Monetary disequilibria and the Euro/Dollar exchange rate

Although stable money demand functions are crucial for the monetary model of the exchange rate, empirical research on exchange rates and money demand is more or less disconnected. This paper tries to fill the gap for the Euro/Dollar exchange rate. We investigate whether monetary disequilibria provided by the empirical literature on U.S. and European money demand functions contain useful information about exchange rate movements. Our results suggest that the empirical performance of the monetary exchange rate model improves when insights from the money demand literature are explicitly taken into account. JEL - Klassifikation: F31 , E41Im Rahmen des monetären Modells des Wechselkurses kommt der Annahme stabiler Geldnachfragefunktionen eine zentrale Bedeutung zu. Über die Gestalt der inländischen und ausländischen Geldnachfragefunktion ist bestimmt, in welcher Weise Geldmengen, Einkommen und Zinsen den Gleichgewichtswert des Wechselkurses beeinflussen. In diesem Papier wird untersucht, ob die Erklärungskraft des monetären Modells durch eine sorgfältigere Berücksichtigung der zugrunde liegenden Geldnachfragebeziehungen erhöht werden kann. Insbesondere werden bisherige Ergebnisse der empirischen Literatur zur Geldnachfrage explizit für die Wechselkursanalyse verwandt. Hierzu werden monetäre Ungleichgewichte - d.h. kurzfristige Abweichungen von der inländischen sowie der ausländischen Geldnachfragefunktion - separat in die Wechselkursgleichung einbezogen. Dabei stützt sich die Analyse auf geschätzte Geldnachfragebeziehungen aus der empirischen Literatur. Anders als in bisherigen Studien ergeben sich Erkenntnisse über Geldnachfragefunktionen somit nicht residual aus der Wechselkursanalyse, sondern dienen als zentrale Information für die Untersuchung von Wechselkursdynamik. Darüber hinaus erlaubt es die separate Modellierung monetärer Ungleichgewichte, die verschiedenen Wirkungskanäle aufzuzeigen, über die der Wechselkurs beeinflusst wird. Der vorgeschlagene Ansatz wird am Beispiel des Euro/Dollar-Wechselkurses veranschaulicht. Die empirischen Ergebnisse zeigen, dass der Euro/Dollar-Wechselkurs in plausibler und statistisch signifkanter Weise auf monetäre Ungleichgewichte in den USA und Europa reagiert. Weiterhin wird im Rahmen einer in-sample sowie out-of-sample Evaluation gezeigt, dass die Erklärungskraft von Schätzgleichungen für den Wechselkurs durch die Berücksichtigung wohlspezifizierter Geldnachfragefunktionen verbessert werden kann. Somit scheint sich die empirische Evidenz für das monetäre Modell des Wechselkurses zu erhöhen, wenn Erkenntnisse der Geldnachfrage-Literatur explizit in die Wechselkursanalyse einbezogen werden

Idiosyncratic volatility, economic fundamentals, and foreign exchange rates

This paper shows that a relatively high level of average U.S. industry- or firm-level idiosyncratic stock volatility is usually associated with a future appreciation in the U.S. dollar. For most foreign currencies, the relation is statistically significant in both in sample and out-of-sample tests, even after we use a bootstrap procedure to explicitly account for data mining. We also document a positive and significant relation between a country’s idiosyncratic volatility and the future U.S. dollar price of its currency—in France, Germany, and Japan. Moreover, among a number of commonly used financial variables, only idiosyncratic volatility forecasts output growth in both U.S. and foreign countries. Our results suggest that there might be a close link between exchange rates and economic fundamentals. ; Earlier title: Foreign exchange rates don't follow a random walkForeign exchange ; International finance

Forecasting the European carbon market

In an effort to meet its obligations under the Kyoto Protocol, in 2005 the European Union introduced a cap-and-trade scheme where mandated installations are allocated permits to emit CO2. Financial markets have developed that allow companies to trade these carbon permits. For the EU to achieve reductions in CO2 emissions at a minimum cost, it is necessary that companies make appropriate investments and policymakers design optimal policies. In an effort to clarify the workings of the carbon market, several recent papers have attempted to statistically model it. However, the European carbon market (EU ETS) has many institutional features that potentially impact on daily carbon prices (and associated …nancial futures). As a consequence, the carbon market has properties that are quite di¤erent from conventional financial assets traded in mature markets. In this paper, we use dynamic model averaging (DMA) in order to forecast in this newly-developing market. DMA is a recently-developed statistical method which has three advantages over conventional approaches. First, it allows the coefficients on the predictors in a forecasting model to change over time. Second, it allows for the entire forecasting model to change over time. Third, it surmounts statistical problems which arise from the large number of potential predictors that can explain carbon prices. Our empirical results indicate that there are both important policy and statistical benefits with our approach. Statistically, we present strong evidence that there is substantial turbulence and change in the EU ETS market, and that DMA can model these features and forecast accurately compared to conventional approaches. From a policy perspective, we discuss the relative and changing role of different price drivers in the EU ETS. Finally, we document the forecast performance of DMA and discuss how this relates to the efficiency and maturity of this market

International financial contagion: what do we know?

This paper attempts a synthesis of theoretical and empirical work on international financial contagion. Although a professional consensus on the appropriate definitions of contagion has yet to emerge, we document substantial research progress towards this goal. On the empirical front, determining when returns are ‘excessive’ is a pre-condition for designing effective policy response to crises. At the theoretical level, tracing the observed herding behavior to market participants’ uncertain beliefs and information asymmetries is a key element for understanding how contagious effects arise. It is argued that the recent focus on better understanding of high-frequency financial returns data and decision making at the market microstructure level are promising avenues for understanding the transmission of shocks across markets and countries

Can Exchange Rates Forecast Commodity Prices?

This paper demonstrates that “commodity currency” exchange rates have remarkably robust power in predicting future global commodity prices, both in-sample and out-of-sample. A critical element of our in-sample approach is to allow for structural breaks, endemic to empirical exchange rate models, by implementing the approach of Rossi (2005b). Aside from its practical implications, our forecasting results provide perhaps the most convincing evidence to date that the exchange rate depends on the present value of identifiable exogenous fundamentals. We also find that the reverse relationship holds; that is, that commodity prices Granger-cause exchange rates. However, consistent with the vast post-Meese-Rogoff (1983a,b) literature on forecasting exchange rates, we find that the reverse forecasting regression does not survive out-of-sample testing. We argue, however, that it is quite plausible that exchange rates will be better predictors of exogenous commodity prices than vice-versa, because the exchange rate is fundamentally forward looking. Therefore, following Campbell and Shiller (1987) and Engel and West (2005), the exchange rate is likely to embody important information about future commodity price movements well beyond what econometricians can capture with simple time series models. In contrast, prices for most commodities are extremely sensitive to small shocks to current demand and supply, and are therefore likely to be less forward looking. J.E.L. Codes: C52, C53, F31, F47. Key words: Exchange rates, forecasting, commodity prices, random walk. Acknowledgements. We would like to thank C. Burnside, C. Engel, M. McCracken, R. Startz, V. Stavreklava, A. Tarozzi, M. Yogo and seminar participants at the University of Washington for comments. We are also grateful to various staff members of the Reserve Bank of Australia, the Bank of Canada, the Reserve Bank of New Zealand, and the IMF for helpful discussions and for providing some of the data used in this paper.

Budget support, conditionality and poverty

This paper examines the effectiveness of budget support aid as an anti-poverty instrument. We argue that a major determinant of this effectiveness is the element of trust – or `social capital´, as it may be seen – which builds up between representatives of the donor and recipient. Thus we model the conditionality processes attending budget support aid, not purely in the conventional way as a non-cooperative two-person game, but rather as a non-cooperative game which may mutate into a collaborative equilibrium if sufficient trust between the negotiating parties builds up. Whether or not this happens is, we argue, fundamental to the effectiveness of conditionality, and of budget support aid. This then requires us to enquire into the determinants of trust, which - we empirically demonstrate - derive from the experience of the negotiating parties with one another, from the incentives they are able to provide to trust one another and from the processes within which their negotiations are conducted. The model is tested against two samples: extensively against a broad sample of all African countries undergoing budget support operations and intensively against a narrow sample of Ethiopia, Uganda, Malawi and Zambia. The statistical analysis suggests that trust has in practice been achieved not only through a positive `social history´ but by the transmission of forward-looking `signals´ or `bona fides´ concerning fundamentals: high pro-poor expenditure, low military expenditure, and low corruption show a positive relationship with growing trust (measured in terms of freedom from programme interruptions). Where these signals are present, budget support aid is in general growing, and slippage on overt conditionality is in general forgiven; but there are exceptions to this trend, as our case-study analysis demonstrates . A proactive stance in defence of a pro-poor strategy is positive for trust, as are certain procedural reforms including the presence of an IMF resident mission and frequent face-to-face meetings between negotiators for donor and recipient. High trust generates stability of aid, and stability of aid, in conjunction with its level and its targeting, significantly influences growth and poverty outcomes

Introducing shrinkage in heavy-tailed state space models to predict equity excess returns

We forecast S&P 500 excess returns using a flexible Bayesian econometric state space model with non-Gaussian features at several levels. More precisely, we control for overparameterization via novel global-local shrinkage priors on the state innovation variances as well as the time-invariant part of the state space model. The shrinkage priors are complemented by heavy tailed state innovations that cater for potential large breaks in the latent states. Moreover, we allow for leptokurtic stochastic volatility in the observation equation. The empirical findings indicate that several variants of the proposed approach outperform typical competitors frequently used in the literature, both in terms of point and density forecasts

Predicting Stock Returns in a Cross-Section : Do Individual Firm chatacteristics Matter ?

It is a common wisdom that individual stocks' returns are difficult to predict, though in many situations it is important to have such estimates at our disposal. In particular, they are needed to determine the cost of capital. Market equilibrium models posit that expected returns are proportional to the sensitivities to systematic risk factors. Fama and French (1993) three-factor model explains the stock returns premium as a sum of three components due to different risk factors : the traditional CAPM market beta, and the betas to the returns on two portfolios, "Small Minus Big" (the differential in the stock returns for small and big companies) and "High Minus Low" (the differential in the stock returns for the companies with high and low book-to-price ratio). The authors argue that this model is sufficient to capture the impact on returns of companies' accounting fundamentals, such as earnings-to-price, cash flow-to-price, past sales growth, long term and short-term past earnings. Using a panel of stock returns and accounting data from 1979 to 2008 for the companies listed on NYSE, we show that this is not the case, at least at individual stocks' level. According to our findings, fundamental characteristics of companies' performance are of higher importance to predict future expected returns than sensitivities to the Fama and French risk factors. We explain this finding within the rational pricing paradigm : contemporaneous accounting fundamentals may be better proxies for the future sensitivity to risk factors, than the historical covariance estimates.Accounting fundamentals, equity performance, style analysis, value and growth, cost of capital.