This project examines in the first part the covered and uncovered interest parity between US dollar and Swiss Franc. We present simple summary statistics, unit root tests, deviations from covered interest parity, regression analysis, threshold autoregression and exponential transition autoregression. Then we present the uncovered interest parity and, as in the case of covered interest parity, we apply some tests to examine if it’s valid. We apply Johansen cointegration tests between spot and forward rates, but also between forward premia and interest rates differentials and we test if there is a cointegration equation and we estimate the vector error correction model. After this procedure we present the impulse responses. Next we test if there is a threshold cointegration relation between the above variables. Finally in the last section we apply a dynamic OLS (DOLS) estimation with Newey-West HAC standard errors.
In the second part the purchasing power parity (PPP) hypothesis is examined with a similar methodology followed, where additionally we present a long span study, unit root tests allowing for structural breaks in data, panel unit root tests as also Markov switching regime autoregressive model is examined in the category of the non linear models
Table of Contents
PART 1
COVERED AND UNCOVERED INEREST RATE PARITY
Introduction
Literarute review
Data.
Summary Statistics.
Random Walk
Unit Root and Stationary Tests
Covered Interest Rate Parity
1. Linear Tests
2. Non Linear Tests
2.1. Threshold Autoregressive (TAR)Model
2.2. Smoothing Transition Autoregressive (STAR) Models
Uncovered Interest Rate Parity.
Vector Error-Equilibrium Correction Model (VECM).
Impulse Responses
Threshold Vector error correction model.
Dynamic OLS (DOLS).
Conclusions.
PART 2.
PURCHASING POWER PARITY HYPOTHESIS.
Introduction.
Literature Review.
Data
Summary Statistics
Unit Root and Stationary Tests
Power Purchasing Parity tests
1. Linear Tests
2. Cointegration Tests
3. Panel Unit Root Tests
4. Long span Tests
5. Non-Linear Tests
5.1. Threshold Autoregressive Model (TAR)
5.2. Smoothing Transition Autoregressive Models (STAR)
5.3 Markov two-regime switching model.
Conclusions.
Objectives and Research Themes
The research project aims to empirically examine the validity of Covered Interest Rate Parity (CIP), Uncovered Interest Rate Parity (UIP), and the Purchasing Power Parity (PPP) hypothesis. Utilizing statistical applications in MATLAB, RATS, and EVIEWS, the study tests the equilibrium relationships between exchange rates, interest rates, and price indices, focusing on the US dollar against the Swiss Franc and the Swedish Kronor.
- Empirical validation of CIP and UIP using linear and non-linear models.
- Application of Cointegration and Vector Error Correction Models (VECM) for exchange rate analysis.
- Testing for non-linearities using Threshold Autoregressive (TAR) and Smoothing Transition Autoregressive (STAR) models.
- Evaluation of the PPP hypothesis across different inflation environments and time spans.
- Comparison of consumer (CPI) and producer (PPI) price index impacts on market efficiency.
Excerpt from the Book
Literature review
Fama ( 1984) obtained spot exchange rates and one-monthly forward rates for nine major currencies, including Belgian Franc (BFR), Canadian Dollar (CAD), French Frank (FFR), Italian Lira (ITL), the Japanese Yen (JPY), Swiss Frank (SFR), British Pound (GBP), Netherlands Guilder (NGL) and German Mark (DEM). He finds that according to standard deviation the current spot rate is a better predictor of the future spot rate than the current forward rate. Also he finds that autocorrelations of changes in spot rates are close to zero. The same situation is observed for the premium, but not for the forecast error, which is Ft – St, where Fama found a first order autoregressive process. Regressing Ft – St+1 on Ft – St Fama finds that β1 is positive in contrary to the negative β2 which is generated by St+1 regressing on Ft – St.
Fama notes that the negativity of β is owned to the covariation between the risk premium and the expected rate of depreciation. McMillan (2005) tests the forward exchange rate unbiasedness hypothesis (FRUH) applying a panel cointegration test between five major currencies – the Canadian Dollar, French Franc, German Deutschemark, Japanese Yen, and UK Sterling – relative to the US Dollar and he finds that, overall, results support cointegration but not the FRUH. Hai et al. (1997) using the Kalman filter and obtaining maximum likelihood estimates of trend VARMA(1,1) for log spot and forward dollar prices of the pound, the franc, and the yen they found that log spot and forward exchange rates appear to be cointegrated with cointegration vector (1, -1).
Chapter Summaries
Introduction: Outlines the research scope, specifically covering the parity relationships between the US Dollar, Swiss Franc, and Swedish Kronor, and establishes the analytical framework using econometrics.
Literarute review: Provides a comprehensive overview of existing empirical studies on interest rate parity and PPP, highlighting key findings from researchers like Fama, McMillan, and others.
Data: Details the sources of monthly and yearly datasets, including exchange rates, consumer, and producer price indices, and interest rates used for the project.
Summary Statistics: Presents descriptive metrics such as mean, kurtosis, skewness, and standard deviation for the variables under consideration.
Random Walk: Investigates the stochastic properties of spot rates to determine if they follow a random walk process using regression and residual diagnostics.
Unit Root and Stationary Tests: Applies Augmented Dickey-Fuller, Phillips-Perron, and KPSS tests to check for stationarity in exchange rates, price indices, and interest rates.
Covered Interest Rate Parity: Analyzes the validity of CIP using linear tests, regression analysis, and non-linear threshold models.
Uncovered Interest Rate Parity: Tests the UIP hypothesis by regressing future exchange rate changes on interest rate differentials.
Vector Error-Equilibrium Correction Model (VECM): Utilizes Johansen cointegration tests to evaluate long-run equilibrium relationships.
Impulse Responses: Examines the dynamic response of variables to exogenous shocks through impulse response functions.
Threshold Vector error correction model: Explores non-linear cointegration patterns using Hansen and Seo’s methodology.
Dynamic OLS (DOLS): Employs Stock-Watson DOLS with Newey-West standard errors to refine the estimation of long-run elasticities.
Conclusions: Summarizes the rejection or acceptance of the parity hypotheses based on the various models tested throughout the study.
Keywords
Interest Rate Parity, Purchasing Power Parity, Cointegration, Unit Root Tests, VECM, Threshold Autoregressive, STAR Models, Exchange Rates, Market Efficiency, Econometrics, MATLAB, GARCH, Volatility, Structural Breaks, Time Series Analysis.
Frequently Asked Questions
What is the primary objective of this research?
The work examines the empirical validity of Covered Interest Rate Parity, Uncovered Interest Rate Parity, and the Purchasing Power Parity hypothesis, primarily focusing on the US Dollar against the Swiss Franc and the Swedish Kronor.
Which parity relationships are analyzed?
The study investigates three main parity conditions: Covered Interest Rate Parity (CIP), Uncovered Interest Rate Parity (UIP), and Purchasing Power Parity (PPP).
What is the core research question?
The research seeks to determine whether these parity hypotheses hold in real-world market data when tested against different economic indicators and non-linear dynamics.
Which scientific methods are utilized?
The author uses a variety of econometric methods including OLS, GARCH, VECM, Dynamic OLS (DOLS), and advanced non-linear techniques like TAR, LSTAR, ESTAR, and Markov-Switching models.
What content is covered in the main section of the book?
The main sections include comprehensive data analysis, unit root testing, cointegration testing, and the estimation of complex models to identify equilibrium relationships between exchange rates and various price or interest rate variables.
What defines the characterizing keywords of this work?
Keywords reflect the study's emphasis on time-series econometrics, exchange rate dynamics, market equilibrium models, and specific parity theories like PPP and UIP.
Does the study find evidence for the Purchasing Power Parity (PPP) hypothesis?
The study provides mixed results; while linear models often reject PPP, non-linear models and certain cointegration estimations suggest that the hypothesis may hold under specific conditions.
What is the significance of the threshold cointegration test?
The threshold cointegration test, based on Hansen and Seo (2002), is used to identify non-linear equilibrium relationships that linear models might miss, helping to explain deviations in exchange rate parity.
- Quote paper
- Eleftherios Giovanis (Author), 2008, A Research Examination of Covered-Uncovered Interest Rate Parity and the Purchase Power Parity (PPP) hypothesis: Applications in MATLAB, RATS and EVIEWS, Munich, GRIN Verlag, https://www.grin.com/document/142520
