8/12/2019 A History of Failure. Review of Empirical Work of Exchange Rate Since 1981

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A H ISTORY OF F AILURE .R EVIEW OF E MPIRICAL W ORK OF

E XCHANGE R ATE S INCE 1981.David Solomon Hadi - Chief StrategistFinancial ServicesRock Star Consulting Groupwww.rockstarconsultinggroup.com

http://www.rockstarconsultinggroup.com/http://www.rockstarconsultinggroup.com/

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HISTORY OF EMPIRICAL WORK This presentation provides a historicalbackground of empirical work on exchange rateeconomics.The reason is to motivate the idea that a newtheory of exchange rate is needed rather than oldones with new empirical methods.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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OLD THEORIESOld Theories all base them self on

Purchasing Power Parity And Interest Rate Parity

The models assume price to be rigid in short runor not.First class of models is called Sticky Price andsecond is called Flexible Price.

These are called monetary models. All researchesin this history covered use them.These have been tested with several methods.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1983: ROGOFF AND MEESE Models: Several.ResultsFundamental based models perform with same

out of sample forecast as a nave random walkmodel.Random walk means analyst cannot predict.

And same holds for uni-variate models.

Fundamental based means monetary modelsusing economic variables such as price, interestrate etc

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1984: FRANKEL Models: Both Sticky and Flexible Models.Results:Only one of five currencies shows correct sign and

significance according to theory.Interest rate shows always sign consistent withthe Sticky Price Model.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1984: B ACKUS Model: Sticky Price ModelsResults:

All failures; the best way to describe exchange

rate is through random walk.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1994: B AXTER Model: Exploratory ResearchResult:Noise filtering in exchange rate is critical.

The first difference leaves only high frequencyirregular movements.

There is an evidence of the relation (theory free)

between interest rate and exchange rate at thebusiness cycle frequency, but no relation waspresent at the high frequency.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1994: CLARIDA AND G ALI Model: Structural Vector Auto Regressionanalysis to see the sources of real and nominalshocks to exchange rate.Results: The results were consistent with theorymodel for only two out of four countries.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1994: MCDONALD AND T AYLOR Model: A Johansen Cointegration Method.Results:It was claimed that there is evidence in favor of

Monetary Model if allowance is given for complexshort term dynamics.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1995: CHIA AND B AUER Model: Sticky and Flexible Price for Singapore.Results:Theory inconsistent results for reduced form

model of Sticky and Flexible Price for Singapore.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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1998: HUSTED AND MCDONALD Model: An innovative Panel Approach forMonetary Models of the exchange rate.Results:

Majority of coefficients are rightly signed, forexample for OECD countries it is 90 out of 144signed correctly.It is claimed that monetary model acquits itselfin the Panel regression with many of thecoefficients with correct sign.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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2000 AND 2001: CHEUNG AND WONG (2000) AND CHEUGN AND CHIN (2001):

Model: Survey of major traders in US and Asiadealing with major currencies.Results:

Predictability remains low on short horizon.63 % of the respondents claimed, that PPP is anacademic jargon.The reaction to overvaluation was caught in the

reply of the agents - take no action - withconsensus rising to 81.02 percent.Intraday movements and within six monthsmovement reflect bandwagon, technical tradeand overreaction.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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2002: FUNG Model: Vector Auto Regression analysis of theeffects of monetary policy in East Asia.Result:

The results were mixed.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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2005: FRMMEL ET ALL Model: Regime shift model.Results:Two regimes were identified among three

countries.Only in one regime, and only for one pair, signand significance holds, i.e. 1/6 cases were correct.The presence of the second regime, whose

coefficients were difficult to interprettheoretically is found.Finally, it was described that structural stabilitywas not good enough to produce out of sampleforecasts.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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2005: B AILLIU AND K ING Model: None.

A short summary of macro models and reasons oftheir failure and introduction to new field ofmicro structures.Result:Macroeconomic models of exchange rate haveperformed poor in forecasting exchange rate.

The author claims that micro structures basedmodels provide hope.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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2011: T AKIZAWA & H AUNER Model: Pooled and Fixed Effects, OLS.Result:

A little support for the Un Covered Interest

Parity and the major support for the Growth ofGDP and Inflation as variables that couldforecast better.Thereby, they concluded that this was an indirectevidence of the PPP hypothesis.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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RESULTS OF HISTORICAL SURVEY Monetary Models have been tested using:

Simple OLS, Vector Auto Regressions, Co-integration, Panel Regressions, Panel Co-integration,Regime Shift and State of Art Neural Networks.

Has any of these basic to advanced modelsforecasted or explained exchange rates?NO

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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RESULTS OF HISTORICAL SURVEY What should one conclude: Method is wrong ortheory missed something?Especially when Baxter 1994 was able to see atheory free relation and Frmmel et all 2005found a second regime whose coefficients cannotbe explained using existing theories.

It is logical to conclude that exchange rateeconomics needs a new thinking. New theoreticaldevelopments and new models.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

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REFERENCES Backus, D. (1984). Empirical models of the exchange rate: Separatingthe wheat from the chaff. Canadian Journal of Economics, 824-846.Bailliu, J., & King, M. R. (2005). What Drives Movements inExchange Rates?. Bank of Canada Review, 2005(Autumn), 27-39.Baxter, M. (1994). Real exchange rates and real interest differentials:Have we missed the business-cycle relationship?. Journal of MonetaryEconomics, 33(1), 5-37.Cheung, Y. W., & Chinn, M. D. (2001). Currency traders andexchange rate dynamics: a survey of the US market. Journal ofInternational Money and Finance, 20(4), 439-471.Cheung, Y. W., & Wong, C. Y. P. (2000). A survey of marketpractitioners views on exchange rate dynamics. Journal ofInternational Economics, 51(2), 401-419.

Chia, A., & Bauer, J. G. (1995). Analysis of exchange rate movements:a case study of Singapore. Regional Issues in Economics, 1, 3-38.Clarida, R., & Gali, J. (1994, December). Sources of real exchange-rate fluctuations: How important are nominal shocks?. In Carnegie-Rochester conference series on public policy (Vol. 41, pp. 1-56). North-Holland.

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief StrategistFinancial Services Rock Star Consulting Group ( www.rockstarconsultinggroup.com )

http://www.rockstarconsultinggroup.com/http://www.rockstarconsultinggroup.com/http://www.rockstarconsultinggroup.com/http://www.rockstarconsultinggroup.com/http://www.rockstarconsultinggroup.com/http://www.rockstarconsultinggroup.com/

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Driskill, R. A. (1981). Exchange-rate dynamics: An empirical investigation. The Journal ofPolitical Economy, 357-371.Frankel, J. A. (1984). Tests of monetary and portfolio balance models of exchange ratedetermination. In Exchange Rate Theory and Practice (pp. 239-260). University of ChicagoPress.Frmmel, M., MacDonald, R., & Menkhoff, L. (2005). Markov switching regimes in amonetary exchange rate model. Economic Modelling, 22(3), 485-502.Fung, B. (2002). A VAR analysis of the effects of monetary policy in East Asia.

Husted, S., & MacDonald, R. (1998). Monetary-based models of the exchange rate: a panelperspective. Journal of International Financial Markets, Institutions and Money, 8(1), 1-19.MacDonald, R., & Taylor, M. P. (1994). The monetary model of the exchange rate: long-runrelationships, short-run dynamics and how to beat a random walk. Journal of internationalMoney and finance, 13(3), 276-290.Meese, R. A., & Rogoff, K. (1983). Empirical exchange rate models of the seventies: Do theyfit out of sample?. Journal of international economics, 14(1), 3-24.

Panda, C., & Narasimhan, V. (2007). Forecasting exchange rate better with artificialneural network. Journal of Policy Modeling, 29(2), 227-236.Zhang, G., Eddy Patuwo, B., & Y Hu, M. (1998). Forecasting with artificial neuralnetworks:: The state of the art. International journal of forecasting, 14(1), 35-62.Takizawa, H., Lee, J., & Hauner, D. (2011). In Which Exchange Rate Models DoForecasters Trust?. IMF Working Papers, 1-17.

REFERENCES

A History of Failure. Review of Empirical Work of Exchange Rate Since 1981. David Solomon Hadi - Chief Strategist