Why Economic Theory Fails To Explain Exchange Rates?

WHY ECONOMIC THEORY OF EXCHANGE RATES FAILS TO EXPLAIN EXCHANGE RATE?
David Solomon Hadi - Chief Strategist Financial Services Rock Star Consulting Group www.rockstarconsultinggroup.com
EXCHANGE RATE THEORY FAILED!
Exchange Rates show random walk and a fundamental disconnect puzzle.
Random Walk: Exchange Rate cannot be predicted. This was first discovered by Rogoff and Meese (1983).
Fundamental Disconnect Puzzle: Exchange rate show no relation to economic fundamentals . This was discovered by several authors. Among them were Obstfeld & Rogoff (2001).
Why Economic Theory of Exchange Rates Fails to Explain Exchange rate? David Solomon Hadi - Chief Strategist Financial Services Rock Star Consulting Group (www.rockstarconsultinggroup.com)
IMPLICATIONS OF RANDOM WALK AND DISCONNECT PUZZLE .
As a result of these random walk and disconnect puzzle:
Economist remain unable to forecast. Economist remain unable to explain reasons of changes. Economist remain unable to engage in policy advisory about exchange rate.
3
WHY THESE TWO PROPERTIES HOLD?
Other than the known problems, for example for Purchasing Power Parity it is transportation cost, price index of traded versus non traded goods, taxes etc, four new or less known problems are collected:
Missing Behavior of Traders Rational Inattention Mistaking Noise as Fundamental Variable Triangular Arbitrage
4
MISSING BEHAVIOR OF TRADERS

Cheung et al (2000 and 2001) surveyed major exchange rate markets and found that traders do not care about economic fundamentals. They found, among other things, that market in short run is dominated :
By bandwagon effect. By New over reaction. By manipulators who change market. Trend followers.
5

Three crucial questions from Cheung et al (2000 and 2001) survey are given below: What is meant by Purchasing Power Parity (PPP)?

63% of respondents claimed PPP as an academic jargon. 81.02% of agents replied take no action. Common answer was no for time up to six months.
6
What would be ones reaction to overvaluation?
Does PPP reflect exchange rate movement?
A model of behavior of trader is missing. Models of traders are available for example Lux (1995) and Alfarano and Lux (2007).
These model a noise trader. For example, show herd behavior etc. This in turn leads to the market whose time series resemble one observed in real life.
However, they are not embedded into exchange rate models.
RATIONALLY INATTENTIVE AGENTS
Information in exchange rate market is large and frequency of arrival is high.
Several countries, several goods markets, several finance markets change every hour every day.
A rational choice of being inattentive to some markets is optimal in order to avoid losing time in information processing only.
Sims (2003, 2005, 2006, 2010) mathematical presentation of Rational Inattention could be embedded in exchange rate. However, this is not done yet.
USING DIFFERENCED EXCHANGE RATE IS SAME AS MODELING NOISE WITH FUNDAMENTALS

Noise is high frequency movement. It is irregular. First difference of exchange rate on monthly data is high frequency and unpredictable (Irregular).

Therefore first difference which is commonly used is noise. Baxter (1994). Should one model exchange rates noise using economic fundamentals such as interest rate which is non noisy?
9
USING DIFFERENCED EXCHANGE RATE IS SAME AS MODELING NOISE WITH FUNDAMENTALS
Answer by Baxter is NO. Modeling exchange rate using economic fundamentals would require to focus on non noisy component of time series.
Baxter proposed using a frequency domain filter. Baxter King Filter is one example.
This understanding can be taken to next level.
10
ARBITRAGE FREE MARKET AND ITS IMPLICATIONS
The Triangular Arbitrage is defined as a round trip of buying/selling currencies that ends up adding in positive return (Marshall et al, 2008).
Hypothetical Example: 1 Dollar is converted to 1.5 Pounds. 1.5 Pounds are converted to 2.0 Euro. 2.0 Euro are converted back into 1.1 Dollars. Net gain is 0.1 dollars.
11
ARBITRAGE FREE MARKET AND ITS IMPLICATIONS
In exchange rate market such situation is exploited quickly.
This moves demand supply of currencies and moves market to state where this risk free profit do not not exist anymore. Therefore, an effect of change in one currency pair price ripples through whole set of currency pairs.
However, no model of exchange rate considers effects of this kind of arbitrage.
12
REFERENCES

Alfarano, S., & Lux, T. (2007). A noise trader model as a generator of apparent financial power laws and long memory. Macroeconomic Dynamics, 11(S1), 80-101. Baxter, M. (1994). Real exchange rates and real interest differentials: Have we missed the business-cycle relationship?. Journal of Monetary Economics, 33(1), 5-37.
Black, F. (2012). Noise. The Journal of Finance, 41(3), 529-543. Cheung, Y. W., & Chinn, M. D. (2001). Currency traders and exchange rate dynamics: a survey of the US market. Journal of International Money and Finance, 20(4), 439-471. Cheung, Y. W., & Wong, C. Y. P. (2000). A survey of market practitioners views on exchange rate dynamics. Journal of International Economics, 51(2), 401-419. Lux, T. (1995, July). Herd behaviour, bubbles and crashes. In Economic Journal-Including Annual Conference Paper Supplement (Vol. 105, No. 431, pp. 881-896). London, 1891-. Marshall, B., Treepongkaruna, S., & Young, M. (2008). Exploitable arbitrage opportunities exist in the foreign exchange market. In American Finance Association Annual Meeting, New Orleans. Meese, R. A., & Rogoff, K. (1983). Empirical exchange rate models of the seventies: Do they fit out of sample?. Journal of international economics, 14(1), 3-24. Obstfeld, M., & Rogoff, K. (2001). The six major puzzles in international macroeconomics: is there a common cause?. In NBER Macroeconomics Annual 2000, Volume 15 (pp. 339-412). MIT press. Sims, C. A. (2003). Implications of rational inattention. Journal of monetary Economics, 50(3), 665-690. Sims, C. A. (2006). Rational inattention: Beyond the linear-quadratic case. The American economic review, 158-163. Sims, C. A. (2005). Rational inattention: a research agenda (No. 2005, 34). Discussion paper Series 1/Volkswirtschaftliches Forschungszentrum der Deutschen Bundesbank. Sims, C. A. (2010). Rational inattention and monetary economics.
13

Why Economic Theory Fails To Explain Exchange Rates?

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Why Economic Theory Fails To Explain Exchange Rates?

Caricato da

Copyright:

Formati disponibili

WHY ECONOMIC THEORY OF EXCHANGE RATES FAILS TO EXPLAIN EXCHANGE RATE?

EXCHANGE RATE THEORY FAILED!

Exchange Rates show random walk and a fundamental disconnect puzzle.

IMPLICATIONS OF RANDOM WALK AND DISCONNECT PUZZLE .

As a result of these random walk and disconnect puzzle:

WHY THESE TWO PROPERTIES HOLD?

MISSING BEHAVIOR OF TRADERS

MISSING BEHAVIOR OF TRADERS

What would be ones reaction to overvaluation?

Does PPP reflect exchange rate movement?

MISSING BEHAVIOR OF TRADERS

RATIONALLY INATTENTIVE AGENTS

Information in exchange rate market is large and frequency of arrival is high.

USING DIFFERENCED EXCHANGE RATE IS SAME AS MODELING NOISE WITH FUNDAMENTALS

USING DIFFERENCED EXCHANGE RATE IS SAME AS MODELING NOISE WITH FUNDAMENTALS

ARBITRAGE FREE MARKET AND ITS IMPLICATIONS

ARBITRAGE FREE MARKET AND ITS IMPLICATIONS

In exchange rate market such situation is exploited quickly.

Potrebbero piacerti anche