Currency Intervention. Manipulation

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Foreign Exchange Intervention

What is Foreign Exchange Intervention?
Definition and the Legal Status of Intervention
Foreign exchange intervention is defined generally as foreign exchange transactions
conducted by the monetary authorities with the aim of influencing exchange rates. It is the
process by which the monetary authorities attempt to influence market conditions and/or the
value of the home currency on the foreign exchange market. Intervention usually aims to
promote stability by countering disorderly markets, or in response to special circumstances.
In Japan, the Minister of Finance is legally authorized to conduct intervention as a means to
achieve foreign exchange rate stability. In the United States, the Government and Federal
Reserve Board (FRB); in Euro Area, the European Central Bank (ECB); in the United
Kingdom, the Bank of England (BOE) operates it.
General Ideas of Foreign Exchange Market
Foreign Exchange Market
To invest in other countries or to buy foreign products, firms and individuals may first need
to acquire the currency of the country with which they intend to deal with. In addition,
exporters may demand to be paid for their goods and services either in their own currency or
in U.S. dollars, which are accepted worldwide. The Foreign Exchange Market, or "Forex"
market, in which international currencies trades take place, is called foreign exchange
market.
Exchange Rate
Each country has a currency in which the prices of goods and services are quoted - the dollar
in the United States, the euro in Germany, the pound sterling in Britain, the yen in Japan, etc.
Exchange rates play a central role in international trade because they allow us to compare the
prices of goods and services produced in different countries.
A foreign exchange rate is the relative value between two currencies. In particular, it is the
quantity of one currency required to buy or sell one unit of the other currency. The exchange
rate can be quoted in 2 ways: as the price of the foreign currency in terms of home currency
(direct terms) or as the price of home currency in terms of foreign currency (indirect terms).
Three Exchange Rate Regimes
In theory, there are three exchange rate regimes, namely flexile, intermediate and fixed.
Under a flexible currency regime, the external value of a currency is determined more or less
by the force of market supply and demand. Because floating exchange rate permitting enough
flexibility to adjust fundamental disequilibria under international supervision, it can prevent
competitive depreciation. On the other hand, under a fixed exchange rate arrangement, the
monetary authority pegs the domestic currency to one or a basket of foreign currencies.
Exchange rates between currencies that are set at predetermined levels and do not move in
response to changes in supply and demand. The authority has to intervene in the foreign
exchange market whenever the prevailing rate deviates from the specific one. Immediate
exchange rate arrangement has a medium flexibility lying between flexible and fixed.
The arguments in favor of purely floating exchange rate regime:
1.
A simple laissez-faire view - exchange rate should be determined by private demand

and supply without government interference.
2. A parallel view - the exchange rate is easier to be adjusted to respond to the new
development of the economy than wages and prices, which are always assumed to
be sticky.
3. Policy independence - floating exchange rate is said to be able to equilibrate the
trade balance by altering the relative price of imports and exports, hence the amount
of imports and exports. So, the countries can pursue their internal economics goal
such as full employment, low inflation, independently.
The arguments in favor of purely fixed exchange rate:
1.
Certainty of exchange rate - the exchange rate volatility is low under the fixed
exchange rate regime. This reduces the investment risk resulted in larger imports,
exports, lending and borrowing. Thus, stable exchange rate promotes international
trade.
2. Nominal anchor - fixed exchange rate is an effective way of providing a nominal
anchor to monetary policy. Pegging the exchange rate will convince people that
inflation is unlikely. Lower inflation expectation yields a lower actual inflation rate.
Role of Central Bank Under Different Exchange Rate Regimes
Under a fixed exchange rate regime
For those countries with a fixed rate regime, operations in the foreign exchange market are
largely passive, with the central bank automatically clearing any excess demand or supply of
foreign currency to maintain a fixed exchange rate. When there is an increase in the demand
of foreign currency, central bank purchases the local currency against foreign currency.
When there is increase in the demand of foreign currency, central bank sells foreign currency
for local currency. Interest rates in the inter-bank market adjust to clear the market. Under
this system, both the stock and the flow of the monetary base must be fully backed by foreign
reserves. Hence, any change in the monetary base must be matched by a corresponding
change in reserves and the central bank is passive in intervening in the market.
Under a flexible exchange rate regime
Although central banks in countries adopt flexible exchange rate regimes, they have still
retained discretion to intervene in the foreign exchange market. Governments concern on FX
rates because changes in the rates affect the value of products and financial instruments. As a
result, unexpected or large changes can affect the health of nations' markets and financial
systems, as well as inflation and economic growth. For example, if the Japanese yen rises in
value compared with the dollar, U.S. exports become less expensive for the Japanese to buy;
that could lead to an increase in U.S. exports and a boost to U.S. employment. At the same
time, the lower value of the dollar compared with the yen could raise U.S. import prices and
act as an inflationary influence in the United States.
Why Central Banks Intervene in the Foreign Exchange Market?
Minimizing Overshooting Effect
The motivation for intervention decision has been widely researched and often discussed.
There is a general consensus that intervention may be warranted to stabilize the exchange rate
and provide liquidity to the market; and to correct an overshoot, in either direction, in the
exchange rate. Foreign exchange intervention is a tool used in the short-term to smooth the
transition in the exchange rate by minimizing overshooting when economic conditions are
changing or when the monetary authority believes that the market has misinterpreted
economic signals.
Reducing Exchange Rate Volatility
Limiting the volatility in the exchange rate may be important due to the adverse effects it can
have on sentiment both within financial markets and the economy. Especially, when the
management of the exchange rate is the major tool for implementing monetary policy,
excessive short-term volatility can erode the market's confidence in the regime.
Central bank wants to reduce the volatility because volatility may impede international
investment flows. By adding risk to the rate of return on a foreign asset, exchange rate
volatility may reduce investment in foreign financial assets. In addition, companies may be
reluctant to build a new plant or purchase a foreign company if exchange rate uncertainty
reduces the expected profits from such projects. As a result, exchange rate volatility creates a
disincentive for domestic investment and inefficient allocation of resources in the world
economy.
Another reason why authorities may want to reduce volatility is that it may adversely affect
international trade. Stable currency can facilitate international trade by reducing investment
risk. Because volatile exchange rates create uncertainty about the revenues to be earned on
international transactions, such volatility could force companies to add a risk premium to the
costs of goods they sell abroad. If these costs are passed on to consumers in the form of
higher prices, the demand for traded goods could decrease. In addition, firms themselves may
be more reluctant to engage in international trade if exchange rate volatility adds an extra risk
to their profits.
A final reason to reduce exchange rate volatility is that it could spill over into the financial
markets. If exchange rate volatility increases the risk of holding domestic assets, the prices of
these assets could also become more volatile. The increased volatility of financial markets
could threaten the stability of the financial system and make monetary policy goals more
difficult to attain.
Leaning-against-the-wind
Research and official pronouncements support the idea that monetary authorities with
floating exchange rates most often employ intervention to resist short-run trends in exchange
rates. The central bank intervenes the disorderly market to moderate the movements of the
exchange rate by providing support to either domestic or foreign currency. This kind of
intervening strategy is called "leaning-against-the-wind".
Correct Misalignment of Exchange Rate
Another motivation of is to correct medium-term "misalignments" of exchange rates away
from "fundamental" values. Where the exchange rate depart from fundamentals - such as
moving the inflation rate outside of a target range - it may be appropriate to intervene in the
market. The stabilizing role that a central bank can bring to the market may be sufficient to
alter investor sentiment and move the exchange rate back towards equilibrium.
Profitability of Intervention
There have been several empirical studies on the profitability of intervention for major
countries. One of the first was that published by Taylor (1982), which examined nine
industrial countries early in the floating period, from the early 1970s to the end of 1979.5
According to his estimates, central banks lost more than $US11 billion over the whole
period.
Several subsequent studies challenged Taylor's results, reworking his calculations using
several refinements. By lengthening the sample period and taking account of the interest
differential between investing in foreign currencies and the local currency, Argy (1982),
Jacobson (1983), and the Bank of England (1983) found that these large losses were in fact
profits. For the US, for instance, Jacobson estimated that total losses are around $US500
million for the 1973-79 period, but over the entire 1973-1981 period, net profits amounted to
almost $US300 million. Moreover, including a measure of net interest earnings increased
profits by up to $US470 million over the longer period.
The goal of foreign exchange intervention is to maintain orderly market conditions - to help
achieve macroeconomic goals like price stability or full employment. Therefore, profitability
of foreign exchange intervention is not a necessary condition for intervention.
Technical Trading Rule Profitability
A strong and consistent result in international finance is the evidence that technical trading
rules - rules that use the information on past price to determine trading decisions - can
generate persistent profits in dollar exchange rate markets.
Among the trading rules, moving average is the one that receives most attention. The rule
attempts to filter the data to discover trends in exchange rates. It is also called double
moving-average rules (MA rules). A double moving average prescribes buying an asset - e.g.
a foreign currency-denominated bank deposit - if a moving average of past exchange rates
over a short time window is greater than a moving average of past exchange rates over a
longer time window. Conversely, if the short moving average is less than the long moving
average, the rule instructs that the trader should sell the asset.
Evidence has accumulated in recent years that technical analysis can be useful in the foreign
exchange market (Sweeney (1986), Levich and Thomas (1993), Neely, Weller and Dittmar
(1997)). This finding has challenged the efficient markets hypothesis, which holds that
exchange rates reflect information to the point where the potential excess returns do not
exceed the transactions costs of acting (trading) on that information (Jensen (1978)).
Causes of Volatility
In the previous section, we mentioned that one of the objectives of foreign exchange
intervention is to smooth the exchange rate volatility. But what are the causes and
consequences of this volatility?
Exchange rate volatility is often attributed to three factors: volatility in market fundamentals,
changes in expectations due to new information, and speculative "bandwagons".
Volatility in Market Fundamentals
Volatility in market fundamentals, such as the money supply, income, and interest rates,
affects exchange rate volatility because the level of the exchange rate is a function of these
fundamentals. For example, large changes in the money supply can lead to changes in the
level of the exchange rate. Changes in the level of the exchange rate in turn imply exchange
rate volatility.
Changes in Expectations
Changes in expectations about future market fundamentals or economic policies also affect
exchange rate volatility. When market participants receive new information, they alter their
forecasts of future economic conditions and policies. Exchange rates based on these forecasts
will also change, thereby leading to exchange rate volatility. For example, news about a
change in monetary policy may cause market participants to revise their expectations of
future money supply growth and interest rates, which could alter the level and hence the
volatility of the exchange rate.
Degree of Confidence
In addition to being affected by expectations of future fundamentals and policies, volatility is
also affected by the degree of confidence with which these expectations are held. Exchange
rate volatility tends to rise with increases in market uncertainty about future economic
conditions and tends to fall when new information helps resolve market uncertainty.
Speculative Bandwagons
Finally, exchange rate volatility can be caused by speculative bandwagons, or speculative
exchange rate movements unrelated to current or expected market fundamentals. For
example, if enough speculators buy dollars because they believe the dollar will appreciate,
the dollar could appreciate regardless of fundamentals. If speculators then think that the
market fundamentals will not sustain, active selling by the same speculators could cause the
dollar to depreciate. Fluctuation in the value of the dollar arising from such speculative forces
will contribute to exchange rate volatility.
Types of Foreign Exchange Intervention
Entrustment Intervention
"Entrustment Intervention" means intervention that is conducted in overseas markets with
funds of local monetary authorities. It is different from the intervention that is conducted in
overseas markets with funds of respective foreign monetary authorities.
Reverse-Entrustment Intervention
Similarly, when foreign monetary authorities need to intervene in a country's foreign
exchange market, say Tokyo market, the central bank of Japan can conduct interventions on
their behalf upon request. This is called "Reverse-Entrustment Intervention"
Concerted or Coordinated Intervention

There are cases where two or more monetary authorities implement intervention jointly by
using their own funds at the same time or in succession. This is called "Concerted or
Coordinated Intervention." For instance, the Plaza Agreement in 1985 (a G5 meeting) and the
Louvre Accord in 1987 (a G7 meeting) were held for the discussion of multilateral
intervention to depreciate the overvalued US dollar and to restore equilibrium in current
account. These kinds of interventions are called concerted or coordinated intervention.
Sterilization and Non-sterilization

Studies of foreign exchange intervention generally distinguish between intervention that does
or does not change the monetary base. The former type is called non-sterilized intervention
while the latter is referred to as sterilized intervention. Central banks sometimes carry out
equal foreign and domestic assets transaction in opposite directions to nullify the impact of
their foreign exchange operations on the domestic money supply. When a monetary authority
buys (sells) foreign exchange, its own monetary base increases (decreases) by the amount of
the purchase (sale). In order to prevent the money stock from increasing (decreasing), the
monetary authorities can sterilize the effect of the exchange market intervention by selling
(buying) short-term domestic assets to (from) the banking system leaving the monetary base
of the country unchanged. Since sterilized intervention does not affect the money supply, it
does not affect prices or interest rate and so does not influence the exchange rate. Rather,
sterilized intervention might affect the foreign exchange market through two routes: the
portfolio-balance channel and the signaling channel.
According to the portfolio-balance channel, it is assumed that risk-averse wealth holders

diversify their portfolio across assets denominated in different currencies. Let's use the
United States and Japan as an example. The portfolio balance channel theory holds that
sterilized purchases of yen raise the dollar price of yen because investors must be
compensated with a higher expected return to hold the relatively more numerous U.S. bonds.
To produce a higher expected return, the yen price of the U.S. bonds must fall immediately.
That is, the dollar price of yen must rise.
In contrast, the signaling channel assumes that intervention affects exchange rates by
providing the market with new relevant information, under an implicit assumption that the
authorities have superior information to other market participants. The authorities are willing
to reveal this information through their actions in the foreign exchange market. Because
private agents may change their exchange rate expectation after intervention, the exchange
rate then will be expected to change immediately after the effect occurs.
Spot and Forward Markets for Intervention
There are two primary types of transactions in the FX (Foreign Exchange) market. An
agreement to buy or sell currency at the current exchange rate is known as a spot transaction.
By convention, spot transactions are settled two days later. In a forward transaction, traders
agree to buy and sell currencies for settlement at least three days later, at predetermined
exchange rates. The forward market transaction is often used by businesses to reduce their
exchange rate risk.
The previous example used in sterilization section is implicitly assumed that the Federal
Reserve Bank of New York conducted its purchase of yen in the spot market-the market for
delivery in two days or less. Other than intervention in spot market, it also may be carried out
in the forward market. Because the forward price is linked to the spot price through covered
interest parity, intervention in the forward market can influence the spot exchange rate.
Forward market interventions-the purchase or sale of foreign exchange for delivery at a
future date-have the advantage that they do not require immediate cash outlay. If a central
bank expects that the need for intervention will be short-lived and will be reversed, then a
forward market intervention may be conducted discreetly - with no observable effect on
foreign exchange reserves.
Both the spot and forward markets may be used simultaneously. A transaction in which a
currency is bought in the spot market and simultaneously sold in the forward market is
known as a currency swap. While a swap itself will have little effect on the exchange rate,
they can be used as part of an intervention. Some central banks used the swaps market to
sterilize spot interventions. In these transactions, the spot leg of the swap is conducted in the
opposite direction to the spot market intervention, leaving the sequence equivalent to a
forward market intervention.
The Options Market and Intervention
The options market has also been used by central banks for intervention. A European style
call (put) option confers the right, but not the obligation to purchase (sell) a given quantity of
the underlying asset on a given date. Usually, the option contract specifies the prices for
which the asset may be bought or sold, called the strike or exercise price. Monetary
authorities seeking to prevent depreciation or devaluation of their currency may sell put
options on the domestic currency or call options on the foreign currency.
Indirect Intervention
Recall that while official intervention is generally defined as foreign exchange transactions of
monetary authorities designed to influence exchange rates, it can also refer to other (indirect)
policies for that purpose. There are innumerable methods of indirectly influencing the
exchange. These methods involve capital controls (taxes or restrictions on international
transactions in assets like stocks or bonds) or exchange controls (the restriction of trade in
currencies)
Effectiveness of Central Bank Intervention

Most of the interventions were aiming at stabilizing the disorderly exchange rate market;
unfortunately, many studies revealed that intervention could not smooth the exchange rate
movement.
Intervention may Decrease Volatility
Central bank intervention may reduce exchange rate volatility if it resolves uncertainty by
market participants about future monetary policy. For example, if the market is uncertain
about the stance of monetary policy, then intervention to halt a drop in the dollar may signal
that the Federal Reserve is committed to a tight monetary policy. The resolution of
uncertainty about future monetary policy may then lead to less exchange rate volatility.
Central bank intervention may also reduce exchange rate volatility by reducing the likelihood
of a speculative bandwagon. Suppose the dollar exchange rate falls from
120/$ to 115/$. As speculators see the dollar falling, they may jump on the bandwagon
thinking the dollar may fall further to 110/$. Under this scenario, speculators who sell $1
million at 115/$ could make a profit if the dollar falls to
110/$ and they reacquired dollars at the lower value. However, if the central bank
intervenes at 115/$ and pushes the dollar back to 120/$, then speculators could suffer a
loss. Speculators may therefore become reluctant to push the dollar down too rapidly if they
believe the central bank will intervene to prevent the dollar from falling. By reducing selling
pressure when the dollar starts to fall, central bank intervention could reduce speculative
bandwagons and thereby reduce volatility.
Intervention may Increase Volatility
Central bank intervention could actually increase exchange rate volatility if intervention
increases private sector uncertainty about central bank policies. Suppose the central bank
surprises traders by intervening to increase the value of the dollar but announces neither the
intervention's magnitude nor its motivation. In making their trades, foreign exchange traders
have to guess the meaning of the intervention and attempt to infer the implications of the
action for future policy. Because their trades are based on incomplete information, traders
will need to revise their currency positions once more information about intervention policy
becomes available. These changes in currency positions imply changes in the exchange rate
and hence greater exchange rate volatility.
Market uncertainty about the likelihood of future central bank intervention could also lead to
greater exchange rate volatility. Because central banks do not announce their plans for
intervention, foreign exchange traders must base their currency positions on their best
guesses of whether and when central banks will intervene. These currency positions and
hence exchange rates will change over time as traders reassess the likelihood of central bank
intervention. Uncertainty over central bank intervention policy can contribute to exchange
rate volatility.
Central bank intervention can also increase exchange rate volatility by increasing the
likelihood of speculative bandwagons. For instance, intervention might increase volatility if
market participants think the central bank is unable or unwilling to prevent speculative forces
from pushing the exchange rate in a particular direction. Suppose the dollar exchange rate
falls from 120/$ to 115/$ and that speculators expect the dollar to fall further to 110/$.
As before, a speculator selling the dollar at 115/$ might expect to realize a profit if the
dollar falls to 110/$. The expected profit opportunity encourages other speculators to jump
on the bandwagon, thereby actually pushing down the dollar. Since the traders are uncertain
about the intervention policy. The uncertainty about intervention policy may encourage
speculation and cause price changes and exchange rate volatility to be higher than in the
absence of such intervention.
However, there is still much evidence that interventions are effective in stabilizing the market
and influencing the exchange rate if the interventions are:

1.
Large in amount - The larger the amount of interventions, the greater the possibility
of success.
2. Coordinated - Evidence suggests that coordinated intervention is more effective than
the individual intervention. It is because where the monetary authorities for both the
undervalued and overvalued currencies participate; the coordinated signals offered
by the intervention may view as more credible.
3. In series - spread out the intervention transaction over a number of days to maximize
the effects of intervention through the signaling channel. The intervention stance
may be perceived to be more credible to market participants if they see a series of
intervention transaction rather a one-off entry into market. Publicized - reported
interventions are the most effective central bank action because it is regarded as a
credible source of information about the future monetary policy while secret
interventions have little effect on exchange rate.
4. Publicized - reported interventions are the most effective central bank action
because it is regarded as a credible source of information about the future monetary
policy while secret interventions have little effect on exchange rate.
Draft Guidelines for Foreign Exchange Reserve Management
Although each country is free to manage its foreign reserve, management of foreign
exchange reserves is important because reserves are a key determinant of a country's ability
to avoid economic and financial crisis. Therefore, since 2000 the IMF - in collaboration with
the Bank for International Settlements (BIS), World Bank, and many member countries - has
been engaged in the development of a set of Draft Guidelines for Foreign Exchange Reserve
Management. For further information, we can approach to the IMF site
http://www.imf.org/external/np/mae/ferm/eng/
Keywords: Central Bank Intervention, Foreign exchange
intervention, Exchange Rate
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The Freezing of Assests Imposed by the Brazilian Central Bank in
Cases of Intervention and Extrajudicial Liquidation - Subjective Limits
URL: http://www.levysalomao.com.br/LRMar97b.htm
"The Freezing of Assests Imposed by the Brazilian Central Bank in
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tries to identify whether it is legal for the Brazilian Central Bank,
pursuant to Law n 6.024, dated March 13, 1974, to freeze the assets
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To Dollarize or not to Dollarize: Currency Choices for the Western
Hemisphere
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This paper was written by Roy Culpeper. The paper is divided into 4
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References
References related to Central Bank Intervention (8 references are shown.)
Intraday Technical Trading in the Foreign Exchange Market
Author: hristopher J. Neely and Paul A. Weller
Book:
Year: January 2001
It is provided by the Federal Reserve Bank of St. Lois. This paper
examines the out-of-sample performance of intraday technical trading
strategies selected using two methodologies, a genetic program and an
optimized linear forecasting model. When realistic transaction costs
and trading hours are taken into account, we find no evidence of
excess returns to the trading rules derived with either methodology.
Thus, our results are consistent with market efficiency. We do,
however, find that the trading rules discover some remarkably stable
patterns in the data.
Remarks: This paper is downloaded at:
http://www.stls.frb.org/docs/research/wp/99-016B.pdf
Technical Analysis and Central Bank Intervention
Author: Christopher Neely and Paul Weller
Book:
Year: Feburary 2000
This paper extends the genetic programming techniques developed in
Neely, Weller and Dittmar (1997) to provide some evidence that
information about U.S. foreign exchange intervention can improve
technical trading rules?profitability for two of four exchange rates over
part of the out-of-sample period. Rules tend to take positions contrary
to official intervention and are unusually profitable on days prior to
intervention, indicating that intervention is intended to check or
reverse predictable trends. Intervention seems to be more successful
in checking predictable trends in the out-of-sample (1981-1998) period
than in the in-sample (1975-1980) period. We conjecture that
instability in the intervention process prevents more consistent
improvement in the excess returns to rules. We find that the
improvement in performance results from more precise estimation of
the information in the past exchange rate series, rather than from
information about contemporaneous intervention.
Remarks: This paper is downloadable at:
http://www.stls.frb.org/docs/research/wp/97-002c.pdf
Foreign Exchange Market Trading Volume and Federal Reserve

Intervention
Author: Alain Chaboud, Federal Reserve, Board of Governors
Book:
Year: July 1999
The authors find a large positive correlation between daily trading
volume in currency futures markets and foreign exchange intervention
by the Federal Reserve over the period 1979-1996. Neither
contemporaneous nor predicted volatility can fully account for the
increases in trading activity. Whether or not the intervention operation
is publicly reported appears to be an important determinant of trading
volume.
http://www.unet.brandeis.edu/~blebaron/wps/volpap.pdf
Fed Intervention, Dollar Appreciation, and Systematic Risk
Author: Richard J. Sweeney
Book:
Year: August 2000
This paper is the first to investigate intervention effects in asset pricing
models that relate appreciation to risk-factor realizations. Fed foreigncurrency sales show economically and statistically significant
association with increases in beta risk in the dollar's appreciation rate
and thus with the dollar's ex ante appreciation rate. But interventions
ex post effects may be unreliable: they depend on the size of worldasset-market movements, and the size of interventions association
with beta varies importantly from year to year. Even successful
intervention to strengthen the dollar may be costly: By increasing the
dollars systematic risk, it makes U.S. investments less attractive
relative to foreign investments. Further, uncertainty about the timing
and size of Fed intervention makes it harder for investors to select
appropriate risk-adjusted discount rates and to forecast the dollar value
of cash flows, and thus may induce resource misallocation. This papers
results are consistent with both portfolio balance and signaling
channels.
Remarks: The full text is downloadable at:
http://www.msb.georgetown.edu/faculty/sweeneyr/wp/effects.new.inte
rvention.pdf
Does Central Bank Intervention Stabilize Foreign Exchange Rates?
Author: Catherine Bonser-Neal
Book: Federal Reserve Bank of Kansas City
Year:
This paper is written by Catherine Bonser-Neal. It's about the
exchange rate volatility, its causes and its consequence, how it
measures, how central bank intervention affects the volatility, etc.
Remarks: The paper is downloadable at:
http://www.kc.frb.org/publicat/econrev/pdf/1q96bons.pdf
The Market Microstructure of Central Bank Intervention
Author: Kathryn M. Dominguez
Book: NBER Working Paper Series No. 7337
Year: September 1999
One of the great unknowns in international finance is the process by
which new information influences exchange rate behavior. This paper

focuses on one important source of information to the foreign
exchange markets, the intervention operations of the G-3 central
banks. Previous studies using daily and weekly foreign exchange rate
data suggest that central bank intervention operations can influence
both the level and variance of exchange rates, but little is known about
how exactly traders learn of these operations and whether intra-daily
market conditions influence the effectiveness of central bank
interventions. This paper uses high-frequency data to examine the
relationship between the efficacy of intervention operations and the
"state of the market" at the moment that the operation is made public
to traders. The results indicate that some traders know that a central
bank is intervening at least one hour prior to the public release of the
information in newswire reports. Also, the evidence suggests that the
timing of intervention operations matter interventions that occur
during heavy trading volume and that are closely timed to scheduled
macro announcements are the most likely to have large effects. Finally,
post-intervention mean reversion in both exchange rate returns and
volatility indicate that dealer inventories are affected by market
reactions to intervention news.
http://papers.nber.org/papers/W7337.pdf
Further evidence on technical analysis and profitability of foreign
exchange intervention
Author: Simn Sosvilla-Rivero, Julin Andrada-Flix and Fernando
Fernndez-Rodrguez
Book:
Year: 1999
In this paper the authors present new evidence on the positive
correlation Between returns from technical trading rules and periods of
central bank intervention. To that end, they evaluate the profitability of
a trading strategy based on nearest-neighbour (nonlinear) predictors,
which may be viewed as a generalisation of graphical methods widely
used in financial markets. The authors use daily data on the US
Dollar/Deutsche mark and US Dollar/Japanese Yen covering the 1
February 1982-31 December 1996 period. The results suggest that the
exclusion of days of US intervention implies a substantial reduction in
all profitability indicators (net returns, ideal profit measure, Sharpe
ratio and directional forecast), being the reduction grater in the US
Dollar-Deustchmark case than in the US Dollar-Japanese yen case.
Remarks: The text is downloadable at:
ftp://ftp.fedea.es/pub/Papers/1999/DT99-01.pdf
Smoke and Mirrors in the Foreign Exchange Market
Author: Willem H. Buiter and Anne C. Sibert
Book:
Year:
The plight of manufacturing has focussed attention on the sterlings
persistent strength. The MPC recognises the problem, but argues there
is little it can do. It is mandated to pursue the governments inflation
target. Only subject to this target being met, can other objectives be
pursued. This leaves little scope for reining in the pound; the shortterm interest rate the MPC uses as its instrument cannot be used to
achieve both inflation and exchange rate goals. The authors claim that
there are additional monetary and financial policy tools available.

http://www.nber.org/~wbuiter/observer.pdf
References related to Foreign exchange intervention (26 references are shown.)

Does Foreign Exchange Intervention Work?
Author: Kathryn M. Dominguez and Jeffrey A. Frankel
Book: Book Title: Does Foreign Exchange Intervention Work?
Following the Versailles G-7 summit of 1982, most government officials
and academic analysts downplayed the potential impact of exchange
market intervention unless such intervention was permitted to affect
national monetary policies. This study challenges the conventional
wisdom. Using previously unavailable data on daily intervention by the
US Federal Reserve and the German Bundesbank, the authors find to
the contrary that even "sterilized" intervention can have an effect,
especially if it is known to the markets. Implications are drawn for
intervention policy and its role in the international coordination
process.
Remarks:
An Intraday Analysis of the Effectiveness of Foreign Exchange
Intervention
Author: Neil Beattie and Jean-Franois Fillion
Book:
Year: February 1999
This paper assesses the effectiveness of Canada's official foreign
exchange intervention in moderating intraday volatility of the
Can$/US$ exchange rate, using a 2-1/2-year sample of 10-minute
exchange rate data. The use of high frequency data (higher than daily
frequency) should help in assessing the impact of intervention since
the foreign exchange market is efficient and reacts rapidly to new
information. The estimated equations explain volatility in terms of four
major factors: intraday seasonal pattern; daily volatility persistence;
macroeconomic news announcements; and the impact of central bank
intervention. Rule-based (or expected) intervention apparently had no
direct impact on the reduction of foreign exchange volatility, although
the existence of a non-intervention band seemed to provide a small
stabilizing influence. This result is interpreted to mean that the
stabilizing effect of expected intervention came into play as the
Canadian dollar approached the upper or lower limits of the band.
When the dollar exceeded the band, actual intervention did not have
any direct impact because it was expected. Moreover, the results show
that discretionary (or unexpected) intervention might have been
effective in stabilizing the Canadian dollar, although the impact of an
intervention sequence diminished as it increased beyond a few days.
Remarks: The paper can be downloaded in PDF format at:
http://www.bankofcanada.ca/publications/working.papers/1999/wp994.pdf
Measuring the Profitability and Effectiveness of Foreign Exchange
Market Intervention: Some Canadian Evidence
Author: John Murray, Mark Zelmer, and Shane Williamson

Book: Technical Report No. 53
Year: March 1990
When the major industrial countries decided to move to a system of
managed flexible exchange rates following the collapse of the Bretton
Woods system, many observers thought that this would reduce, if not
eliminate, the need for official foreign exchange market intervention.
During the past fifteen years, however, intervention in most countries,
including Canada, has risen steadily in both frequency and intensity.
This paper presents new empirical evidence on the profitability and
effectiveness of Canadian intervention from 1975 to 1988. The results
suggest that the government's foreign exchange operations have been
very profitable and have tended to be stabilizing, in the sense that
authorities were typically pushing the exchange rate towards its longrun trend and helping to reduce short-run volatility in the market.
Remarks: We can order printed copies of this paper at no charge
from: Publications Distribution, Bank of Canada 234 Wellington Street,
Ottawa, Canada K1A 0G9 E-mail: publications@bank-banquecanada.ca Telephone: 613-782-8248 Fax: 613-782-8874
Official Intervention in the Foreign Exchange Market: Is It Effective,
and, If So, How Does It Work?
Author: Lucio Sarno and Mark P Taylor
Book:
Year: February 2001
This paper is provided by Centre for Economic Policy Research. In this
Paper we assess the progress made by the profession in understanding
whether and how exchange rate intervention works. To this end, we
review the theory and evidence on official intervention, concentrating
primarily on work published within the last decade or so. Our reading
of the recent literature leads us to conclude that, in contrast with the
profession's consensus view of the 1980s, official intervention can be
effective, especially through its role as a signal of policy intentions, and
especially when it is publicly announced and concerted. We also note,
however, an apparent empirical puzzle concerning the secrecy of much
intervention and suggest an additional way in which intervention may
be effective but which has so far received little attention in the
literature, namely through its role in remedying a coordination failure
in the foreign exchange market.
Remarks: The full text can be downloaded at
http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=2690
Foreign Exchange Intervention, Policy Objectives and Macroeconomic
Stability
Author: Paolo Vitale
Book:
Year: July 2001
Within a simple model of monetary policy for an open economy, it
studies how foreign exchange intervention may be used to condition
agents' beliefs of the objectives of the policymakers. Differently from
cheap talk foreign exchange intervention guarantees a unique
equilibrium. Foreign exchange intervention does not bring about a
systematic policy gain, such as an increase in employment or a
reduction in the inflationary bias. It can, however, stabilise the national
economy, for it drastically reduces the fluctuations of employment and

output. Foreign exchange intervention is profitable, but a trade-off
exists between these profits and the stability gain it brings about.
Finally, an important normative conclusion of our analysis is that
foreign exchange intervention and monetary policy should be kept
separated, in that a larger stability gain is obtained when these two
instruments of policy making are under the control of different
governmental agencies.
Remarks: The full text is downloadable at
http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=2886
The Practice of Central Bank Intervention: Looking Under the Hood
Author: Christopher J. Neely
Book:
Year: October 2000
This article first reviews methods of foreign exchange intervention and
such intervention. Types of intervention, instruments, timing, amounts,
motivation, secrecy and perceptions of efficacy are discussed.
Remarks: The paper can be downloaded at:
http://www.stls.frb.org/docs/research/wp/2000-028.pdf
The Temporal Pattern of Trading Rule Returns and Central Bank
Intervention: Intervention Does Not Generate Technical Trading Rule
Profits
Book:
Year: November 2000
It is provided by the Federal Reserve Bank of St. Louis. This paper
characterizes the temporal pattern of trading rule returns and official
intervention for Australian, German, Swiss and U.S. data to investigate
whether intervention generates technical trading rule profits. High
frequency data show that abnormally high trading rule returns precede
German, Swiss and U.S. intervention, disproving the hypothesis that
intervention generates inefficiencies from which technical rules profit.
Australian intervention precedes high trading rule returns, but
trading/intervention patterns make it implausible that intervention
actually generates those returns. Rather, intervention responds to
exchange rate trends from which trading rules have recently profited.
http://www.stls.frb.org/docs/research/wp/2000-018C.pdf
Book:
Year: January 2001

Is Technical Analysis in the Foreign Exchange Market Profitable? A
Genetic Programming Approach
Author: Christopher Neely, Paul Weller and Robert Dittmar
Book:
Year: August 1997
Using genetic programming techniques to find technical trading rules,
the authors find strong evidence of economically significant out-ofsample excess returns to those rules for each of six exchange rates
($/DM, $/, $/SF, $/, /DM, SF/), over the period 1981-1995.
Further, then the $/DM rules were allowed to determine trades in the
other markets, there was a significant improvement in performance in
all cases except for the /DM. Betas calculated for the returns
according to four international benchmark portfolios provide no
evidence that the returns to these rules are compensation for bearing
systematic risk. Bootstrapping results on the $/DM indicate that the
trading rules are detecting patterns in the data that are not captured
by standard statistical models.
Foreign Exchange Market Trading Volume and Federal Reserve
Intervention
Author: Alain Chaboud, Federal Reserve, Board of Governors
Book:
Year: July 1999
The authors find a large positive correlation between daily trading
volume in currency futures markets and foreign exchange intervention
by the Federal Reserve over the period 1979-1996. Neither
contemporaneous nor predicted volatility can fully account for the
increases in trading activity. Whether or not the intervention operation
is publicly reported appears to be an important determinant of trading
volume.
http://www.unet.brandeis.edu/~blebaron/wps/volpap.pdf
The Determinants of Foreign Exchange Intervention by Central
Banks: Evidence from Australia
Author: Suk-Joong Kim and Jeffrey Sheen
Book:
Year: December 1999
This paper is a working series of the University of New South Wales.
Intervention by the Reserve Bank of Australia on foreign exchange
markets from 1983 to 1997 is conjectured to have been determined by
exchange rate trend correction, exchange rate volatility smoothing and
profitability considerations. Using Probit and friction models, we show
that these factors were significant influences on intervention
behaviour. Consistent with the constraint of intervening only when a
clear trend is apparent, we find that above average measures of
deviations from trend and of volatility muted the response of the
Reserve Bank.

http://banking.web.unsw.edu.au/workpap/wp1_00.pdf
Are changes in foreign exchange reserves well correlated with official
intervention?
Book: Review - Federal Reserve Bank of St. Louis
Year: Sept/Oct 2000 Vol: Vol. 82, Iss. 5; pg. 17, 15 pgs
This review is writtne by Christopher J. Neely, a senior economist at
the Federal Reserve Bank of St. Louis. It's about why countries hold
international reserves, correlations between Central Bank intervention
and changes in reserves.
Remarks: This article is downloadable at:
http://www.stls.frb.org/docs/publications/review/00/09/0009cn.pdf
Why intervention rarely works?
Author: Owen F Humpage and William P Osterberg
Book: Federal Reserve Bank of Cleveland. Economic Commentary;
Cleveland;
Year: Feb 2000 Vol: pg. 1, 4 pgs
In the late 1980s, the US frequently intervened in the foreign-exchange
market. Unconvinced of the effectiveness of such operations and
worried about possible conflicts with monetary policy, the US curtailed
its interventions during the early part of the last decade. Calls for action
are being heard again, however. Most economists now regard foreignexchange-market intervention as generally ineffectual. Intervention
cannot systematically affect a nation's exchange rates when undertaken
independent of its monetary policy, and when undertaken as a goal of
monetary policy, exchange rate-management can compromise price
stability and create confusion about long-term policy objectives. Central
banks cannot regularly influence day-to-day exchange-rate movements
through sterilized intervention because they do not customarily possess
an information advantage over private-sector traders.
http://global.umi.com/pqdweb?Did=000000052108260&Fmt=4&Deli=1
&Mtd=1&Idx=45&Sid=1&RQT=309
Is intervention a signal of future monetary policy? Evidence from the
federal funds futures market
Author: Rasmus Fatum and Michael Hutchison;
Book: Journal of Money, Credit, and Banking; Columbus;
Year: Feb 1999 Vol: Vol. 31, Iss. 1; pg. 54, 16 pgs
Sterilized foreign exchange market intervention may affect the
exchange rate if it signals future monetary actions. Signaling will be
effective if the central bank backs up intervention with predictable
changes in the stance of monetary policy and, in turn, affects current
expectations. This paper investigates whether intervention operations in
the US are related to changes in expectations over the stance of future
monetary policy, where expectations are proxied by federal funds
futures rates. This relatively new futures market instrument has proved
to be an efficient and unbiased predictor of the future spot federal
funds rate. Estimates obtained from a GARCH time-series model over
the 1989-1993 period using daily data do not support the signaling
hypothesis.

&Mtd=1&Idx=77&Sid=1&RQT=309
On the effectiveness of sterilized foreign exchange intervention
Author: Rasmus Fatum
Book: ECB Working Paper No. 10
Year: February 2000
This paper addresses the question of whether sterilized Central Bank
intervention systematically affect exchange rates. Furthermore, the
paper analyze whether the central bank can conduct its intervention
operations in a specific manner, in order to increase the likelihood of
achieving its objectives.
Remarks:
Fed Intervention, Dollar Appreciation, and Systematic Risk
Author: Richard J. Sweeney
Book:
Year: August 2000
This paper is the first to investigate intervention effects in asset pricing
models that relate appreciation to risk-factor realizations. Fed foreigncurrency sales show economically and statistically significant
association with increases in beta risk in the dollar's appreciation rate
and thus with the dollar's ex ante appreciation rate. But interventions
ex post effects may be unreliable: they depend on the size of worldasset-market movements, and the size of interventions association
with beta varies importantly from year to year. Even successful
intervention to strengthen the dollar may be costly: By increasing the
dollars systematic risk, it makes U.S. investments less attractive
relative to foreign investments. Further, uncertainty about the timing
and size of Fed intervention makes it harder for investors to select
appropriate risk-adjusted discount rates and to forecast the dollar value
of cash flows, and thus may induce resource misallocation. This papers
results are consistent with both portfolio balance and signaling
channels.
http://www.msb.georgetown.edu/faculty/sweeneyr/wp/effects.new.inte
rvention.pdf
The Foreign-Exchange Costs of Central Bank Intervention: Evidence
from Sweden
Author: Boo Sj and Richard J. Sweeney
Book:
This study presents evidence on risk-adjusted profits for the Swedish
central bank. Estimated profits can be quite sensitive as to whether
rates of return are risk-adjusted or not, and how the risk-adjustment is
done. Various ways of adjusting for abnormal returns, and extracting
buy-sell signals, are tried. Results, on daily data, support the view that
Riksbank intervention did not make risk-adjusted losses over the
period 1986-1990. The results might be challenged as arising from
inappropriate risk adjustment.
http://www.msb.georgetown.edu/faculty/sweeneyr/wp/JIMFPA44.pdf
Is Sterilized Foreign Exchange Intervention Effective After All? An

Event Study Approach
Author: Rasmus Fatum and Michael Hutchison
Book:
Year: February 1999
Central banks actively engage in sterilized foreign exchange market
intervention despite numerous empirical studies indicating that these
operations do not systematically affect the exchange rate. Are these
policies misguided and central bankers irrational? Or is evidence
showing the effectiveness of sterilized intervention being overlooked?
This paper argues the latter, providing evidence on the effectiveness of
sterilized intervention using an event study approach linking
intervention with systematic exchange rate changes. We argue that
this is an important methodological innovation since studies using
time-series techniques are limited by the nature of the data: intense
and sporadic bursts of intervention activity juxtaposed against
exchange rates that change almost continuously on a daily basis. The
event study framework used in standard finance studies, by contrast, is
ideally suited to this circumstance. Focusing on daily US official
intervention operations, we identify separate intervention episodes
and analyze the subsequent effect on the exchange rate. Using the
matched-sample mean test and the nonparametric sign test of the
median, we find strong evidence that sterilized intervention
systemically affects the exchange rate. These results are especially
strong when episodes are distinguished by the intervention currency,
the form of intervention (sales or purchases of foreign exchange), and
exchange rate developments immediately prior to the intervention
activity.
Remarks: The paper can be downloaded from:
http://www.econ.ku.dk/epru/files/wp/wp9909.pdf
Foreign Exchange Intervention for Internal Balance
Author: Kyung Soo Kim
Book: International Economic Journal
Year: 2000 Vol: Volume 14, Number 4, Winter 2000
This paper is concerned with the optimal combination of sterilization
and wage indexation in a small open economy subject to various
disturbances. In most cases the effects of these policy instruments are
interdependent such that they act like a single instrument. At the
optimum, in addition to the well-known substitutability of foreign
exchange intervention and wage indexation, the complementarity of
foreign exchange intervention and sterilization is obtained. The
relationship between the degree of capital mobility and the optimal
combination of the policy instruments is also examined.
http://gias.snu.ac.kr/wthong/IEJ/00winter/00-W3.PDF
Sterilized Central Bank Intervention in the Foreign Exchange Market
Author: Paolo Vitale
Book:
Year: Feb 1997
In this paper we study the signalling role of sterilised central bank
intervention. Through a market micro-structure framework, we show
that in some circumstances sterilised intervention may represent an

independent tool of policy and an instrument to influence exchange
rates. Central bank intervention in the foreign exchange market also
has important effects on the efficiency and liquidity of the market, the
volume of trading and the conditional volatility of the exchange rate.
Our results also question the general opinion that visible intervention
should be preferred to secret one.
http://fmg.lse.ac.uk/download/fmgdps/dp0259.pdf
Treasury and Federal Reserve Foreign Exchange Operations
Author: Kos,-Dino and Schwarz,-Krista
Book: Federal-Reserve-Bulletin
Year: June 2001 Vol: 87(6), pages 394-99.
During the first quarter of 2001, the dollar appreciated 7.3 percent
against the euro and 10.3 percent against the yen in an atmosphere of
increased market uncertainty about the extent and duration of global
economic slowing. On a trade-weighted basis, the dollar ended the
quarter 7.4 percent stronger against an index of major currencies. The
U.S. monetary authorities did not intervene in the foreign exchange
markets during the quarter.
http://www.federalreserve.gov/pubs/bulletin/2001/0601forex.pdf
The Rise and Fall of Foreign Exchange Market Intervention as a Policy
Tool
Author: Schwartz,-Anna-J.
Book: Journal-of-Financial-Services-Research
Year: December 2000 Vol: 18(2-3), December 2000, pages 319-39..
The premise of the paper is that the fervor for foreign exchange
market intervention by U.S., and European monetary authorities has
ebbed in recent years. A pattern of initial belief in the effectiveness of
foreign exchange market intervention has recently been eroded, as is
revealed by the absence of intervention in circumstances that in earlier
times would have invoked it. Only the Bank of Japan among central
banks of the developed world has not thus far abandoned its faith that
intervention can change the relative value of the yen as determined by
market forces to conform with its notion of what that value should be.
To explain why U.S. and European monetary authorities no longer
believe that intervention is a tool that works, the author reviews the
equivocal record of past episodes, the inconclusive results of empirical
research, and the problems of implementation that intervention
advocates ignore.
Remarks:
Government Intervention and Adverse Selection Costs in Foreign
Exchange Markets
Author: Naranjo, Andy and Nimalendran, M.
Book: Review-of-Financial-Studies; 13(2), Summer 2000, pages 45377.
Year: Summer 2000
An important group of traders in the foreign exchange market is
governments who often adhere to a foreign exchange rate policy of
occasional interventions with otherwise floating rates. In this article we
provide a theoretical model and empirical evidence that government

foreign exchange interventions create significant adverse selection
problems for dealers. In particular, our model shows that the adverse
selection component of the foreign exchange spread is positively
related to the variance of unexpected intervention and that expected
intervention has no impact on the spread. After controlling for
inventory and order processing costs, we find that bid-ask spreads
increase with U.S. dollar and German deutsche mark foreign exchange
rate intervention during the period 1976-94. Furthermore, when the
intervention is decomposed into expected and unexpected components,
we find a statistically and economically significant increase in spreads
with the variance of unexpected intervention, while expected
intervention has no significant impact on spreads.
Remarks: The text is found in EconLit. It can be found after clicking
'check for CUHK holdings'
Book:
Year:
iMarket Microstructure Effects of Government Intervention n the
Foreign Exchange Market
Author: Peter Bossaerts and Pierre Hillion
Book: Review of Financial Studies
Year: 1991 Vol: vol. 4, issue 3, pages 513-41
An asymmetric information model of the bid-ask spread is developed
for a foreign exchange market subject to occasional government
interventions. Traditional tests of the unbiasedness of the forward rate
as a predictor of the future spot rate are shown to be inconsistent
when the rates are measured as the average of their respective bid
and ask quotes. Larger bid-ask spreads on Fridays are documented.
Reliable evidence of asymmetric bid-ask spreads for all days of the
week, albeit more pronounced on Fridays, are presented. The null
hypothesis that the forward rate is an unbiased predictor of the future
spot rate continues to be rejected. The regression slope coefficients
increase toward unity, however, indicating a less variable risk
premium. Article published by Oxford University Press on behalf of the
Society for Financial Studies in its journal, The Review of Financial
Studies.
Remarks: Order is required.
Should the European Central Bank Intervene in the Foreign Exchange
Market?
Author: Prof. Dr. Sylvester C.W. Eijffinger (CentER, Tilburg University

and CEPR)
Book:
Year: November 2000
After the co-ordinated intervention of the G7 countries on 22
September 2000, the European (System of) Central Bank(s) decided to
intervene unilaterally in the foreign exchange markets on 3 and 6
November 2000. The European Central Bank intervened in the foreign
exchange market owing to its concern about the global and domestic
repercussions of the exchange rate of the euro, including its impact on
price stability The European Central Bank confirmed then its view that
the external value of the euro did not reflect the favourable conditions
of the euro area. The consequences of these foreign exchange
interventions were negligible for the euro-dollar exchange rate. One
could ask the question: should the European Central Bank intervene in
the foreign exchange market, in particular on its own? In other words,
what is the effectiveness of co-ordinated and unilateral foreign
exchange intervention by a central bank? In order to answer this
question, the authors have to analyse the various transmission
channels of foreign exchange intervention both in theory and practice.
Remarks: The paper in pdf format is downloadable at:
http://www.europarl.eu.int/comparl/econ/pdf/emu/speeches/20001123
/eijfinger/default_en.pdf
References related to Exchange Rate (51 references are shown.)

China's exchange rate policy
Author: Xu, Yingfeng
Book: China Economic Review
Year: 2000 Vol: Vol. 11
Should or will the yuan depreciate? This is an important question
widely speculated in world financial markets and intensively debated in
China in the wake of the East Asian financial crisis in 1997. The present
paper examines in detail the fundamentals that determine the
exchange rate in China and concludes with two important findings. One
is that the past two decades of economic reform has made domestic
prices in China sufficiently market-determined and linked to world
prices so that the exchange rate can serve as an effective nominal
anchor. Exchange rate stability leads to domestic price stability. The
other result is that because of the flexibility of domestic prices, a
change in the exchange rate has only a modest and ephemeral effect
on the terms of trade and trade flows. Therefore, exchange rate
flexibility is not essential to keep the current account in balance. Such
evidence suggests that China should continue the policy to maintain
exchange rate stability, as it has done since 1994.
Remarks:
Fear of Floating
Author: Guillermo A. Calvo University of Maryland and NBER Carmen
M. Reinhart* University of Maryland and NBER
Book:
Year: September 25, 2000 Vol: 63 pages
In recent years, many countries have suffered severe financial crises,
producing a staggering toll on their economies, particularly in emerging

markets. One view blames fixed exchange rates-- "soft pegs"--for
these meltdowns. Adherents to that view advise countries to allow their
currency to float. They analyze the behavior of exchange rates,
reserves, the monetary aggregates, interest rates, and commodity
prices across 154 exchange rate arrangements to assess whether
"official labels" provide an adequate representation of actual country
practice. We find that, countries that say they allow their exchange
rate to float mostly do not--there seems to be an epidemic case of
"fear of floating". Since countries that are classified as having a free or
a managed float mostly resemble noncredible pegs--the so-called
"demise of fixed exchange rates" is a myth--the fear of floating is
pervasive, even among some of the developed countries. They present
an analytical framework that helps to understand why there is fear of
floating.
Remarks: Paper can be downloaded in
http://www.bsos.umd.edu/econ/ciecrp11.pdf
Fixed vs. Flexible Exchange Rates. Preliminaries of a Turn-ofMillennium Rematch
Author: Guillermo A. Calvo - University of Maryland
Book:
Year: May 16, 1999 Vol: 17 pages
This note examines the pros and cons of flexible and fixed exchange
rates in terms of a bear-bones model which, however, takes into
account features that have played a prominent role in recent currency
crises, namely, volatility of capital flows and the real exchange rate,
currency substitution and financial fragility, and the Credit Channel.
Remarks: The paper is downloadable at
http://www.bsos.umd.edu/econ/ciecrp10.pdf
Exchange Rate Regimes and Institutional Arrangements in the Shadow
of Capital Flows
Author: Dani Rodrik
Book:
Year: Sep 2000 Vol: 20 Pages
This paper has been prepared for a conference on Central Banking and
Sustainable Development, held in Kuala Lumpur, Malaysia, August, 2830, 2000, in honor of Tun Ismail Mohamed Ali. It talks about the Choice
of exchange rate regimes. The conventional wisdom today is that
countries need to choose between two corners: either floating
exchange rates or irrevocably fixed rates. The reason is the potential of
capital flows to wreak havoc with any intermediate regime (soft
pegs). So much of the debate on exchange rate policy focuses on the
pros and cons of currency boards/dollarization versus floats. The
trouble with this debate is that the evidence shows clearly that neither
corner works very well for developing countries for long periods of
time. Countries that have done well in the postwar period in terms of
economic performance have in almost all cases had intermediate
exchange rate regimes. Then he discussed 1) Why floating is not a
solution; 2) Why currency boards or dollarization are not a solution
Remarks: This paper can be downloaded in
http://ksghome.harvard.edu/~.drodrik.academic.ksg/Malaysia%20conf
erence%20paper.PDF
International Financial Crises and Flexible Exchange Rates: Some

Policy Lessons from Canada
Author: John Murray, Mark Zelmer and Zahir Antia
Book: Technical Report
Year: April 2000 Vol: No. 88
This paper examines the behaviour of the Canadian dollar from 1997 to
1999 to see if there is any evidence of excess volatility or significant
overshooting. A small econometric model of the exchange rate, based
on market fundamentals, is presented and used to make tentative
judgments about the extent to which the currency might have been
systematically over- or undervalued. Three major conclusions emerge
from the analysis. First, movements in world commodity prices and
Canada-U.S. interest rate differentials can account for most of the
observed variation in the value of the Canadian dollar. Any deviations
that were recorded between actual and predicted values of the
exchange rate were generally small and short-lived, suggesting that
destabilizing speculative behaviour did not play a very important role in
recent market developments. Second, while it is possible to explain
most of the past movements in the Canadian dollar using a simple
exchange rate equation, its ability to predict future movements in the
exchange rate is limited due to the inherent instability of the
fundamental variables guiding its behaviour. Exchange rate
predictions, in short, are only as accurate as the forecasts of future
commodity prices and interest rates. Third, it appears that periods of
market turbulence are often dominated by fundamentalists as opposed
to noise traders and are triggered typically by large external shocks.
Monetary authorities should therefore be wary of resisting any
movements in the exchange rate, since they are often part of a
necessary and unavoidable adjustment process. Aggressive foreign
exchange market intervention and other monetary policy actions
designed to stabilize the exchange rate could easily prove
counterproductive and subvert market efficiency.
Remarks: This paper is accessible at:
http://www.bankofcanada.ca/en/res/tr88-e.htm
The "Exchange Risk Premium," Uncovered Interest Parity, and the
Treatment of Exchange Rates in Multicountry Macroeconomic Models
Author: Ralph C. Bryant, Senior Fellow, Economic Studies
Book: Brookings Discussion Papers in International Economics
Year: 1995
The literature on exchange markets conventionally defines the gap
between the forward exchange rate and the expected future spot
exchange rate as an "exchange risk premium." Part I of this paper
skeptically reviews existing interpretations of the exchange risk
premium and then presents an alternative conceptual framework. Part
II revisits the issue of how to model the determination of exchange
rates in empirical macroeconomic models, focusing on the typical use
of the uncovered interest parity condition combined with the
assumption of model-consistent expectations. The paper discusses why
this treatment of exchange rates is inadequate and makes some
suggestions for future research. Part III of the paper replicates some
"standard" regressions, widely reported in the empirical literature,
thought to have a bearing on whether the forward exchange rate is an
unbiased predictor of the future spot rate, whether survey expectations
produce unbiased predictions of actual changes in exchange rates, and

whether a bias in the forward rate can be attributed to a time-varying
risk premium. If the perspective in this paper is accepted, the
conventional statistical literature has devoted excessive resources to
estimation of these standard but not particularly revealing regressions.
All three parts of this paper make use of empirical data on exchange
rate expectations collected since 1985 by the Japan Center for
International Finance.
Remarks: The full version of the paper in PDF format can be
downloaded at: http://www.brook.edu/views/papers/bryant/111.htm
Currency crises and fixed exchange rates in the 1990s: A review
Author: Patrick Osakwe and Lawrence Schembri
Book: Bank of Canada Review article
Year: Autumn 1998
Currency crises in the 1990s, especially those in emerging markets,
have sharply disrupted economic activity, affecting not only the
country experiencing the crisis, but also those with trade, investment,
and geographic links. The authors review the theoretical literature and
empirical evidence regarding these crises. They conclude that their
primary cause is a fixed nominal exchange rate combined with
macroeconomic imbalances, such as current account or fiscal deficits,
that the market perceives as unsustainable at the prevailing real
exchange rate. They also conclude that currency crises can be
prevented through the adoption of sound monetary and fiscal policies,
effective regulation and supervision of the financial sector, and a more
flexible nominal exchange rate.
http://www.bankofcanada.ca/en/res/r984b-ea.htm
International price comparisons based on purchasing power parity
Author: Michelle A. Vachris - Associate professor of economics at
Christopher Newport University James Thomas - enior economist,
Office of Prices and Living Conditions, Bureau of Labor Statistics
Book: Montly Labor Review Online
Year: October 1999 Vol: October 1999, Vol. 122, No. 10
Because exchange rate movements, in general, tend to be more
volatile than changes in national price levels, the purchasing power
parity approach provides the proper basis for comparing living
standards and examining productivity levels over time.
Remarks: The full document can be downloaded at:
http://stats.bls.gov/opub/mlr/1999/10/art1abs.htm
The Failure of Uncovered Interest Parity: Is It Near-Rationality in the
Foreign Exchange Market?
Author: David Gruen, Gordon Menzies
Book: Publication of Reserve Bank of Australia
Year: May 1991
A risk-averse US investor adjusts the shares of a portfolio of shortterm nominal domestic and foreign assets to maximise expected utility.
The optimal strategy is to respond immediately to all new information
which arrives weekly. They calculate the expected utility foregone
when the investor abandons the optimal strategy and instead optimises
less frequently. They also consider the cases where the investor
ignores the covariance between returns sourced in different countries,

and where the investor makes unsystematic mistakes when forming
expectations of exchange rate change. They demonstrate that the
expected utility cost of sub-optimal behaviour is generally very small.
Thus, for example, if investors adjust portfolio shares every three
months, they incur an average expected utility loss equivalent to about
0.16 per cent p.a.. It is therefore plausible that slight opportunity costs
of frequent optimisation may outweigh the benefits. This result may
help explain the failure of uncovered interest parity.
Remarks: An electronic version of this paper is not available. If you
want to the printed copy of the paper, you can simply follow the
instruction in this site:
http://www.rba.gov.au/PublicationsAndResearch/RDP/RDP9103.html
Long-Horizon Uncovered Interest Rate Parity
Author: Guy Meredith, Menzie D. Chinn
Book: NBER Working Paper
Year: November 1998 Vol: No. W6797
Uncovered interest parity (UIP) has been almost universally rejected in
studies of exchange rate movements, although there is little consensus
on why it fails. In contrast to previous studies, which have used
relatively short-horizon data, we test UIP using interest rates on
longer-maturity bonds for the G-7 countries. These long-horizon
regressions yield much more support for UIP -- all the coefficients on
interest differentials are of the correct sign, and almost all are closer to
the UIP value of unity than to the zero coefficient implied by the
random walk hypothesis. We then use a small macroeconomic model to
explain the differences between the short- and long-horizon results.
Regressions run on data generated by stochastic simulations replicate
the important regularities in the actual data, including the sharp
differences between short- and long-horizon parameters. In the short
run from risk premium shocks in the face of endogenous monetary
policy. In the long run, in contrast, exchange rate movements are
driven by the "fundamentals," leading to a relationship between
interest rates and exchange rates that is more consistent with UIP.
downloaded at: http://papers.nber.org/papers/W6797
Purchasing Power Parity and Interest Parity in the Laboratory
Author: Eric ON. Fisher, Department Of Economics, The Ohio State
University
Book:
Year: 10 April 2001
This paper analyzes purchasing power parity and uncovered interest
parity in the laboratory. It finds strong evidence that purchasing power
parity, covered interest parity, and uncovered interest parity hold.
Subjects are endowed with an intrinsically useless (green) currency
that can be used to purchase another useless (red) currency. Green
goods can be bought only with green currency, and red goods can be
bought only with red currency. The foreign exchange markets are
organized as call markets. In the treatment analyzing purchasing
power parity, the price of the red good varies. In a second treatment,
the interest rate on red currency varies. In a third treatment, the
interest rate on red currency varies, and the price of the red good is
random. The paper is 35-page long and can be downloaded at:
http://econ.ohio-state.edu/efisher/pppuip.pdf
Remarks:
Haircuts or Hysteresis? Sources of Movements in Real Exchange
Rates
Author: Rogers,John H.; Jenkins, Michael
Book: Journal of International Economics
Year: 1995 Vol: 38(3-4), pages 339-60.
The authors empirically assess the importance of two sources of real
exchange rate movements. In models where purchasing power parity
holds only among traded goods, real exchange rate variation results
from relative price movements within countries. An alternative
explanation relies on hysteretic price-setting and nominal exchange
rate changes. Using disaggregated price data from eleven OECD
nations, the authors find some support for the nontraded goods
models. For example, prices of haircuts in Canada and the United
States are related in the long run. The authors find stronger evidence
to support models that emphasize sticky prices, transportation costs,
or other impediments to frictionless trade.
Remarks:
Risk, Policy Rules, and Noise: Rethinking Deviations from Uncovered
Interest Parity
Author: Nelson Mark, Ohio State University Yangru Wu, West Virginia
University
Book:
Year:
This paper attempts to understand why the forward premium helps to
predict the future change in the exchange rate, but with the wrong
(negative) sign. A corollary to the negative forward premium bias is
that the rational deviation from uncovered interest parity (DUIP) is
negatively correlated with the rationally expected rate of depreciation.
These facts have long posed a challenge to international economic
theory. In this paper, they explore three approaches to explain these
puzzles: (i)the standard representative-agent asset pricing model, (ii)a
monetary-policy rule model with exchange-rate feedback, and (iii)a
model of noise trading. They begin by presenting some stylized facts
that characterize the problem. They obtain implied values of the
rational DUIP and the rationally expected depreciation from a vector
error correction model (VECM) for log spot and forward exchange rates
and demonstrate the credibility of the estimates of these unobserved
series by showing that they match a number key sample moments.
With these credible estimates of the rational DUIP in hand, They then
ask if they behave like risk premia implied by the standard
representative agent asset pricing approach. The answer to this
question is no. The risk premium is a conditional covariance between
the intertemporal marginal rate of substitution of money and the
payoff from forward currency speculation. Since the rational DUIP
fluctuates between positive and negative values, according to the risk
premium hypothesis, this conditional covariance must also. Our
empirical analysis shows, however, that required conditional
correlations required by the theory are largely absent from the data.
Next, they re-examine a recent contribution by McCallum~(1994), who
develops a non-risk interpretation of the rational DUIP. There,
monetary policy involves the setting of the interest differential
according to a rule that partially offsets the contemporaneous

depreciation of the domestic currency. The feedback of the
contemporaneous depreciation to the interest differential induces an
error in the variables problem in the regression of the future
depreciation on the forward premium and perfectly negatively
correlated rational DUIPs and rationally expected depreciations. The
error in the variables problem is the source of the forward premium
bias in this model. Their investigation of McCallum's model uncovers
suggests two reasons to apply his results with caution. First, they
report econometric estimates of the policy rule parameters which have
the wrong sign required to explain the forward premium bias. The
second reason is that the results are not robust to a reasonable
reformulation of the policy rule. In the original formulation, the interest
rate differential depends on the contemporaneous rate of depreciation.
A trading sequence that rationalizes this rule is that the foreign
exchange market closes before the monetary policy authorities
determine the current period interest differential. But an alternative
and equally plausible sequence is to have the authorities determine the
interest differential prior to the opening of the foreign exchange
market. Under the alternative sequence, the interest rate rule depends
on the lagged depreciation and the forward premium bias vanishes.
The third approach that they explore is the Delong et. al. noise trader
model. This model combines rational investors with noise traders who
hold distorted beliefs concerning future currency returns. They model
this distortion in beliefs in a particular way by building in Frankel and
Froot's (1989) finding that foreign exchange traders place excessive
weight on the forward premium in forming their expectations of the
future depreciation. Their model of noise-trader beliefs also induces an
error in the variables problem into the forward premium regression
which forms the basis of the noise trader model's explanation of the
forward premium bias. Trading volume is induced entirely by the
presence of noise traders and the rational DUIP is not compensation for
risk. In addition to the forward premium bias, the noise-trader model
provides an explanation for the apparent short-term overreaction of
exchange rate changes and the gradual adjustment towards its
(economic) fundamental value in the long run that has been
documented in recent empirical work.
Remarks: The paper is not available in the Internet, JEL classification
is available -- F31, F47
Co-Movements in Long-Term Interest Rates and the Role of PPPBased Exchange Rate Expectations
Author: Jan Marc Berk and Klaas H.W. Knot
Book:
Year: April 1999
They investigate international co-movements in bond yields by testing
for uncovered interest parity. They supplement existing work by
focussing on long instead of short-term interest rates, and, related to
that, by employing exchange rate expectations derived from
purchasing power parity instead of actual outcomes. For the major
floating currencies over the period 1975-97, they cannot support the
notion of further increases in co-movement beyond that associated
with the wave of financial market liberalization and deregulation in the
early 1980s. Given the similarity between PPP-based UIP tests and
those employing actual exchange rate outcomes, the value added of
the former mainly lies with their ready availability.

Remarks:
Testing Uncovered Interest Parity at Short and Long Horizons
Author: Menzie Chinn, University of California Guy Meredith, IMF and
HKMA
Book:
Year: July 11, 2000
The unbiasedness hypothesis -- the joint hypothesis of uncovered
interest parity (UIP) and rational expectations -- has been almost
universally rejected in studies of exchange rate movements. In
contrast to previous studies, which have used short-horizon data, we
test this hypothesis using interest rates on longer-maturity bonds for
the G-7 countries. The results of these long-horizon regressions are
much more positive the coefficients on interest differentials are of
the correct sign, and almost all are closer to the predicted value of
unity than to zero. These results are robust changes in data type and
to base currency (i.e., Deutschemark versus US dollar). We appeal to
an econometric interpretation of the results, which focuses on the
presence of simultaneity in a cointegration framework.
Remarks: The full version of the paper can be download at:
http://econ.ucsc.edu/faculty/chinn/UIP_empr.pdf
"Purchasing Power Parity and Interest Parity in the Laboratory"
Author: Eric ON. Fisher, Department Of Economics, The Ohio State
University
Book:
Year: 10 April 2001
This paper analyzes purchasing power parity and uncovered interest
parity in the laboratory. It finds strong evidence that purchasing power
parity, covered interest parity, and uncovered interest parity hold.
Subjects are endowed with an intrinsically useless (green) currency
that can be used to purchase another useless (red) currency. Green
goods can be bought only with green currency, and red goods can be
bought only with red currency. The foreign exchange markets are
organized as call markets. In the treatment analyzing purchasing
power parity, the price of the red good varies. In a second treatment,
the interest rate on red currency varies. In a third treatment, the
interest rate on red currency varies, and the price of the red good is
random.
Remarks: The full version of the paper can be downloaded at:
http://economics.sbs.ohio-state.edu/efisher/pppuip.pdf
Nonlinear dynamics and covered interest rate parity
Author: Nathan S. Balke
Book: Empirical Economics
Year: 1998 Vol: Pages: 535-559 Volume: 23 Issue: 4
This paper examines the dynamics of deviations from covered interest
parity using daily data on the UK/US spot, forward exchange rates and
interest rates over the period January 1974 to September 1993. Like
other studies we find a substantial number of instances during the
sample in which the covered interest parity condition exceeds the
transaction costs band, implying arbitrage profit opportunities. While
most of these implied profit opportunities are relatively small, there is
also evidence of some very large deviations from covered interest

parity in the sample. In order to examine the persistence of these
deviations, we estimated a threshold autoregression in which the
dynamics behavior of deviations from covered interest parity is
different outside the transaction costs band than inside them. We find
that while the impulse response functions when inside the transaction
costs band are nearly symmetric, those for the outside the bands are
asymmetric-suggesting less persistence outside of the transaction costs
band than inside the band.
downloaded at:
http://netec.mcc.ac.uk/WoPEc/data/Articles/sprempecov:23:y:1998:i:
4:p:535-559.html
A Century of Purchasing-Power Parity
Author: Alan M. Taylor
Year: November 2000 Vol: No. W8012
This paper investigates purchasing-power parity (PPP) since the late
nineteenth century. I collected data for a group of twenty countries
over one hundred years, a larger historical panel of annual data than
has ever been studied before. The evidence for long-run PPP is
favorable using recent multivariate and univariate tests of higher
power. Residual variance analysis shows that episodes of floating
exchange rates have generally been associated with larger deviations
from PPP, as expected; this result is not attributable to significantly
greater persistence (longer halflives) of deviations in such regimes, but
is due to the larger shocks to the real-exchange rate process in such
episodes. In the course of the twentieth century there was relatively
little change in the capacity of international market integration to
smooth out real exchange rate shocks. Instead, changes in the size of
shocks depended on the political economy of monetary and exchangerate regime choice under the constraints imposed by the trilemma.
Remarks: This paper is available in PDF (527 K) format and can be
downloaded at http://papers.nber.org/papers/W8012
An Empirical Test of Purchasing Power Parity in Selected African
Countries - a Panel Data Approach
Author: Beatrice Kalinda Mkenda
Book: Scandinavian Working papers in Economics
Year: April 30, 2001 Vol: No 39
The paper tests whether the theory of Purchasing Power Parity holds in
a selected sample of twenty African countries. The paper employs a
panel unit root test to test whether the real exchange rates in the
panel are mean reverting or not. The test employed is the Im et al
(1997) test. Results show that the null of a unit root is rejected for the
three real exchange rate indices, namely, the import-based and tradeweighted multilateral indices, and the bilateral indices, while for the
export-based indices, the null hypothesis is not rejected. That is,
Purchasing Power Parity is confirmed for the import-based and tradeweighted multilateral indices, and the bilateral indices, while it is
rejected for the export-based multilateral indices. After performing the
demeaning adjustment to account for cross-sectional dependence, our
results show that the null hypothesis of a unit root is rejected for the
import-based multilateral indices and the bilateral indices, while the
null is not rejected for the trade-weighted multilateral indices.

Purchasing Power Parity is therefore only confirmed for the importbased multilateral indices and bilateral indices, while it is rejected for
the trade-weighted multilateral indices.
Remarks: The paper in PDF format can be downloaded at:
http://swopec.hhs.se/gunwpe/abs/gunwpe0039.htm
Purchasing Power Parity
Author: Steven M. Suranovic
Book: International Finance Theory & Policy
Year: Vol: Chapter 30
This is an online book which collects materials about International
Finance Theory and Policy. In chapter 30, it covers Purchasing Power
Parity. There are 4 sections in chapter 30: 30-1 Introduction to
Purchasing Power Parity (PPP) 30-2 The Consumer Price Index (CPI)
and PPP 30-3 PPP as a Theory of Exchange Rate Determination 30-4
Problems and Extensions of PPP Problem set is available at the end of
the chapter but the answer key in PDF format is subject to sale!!
Remarks: The book is accessible at:
http://internationalecon.com/v1.0/Finance/ch30/ch30.html
Does Purchasing Power Parity Hold in African Less Developed
Countries? Evidence from a Panel Data Unit Root Test.
Author: Holmes, Mark J
Book: Oxford University Press in its journal Journal of African
Economies
Year: March 2000 Vol: Pages: 63-78 Volume: 9 Issue: 1
This study tests for long-run relative purchasing power parity among a
sample of 27 African less developed countries. For this purpose, a new
test advocated by Im and co-workers is employed which allows one to
test for unit roots in heterogeneous panel datasets. This is known as
the t-bar test, by which purchasing power parity is confirmed or
rejected on the basis of whether or not the average augmented
Dickey-Fuller statistic based on demeaned data is significantly different
from zero. Using quarterly data covering the period 1974-97,
purchasing power parity is generally rejected using individual country
unit root tests but support is found using the t-bar test. This suggests
that low power problems in testing for purchasing power parity can be
overcome using this panel data procedure. The findings also support
the view that purchasing power parity is most likely to be found among
high inflation less developed countries and that the half-life of a one-off
random shock to parity is approximately six quarters. These results are
generally confirmed for the 1960-73 period. Copyright 2000 by Oxford
University Press.
Remarks: The paper is not downloadable, but you can get the paper
copy if available.
A Cointegration Analysis of Purchasing Power Parity: 1973-96
Author: MIGUEL D. RAMIREZ AND SHAHRYAR KHAN
Book: International Advances in Economic Research
Year: August 1999 Vol: VOLUME 5 NUMBER 3 Pages 369-385
This paper tests the purchasing power parity (PPP) hypothesis for five
industrial countries using cointegration and error-correction modeling.
The cointegration test indicated that for all countries the PPP
hypothesis holds in the long run but not in the short run. Further, the
error-correction models suggested that deviations of the actual
exchange rate from its long-run PPP value were corrected in
subsequent periods. Finally, the high frequency monthly data models
did a better job of tracking the turning points of the actual data than
the low-frequency quarterly and yearly models.
Remarks: The whole paper is available at:
http://www.iaes.org/journal/iaer/aug_99/ramirez/
A Panel Project on Purchasing Power Parity: Mean Reversion Within
and Between Countries
Author: Jeffrey A. Frankel, Andrew K. Rose
Year: February 1995 Vol: No. W5006
Previous time-series studies have shown evidence of mean- reversion
in real exchange rates. Deviations from purchasing power parity (PPP)
appear to have half-lives of approximately four years. However, the
long samples required for statistical significance are unavailable for
most currencies, and may be inappropriate because of regime changes.
In this study, we re-examine deviations from PPP using a panel of 150
countries and 45 annual observations. Our panel shows strong
evidence of mean-reversion that is similar to that from long timeseries. PPP deviations are eroded at a rate of approximately 15%
annually, i.e., their half-life is around four years. Such findings can be
masked in time-series data, but are relatively easy to find in crosssections.
http://papers.nber.org/papers/W5006
External Shocks, Purchasing Power Parity, and the Equilibrium Real
Exchange Rate
Author: Shantayanan Devarajan, Jeffrey D. Lewis, and Sherman
Robinson
Book: The World Bank Economic Review
Year: January 1993 Vol: Volume 7, Number 1
Two approaches are commonly used to determine the equilibrium real
exchange rate in a country after external shocks: purchasing power
parity (PPP) calculations and the Salter-Swan, tradables-nontradables
model. There are theoretical and empirical problems with both
approaches, and tensions between them. In this article we resolve
these theoretical and empirical difficulties by presenting a model which
is a generalization of the Salter-Swan model and which incorporates
imperfect substitutes for both imports and exports. Within the
framework of this model, the definition of the real exchange rate is
consistent both with that of the PPP approach and with that of the
Salter-Swan model (suitably extended). Our model, however, is
capable of capturing a richer set of phenomena, including terms of
trade shocks and changes in foreign capital inflows. It also provides a
practical way to estimate changes in the equilibrium real exchange
rate, requiring little more information than is required to do PPP
calculations. The results are consistent with those of multisector
computable general equilibrium models, which generalize the trade
specification of the small model.
Remarks: The full text of this article is not available on-line. Many
past issues of the WBER can be purchased for $13 per issue at:
http://www.worldbank.org/research/journals/wber/revjan93/external.h
tm
Purchasing Power Parity: Three Stakes through the Heart of the Unit
Root Null
Author:
Book: Staff report of Federal Reserve Bank of New York.
Year: June 1999 Vol: Number 80
A recent influential paper (O'Connell 1998) argues that panel data
evidence in favor of purchasing power parity disappears once test
procedures are altered to accommodate heterogenous cross-sectional
dependence among real exchange rate innovations. We present
evidence to the contrary. First, we modify two extant panel unit root
panel unit root tests to eliminate the upward size distortion induced by
contemporaneous cross-sectional dependence. Second, we exploit a
recently-introduced test, based on SUR techniques, that also remains
valid in the presence of cross-sectional dependence. Using the three
new tests, we find overwhelming evidence in favor of real exchange
rate stationarity during the post-Bretton Woods era among OECD
s. We
also find emphatic evidence of stationarity using O'Connell's GLS test.
Bias-corrected parameter estimates indicate that deviations from PPP
erode more quickly for real exchange rates defined using wholesale
rather than consumer price indices. Monte Carlo experiments indicate
that several of the tests discussed here have considerable power
against the unit root null.
Remarks: The entire paper in PDF format can be downloaded at:
http://www.ny.frb.org/rmaghome/staff_rp/sr80.html
Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling
and Specification Biases in Mean-Reversion Tests of the Law of One
Price
Author: Alan M. Taylor
Year: March 2000 Vol: No. W7577
The PPP puzzle is based on empirical evidence that international price
differences for individual goods (LOOP) or baskets of goods (PPP)
appear highly persistent or even non-stationary. The present
consensus is these price differences have a half-life that is of the order
of five years at best, and infinity at worst. This seems unreasonable in
a world where transportation and transaction costs appear so low as to
encourage arbitrage and the convergence of price gaps over much
shorter horizons, typically days or weeks. However, current empirics
rely on a particular choice of methodology, involving (i) relatively lowfrequency monthly, quarterly, or annual data, and (ii) a linear model
specification. In fact, these methodological choices are not innocent,
and they can be shown to bias analysis to-wards findings of slow
convergence and a random walk. Intuitively, if we suspect that the
actual adjustment horizon is of the order of days then monthly and
annual data cannot be expected to reveal it. If we suspect arbitrage
costs are high enough to produce a substantial band of inaction' then a
linear model will fail to support convergence if the process spends
considerable time random-walking in that band. Thus, when testing for
PPP or LOOP, model specification and data sampling should not
proceed without consideration of the actual institutional context and
logistical framework of markets.

http://papers.nber.org/papers/W7577
Deviations from Purchasing Power Parity: The Australian Case
Author: Adrian Blundell-Wignall, Marilyn Thomas
Book: Reserve Bank of Australia Discussion Paper
Year: September 1987 Vol: RDP8711
The hypothesis that deviations from PPP follow a random process is
tested against two alternatives: that the real exchange rate reverts to
a constant equilibrium level (long-run PPP); and that it reverts to an
equilibrium level which is itself a function of shifts in commodity prices
(long-run PPP doesn't hold, but for reasons that are predictable). The
random walk hypothesis cannot be rejected if commodity prices are
ignored or if the nominal exchange rate is fixed. It is consistently
rejected when commodity prices are included and the exchange rate is
floating.
Remarks: An electronic version of this paper is not available. To order
a printed copy you have to complete an RDP Order Form at:
http://www.rba.gov.au/PublicationsAndResearch/RDP/RDP_Order/inde
x.html
International price comparisons based on purchasing power parity
Author: Michelle A. Vachris and James Thomas
Book: Monthly Labor Online review
Year: October 1999 Vol: Vol. 122, No. 10
This paper is interesting and you may understand more about PPP via
studying daily cases: magine you are planning a trip to France and
would like to figure out how much currency you will need during your
visit. You would need to know how much in French francs it would cost
for incidentals such as meals, sightseeing, and souvenirs. What
information would be helpful to you in making your estimate? You
could check the price of, say, a lunch in your hometown and then
convert that figure into francs using the exchange rate. This type of
estimate would not be very accurate, however, because it is likely that
a lunch in your hometown costs relatively more or less than a lunch in
France. A better estimate would be based on the price of a lunch in
France. Similarly, if you were opening a subsidiary company in Japan,
how would you determine the salaries for your employees? Again,
using the exchange rate to convert the salary you would pay in the
United States into yen would not be accurate. To adequately
compensate employees moving overseas, you would need information
about the cost of living in Japan. Finally, if a government or
international organization were comparing national expenditures across
different countries, merely collecting the gross domestic products
(GDPs) of the countries and using exchange rates to convert them into
a single currency would not yield an accurate comparison. Again, the
comparison based on exchange rates does not take into account
differing prices among the countries.
http://stats.bls.gov/opub/mlr/1999/10/art1exc.htm
Official Exchange Rate Arrangements and Real Exchange Rate
Behavior
Author: David C. Parsley and Helen A. Popper

Book: Journal of Money, Credit and Banking
Year: March 2000
Here is the abstract of the paper: We study the behavior of real
exchange rates under various official designations of exchange rate
arrangements. Examining many currencies, we find important
differences across the designations. Most notably, real exchange rate
mean reversion is fastest when nominal exchange rates are officially
pegged. We also find a large nonlinear effect: adjustment is fastest
when the real exchange rate deviates greatly from its mean. This
nonlinear effect is also most striking among officially pegged
currencies. Finally, we find that nominal exchange rates, rather than
prices, do most of the adjusting.
http://mba.vanderbilt.edu/fmrc/papers/wp9730.htm
Testing Deviations from Purchasing Power Parity (PPP)
Author: Aizenman, Joshua
Year: 1984 Vol: NBER Working Paper:1475
The purpose of this paper is to study analytically how the presence of
transportation costs in a model of deviations from PPP affects the
testing procedure of the PPP hypothesis. The analysis shows that in the
presence of transportation costs traditional regression analysis will
tend to reject the PPP hypothesis even if goods markets are well
arbitraged, because the values of the regression coefficients are
affected systematically by considerations that are independent of the
degree to which markets are arbitraged. Thus, the content of the PPP
approach cannot be tested satisfactorily without considering the
systematic affects of transportation costs and other costs of goods
arbitrage.
Remarks:
Monopolistic Competition and Deviations from PPP
Author: Aizenman, Joshua
Year: 1985 Vol: NBER Working Paper:1552
The purpose of this paper is to explain deviations from PPP in an
economy characterized by a monopolistic competitive market structure
in which pricing decisions incur costs that lead producers to pre-set the
price path for several periods. The paper derives an optimal pricing
rule, including the optimal pre-setting horizon. It does so for a rational
expectation equilibrium, characterized by staggered, unsynchronized
price setting, for which the degree of staggering is endogenously
determined. The discussion focuses on the critical role of the degree of
domestic-foreign goods substitutability in explaining observable
deviations from PPP.
Remarks:
Idiosyncratic Tastes in a Two-Country Optimizing Model: Implications
of a Standard Presumption
Author: Warnock, Francis E.
Book: Board of Governors of the Federal Reserve System, International
Finance Discussion Paper
Year: 1998 Vol: 631, pages 21

International spillovers and exchange rate dynamics are examined in a
two-country dynamic optimizing model that allows for idiosyncratic
tastes across countries. Specifically, there is a home-good bias in
consumption patterns: at given relative prices the ratio of home goods
consumed to foreign goods consumed is higher in the home country.
The setup nests Obstfeld and Rogoff (1995), who assume identical
tastes. Allowing for idiosyncratic tastes produces results that differ
from Obstfeld and Rogoff's: expansionary monetary policy increases
home utility by more, the positive spillovers of a fiscal expansion are
reduced, and both short-run and long-run deviations from
consumption-based purchasing power parity (PPP) are possible. The
model's predictions are broadly consistent with those from the Frenkel,
Razin and Yuen (1996) version of the two-country Mundell-Fleming
model and with observed behavior of real and nominal exchange rates.
Remarks:
Beyond the Purchasing Power Parity: Testing for Cointegration and
Causality between Exchange Rates, Prices, and Interest Rates
Author: Cheng, Benjamin S.
Book: Journal of International Money and Finance
Year: 1999 Vol: 18(6), pages 911-24.
This paper reexamines the causality between the dollar and the yen in
a multivariate framework with the aid of cointegration and errorcorrecting modeling for the 1951-94 period. The Phillips-Perron tests
and Johansen's tests are performed. While causality from interest rates
to exchange rates is found in the short run, no causality between
prices and exchange rates is found in the short run. However, causality
is found running from relative prices to exchange rates along with
interest rates between the U.S. and Japan in the long run, which
supports the long-run PPP hypothesis.
Remarks:
Does PPP Hold between Asian and Japanese Economies? Evidence
Using Panel Unit Root and Panel Cointegration
Author: Azali, M.; Habibullah, M. S.; Baharumshah, A. Z.
Book: Japan and the World Economy
Year: 2001 Vol: 13(1), pages 35-50.
This paper presents an empirical analysis of panel unit root and panel
cointegration tests of long-run absolute purchasing power parity (PPP)
for seven Asian developing economies (ADE). The evidence shows that
the panel parametric and non-parametric tests either with a trend term
or without a trend term support the hypothesis of cointegration
between the bilateral exchange rates and relative prices against the
selected foreign country--Japan.
Remarks:
An Empirical Investigation into the Causes of Deviations from
Covered Interest Parity across the Tasman
Author: Moosa, Imad A.
Book: New Zealand Economic Papers
Year: 1996 Vol: 30(1), pages 39-54.
This paper examines deviations from the equilibrium condition implied
by covered interest parity as applied to the exchange rate between the
Australian and New Zealand dollars over the period 1985 to 1994.
Formal empirical evidence shows that spot and forward speculation do
not play any role in determining the forward exchange rate. The
significant deviations in 1985 are attributed to political risk. Further
shrinkage of the deviations in the 1990s is attributed to a possible
reduction in transaction costs resulting from financial deregulation.
Remarks:
Exchange Controls, Political Risk and the Eurocurrency Market: New
Evidence from Tests of Covered Interest Rate Parity
Author: Cody, Brian J.
Book: International Economic Journal
Year: 1990 Vol: 4(2), pages 75-86.
This study employs daily data to examine the effects on Eurocurrency
and onshore returns of the May 21, 1981 imposition of exchange
controls by French President Mitterand. Prior to this time, transaction
costs explain the average onshore deviations from covered parity;
however, these averages ignore short-lived political risk premia which
emerged just before the imposition of controls. As expected, there is
no evidence of political risk on Eurocurrency markets. Yet when
exchange controls were in effect, premia in excess of transaction costs
surfaced on nonfranc Eurocurrency deposits at the time of devaluations
of the franc within the EMS.
Remarks:
Forward and Spot Exchange Rates
Author: Fama, Eugene F.
Book: Journal of Monetary Economics
Year: 1984 Vol: 14(3), pages 319-38.
In this study Fama decomposes the forward premium into a risk
premium and an expected depreciation premium based on the
information set available. By constructing a statistical model on this
relation, he finds the relative importance of the risk premium and the
expected depreciation premium.
Remarks:
Exchange Rate Forecasting Techniques, Survey Data, and Implications
for the Foreign Exchange Market
Author: Frankel, Jeffrey A.; Froot, Kenneth
Book: International Monetary Fund Working
Year: 1990 Vol: Paper: WP/90/43, pages 26.
This paper examines the dynamics of the foreign exchange market.
The first half addresses a number of key questions regarding the
forecasts of future exchange rates made by market participants, by
means of updated estimates using survey data. Here the authors follow
most of the theoretical and empirical literature in acting as if all market
participants share the same expectation. The second half then
addresses the possibility of heterogeneous expectations, particularly
the distinction between "chartists" and "fundamentalists," and the
implications for trading in the foreign exchange market and for the
formation of speculative bubbles.
Remarks:
A Multivariate GARCH Model of Risk Premia in Foreign Exchange
Markets
Author: Malliaropulos, Dimitrios
Book: Economic Modelling
Year: 1997 Vol: 14(1), pages 61-79.
This paper investigates the existence of time-varying risk premia in
deviations from uncovered interest parity based on the market capital
asset pricing model. The empirical analysis is conducted using a broad
data set of seven major currencies against the US dollar, and a world
equity index in order to approximate the benchmark portfolio. The
conditional covariance matrix of excess returns is modelled as a
multivariate GARCH process. The results indicate significant conditional
systematic risk. Estimated conditional beta coefficients are very similar
across currencies and behave uniformly over time. The explanatory
power of the model is significantly higher compared to the constant
beta CAPM specification. Furthermore, estimation results suggest that
(1) expected excess returns are less volatile in foreign exchange
markets compared to stock markets, and (2) including nominal dollar
assets in international equity portfolios can reduce overall portfolio
risk.
Remarks:
International Financial Relations under the Current Float: Evidence
from Panel Data
Author: Lothian, James R.; Simaan, Yusif
Book: Open-Economies-Review
Year: 1998 Vol: 9(4), pages 293-313.
This paper uses multi-country data for the period 1973-94 to
investigate five key equilibrium conditions in international finance-purchasing power parity, the Fisher equation, uncovered interest
parity, and the equity-return analogues of the latter two. The results
are largely consistent with theoretical expectations. Over the long run,
purchasing power parity, uncovered interest parity and the Fisher
effect prove to be rather good first approximations. The equity-return
relations, though somewhat less so are nevertheless much better
behaved than past studies would lead one to expect. Average rates of
equity returns keep pace with inflation within countries in almost all
instances; across countries, they are positively correlated with average
rates of inflation. This is particularly the case when the data period is
extended to include earlier decades.
Remarks:
An Alternative Approach to Testing Uncovered Interest Parity
Author: Bhatti, Razzaque H.; Moosa, Imad A.
Book: Applied-Economics-Letters
Year: 1995 Vol: 2(12), pages 478-81.
Supportive evidences of UIP hypothesis through a cointegration
analysis. The authors compare the Treasury bill rates denominated in
11 currencies to the U.S. dollar, and find a long-run relationship in all
cases.
Remarks:
Uncovered Interest Parity in Crisis: The Interest Rate Defense in the
1990s
Author: Flood, Robert P; Rose, Andrew K.
Book:
Year: 2001 Vol: This paper is available online at
http://haas.berkeley.edu/~arose/UIPC.pdf
This paper tests for uncovered interes parity (UIP) using daily data for
twenty-three developing and developed countries through the crisisstrewn 1990s. The authors find that UIP works better on average in the
1990s than previous eras in the sense the slope coefficient from a
regression of exchange rate changes on interest differentals yields a
positive coefficient (which is sometimes insignificantly different from
unity). UIP works systematically worse for fixed and flexible exchange
countries than for crisis countries, but we find no significant differences
between rich and poor countries. Finally, the authors find evidence that
varies considerably across countries and time, but is usually weakly
consistent with an effective "interest defense" of the exchange rate.
Remarks:
An Intraday Analysis of the Effectiveness of Foreign Exchange
Intervention
Author: Neil Beattie and Jean-Franois Fillion
Book:
Year: February 1999
This paper assesses the effectiveness of Canada's official foreign
exchange intervention in moderating intraday volatility of the
Can$/US$ exchange rate, using a 2-1/2-year sample of 10-minute
exchange rate data. The use of high frequency data (higher than daily
frequency) should help in assessing the impact of intervention since
the foreign exchange market is efficient and reacts rapidly to new
information. The estimated equations explain volatility in terms of four
major factors: intraday seasonal pattern; daily volatility persistence;
macroeconomic news announcements; and the impact of central bank
intervention. Rule-based (or expected) intervention apparently had no
direct impact on the reduction of foreign exchange volatility, although
the existence of a non-intervention band seemed to provide a small
stabilizing influence. This result is interpreted to mean that the
stabilizing effect of expected intervention came into play as the
Canadian dollar approached the upper or lower limits of the band.
When the dollar exceeded the band, actual intervention did not have
any direct impact because it was expected. Moreover, the results show
that discretionary (or unexpected) intervention might have been
effective in stabilizing the Canadian dollar, although the impact of an
intervention sequence diminished as it increased beyond a few days.
Remarks: The paper can be downloaded in PDF format at:
http://www.bankofcanada.ca/publications/working.papers/1999/wp994.pdf
Measuring the Profitability and Effectiveness of Foreign Exchange
Market Intervention: Some Canadian Evidence
Author: John Murray, Mark Zelmer, and Shane Williamson
Book: Technical Report No. 53
Year: March 1990
When the major industrial countries decided to move to a system of
managed flexible exchange rates following the collapse of the Bretton
Woods system, many observers thought that this would reduce, if not
eliminate, the need for official foreign exchange market intervention.
During the past fifteen years, however, intervention in most countries,

including Canada, has risen steadily in both frequency and intensity.
This paper presents new empirical evidence on the profitability and
effectiveness of Canadian intervention from 1975 to 1988. The results
suggest that the government's foreign exchange operations have been
very profitable and have tended to be stabilizing, in the sense that
authorities were typically pushing the exchange rate towards its longrun trend and helping to reduce short-run volatility in the market.
Remarks: We can order printed copies of this paper at no charge
from: Publications Distribution, Bank of Canada 234 Wellington Street,
Ottawa, Canada K1A 0G9 E-mail: publications@bank-banquecanada.ca Telephone: 613-782-8248 Fax: 613-782-8874
The Temporal Pattern of Trading Rule Returns and Central Bank
Intervention: Intervention Does Not Generate Technical Trading Rule
Profits
Book:
Year: November 2000
It is provided by the Federal Reserve Bank of St. Louis. This paper
characterizes the temporal pattern of trading rule returns and official
intervention for Australian, German, Swiss and U.S. data to investigate
whether intervention generates technical trading rule profits. High
frequency data show that abnormally high trading rule returns precede
German, Swiss and U.S. intervention, disproving the hypothesis that
intervention generates inefficiencies from which technical rules profit.
Australian intervention precedes high trading rule returns, but
trading/intervention patterns make it implausible that intervention
actually generates those returns. Rather, intervention responds to
exchange rate trends from which trading rules have recently profited.
http://www.stls.frb.org/docs/research/wp/2000-018C.pdf
Book:
Year: January 2001
Technical Analysis and Central Bank Intervention
Author: Christopher Neely and Paul Weller
Book:
Year: Feburary 2000
This paper extends the genetic programming techniques developed in
Neely, Weller and Dittmar (1997) to provide some evidence that

information about U.S. foreign exchange intervention can improve
technical trading rules?profitability for two of four exchange rates over
part of the out-of-sample period. Rules tend to take positions contrary
to official intervention and are unusually profitable on days prior to
intervention, indicating that intervention is intended to check or
reverse predictable trends. Intervention seems to be more successful
in checking predictable trends in the out-of-sample (1981-1998) period
than in the in-sample (1975-1980) period. We conjecture that
instability in the intervention process prevents more consistent
improvement in the excess returns to rules. We find that the
improvement in performance results from more precise estimation of
the information in the past exchange rate series, rather than from
information about contemporaneous intervention.
The exchange rate and the MPC: What can we do?
Author: Sushil Wadhwani
Book: Bank of England. Quarterly Bulletin; London
Year: Aug 2000 Vol: Vol. 40, Iss. 3; pg. 297-306, 10 pgs
In Sushil Wadhwani's speech (member of the Bank of England's
Monetary Policy Committee), he argued that looking only at a two-year
ahead inflation forecast when setting interest rates is likely to be
suboptimal, and that allowing asset price misalignments to have an
additional impact on interest rates could enable a reduction in the
volatility of inflation. Currently, sterling is probably overvalued against
the euro, and so this might affect the appropriate level of interest rates.
He also suggested that, under certain circumstances, sterilized
intervention can be effective.
&Mtd=1&Idx=36&Sid=1&RQT=309&Q=1&IE=x.pdf
The Use of Fundamental and Technical Analyses by Foreign Exchange
Dealers: Honk Kong Evidence
Author: Lui,Yu Hon; Mole, David
Book: Journal of International Money and Finance
Year: 1998 Vol: 17(3), pages 535-45.
This article reports the results of a questionnaire survey conducted in
February 1995 on the use by foreign exchange dealers in Hong Kong of
fundamental and technical analyses to form their forecasts of exchange
rate movements. The authors' findings reveal that > 85 percent of
respondents rely on both fundamental and technical analyses for
predicting future rate movements at different time horizons. At shorter
horizons, there exists a skew towards reliance on technical analysis as
opposed to fundamental analysis, but the skew becomes steadily
reversed as the length of horizon considered is extended. Technical
analysis is considered slightly more useful in forecasting trends than
fundamental analysis, but significantly more useful in predicting
turning points. Interest rate-related news is found to be a relatively
important fundamental factor in exchange rate forecasting, while
moving average and/or other trend-following systems are the most
useful technical technique.
Remarks:
Does Central Bank Intervention Stabilize Foreign Exchange Rates?

Author: Catherine Bonser-Neal
Book: Federal Reserve Bank of Kansas City
Year:
This paper is written by Catherine Bonser-Neal. It's about the
exchange rate volatility, its causes and its consequence, how it
measures, how central bank intervention affects the volatility, etc.
http://www.kc.frb.org/publicat/econrev/pdf/1q96bons.pdf
Book:
Year:

Currency Intervention. Manipulation

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Currency Intervention. Manipulation

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Asian Monetary Cooperation

Foreign Exchange Intervention

A simple laissez-faire view - exchange rate should be determined by private demand

Concerted or Coordinated Intervention

Sterilization and Non-sterilization

According to the portfolio-balance channel, it is assumed that risk-averse wealth holders

Effectiveness of Central Bank Intervention

and influencing the exchange rate if the interventions are:

With Spanish and English version.

Global Financial Data Home Page

Foreign Exchange Market Trading Volume and Federal Reserve

which new information influences exchange rate behavior. This paper

there are additional monetary and financial policy tools available.

References related to Foreign exchange intervention (26 references are shown.)

Author: John Murray, Mark Zelmer, and Shane Williamson

economy, for it drastically reduces the fluctuations of employment and

patterns in the data.

Remarks: This paper is downloadable at:

Remarks: The full text is downloadable at:

Is Sterilized Foreign Exchange Intervention Effective After All? An

that in some circumstances sterilised intervention may represent an

provide a theoretical model and empirical evidence that government

Author: Prof. Dr. Sylvester C.W. Eijffinger (CentER, Tilburg University

References related to Exchange Rate (51 references are shown.)

producing a staggering toll on their economies, particularly in emerging

International Financial Crises and Flexible Exchange Rates: Some

produce unbiased predictions of actual changes in exchange rates, and

ignores the covariance between returns sourced in different countries,

according to a rule that partially offsets the contemporaneous

the former mainly lies with their ready availability.

also evidence of some very large deviations from covered interest

null is not rejected for the trade-weighted multilateral indices.

logistical framework of markets.

Author: David C. Parsley and Helen A. Popper

Year: 1998 Vol: 631, pages 21

During the past fifteen years, however, intervention in most countries,

Neely, Weller and Dittmar (1997) to provide some evidence that

Does Central Bank Intervention Stabilize Foreign Exchange Rates?

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