and methodologically consistent international evidence for dynamic interactions between FDIs and financial variables.     

A theory of mandatory convertibles: distinct features for large repeated financing

In recent years, mandatory convertibles (MCs) have become a popular means of raising capital, especially for large projects. This paper is the first theoretical paper to investigate MCs using the incomplete-contract approach. We show that MCs can be an efficient instrument in sequential financing. MCs have some distinct features compared to other convertibles, such as mandatory conversion, a high dividend rate, and capped capital appreciation. We show in theory that these features are designed to achieve efficiency.     

Asymmetric adjustments in the spread of lending and deposit rates: Evidence from extended threshold unit root tests

In this paper, we test for asymmetric adjustments in the spread of the U.S. prime lending rate and 3-month certificate of deposit rate. In doing so, we extend the pioneering threshold unit root tests of Enders and Granger (1998) to more flexible models where the deterministic terms and short-run dynamics, in addition to the persistent parameters, can differ in two regimes. While some previous works have tested for asymmetric adjustments in the spread of lending and deposit rates using threshold unit root tests, the deterministic terms and short-run dynamics were assumed to be symmetric, which can lead to bias and less accurate conclusions if these conditions do not hold. Overall, we find that the spread in lending and deposit rates is stationary but adjustment to the equilibrium is asymmetric. In particular, we find more rapid adjustment when the spread is narrowing below a threshold level than when widening above this level. Several theoretical implications are suggested.     

Testing for explosive bubbles in the presence of autocorrelated innovations

We analyze an empirically important issue with recursive right-tailed unit root tests for bubbles in asset prices. First, we show that serially correlated innovations, which is a feature that is present in most financial series used to test for bubbles, can lead to severe size distortions when using either fixed or automatic (based on information criteria) lag-length selection in the auxiliary regressions underlying the test. Second, we propose a sieve-bootstrap version of these tests and show that this results in tests which control size well across a number of simulation designs both with and without highly autocorrelated innovations. We also find that these improvements in size come at a relatively low cost for the power of the tests. Finally, we apply the bootstrap tests on the housing market of OECD countries, and generally find much weaker evidence of housing bubbles compared to existing evidence.     

Net Asset Value Discounts for Asian-Pacific Real Estate Companies: Long-Run Relationships and Short-Term Dynamics

This study investigates the time series behavior of real estate company net asset value discount/premium (NAVDISC) in eight Asian-Pacific securitized real estate markets from 1995 to 2003. We postulate that if there is a stable NAVDISC for real estate companies in the long-run, then there should be a long-run cointegrating relation between their stock prices (Ps) and net asset values (NAVs). Employing panel data cointegration econometrics that comprises three approaches; panel unit root test, heterogeneous panel cointegration test and dynamic panel error-correction modeling (ECM), we find that long run NAVDISCs persist in individual Asian-Pacific securitized real estate markets and the regional market. All the NAVDISCs exhibit mean reversion and that the respective disequilibrium errors fluctuate around the mean values. Moreover, NAV is an important factor that statistically explains the price variations in real estate stock prices regardless of their speed of mean-reversion in the NAV discount /premium.     

A structural decomposition of the U.S. trade balance: Productivity, demographics and fiscal policy

The US external deficits have been the most striking manifestation of global imbalances. This paper investigates the contribution of productivity growth, demographics and fiscal policy in accounting for the evolution of the US external imbalances against industrialized countries during the last three decades. Productivity growth plays a dominant role. Demographics explain a non-negligible and nearly permanent component of the US trade deficit. Furthermore, the international demographic transition is crucial for large US external imbalances to be consistent with the persistent decline of world real interest rates observed in the data. Fiscal policy is of minor importance.     

A test of the different implications of the overconfidence and disposition hypotheses

Under both the overconfidence and disposition biases, a positive relationship is predicted between prior returns and subsequent trading volume. However, theoretically the overconfidence and disposition effects have different implications on the relationships between the long- and short-position gains of traders and their subsequent buying and selling activities. We examine a unique dataset obtained from the Taiwan Futures Exchange which records all account-level trades and orders. Our data and methodology have the advantage of being able to empirically differentiate these two effects and we demonstrate that different types of traders exhibit different types and levels of behavioral biases.     

The Effects of Productivity Shocks,Financial Shocks,and Monetary Policy on Exchange Rates: An Application of the Currency Crisis Model and Implications for Emerging Market Crises

What kind of shock affects exchange rate dynamics? How much of an effect does the monetary policy have on exchange rates? To answer these questions empirically based on the currency crisis model, I use panel data on 51 emerging countries from 1980 to 2011, identify shocks, and apply instrumental variable methods. I found that both productivity shocks and shocks to a country’s risk premium affect exchange rates and a 1 percentage point increase in the policy interest rate is associated with a 1 percentage point appreciation of domestic currency. I further apply this method to Asian and Latin-American crises.     

A Fractional Cointegration Approach to Testing Mean Reversion Between Spot and Forward Exchange Rates: A Case of High Frequency Data with Low Frequency Dynamics

This paper applies a relatively new but generalised concept of fractional cointegration to shed some light on the validity of a long-run relationship between high frequency daily spot and the lagged forward Australian-US dollar exchange rate. An investigation of the stochastic properties of these rates reveals that, while the relationship is not cointegrated in their logs, they appear to be fractionally cointegrated if we allow for mean reverting processes that are CI (1, d ) with 0< d <1. The paper demonstrates that relaxing the condition that the residual from the cointegration equation must be a I (0) process, captures a much wider class of mean-reversion behaviour. This result is interpreted in the context of the speculative EMH between the spot and forward exchanges rates, as having some empirical support. Furthermore, an analysis of the short-run dynamics propelling the long-run relationship tends to imply that in both the short- and long-term, the forward rate is led by the spot rate. In the longer term, the spot rate is found to be the initial receptor of any exogenous shock to the equilibrium and it is the forward exchange rate that bears the brunt of short-run adjustment to re-establish the long-run equilibrium relationship. The approach illustrated in this paper is shown to hold enormous potential for tests of mean reversion involving hypotheses popular to financial econometrics in general, where the dynamics of high frequency data are under scrutiny.     

International Stock Market Efficiency and Integration: A Study of Eighteen Nations

This study examines the relationships among stock prices in eighteen national stock markets by using unit root and cointegration tests for the period 1961--92. All the markets were analyzed individually and collectively in regions to test for market efficiency. The results from unit root tests suggest that the world equity markets are weak-form efficient. The cointegration test results show that there are only a small number of significant cointegrating vectors over the last three decades. However, the number of significant cointegrating vectors increases after the October 1987 stock market crash, a result that is consistent with the contagion effect.     

A Note on Gaussian Estimation of the CKLS and CIR Models with Feedback Effects for Japan

In this note we extend the Gaussian estimation of two factor CKLS and CIR models recently considered in Nowman, K. B. (2001, Gaussian estimation and forecasting of multi-factor term structure models with an application to Japan and the United Kingdom, Asia Pacif. Financ. Markets 8, 23–34) to include feedback effects in the conditional mean as was originally formulated in general continuous time models by Bergstrom, A. R. (1966, Non-recursive models as discrete approximations to systems of stochastic differential equations, Econometrica 34, 173–182) with constant volatility. We use the exact discrete model of Bergstrom, A. R. (1966, Non-recursive models as discrete approximations to systems of stochastic differential equations, Econometrica 34, 173–182) to estimate the parameters which was first used by Brennan, M. J. and Schwartz, E. S. (1979, A continuous time approach to the pricing of bonds, J. Bank. Financ. 3, 133–155) to estimate their two factor interest model but incorporating the assumption of Nowman, K. B. (1997, Gaussian estimation of single-factor continuous time models of the term structure of interest rates, J. Financ. 52, 1695–1706; 2001, Gaussian estimation and forecasting of multi-factor term structure models with an application to Japan and the United Kingdom, Asia Pacif. Financ. Markets 8, 23–34). An application to monthly Japanese Euro currency rates indicates some evidence of feedback from the 1-year rate to the 1-month rate in both the CKLS and CIR models. We also find a low level-volatility effect supporting Nowman, K. B. (2001, Gaussian estimation and forecasting of multi-factor term structure models with an application to Japan and the United Kingdom, Asia Pacif. Financ. Markets 8, 23–34).     

A Binomial Basis for the Cox, Ingersoll and Ross Model of the Term Structure of Interest Rates

The technical demands of the Cox, Ingersoll and Ross (1985a and 1985b) papers are such that they can only be mastered by those who have a good understanding of some deep mathematics and statistical concepts, including the techniques of continuous time stochastic calculus and the measure theory upon which it is based, the Kuhn-Tucker theory surrounding non-linear optimisation techniques as well as variational methods founded on solutions of non-linear differential equations. Hence, our purpose here is to formalise both investor preferences and the supply side which underscores the Cox, Ingersoll and Ross (1985b) 'square root' model of the term structure of interest rates in terms of some simple binomial filtration processes, thereby avoiding most of the intricate technical detail contained in the original papers. These procedures not only allow for a more focused evaluation of the model's underlying strengths and weaknesses but also provide a framework for assessing some of the strategies which the model makes available for hedging exposure against adverse interest rate movements.     

A Unifying Microstructure Framework for Modeling Intraday and Interday Asset Pricing Dynamics: the Case of Exchange Rates

A model of the dynamics of intradaily exchange rates is presented. The current Over‐The‐Counter (OTC) exchange rate is the quote of the quoting bank.Two polar cases are considered: (i) If each bank is able to observe the noises relative to the orders of its own clients, then the OTC exchange rate is shown to obey a random walk with a constant conditional variance. (ii) If each bank is not able to observe the noises relative to the orders of its own clients, the OTC exchange rate is no more a random walk and conditional heteroskedasticity appears.