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Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach

Year 2019, , 1 - 22, 28.06.2019
https://doi.org/10.26650/ISTJECON2019-0004

Abstract

This paper studies whether dynamic relationship between exchange rate and economic and financial fundamentals vary depending on exchange rate is overvalued and undervalued with respect to its fundamental value. To achieve this, we implement two-state Markov Switching Vector Auto Regression (MSVAR) model with time varying transition probabilities to investigate whether the relationship among exchange rate, interest rate and inflation dynamics depend on overvaluation and undervaluation of exchange rates for the pre-crises period between years 1972-2009. We govern the transition between the undervalued and overvalued states by using Sharpe Ratios of debt and equity investments of the currency to assess whether risk adjusted returns induce overvaluation or undervaluation of the currencies. We employ this model to the bilateral exchange rate, which is defined between US Dollar and four highly traded currencies (AUD, CAD, JPY, and UKS). We provide evidence that the relationship among these variables varies in terms of on magnitude, direction and statistical significance in between the overvalued and undervalued regimes. Furthermore, we show that risk adjusted excess debt and equity returns influence the overvaluation and the undervaluation of the currencies.

References

  • Abiad, A. G. (2002). Early Warning Systems for Currency Crises: A Markov Switching Approach with Applications to Southeast Asia. (Doctoral dissertation, University of Pennsylvania, Philadelphia). Retrieved from: https://www.researchgate.net/publication/268200580_Early_Warning_Systems_ For_Currency_Crises_A_Markov-Switching_Approach_with_Application_to_Southeast_Asia.
  • Bekaert, G., & Hodrick, R. J. (2001). Expectations Hypotheses Tests. The Journal of Finance, 56, 1357–1394.
  • Bekaert, G., Min, W., & Yuhang, X. (2002). Uncovered Interest Rate Parity and the Term Structure, NBER Working Paper No. 8795 (Cambridge, Massachusetts: National Bureau of Economic Research)
  • Bjorland, H. C., & Hungness, H. (2002). Fundamental determinants of the long-run real exchange rate: the case of norway, memorandum, Department of Economics, Oslo, Universty of Oslo, 1–36.
  • Boschen, J. F., & Smith, K. J. (2012). The Uncovered Interest Rate Parity Anomaly and Foreign Exchange Market Turnover. International Business and Economics Research Journal, 11, 299–306.
  • Chinn, M. D., & Meredith, G. (2001). Testing Uncovered Interest Parity at Short and Long Horizons During the Post-Bretton Woods Era. NBER Working Paper Series, 11077.
  • Chinn, M. D., & Alquist, R. (2006). Conventional and Unconventional Approaches to Exchange Rate Modeling and Assessment. NBER Working Paper Series, 12481.
  • Clarida, R. H., Sarno, L., Taylor, M. P., & Valente, G. (2001). The Out-of Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond. Journal of International Economics, 60(1), 61–83.
  • De Grauwe, P., & Vansteenkiste, I. (2001). Exchange Rates and Fundamentals a Non-Linear Relationship?. CES ifo Working Paper Series, 577.
  • Diebold, F. X., Lee, J.-H., & Weinbach, G. C. (1994). Regime Switching with Time-Varying Transition Probabilities. In C. Hargreaves (ed.), Nonstationary Time Series Analysis and Cointegration, (pp. 283-302). Oxford, UK: Oxford University Press.
  • Engel, C. (1994). Can the Markov Switching Model Forecast Exchange Rates?. Journal of International Economics, 36, 151–165.
  • Fama, E. F. (1984). Forward and Spot Exchange Rates. Journal of Monetary Economics, 14, 314–338.
  • Fisher, I. (1930). The Theory of Interest, New York: Macmillan Company. Froot, K. A. (1990). On the Efficiency of Foreign Exchange Markets. (Unpublished Mimeograph), November 16.
  • Froot, K. A., & Rogoff, K. (1995). Perspectives on PPP and Long-Run Real Exchange Rates. Handbook of International Economics, 3, 679–747.
  • Froot, K. A., & Thaler, R. H. (1990). Foreign exchange. Journal of Economic Perspectives, 4(3), 179– 192. Retrieved from: https://sites.hks.harvard.edu/fs/jfrankel/ITF-220/readings/Froot&Thaler_ Anomalies.pdf.
  • Frommel, M., MacDonald, R., & Menkhoff, L. (2005). Markov Switching Regimes in a Monetary Exchange Rate Model. Economic Modelling, 22(3), 485–502. Retrieved from: https://www. sciencedirect.com/science/article/pii/S0264999304000537.
  • Goldfeld, S. M., & Quandt, R. E. (1973). A Markov Model for Switching Regressions. Journal of Econometrics, 1(1), 3–15. Retrieved from: https://www.sciencedirect.com/science/article/ pii/030440767390002X.
  • Hamilton, J. D. (1989). A new approach to the economic analysis of nonstationary time series and the business cycle. Econometrica: Journal of the Econometric Society, 357–384.
  • Hamilton, J. D. (1990). Analysis of Time Series Subject to Changes in Regime. Journal of Econometrics, 45, 39–70.
  • Hamilton, J. D. (1994). Time Series Analysis. New Jersey: Princeton University Press.
  • Johansen, S. J., & Juselius, K. K. (1992). Testing structural hypothesis in a multivariate cointegration analysis of the PPP and the UIP for UK. Journal of Econometrics, 53(21), 1–244.
  • Juselius, K. (1991). ”Long-run relations in a well-defined statistical model for the data generating process. Cointegration analysis of the PPP and the UIP relations for Denmark and Germany” in Econometric Decision Models, Springer, Berlin-Heidelberg, pp. 336–357.
  • Juselius, K. (1995). Do purchasing power parity and uncovered interest rate parity hold in the long run? An example of likelihood inference in a multivariate time-series model. Journal of econometrics, 69(1), 211–240.
  • Juselius, K., & MacDonald, R. (2003). International Parity Relationships Between Germany and the United States: A Joint Modelling Approach. Finance Research Unit (FRU), No: 2004/08, Institute of Economics, University of Copenhagen, pp. 1–34.
  • Kanas, A. (2006). Purchasing Power Parity and Markov Regime Switching. Journal of Money Credit and Banking, 38, 1669–1687.
  • Kanas, A. (2005). Regime linkages in the US/UK real exchange rate-real interest differential relation. Journal of International Money and Finance, 24, 257–274.
  • Krolzig, H. M., & Autoregressions, M. S. V. (1997). Modelling, statistical inference and application to Business Cycle Analysis. Lecture Notes in Economics and Mathematical Systems, Springer, New York.
  • Lee, H. T., & Yoon, G. (2007). Does Purchasing Power Parity Hold Sometimes? Regime Switching in Real Exchange Rates. Economics Working Paper Christian-Albrechts –Universitat Kiel, Department of Economics.
  • Lothian, J. R., & Wu, L. (2005). Uncovered Interest-Rate Parity over the Past Two Centuries. Journal of International Money and Finance, 30, 448–473.
  • MacDonald, R., & Marsh, I. W. (1997). On fundamentals and exchange rates: a Casselian perspective. Review of Economics and Statistics, 79(4), 655–664.
  • MacDonald, R., & Marsh, J. (1999). Employment, unemployment and social polarization: young people and cyclical transitions. The Sociological Review, 47(2_suppl), 120–140.
  • Marsh, I. W. (2000). High-frequency Markov Switching Models in Foreign Exchange Market. Journal of Forecasting, 19, 123–134.
  • Martinez, P., & Maria, S. (2002). A Regime-Switching Approach to Studying Speculative Attacks: A Focus on European Monetary System Crises. Empirical Economics, 27, 299–334.
  • MayHodrick, R. J. (1987). The Empirical Evidence on the Efficiency of Forward and Futures Foreign Exchange Markets. Chur, Switzerland: Harwood Academic Publishers.
  • Meese, R. A., & Rogoff, K. (1983). Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics, 14, 3–24.
  • Omer, M., De Haan, J., & Scholtens, B. (2012). Testing Uncovered Interest Rate Parity Using LIBOR. CESifo Working Papers, 3839.
  • Olivier, J., & Masson, P. (2000). Currency crises, sunspots and Markov-switching regimes. Journal of International Economics, 50, 327–350.
  • Peria, M. S. M. (2002). A regime-switching approach to the study of speculative attacks: A focus on EMS crises. In Advances in Markov-Switching Models (pp. 159–194). Physica, Heidelberg.
  • Quandt, R. E. (1958). The Estimation of Parameters of Linear Regression System Obeying Two Separate Regimes. Journal of the American Statistical Association, 55, 873–880.
  • Sarno, L., & Taylor, M. P. (2002). Purchasing power parity and the real exchange rate. IMF Staff Papers, 49(1), 65–105.
  • Sercu, P., Uppal, R., & Van Hulle, C. (2012). The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity. The Journal of Finance, 50, 1309–1319.
  • Sims, C. A. (1980). Macroeconomics and reality. Econometrica: Journal of the Econometric Society, 1–48.
  • Taylor, M. P. (1995). The Economics of Exchange Rates. Journal of Economic Literature, 33, 13–47.
  • Taylor, A. M. (2002). A century of purchasing-power parity. Review of Economics and Statistics, 84(1), 139–150.
  • Tsangyao, C., & Chi-Wei, S. (2013). Revisiting purchasing power parity for East Asian countries using the rank test for nonlinear cointegration, Applied Economics, 45(19), 2847–2852, DOI: 10.1080/00036846.2012.657354.
  • Van Norden, S. (1996). Regime Switching as a Test for Exchange Rate Bubbles. Journal of Applied Econometrics, 11, 219–51.

Küresel Sermaye Akımları, Zamana Göre Değişen Temeller ve Geçişken Kur Dinamikleri: Bir MS-VAR Yaklaşımı

Year 2019, , 1 - 22, 28.06.2019
https://doi.org/10.26650/ISTJECON2019-0004

Abstract

Bu çalışma döviz kurları ile ekonomik ve finansal değişkenler arasındaki dinamik ilişkinin kurun temel değerine göre daha değerli ve az değerli olmasına bağlı olarak nasıl değiştiğini araştırmaktadır. Bu maksatla, kriz öncesi 1972-2009 yılları arasında, döviz kuru, faiz oranı ve enflasyon dinamikleri arasındaki ilişkinin kurun daha değerli ve az değerli olmasına bağlı olup olmadığını incelemek için zamanla değişen geçiş olasılıklarını kullanan MSVAR yöntemi uygulanmıştır. Riske uyarlanmış getirinin, para birimlerinin daha değerli veya az değerli olmasına neden olup olmadığını belirlemek için, borç ve öz kaynak yatırımlarının Sharpe oranları kullanılarak daha değerli ve az değerli durumlar arasındaki geçişler sağlanmıştır. Bu model en fazla işlem hacmine sahip olan, Amerikan Doları ve 4 para birimi (AUD, CAD, JPY ve UKS) arasındaki ikili döviz kurları için uygulanmıştır. Bu değişkenler arasındaki ilişkinin daha değerli ve az değerli rejimler arasında yön, büyüklük ve istatiksel anlamlılık açısından değiştiği belgelenmiştir. Ayrıca, riske uyarlanmış hisse senedi ve borç senedi getirilerinin kurların daha değerli olmasını ve az değerli olmasını etkilediği gösterilmiştir.

References

  • Abiad, A. G. (2002). Early Warning Systems for Currency Crises: A Markov Switching Approach with Applications to Southeast Asia. (Doctoral dissertation, University of Pennsylvania, Philadelphia). Retrieved from: https://www.researchgate.net/publication/268200580_Early_Warning_Systems_ For_Currency_Crises_A_Markov-Switching_Approach_with_Application_to_Southeast_Asia.
  • Bekaert, G., & Hodrick, R. J. (2001). Expectations Hypotheses Tests. The Journal of Finance, 56, 1357–1394.
  • Bekaert, G., Min, W., & Yuhang, X. (2002). Uncovered Interest Rate Parity and the Term Structure, NBER Working Paper No. 8795 (Cambridge, Massachusetts: National Bureau of Economic Research)
  • Bjorland, H. C., & Hungness, H. (2002). Fundamental determinants of the long-run real exchange rate: the case of norway, memorandum, Department of Economics, Oslo, Universty of Oslo, 1–36.
  • Boschen, J. F., & Smith, K. J. (2012). The Uncovered Interest Rate Parity Anomaly and Foreign Exchange Market Turnover. International Business and Economics Research Journal, 11, 299–306.
  • Chinn, M. D., & Meredith, G. (2001). Testing Uncovered Interest Parity at Short and Long Horizons During the Post-Bretton Woods Era. NBER Working Paper Series, 11077.
  • Chinn, M. D., & Alquist, R. (2006). Conventional and Unconventional Approaches to Exchange Rate Modeling and Assessment. NBER Working Paper Series, 12481.
  • Clarida, R. H., Sarno, L., Taylor, M. P., & Valente, G. (2001). The Out-of Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond. Journal of International Economics, 60(1), 61–83.
  • De Grauwe, P., & Vansteenkiste, I. (2001). Exchange Rates and Fundamentals a Non-Linear Relationship?. CES ifo Working Paper Series, 577.
  • Diebold, F. X., Lee, J.-H., & Weinbach, G. C. (1994). Regime Switching with Time-Varying Transition Probabilities. In C. Hargreaves (ed.), Nonstationary Time Series Analysis and Cointegration, (pp. 283-302). Oxford, UK: Oxford University Press.
  • Engel, C. (1994). Can the Markov Switching Model Forecast Exchange Rates?. Journal of International Economics, 36, 151–165.
  • Fama, E. F. (1984). Forward and Spot Exchange Rates. Journal of Monetary Economics, 14, 314–338.
  • Fisher, I. (1930). The Theory of Interest, New York: Macmillan Company. Froot, K. A. (1990). On the Efficiency of Foreign Exchange Markets. (Unpublished Mimeograph), November 16.
  • Froot, K. A., & Rogoff, K. (1995). Perspectives on PPP and Long-Run Real Exchange Rates. Handbook of International Economics, 3, 679–747.
  • Froot, K. A., & Thaler, R. H. (1990). Foreign exchange. Journal of Economic Perspectives, 4(3), 179– 192. Retrieved from: https://sites.hks.harvard.edu/fs/jfrankel/ITF-220/readings/Froot&Thaler_ Anomalies.pdf.
  • Frommel, M., MacDonald, R., & Menkhoff, L. (2005). Markov Switching Regimes in a Monetary Exchange Rate Model. Economic Modelling, 22(3), 485–502. Retrieved from: https://www. sciencedirect.com/science/article/pii/S0264999304000537.
  • Goldfeld, S. M., & Quandt, R. E. (1973). A Markov Model for Switching Regressions. Journal of Econometrics, 1(1), 3–15. Retrieved from: https://www.sciencedirect.com/science/article/ pii/030440767390002X.
  • Hamilton, J. D. (1989). A new approach to the economic analysis of nonstationary time series and the business cycle. Econometrica: Journal of the Econometric Society, 357–384.
  • Hamilton, J. D. (1990). Analysis of Time Series Subject to Changes in Regime. Journal of Econometrics, 45, 39–70.
  • Hamilton, J. D. (1994). Time Series Analysis. New Jersey: Princeton University Press.
  • Johansen, S. J., & Juselius, K. K. (1992). Testing structural hypothesis in a multivariate cointegration analysis of the PPP and the UIP for UK. Journal of Econometrics, 53(21), 1–244.
  • Juselius, K. (1991). ”Long-run relations in a well-defined statistical model for the data generating process. Cointegration analysis of the PPP and the UIP relations for Denmark and Germany” in Econometric Decision Models, Springer, Berlin-Heidelberg, pp. 336–357.
  • Juselius, K. (1995). Do purchasing power parity and uncovered interest rate parity hold in the long run? An example of likelihood inference in a multivariate time-series model. Journal of econometrics, 69(1), 211–240.
  • Juselius, K., & MacDonald, R. (2003). International Parity Relationships Between Germany and the United States: A Joint Modelling Approach. Finance Research Unit (FRU), No: 2004/08, Institute of Economics, University of Copenhagen, pp. 1–34.
  • Kanas, A. (2006). Purchasing Power Parity and Markov Regime Switching. Journal of Money Credit and Banking, 38, 1669–1687.
  • Kanas, A. (2005). Regime linkages in the US/UK real exchange rate-real interest differential relation. Journal of International Money and Finance, 24, 257–274.
  • Krolzig, H. M., & Autoregressions, M. S. V. (1997). Modelling, statistical inference and application to Business Cycle Analysis. Lecture Notes in Economics and Mathematical Systems, Springer, New York.
  • Lee, H. T., & Yoon, G. (2007). Does Purchasing Power Parity Hold Sometimes? Regime Switching in Real Exchange Rates. Economics Working Paper Christian-Albrechts –Universitat Kiel, Department of Economics.
  • Lothian, J. R., & Wu, L. (2005). Uncovered Interest-Rate Parity over the Past Two Centuries. Journal of International Money and Finance, 30, 448–473.
  • MacDonald, R., & Marsh, I. W. (1997). On fundamentals and exchange rates: a Casselian perspective. Review of Economics and Statistics, 79(4), 655–664.
  • MacDonald, R., & Marsh, J. (1999). Employment, unemployment and social polarization: young people and cyclical transitions. The Sociological Review, 47(2_suppl), 120–140.
  • Marsh, I. W. (2000). High-frequency Markov Switching Models in Foreign Exchange Market. Journal of Forecasting, 19, 123–134.
  • Martinez, P., & Maria, S. (2002). A Regime-Switching Approach to Studying Speculative Attacks: A Focus on European Monetary System Crises. Empirical Economics, 27, 299–334.
  • MayHodrick, R. J. (1987). The Empirical Evidence on the Efficiency of Forward and Futures Foreign Exchange Markets. Chur, Switzerland: Harwood Academic Publishers.
  • Meese, R. A., & Rogoff, K. (1983). Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics, 14, 3–24.
  • Omer, M., De Haan, J., & Scholtens, B. (2012). Testing Uncovered Interest Rate Parity Using LIBOR. CESifo Working Papers, 3839.
  • Olivier, J., & Masson, P. (2000). Currency crises, sunspots and Markov-switching regimes. Journal of International Economics, 50, 327–350.
  • Peria, M. S. M. (2002). A regime-switching approach to the study of speculative attacks: A focus on EMS crises. In Advances in Markov-Switching Models (pp. 159–194). Physica, Heidelberg.
  • Quandt, R. E. (1958). The Estimation of Parameters of Linear Regression System Obeying Two Separate Regimes. Journal of the American Statistical Association, 55, 873–880.
  • Sarno, L., & Taylor, M. P. (2002). Purchasing power parity and the real exchange rate. IMF Staff Papers, 49(1), 65–105.
  • Sercu, P., Uppal, R., & Van Hulle, C. (2012). The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity. The Journal of Finance, 50, 1309–1319.
  • Sims, C. A. (1980). Macroeconomics and reality. Econometrica: Journal of the Econometric Society, 1–48.
  • Taylor, M. P. (1995). The Economics of Exchange Rates. Journal of Economic Literature, 33, 13–47.
  • Taylor, A. M. (2002). A century of purchasing-power parity. Review of Economics and Statistics, 84(1), 139–150.
  • Tsangyao, C., & Chi-Wei, S. (2013). Revisiting purchasing power parity for East Asian countries using the rank test for nonlinear cointegration, Applied Economics, 45(19), 2847–2852, DOI: 10.1080/00036846.2012.657354.
  • Van Norden, S. (1996). Regime Switching as a Test for Exchange Rate Bubbles. Journal of Applied Econometrics, 11, 219–51.
There are 46 citations in total.

Details

Primary Language English
Subjects Business Administration
Journal Section Research Article
Authors

Süleyman Hilmi Kal This is me

İlhami Gündüz This is me

Publication Date June 28, 2019
Submission Date March 13, 2019
Published in Issue Year 2019

Cite

APA Kal, S. H., & Gündüz, İ. (2019). Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach. İstanbul İktisat Dergisi, 69(1), 1-22. https://doi.org/10.26650/ISTJECON2019-0004
AMA Kal SH, Gündüz İ. Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach. İstanbul İktisat Dergisi. June 2019;69(1):1-22. doi:10.26650/ISTJECON2019-0004
Chicago Kal, Süleyman Hilmi, and İlhami Gündüz. “Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach”. İstanbul İktisat Dergisi 69, no. 1 (June 2019): 1-22. https://doi.org/10.26650/ISTJECON2019-0004.
EndNote Kal SH, Gündüz İ (June 1, 2019) Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach. İstanbul İktisat Dergisi 69 1 1–22.
IEEE S. H. Kal and İ. Gündüz, “Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach”, İstanbul İktisat Dergisi, vol. 69, no. 1, pp. 1–22, 2019, doi: 10.26650/ISTJECON2019-0004.
ISNAD Kal, Süleyman Hilmi - Gündüz, İlhami. “Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach”. İstanbul İktisat Dergisi 69/1 (June 2019), 1-22. https://doi.org/10.26650/ISTJECON2019-0004.
JAMA Kal SH, Gündüz İ. Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach. İstanbul İktisat Dergisi. 2019;69:1–22.
MLA Kal, Süleyman Hilmi and İlhami Gündüz. “Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach”. İstanbul İktisat Dergisi, vol. 69, no. 1, 2019, pp. 1-22, doi:10.26650/ISTJECON2019-0004.
Vancouver Kal SH, Gündüz İ. Global Capital Flows, Time Varying Fundamentals and Transitional Exchange Rate Dynamics: An MS-VAR Approach. İstanbul İktisat Dergisi. 2019;69(1):1-22.