Real exchange rates and real interest rate

Meese and Rogoff (1988) explore the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom. Contrary to theories based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, research find little evidence of a stable relationship between real interest rates and real exchange rates. Research consider both in sample and out of sample tests. One hypothesis that is consistent with findings is that real disturbances (such as productivity shocks) may be a major source of exchange rate volatility.

The results research has presented are slightly more favorable than the results of earlier studies. Research does find that the real exchange rate and the real interest differential have the theoretically anticipated sign (although trade balance regressors tend not to have the anticipated sign). However, the relationship is not statistically significant, and real interest differentials do not provide significant improvement over a random-walk model in forecasting real exchange rates (except in a few isolated cases). Research has already alluded to one possible explanation of why monetary models perform so poorly, which is that the disturbances impinging on exchange markets are predominantly real. Thus, models that focus primarily on monetary disturbances should not be expected to explain very much. The real shocks hypothesis require auxiliary consideration though it is not yet assured whether it will be helpful in building better empirical exchange rate models. It has proven extremely difficult to identify which real factors (such as technology shocks or changes in preferences) affected exchange rates over what periods. Still, it seems that further study along the lines of modern real business cycle research would be worthwhile. Research has also mentioned another popular current explanation of the failure of monetary exchange rate models, which is the existence of self-fulfilling expectations or exchange market bubbles. However, Flood has demonstrated that the results of rolling regression methodology are robust to the possibility of (linear) rational bubbles. Finally, examination of the empirical implications of Partial equilibrium asset pricing models of exchange rates also merits further research.

Bailey and Chung (1995) estimate the impact of exchange rate fluctuations and political risk on the risk premiums reflected in cross sections of individual equity returns from Mexico, a country that has experienced significant monetary and political turbulence. Mexico's currency and sovereign debt markets indicators are employed as proxies for exchange rate and political risks. Research finds some evidence of equity market premiums for exposure to these risks. The results have several implications for corporate and portfolio management and for the use of emerging market data by researchers and suggest common factors in emerging market equity, currency, and sovereign debt markets.

To the extent that exchange rate fluctuations and political risk are significant, we expect to observe similar effects in the equity markets of other countries. Results complement the importance attached to exchange rate and political risks in the international finance literature. They also validate the usefulness of mainstream empirical asset pricing concepts and methodologies in studying international finance issues and, in particular, highlight the usefulness of information from currency and sovereign debt markets.

Research show results for the pricing of Mexican sovereign default risk have further implications for international finance. Research would expect Mexican political risk to have a significant impact only on Mexican investors, given the ability of non Mexicans to hold globally diversified portfolios. Results suggest several further directions for future research. The search for evidence of currency risk premiums in cross-sections of U.S. stocks may be more fruitful if tests are designed to capture time varying risk premiums. Further evidence may be obtained using data from developed countries that have a long history of stock prices similar to the U.S. but have experienced substantially greater price and exchange rate volatility. Similarly, results from developing countries with a more turbulent history of inflation and political changes than Mexico may prove interesting. The researcher can now observe prices for domestic equities, domestic debt, corporate Eurobonds, Brady bonds, ADRs, and country funds for such countries as Mexico, Brazil, Argentina, and the Philippines.

Philippe Jorion(1991) examines the pricing of exchange rate risk in the U.S. stock market using two factor and multifactor arbitrage pricing models. Substantiation is presented that the relation between stock returns and the value of the dollar differs thoroughly across industries. The results do not suggest that exchange risk is priced in the stock market. The absolute risk premium attached to foreign currency exposure appears to be small and never considerable. It shows active hedging policies by financial managers cannot affect the cost of capital, and other reasons must explain why firms decide to hedge.

Research examines the exposure of U.S. industries to movements in the value of the dollar. U.S. industries display significant cross sectional differences in their exposure to movements in the dollar. Research evaluate whether the currency exposure of U.S. firms was priced in the sense of Ross's APT. In spite of using relatively powerful statistical techniques, the premium attached to pure foreign exchange exposure is found to be of the order of 0.2 percent per annum, which is both economically and statistically insignificant. Exchange rate risk seems to be diversifiable. It shows that active hedging policies by financial managers cannot affect the cost of capital, and reasons other than pricing arguments must explain why firms actively manage foreign exchange risk.

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