1. The document discusses various models of exchange rate determination and their ability to explain movements in exchange rates. 2. Empirical tests of exchange rate models have found that no single model is able to outperform a simple random walk model in predicting short-term exchange rate movements. 3. Over longer time horizons, models based on economic fundamentals like monetary and real factors have more predictive power for explaining exchange rate movements.

1. EMPIRICAL EVIDENCE ON
EXCHANGE RATE
KAEDE NAKAKURA 120310159007
PANJI SURYAPUTRA 120210130041
KAZUKI YAMAMOTO 120310159008
MUHAMMAD LEVI 120210120046

2. Introduction
• What for we try to identify a model that
successfully explains exchange rate
determination?
To make it possible for us to determine the best
way to influence exchange rates & limit exchange
rate volatility.
Identifying a efficient model will link with
stabilizing exchange rate.

3. WHAT IS AN EFFICIENT MARKET?
Definition
‘in which prices always “fully reflect” available
information’ (Eugene Fama, 1970)
Unusual profit cannot be made by speculators who make
exchange rate forecasts on a seminar information set.
 Two key concerns
I. Is new information instantaneously and fully
reflected in the exchange rate?
II. What is relevant and what is irrelevant information?

4. Exchange market efficiency tests
• When examining the concept of exchange market
efficiency, the rational expectation hypothesis
(REH) is particularly useful. Because it presumes
that economic agents do not make systematic.
(e.g. Booth and Longworth)
• It may be evidence of exchange market
inefficiency ( that is, REH does not hold ) or be
indicative risk premium (possibly time-varying) in
the foreign exchange market.
•

5. Efficiency Market Hypothesis (EMH)
Definition of EMH
stocks always trade at their fair value on stock
exchanges, making it impossible for investors to
either purchase undervalued stocks or sell stocks
for inflated prices
impossible to outperform the overall market
through expert stock selection or market timing
the only way an investor can possibly obtain
higher returns is by purchasing riskier
investments.

6. Summary of finding on exchange market
efficiency
• When the joint hypothesis is rejected, there is
no means of knowing whether this is due to
the existence of a risk premium or the failure of
foreign exchange market efficiency
• Overall, various exchange market efficiency
tests are depending on currency and particular
test considered.
• But certain period and rates, the joint
hypothesis don’t hold.
→test of EMH

7. • If hypothesis is rejected, what is causes?
• Existence of a risk premium? Or existence of
inefficiency/non-rational expectations in the
foreign exchange market?
• Frankel(1986), Frankel and Rogoff(1986)
studies argued about Risk Premium
• In Both studies, the relevant coefficients to
prove statistically insignificant
• In a tentative suggestion, more likely candidate
for the failure is non rational expectation in the
foreign exchange market

8. • models of ER determination for the
authorities effect on implications
concerning the effectiveness of sterilized
intervention
Empirical tests of exchange rate model

9. • Synthesis equation below:
• In the fully flexible price monetarist version,
Θ and β approach infinity
• this reduces equation(9.12) to the flexible
price monetary equation(7.9)

10. • In the sticky price monetarist version,
Θ is less than infinity but β is infinity, so that end up with
the real interest differential equation(7.31)
• Whereas the sticky price portfolio balance model that
holds Θ and β are less than infinite so that relative bod
supplies have an impact on the ER and the relevant
equation is therefore (9.12)
• Equation(9.12) yields the following reduced form
regression for the ER:

11. Predictions of exchange rate models
a2(m-m*) a3(y-y*) a4(r-r*) a5(Pe-Pe*) a6(b-f)
Flexible price
monetary model
+ - 0 + 0
Sticky-price
Dombusch monetary
model + - - 0 0
Real interest
differential monetary
model + - - + 0
Sticky-price portfolio
model + - - + +

13. • Pilbeam(1991) tested the forecasting accuracy
of popular ER models by replicating Meese and
Rogoff(1983a,1983b) report result
• Three models are tested for the purpose of
forecasting the ER
– 1 the flexible-price monetary model
– 2the real interest rate model
– 3the sticky-price portfolio balance model
• The period is 1979:1 to 1988:3 using a
quarterly data set
Exchange rate models: a forecasting
analysis

14. • In order to forecast the one-period-ahead ER, a
rolling regression technique was used
• Rolling regression →reestimating the regression
coefficients for each period t to forecast the ER in
time t+1
• For the purpose of forecasting the ER in time t+1,
the actual values of the exogenous variables in time
t+1 were used
• This is very important because forecast for one
period ahead will not be based on the wrong money
supplies, interest rate etc so that any forecasting
error is due to the weakness of the models rather
than inaccurate forecasting of the fundamentals.

15. Meese and Rogoff(1983b)
• Used plausible theoretical coefficient values as
opposed to the estimated coefficients for forecasting
purposes.
• the forecast values of the ER of the three alternative
models tested in the Pilbeam study and the actual
ER
• For the purposes of ranking the forecasting
accuracy of the three model, used root-mean-
squared error(RMSE) criterion
• The lower the RMSE, the better the forecasting
capability of the model

16. • Three alternative ER models and simple random walking
model of the ER whereby the current ER at time t is used as
the forecast for the ER in period t+1
• A simple random-walk model has a superior forecasting
power than any of the popular models of ER determination

18. • None of the models does very well at
forecasting eh ER at the three month
horizon.
• In fact, in the Meese and Rogoff studies, it is
shown that it is only at the 12 months plus
horizon that ER models star to outperform
the random-walk model.

19. Explaining the poor results of exchange
rate model
The exchange rate theories provide many reasons as to why exchange
rates will be difficult to model empirically
• Exchange rates are determined not simply by the stance of monetary
policy,
• It is extremely difficult to identify and model changes in new
information and how they are discounted into the current exchange
rate
• “Finance Minister Problem” or “Peso Problem”
• The dynamic path of exchange rate will be completely different
depending upon whether a given shock or policy disturbance has been
anticipated or unanticipated

20. Explaining the poor results of exchange
rate model(con’t)
• Both in theory and when it comes to empirical test
of a theory, the econometrics requires that we
adopt need to be in some major simplifications
• Instability in the demand for money schedules is
necessary in order to explaining exchange rate
• Problem to incorporate into the empirical model
the role of real shocks on exchange rate movements
• Enormous changes in the financial and real
structure of economies had important implication
for the performance of economics and thereby on
the exchange rate

21. The ‘news’ approach to modelling
exchange rates
• The basic tenet of the news approach is that if the foreign
exchange market is efficient then any difference between the
forward rate and the corresponding rate that later transpires
must in efficient market ( with no risk premium) be due to
then arrival of new information. A typical specification of a
‘news’ model of exchange rates is the following:
• The main problem for the news type models is obtaining a
proxy for the unexpected change in the fundamentals (right-
hand side of equation)

22. The ‘news’ approach to modelling
exchange rates(con’t)
• In a test of the news version of the real interest rate
differential model, Edwards(1982) runs the following
regression
• Where ft/t-1 is the one period ahead forward exchange
rate at time t-1, um is the log of unexpected change in
domestic money supply, uy is the unexpected increase in
domesitic income and ui is the enexpected change in
domestic real interest rate, an asterisk denotes the
corresponding unexpected change in the foreign variable.
Hypothesis in expected coefficient is a1=1; a2>0; a3<0;
a4<0

23. The ‘news’ approach to modelling
exchange rates(con’t)
• MacDonald found that monetary development are sometimes statistically
important but occasionally in the wrong sign This problem might have been caused
due to lag in publication of data required; whether using vintage or revise data;
and market conditions

24. The longer-run predictability of exchange rate
movements
• The basic approach taken by mark is to run
regression the following equation
• Mark’s study suggest that economic
fundamentals and the monetary model
contain significant information for the
determination of the long run exchange rate

25. The longer-run predictability of exchange rate
movements(con’t)

26. The longer-run predictability of exchange rate
movements(con’t)
• Further support for the monetary model as a long run description of the data is
provided by Groen(2000), using cross-sectional data, groen estimates if the
average rate change is related to the average differential money supply growth
rate and the average differential change in real income

27. The longer-run predictability of exchange rate
movements(con’t)
• In rapach and Wohar (2002) take a difference
approach to mark, a key test in the paper is as
follows

28. The longer-run predictability of exchange rate
movements(con’t)

29. Modelling exchange rate expectations
• Given the Importance of future expected ER for the
current ER, any satisfactory model of ER must model
ER expectations.
• There are a variety of alternative but plausible
methods of modelling expectation.
• There are six plausible theoretical methods for
modelling the expected future ER:

30. Modelling exchange rate expectations
• Static Expectations
• 𝐸𝑠𝑡+1/𝑡 = 𝑆𝑡
• Adaptive Expectations
• 𝐸𝑠𝑡+1𝑡 = 𝐸𝑠𝑡
𝑡
−1
0 < ∝ < 1
• Extrapolative Expectations
• 𝐸𝑠𝑡+1/𝑡 = 𝑆𝑡 + 𝑚 𝑆𝑡 − 𝑆𝑡−1
• 𝑚 > 0

31. Modelling exchange rate expectations
• Rational Expectations
• 𝐸𝑠𝑡+1/𝑡 = 𝑆𝑡+1 + 𝑢 𝑡+1
• Regressive Expectations
• 𝐸𝑠𝑡+1/𝑡 = 𝑎𝑠𝑡 + (1 − 𝑎)𝑠∗
• 0 < 𝑎 < 1
• Perfect Foresight
• 𝐸𝑠𝑡+1/𝑡 = 𝑆𝑡+1

32. Empirical test of different expectations
mechanisms
The Empirical evidence concerning which expectations
is very mixed. The most plausible story is that the
appropiate expectations mechanism is itself time-
variant, with market participants sometimes having
static expectations, sometimes extrapolative
expectations mechanism, while theoritically highly
plausible, seems to be far from the complete study.

33. Thanks for your attention