Exchange rates, interest rates, and prices using models of exchange rate determination
Learning outcomes covered
1. Critically discuss the relationship between exchange rates, interest rates, and prices using models of exchange rate determination.
2. Evaluate the determination of current account and international business co- movement.
3. Critically review the operation of the exchange rate systems.
4. Predict and critically assess the financial and macroeconomic impacts of exchange rate fluctuations and exchange rate policies.
Empirical Study:
You should submit your dataset and program with report for evaluation.
1. Test for Risk Premia in Foreign Exchange Markets:
FT.com (UK) reports spot and forward exchange rate of other currencies against Sterling. You can download these data from FT.com data archive: http://markets.ft.com/RESEARCH/Markets/Data-Archive.
Choose one out of 35 currencies (SDR not included) for your analysis.1 Use the data of last date for each month as monthly data, collect spot rate (denoted as St),1-month forward rate (denoted as Ft), and 3-month forward rate (denoted as F3) tfrom January 2000 to December 2013. Make use of the STATA programs on the blackboard to prepare answer for the following questions:
a) Produce a graph of the £/c exchange rate, where c denotes the currency you have chosen. Provide your comments on the graph. Any abnormal observations (outliers)? Double check with the FT.com data archive to make sure these abnormal observations are not due to the errors you made during the data collection process. If they are not error inputs, are there any unexpected events (news) associated with these observations?
b) Produce a graph for monthly forward discount (st -?ft ) and provide your comments, where st ??ln(St ) and ft ??ln(Ft ).
c) Produce a summary statistics table for the variables in your dataset.
d) Download STATA program ‘ex_risk_premia.do’ from blackboard. Modify the program to run the following regressions:
Test for the existence of a risk premium on the 1-month horizon by including the lagged forward discount as a regressor:
Test for the existence of a risk premium on the 3-month horizon by including the 3-month forward discount, lagged three months, as a regressor:
e) Interpret your regression results. Do you find evidence for the presence of risk premia in foreign exchange market? Provide your comments on uncovered interest rate parity (UIP) and covered interest rate parity (CIP) base on your regression results.
Marking scheme:
Your assessment will be marked on a continuous numerical scale which ranges from 0 to 100 and is expressed in percentage terms (%).
You will see below the division of the scale into the classifications used within the University of Lincoln together with an indication of the standard required to achieve each classification.
First Class: 70% – 100% (approx)
To attain this classification the assessed work must demonstrate a thorough and virtually error-free understanding of the topic of the assignment: there should be no major errors of principle. This would include a high degree of familiarity of appropriate literature that the student would have demonstrated by the use of theory and referencing. Referencing will also include examples drawn from current business practice where this is appropriate. A comprehensive and accurate bibliography is required.
Additionally, the work should exhibit evidence of original thinking that could consist of a critical examination of theory and/or practice and might result in the student suggesting original theoretical modifications or changes to practice. In any case, the work should adopt a critical or questioning tone.
It is expected that the work would be written in a fluent and persuasive manner and presented in a contemporary and professional fashion.
60% – 69%
Whilst exhibiting most of the characteristics of the First class work what distinguishes this work is its relative lack of originality. Although largely error-free, including no errors of principle, some small errors will be tolerated.
50% – 59%
Work falling into this classification should show an appreciation of the appropriate reading. It is usually prosaic in nature and does not aspire to creativity or originality. It may also contain a limited number of errors of principle. It will exhibit an accepting rather than a critical tone.
Fail: Below 50%
Such work fails to address and meet the requirements of the assignment. It is invariably poorly researched and will contain many errors of both types. The student will not have demonstrated a convincing grasp of the content of the assignment.
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