A HISTORY OF FAILURE. REVIEW OF EMPIRICAL WORK OF EXCHANGE RATE SINCE 1981.

David Solomon Hadi - Chief Strategist Financial Services Rock Star Consulting Group www.rockstarconsultinggroup.com

HISTORY OF EMPIRICAL WORK

This presentation provides a historical background of empirical work on exchange rate economics. The reason is to motivate the idea that a new theory of exchange rate is needed rather than old ones with new empirical methods.

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

OLD THEORIES

Old Theories all base them self on

Purchasing Power Parity And Interest Rate Parity

The models assume price to be rigid in short run or not. First class of models is called Sticky Price and second is called Flexible Price. These are called monetary models. All researches in 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 Strategist Financial Services Rock Star Consulting Group (www.rockstarconsultinggroup.com)

1981: DRISKILL
Model tested: Sticky Price Model. Results: Cannot reject a priori Purchasing Power Parity. However, other assumptions were rejected. Path to adjustment to long run equilibrium is non-monotonic.

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

1983: ROGOFF AND MEESE

Models: Several. Results Fundamental based models perform with same out of sample forecast as a nave random walk model. Random walk means analyst cannot predict. And same holds for uni-variate models.

Fundamental based means monetary models using economic variables such as price, interest rate etc

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

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 with the Sticky Price Model.

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

1984: BACKUS
Model: Sticky Price Models Results: 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 Strategist Financial Services Rock Star Consulting Group (www.rockstarconsultinggroup.com)

1994: BAXTER
Model: Exploratory Research Result: Noise filtering in exchange rate is critical.

The first difference leaves only high frequency irregular movements.

There is an evidence of the relation (theory free) between interest rate and exchange rate at the business cycle frequency, but no relation was present at the high frequency.

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

1994: CLARIDA AND GALI

Model: Structural Vector Auto Regression analysis to see the sources of real and nominal shocks to exchange rate. Results: The results were consistent with theory model for only two out of four countries.

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

1994: MCDONALD AND TAYLOR

Model: A Johansen Cointegration Method. Results: It was claimed that there is evidence in favor of Monetary Model if allowance is given for complex short term dynamics.

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

1995: CHIA AND BAUER

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 Strategist Financial Services Rock Star Consulting Group (www.rockstarconsultinggroup.com)

1998: HUSTED AND MCDONALD

Model: An innovative Panel Approach for Monetary Models of the exchange rate. Results: Majority of coefficients are rightly signed, for example for OECD countries it is 90 out of 144 signed correctly. It is claimed that monetary model acquits itself in the Panel regression with many of the coefficients with correct sign.

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

2007: PANDA AND NARASIMHAN (ALSO ZHANG AND HU 1998)

Model: Artificial Neural Networks. A purely theory free method of the data mining technique. Result: The evidence was not conclusive.

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

2000 AND 2001: CHEUNG AND WONG (2000) AND CHEUGN AND CHIN (2001):
Model: Survey of major traders in US and Asia dealing with major currencies. Results: Predictability remains low on short horizon. 63 % of the respondents claimed, that PPP is an academic jargon. The reaction to overvaluation was caught in the reply of the agents -take no action - with consensus rising to 81.02 percent. Intraday movements and within six months movement reflect bandwagon, technical trade and overreaction.

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

2002: FUNG
Model: Vector Auto Regression analysis of the effects 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 Strategist Financial Services Rock Star Consulting Group (www.rockstarconsultinggroup.com)

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, sign and significance holds, i.e. 1/6 cases were correct. The presence of the second regime, whose coefficients were difficult to interpret theoretically is found. Finally, it was described that structural stability was not good enough to produce out of sample forecasts.

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

2005: BAILLIU AND KING

Model: None. A short summary of macro models and reasons of their failure and introduction to new field of micro structures. Result: Macroeconomic models of exchange rate have performed poor in forecasting exchange rate. The author claims that micro structures based models provide hope.

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

2011: TAKIZAWA & HAUNER

Model: Pooled and Fixed Effects, OLS. Result: A little support for the Un Covered Interest Parity and the major support for the Growth of GDP and Inflation as variables that could forecast better. Thereby, they concluded that this was an indirect evidence of the PPP hypothesis.

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

RESULTS OF HISTORICAL SURVEY

Monetary Models have been tested using:

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

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

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

RESULTS OF HISTORICAL SURVEY

What should one conclude: Method is wrong or theory missed something? Especially when Baxter 1994 was able to see a theory free relation and Frmmel et all 2005 found a second regime whose coefficients cannot be explained using existing theories.

It is logical to conclude that exchange rate economics needs a new thinking. New theoretical developments and new models.

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

REFERENCES

Backus, D. (1984). Empirical models of the exchange rate: Separating the wheat from the chaff. Canadian Journal of Economics, 824-846. Bailliu, J., & King, M. R. (2005). What Drives Movements in Exchange 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 Monetary Economics, 33(1), 5-37. 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. 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 exchangerate fluctuations: How important are nominal shocks?. In CarnegieRochester conference series on public policy (Vol. 41, pp. 1-56). NorthHolland.

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

REFERENCES

Driskill, R. A. (1981). Exchange-rate dynamics: An empirical investigation. The Journal of Political Economy, 357-371. Frankel, J. A. (1984). Tests of monetary and portfolio balance models of exchange rate determination. In Exchange Rate Theory and Practice (pp. 239-260). University of Chicago Press. Frmmel, M., MacDonald, R., & Menkhoff, L. (2005). Markov switching regimes in a monetary 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 panel perspective. Journal of International Financial Markets, Institutions and Money, 8(1), 119. MacDonald, R., & Taylor, M. P. (1994). The monetary model of the exchange rate: long-run relationships, short-run dynamics and how to beat a random walk. Journal of international Money and finance, 13(3), 276-290. 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. Panda, C., & Narasimhan, V. (2007). Forecasting exchange rate better with artificial neural network. Journal of Policy Modeling, 29(2), 227-236. Zhang, G., Eddy Patuwo, B., & Y Hu, M. (1998). Forecasting with artificial neural networks:: 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 Do Forecasters Trust?. IMF Working Papers, 1-17.

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