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Essays in international finance: Empirical behavior of exchange rates

Venkatraman Anantha-Nageswaran, University of Massachusetts Amherst


This dissertation investigates the empirical behavior of the exchange rates, especially since the advent of the floating era in 1974. In a sequence of three essays, it seeks to verify whether exchange rate movements conform to the well-known international parity conditions such as Purchasing Power Parity and Covered and Uncovered Interest Rate Parity. It also tests the hypothesis that international capital flows and exchange rate volatility help to explain the forward forecast error (also called the risk premium in international finance literature). In all the three essays, data on exchange rates, interest rates and Consumer Price Indices beginning from 1957 (or from 1981, where appropriate) till the end of 1991 (and up to the end of 1992 in some cases) are used. Data are obtained from the International Monetary Fund monthly statistics and the Financial Times of London. This facilitates a more thorough and reliable empirical analysis. The first essay employs the variance ratio test for random-walk in real exchange rates. A version of the Variance ratio technique developed by Lo and Mackinlay (1988) is used to test for random walk in real exchange rates between the G-7 countries. Results remain unchanged when the samples are pooled. Maximum Likelihood procedures are employed to choose an appropriate random walk process for the real exchange rates. Results indicate that real exchange rates are better approximated by a jump-diffusion random walk process than a simple diffusion process. The second essay investigates the Covered and Uncovered Interest Rate Parity theorems involving the U.S. dollar, the Deutsche mark, the Swiss franc and the Japanese yen. The results offer strong support for the Covered Interest Parity Condition. The third essay involves modeling the risk-premium in forward exchange rates with the net foreign investment position of the U.S. investor and spot exchange rate volatility. Nominal interest differentials are chosen as the proxies for the net foreign investment position. Since under the maintained hypothesis of Covered Interest Parity, the forward premium (discount) reflects the nominal interest differential, they are used in empirical testing. Daily data on one monthly forward and spot rates are used. Implied volatility estimates from foreign currency options serve as instruments for exchange rate volatility. Generalized Method of Moments (GMM) estimation procedure is employed to handle serial correlation and heteroscedasticity in the error terms. (Abstract shortened by UMI.)

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Recommended Citation

Anantha-Nageswaran, Venkatraman, "Essays in international finance: Empirical behavior of exchange rates" (1994). Doctoral Dissertations Available from Proquest. AAI9434447.