Endogenous Exchange Rate Volatility, Trading Volume and Interest Rate Differentials in a Model of Portfolio Selection

This paper considers a portfolio model of exchange rate determination and focuses on endogenous sources of exchange rate volatility. It is shown that, in addition to volatility transmitted by conditionally heteroskedastic interest rates, the larger the serial correlation in interest rates the stronger the effect of interest rate differentials on exchange rate volatility. These features are supported by the data. The paper also looks at the volume–volatility relationship implied by the model.     

Interest Rate Volatility Prior to Monetary Union under Alternative Pre-Switch Regimes

Abstract. The volatility of interest rates is relevant for many financial applications. Under realistic assumptions the term structure of interest rate differentials provides an important predictor of the term structure of interest rates. This paper derives the term structure of differentials in a situation in which two open economies plan to enter a monetary union in the future. Two systems of floating exchange rates prior to the union are considered, namely a free-float and a managed-float regime. The volatility processes of arbitrary-term differentials under the respective pre-switch arrangements are compared. The paper elaborates the singularity of extremely short-term (i.e. instantaneous) interest rates under extensive leaning-against-the-wind interventions and discusses policy issues.     

Exchange Rates and Long‐Term Bonds*

There is tentative evidence to suggest that the well‐documented empirical failure of uncovered interest parity (UIP) is confined to short‐term interest rates. However, tests of UIP for long‐term bonds are thwarted by various data problems. These data problems can be avoided by focusing on short investments in long‐term bonds. This paper concerns the relationship between changes in the US dollar–Deutsche Mark exchange rate and returns to short investments in US and German long‐term government bonds. The hypothesis that expected returns to investments in bonds denominated in the two currencies are equal is not rejected, and the estimated slope coefficients are positive. For corresponding short‐term interest rates, the typical finding of negative and large Fama coefficients is confirmed. We conclude that it is the maturity of the asset, rather than the investment horizon, that matters for the results.     

The sensitivity of effective marginal tax rate calculations to alternative arbitrage assumptions

This paper reports some estimates of effective marginal tax rates under alternative assumptions regarding arbitrage and the relationship between inflation and market interest rates. It is shown that the pattern of tax rates is similar whatever assumptions are used.     

The impact of monetary policy on financial markets in small open economies: More or less effective during the global financial crisis?

This paper estimates the impact of monetary policy on exchange rates and stock prices of eight small open economies: Australia, Canada, the Republic of Korea, New Zealand, the United Kingdom, Indonesia, Malaysia, and Thailand. On average across these countries in the full sample, a one percentage point surprise rise in official interest rates leads to a 1% appreciation of the exchange rate and a 0.5–1% fall in stock prices, with somewhat stronger effects in OECD countries than non-OECD countries (though differences are sometimes not significant). We find little robust evidence of a change in the effect of monetary policy surprises during the recent financial crisis.     

When is money neutral under flexible exchange rates?

The paper studies the conditions for the neutrality of money under flexible exchange rates in an extended real-wage Mundell–Fleming model, with special emphasis on the specification of the behavior functions to correspond to their foundations in closed-economy macrotheory.It is shown that monetary expansion causes output first to decline, to eventually rise above its original level. However, if interest earnings on foreign securities dominate the trade balance in the expression for the exchange rate, monetary expansion leads to an appreciation of the exchange rate, while having an expansionary output effect. Money is neutral in the long run if either the wealth effect or foreign interest payments are abstracted from; if both are abstracted from, it is neutral also in the short run. Short and long-run neutrality results also if wealth consists only of foreign securities. The above responses hold both for net creditors and – with a minor qualification – debtors.     

Impact of foreign prices and interest rates on canadian economy under alternative monetary and exchange rate regimes

The main objective of this paper is to analyze the impact of U.S. short- and long-term monetary policy under both flexible and managed floating systems, using the new CANDIDE Model 2.0. We have also examined the role of domestic monetary policy in the Canadian economy under both fixed and flexible exchange rate systems. The following are some of the important findings of our study:

1. Our results support the traditional view that under the fixed exchange rate regime, monetary authorities cannot successfully pursue an independent monetary policy from its trading partners — an effort to increase money supply will be almost offset by increases in the balance of payments deficit. In contrast, in the flexible exchange rate regime, monetary policy is more effective in producing an increased growth in output and employment. However the increased output growth comes at the cost of higher prices induced by increased wages and a depreciation of the Canadian dollar.
2. Our results suggest that the impact of U.S. interest rates on investment, GNE, employment, productivity, and government debt is less severe in a pure floating exchange rate regime, compared to the managed floating system. However, the impact of U.S. interest rate policy on the Canadian inflation rate is worse in the case of flexible exchange rate regime. Even though real income and inflation are less favourable in both cases, our results indicate a trade-off between output growth and inflation.
3. Our results imply that under a pure floating monetary authorities can determine the long-run rate of inflation in Canada independent of others. However, the United States and Canadian economies are interrelated during the adjustment process, even under the flexible exchange rates, through the terms of trade and the wage-price spiral channels.

     

Inflation and real short-term interest rates - A Kalman filter analysis of the term structure

This paper applies the Kalman filter technique to look at the relationship among real interest rates, inflation, and the term structure of interest rate under the expectations hypothesis. Using quarterly data from 1960:1 to 1991:1 for inflation, three month nominal short term interest rates and long term yields with maturities from one to five years, this paper finds that the expectations hypothesis of the term structure holds up well for the data under the assumptions of a time-varying premium and a random-walk real interest rate. In other words, a reconciliation of the expectations hypothesis with the data is attained by assuming time-varying term premium and non-stationary real interest rate.     

Bi‐currency versus Single‐currency Targeting: Lessons from the Russian Experience

This paper examines how the 2005 shift in Russian exchange rate policy from US dollar (USD) single‐currency to USD–EUR (euro) bi‐currency targeting has impacted domestic interest rates. The finding show that this policy shift has disconnected Russian interest rates from US dollar‐denominated interest rates, while instead linking them to a synthetic interest rate composed of USD and EUR rates at the same proportion as that of these two currencies in the currency basket against which the ruble's exchange rate is set. The Russian experience shows that while the adoption of bi‐currency targeting may help ensure that domestic interest rates are less dependent on the monetary cycle of a single country, these rates are instead likely to reflect financial developments in all countries whose currencies are included in the currency basket. This insight is likely to be relevant for other countries that pursue basket‐targeting policies.     

Revisiting the interest rate–exchange rate nexus: a Markov-switching approach

In this paper the interest rate–exchange rate nexus and the effectiveness of an interest rate defense are investigated empirically. I present a reduced form evidence which characterizes the empirical relationship between interest rates and exchange rates. I use a Markov-switching specification of the nominal exchange rate with time-varying transition probabilities. Empirical evidence from six developing countries: Indonesia, South Korea, the Philippines, Thailand, Mexico, and Turkey indicates that raising nominal interest rates leads to a higher probability of switching to a crisis regime. Thus, the empirical results presented here may support the view that a high interest rate policy is unable to defend the exchange rate. Unlike other studies which consider linear models only, my findings are robust and consistent over different countries and crisis episodes (Asian 1997 crises, Mexico 1994 crisis, and Turkey 1994, 2001 crises). In order to explain the empirical findings, I construct a simple theoretical model by incorporating an interest rate rule in the model proposed by Jeanne and Rose (2002) [Jeanne, O., Rose, A.K., 2002. Noise trading and exchange rate regimes, Quarterly Journal of Economics. 117 (2) 537–569]. The model has multiple equilibria, and under plausible conditions, higher exchange rate volatility is associated with higher interest rates.     

Does Shariah compliance make interest rate sensitivity of Islamic equities lower? An industry level analysis under different market states

This paper examines the sensitivity of the Dow Jones Islamic market index and its corresponding industry equity indices to changes in the level, slope and curvature of the U.S. term structure of interest rates over the period 1996–2015 using the quantile regression approach. The empirical results reveal that the Islamic stock market has a considerable negative exposure to interest rate risk, although a declining time pattern of interest rate sensitivity is observed. The unexpected changes in the level factor of the U.S. yield curve, closely linked to long-term interest rates, are identified as the most important interest rate factor in explaining the variability of Islamic equity returns. Furthermore, the interest rate exposure tends to be stronger during extreme bearish conditions in the stock market, possibly due to the greater pessimism and risk aversion under these market circumstances. It is also shown that Islamic equities are not different from their mainstream counterparts in terms of interest rate sensitivity, indicating that the Islamic stock market does not provide a cushion against interest rate risk.     

The Effect of Changes in Monetary Policy on Consumer and Business Confidence

This article examines the response of consumer and business confidence to five measures of change in Australian monetary policy. Actual, expected and surprise increases in the official cash rate target and related interest rates are shown to negatively impact consumer sentiment. Business confidence is less affected by increases in the cash rate target, but is negatively affected by an increase in the 90-day bank accepted bill rate. Tests for model stability and asymmetries in the response of sentiment to increases and decreases in interest rates otherwise find only limited evidence for monetary policy having a perverse signalling effect on sentiment.     

Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium

Under mild assumptions, the data indicate that fluctuations in nominal interest rate differentials across currencies are primarily fluctuations in time-varying risk. This finding is an immediate implication of the fact that exchange rates are roughly random walks. If most fluctuations in interest differentials are thought to be driven by monetary policy, then the data call for a theory which explains how changes in monetary policy change risk. Here, we propose such a theory based on a general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation.     

An essay on the Life Cycle: Characterizing intertemporal behavior with uncertainty,human capital,taxes, durables,imperfect capital markets,and non-separable preferences

This paper formulates a general characterization of a household's portfolio choice and savings behavior in an environment with uncertain future interest rates, prices, wages, and factors influencing tastes. Savings may be invested in three types of assets: financial assets; human capital, which is non-tradable; and consumer durables, in which investment may be partially irreversible. Risk-return relations determine the optimal allocation of resources across assets at a point in time. The optimal intertemporal allocation of resources is determined by a restriction on the planned growth rate for the marginal utility of after-tax wealth, where growth rates depend on rates of time preference and measures of long-term riskless rates of interest. Given special assumptions, this marginal utility follows a martingale process as a consequence of optimizing behavior. Pricing formulae are developed for evaluating shifts in uncertain future income, wage, and price profiles. The relations characterizing portfolio and savings behavior presented here do not rely on particular distributional assumptions; they account for all forms of uncertainty including wage uncertainty induced by human capital investment; they allow for the non-marketability of assets; and the main results apply for very general functional form assumptions for preferences. In later sections, results are extended to incorporate income taxes and to account for a wide variety of imperfections in asset markets.     

Market efficiency broadcasted live: ECB code words and euro exchange rates

This paper examines the impact of the European Central Bank (ECB) monetary policy on euro exchange rate returns using an event study with intraday data for five currencies (the euro exchange rate versus the US dollar, the British pound, the Canadian dollar, the Swiss franc, and the Japanese yen). I construct two indicators of news about monetary policy stemming separately from policy decisions and the press conference. Estimation results show that the surprise component of communication has highly statistically significant effects on exchange rates, whereas the response of euro exchange rates to the unanticipated change in the policy rate is more muted. I also estimate the financial market impact on euro exchange rates of US, European and German macroeconomic news, and I show that the impact of the ECB press conference is economically important. The process of fully incorporating the ECB news shock takes about 1 h, and thus this result suggests that the whole press conference (both the Introductory Statement and the Q&A part) provides valuable information to market participants.     

The impact of interest rate and exchange rate volatility on banks' stock returns and volatility: Evidence from Turkey

This paper investigates the effects of interest rate and foreign exchange rate changes on Turkish banks' stock returns using the OLS and GARCH estimation models. The results suggest that interest rate and exchange rate changes have a negative and significant impact on the conditional bank stock return. Also, bank stock return sensitivities are found to be stronger for market return than interest rates and exchange rates, implying that market return plays an important role in determining the dynamics of conditional return of bank stocks. The results further indicate that interest rate and exchange rate volatility are the major determinants of the conditional bank stock return volatility.     

Government policy with deficit financing,imperfect capital mobility and exchange rate effects on the supply side

This paper examines the impact of monetary and fiscal policy when supply-side effects of prices as well as exchange rates are taken into account in an open economy macro model. Partial deficit financing and imperfect international capital movements are appropriately modelled. It is shown that the well known Mundell–Fleming result, that fiscal policy is completely ineffective under perfect capital mobility and flexible exchange rates, is significantly affected when exchange rate effects on the supply side are taken into account. The paper also shows that such effects significantly alter the effects of devaluation under fixed exchange rates.     

我国国际资本流动：直接投资 与非直接投资影响因素的比较研究

本文基于向量误差修正模型对1982-2010年期间我国直接投资类、间接投资类（含其他投资）、错误与遗漏及投资收益类三种类型国际资本流动的影响因素进行了实证研究。实证检验结果表明：在长期,我国三类国际资本流动与人民币对美元的实际汇率升贴水年率之间为负向变动关系,与中美利差、中美通胀之差、我国实际经济增长及人民币对美元的实际汇率预期之间为正向变动关系;在短期,三类国际资本流动与上述影响因素之间关系并非一致;实际经济增长是我国直接投资类国际资本流动的主要原因,人民币对美元的实际汇率预期是我国非直接投资国际资本流动的主要原因。     

Real exchange rates and target interest rates in a simple VAR model

This paper proposes a simple vector autoregressions (VAR) model with (real) output and exchange rate shocks on interest rates. Rather than assuming non-recursive identification schemes, we test the identifying assumption of the error term decompositions. Applying the model to quarterly data on major currencies against the U.S. dollar (USD) from 1974 to 1997, interest rate shocks explain - after 3 years - 16% of Canadian dollar/USD (CAD) real exchange rate variations and less than 2% for the mark/USD and yen/USD. Positive innovations of interest rates bring about (transitory) CAD real appreciations in differences and (permanent) appreciations in levels. Canadian real output is more explained by domestic interest rate shocks (19%) than Germanys (5%) or Japans (0.2%). Canada is smaller than the other economies and CAD has been shown to suffer from fear of floating. Our findings support the proposition that domestic shocks dominate output variance under fixed exchange rates. They are also consistent with structural interpretations of the VAR.     

Interest Rates, Irreversibility, and Backward-Bending Investment

This paper studies the effect of interest rates on investment in an environment where firms make irreversible investments with uncertain pay-offs. In this setting, changes in the interest rate affect both the cost of capital and the cost of delaying investment to acquire information. These two forces combine to generate an aggregate investment demand curve that is a backward-bending function of the interest rate. At low rates, increasing the interest rate raises investment by increasing the cost of delay.