IDEAS home Printed from https://ideas.repec.org/a/eee/empfin/v34y2015icp99-111.html
   My bibliography  Save this article

Was it risk? Or was it fundamentals? Explaining excess currency returns with kernel smoothed regressions

Author

Listed:
  • Baillie, Richard T.
  • Kim, Kun Ho

Abstract

This paper uses recently developed kernel smoothing regression procedures and uniform confidence bounds to investigate the forward premium anomaly. These new statistical methods estimate the local time-varying slope coefficient of the regression of spot returns on the lagged interest rate differential. Uniform confidence bands are used to test when uncovered interest parity is violated. The estimated betas in the forward premium smoothed regression are found to vary substantially over time and to be partially explicable in terms of lagged fundamentals and money growth volatilities arising from risk premium. Frequentist model averaging procedures indicate the relative importance of these variables in terms of explaining movements in the betas and hence the apparent causes of regimes where UIP fails.

Suggested Citation

  • Baillie, Richard T. & Kim, Kun Ho, 2015. "Was it risk? Or was it fundamentals? Explaining excess currency returns with kernel smoothed regressions," Journal of Empirical Finance, Elsevier, vol. 34(C), pages 99-111.
    • Handle: RePEc:eee:empfin:v:34:y:2015:i:c:p:99-111
    DOI: 10.1016/j.jempfin.2015.08.007
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0927539815000900
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jempfin.2015.08.007?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Charles Engel & Kenneth D. West, 2005. "Exchange Rates and Fundamentals," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 485-517, June.
    2. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-853, October.
    3. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August.
    4. Lothian, James R. & Wu, Liuren, 2011. "Uncovered interest-rate parity over the past two centuries," Journal of International Money and Finance, Elsevier, vol. 30(3), pages 448-473, April.
    5. Hakkio, Craig S, 1981. "Expectations and the Forward Exchange Rate," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 22(3), pages 663-678, October.
    6. Hodrick, Robert J., 1989. "Risk, uncertainty, and exchange rates," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 433-459, May.
    7. Orbe, Susan & Ferreira, Eva & Rodriguez-Poo, Juan, 2005. "Nonparametric estimation of time varying parameters under shape restrictions," Journal of Econometrics, Elsevier, vol. 126(1), pages 53-77, May.
    8. Kim, Kun Ho, 2014. "Counter-cyclical risk aversion," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 384-401.
    9. Baillie, Richard T. & Bollerslev, Tim, 2000. "The forward premium anomaly is not as bad as you think," Journal of International Money and Finance, Elsevier, vol. 19(4), pages 471-488, August.
    10. Adrien Verdelhan, 2010. "A Habit‐Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, February.
    11. Bansal, Ravi & Dahlquist, Magnus, 2000. "The forward premium puzzle: different tales from developed and emerging economies," Journal of International Economics, Elsevier, vol. 51(1), pages 115-144, June.
    12. Giovannini, Alberto & Jorion, Philippe, 1987. "Interest rates and risk premia in the stock market and in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 6(1), pages 107-123, March.
    13. Baillie, Richard T & Lippens, Robert E & McMahon, Patrick C, 1983. "Testing Rational Expectations and Efficiency in the Foreign Exchange Market," Econometrica, Econometric Society, vol. 51(3), pages 553-563, May.
    14. Baillie, Richard T & Bollerslev, Tim, 1994. "The long memory of the forward premium," Journal of International Money and Finance, Elsevier, vol. 13(5), pages 565-571, October.
    15. Bekaert, Geert & Hodrick, Robert J., 1993. "On biases in the measurement of foreign exchange risk premiums," Journal of International Money and Finance, Elsevier, vol. 12(2), pages 115-138, April.
    16. Phillips, Peter C. B., 2001. "Trending time series and macroeconomic activity: Some present and future challenges," Journal of Econometrics, Elsevier, vol. 100(1), pages 21-27, January.
    17. Zhou Zhou & Wei Biao Wu, 2010. "Simultaneous inference of linear models with time varying coefficients," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 72(4), pages 513-531, September.
    18. Sakoulis, Georgios & Zivot, Eric & Choi, Kyongwook, 2010. "Structural change in the forward discount: Implications for the forward rate unbiasedness hypothesis," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 957-966, December.
    19. Lars Peter Hansen & Robert J. Hodrick, 1983. "Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 113-152, National Bureau of Economic Research, Inc.
    20. Chang, Sanders S., 2013. "Can cross-country portfolio rebalancing give rise to forward bias in FX markets?," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 1079-1096.
    21. Nelson C. Mark & Yangru Wu, 1997. "Risk, Policy Rules, and Noise: Rethinking Deviations from Uncovered Interest Parity," Tinbergen Institute Discussion Papers 97-041/2, Tinbergen Institute.
    22. Kun Ho Kim, 2013. "Inference of the environmental Kuznets curve," Applied Economics Letters, Taylor & Francis Journals, vol. 20(2), pages 119-122, February.
    23. Alex Maynard & Peter C. B. Phillips, 2001. "Rethinking an old empirical puzzle: econometric evidence on the forward discount anomaly," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 16(6), pages 671-708.
    24. Ombao, Hernando & von Sachs, Rainer & Guo, Wensheng, 2005. "SLEX Analysis of Multivariate Nonstationary Time Series," Journal of the American Statistical Association, American Statistical Association, vol. 100, pages 519-531, June.
    25. Baillie, Richard T. & P. Osterberg, William, 1997. "Central bank intervention and risk in the forward market," Journal of International Economics, Elsevier, vol. 43(3-4), pages 483-497, November.
    26. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
    27. Baillie, Richard T. & Kilic, Rehim, 2006. "Do asymmetric and nonlinear adjustments explain the forward premium anomaly?," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 22-47, February.
    28. Bruce E. Hansen, 2007. "Least Squares Model Averaging," Econometrica, Econometric Society, vol. 75(4), pages 1175-1189, July.
    29. Bansal, Ravi, 1997. "An Exploration of the Forward Premium Puzzle in Currency Markets," The Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 369-403.
    30. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Sakemoto, Ryuta, 2019. "Currency carry trades and the conditional factor model," International Review of Financial Analysis, Elsevier, vol. 63(C), pages 198-208.
    2. Byrne, Joseph P. & Sakemoto, Ryuta, 2021. "The conditional volatility premium on currency portfolios," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 74(C).
    3. Kim, Kun Ho & Park, Suna, 2016. "Inference and Forecasting Based on the Phillips Curve," KDI Journal of Economic Policy, Korea Development Institute (KDI), vol. 38(2), pages 1-20.
    4. Ok, Hyunmin & Kim, Jinyong & Kim, Yongsik, 2023. "Is the Kimchi premium a speculative bubble?," Finance Research Letters, Elsevier, vol. 57(C).
    5. Tanujit Dey & Kun Ho Kim & Chae Young Lim, 2018. "Bayesian time series regression with nonparametric modeling of autocorrelation," Computational Statistics, Springer, vol. 33(4), pages 1715-1731, December.
    6. Kim, Kun Ho & Kim, Taejin, 2016. "Capital asset pricing model: A time-varying volatility approach," Journal of Empirical Finance, Elsevier, vol. 37(C), pages 268-281.
    7. Richard T. Baillie & Kun Ho Kim, 2016. "Is Robust Inference with OLS Sensible in Time Series Regressions? Investigating Bias and MSE Trade-offs with Feasible GLS and VAR Approaches," Working Paper series 16-04, Rimini Centre for Economic Analysis.
    8. Charfeddine, Lanouar & Khediri, Karim Ben & Mrabet, Zouhair, 2019. "The forward premium anomaly in the energy futures markets: A time-varying approach," Research in International Business and Finance, Elsevier, vol. 47(C), pages 600-615.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Baillie, Richard T. & Cho, Dooyeon, 2014. "Time variation in the standard forward premium regression: Some new models and tests," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 52-63.
    2. Richard T., Baillie, 2011. "Possible solutions to the forward bias paradox," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 21(4), pages 617-622, October.
    3. Baillie, Richard T. & Kilic, Rehim, 2006. "Do asymmetric and nonlinear adjustments explain the forward premium anomaly?," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 22-47, February.
    4. Richard T. Baillie & Dooyeon Cho, 2014. "When Carry Trades in Currency Markets are not Profitable," Review of Development Economics, Wiley Blackwell, vol. 18(4), pages 794-803, November.
    5. Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2012. "Properties of foreign exchange risk premiums," Journal of Financial Economics, Elsevier, vol. 105(2), pages 279-310.
    6. Richard T. Baillie & Rehim Kilic, 2005. "Do Asymmetric and Nonlinear Adjustments Explain the Forward Premium Anomaly?," Working Papers 543, Queen Mary University of London, School of Economics and Finance.
    7. Baillie, Richard T. & Diebold, Francis X. & Kapetanios, George & Kim, Kun Ho, 2023. "A new test for market efficiency and uncovered interest parity," Journal of International Money and Finance, Elsevier, vol. 130(C).
    8. Simpson, Marc W. & Grossmann, Axel, 2014. "An examination of the forward prediction error of U.S. dollar exchange rates and how they are related to bid-ask spreads, purchasing power parity disequilibria, and forward premium asymmetry," The North American Journal of Economics and Finance, Elsevier, vol. 28(C), pages 221-238.
    9. Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2010. "Properties of Foreign Exchange Risk Premia," MPRA Paper 21302, University Library of Munich, Germany.
    10. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
    11. Grossmann, Axel & Simpson, Marc W., 2015. "Bid-ask spreads, deviations from PPP and the forward prediction error: The case of the British pound and the euro," The Quarterly Review of Economics and Finance, Elsevier, vol. 55(C), pages 124-139.
    12. Nessrine Hamzaoui & Boutheina Regaieg, 2016. "The Glosten-Jagannathan-Runkle-Generalized Autoregressive Conditional Heteroscedastic approach to investigating the foreign exchange forward premium volatility," International Journal of Economics and Financial Issues, Econjournals, vol. 6(4), pages 1608-1615.
    13. Baillie, Richard T. & Kilic, Rehim, 2006. "Do asymmetric and nonlinear adjustments explain the forward premium anomaly?," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 22-47, February.
    14. West, Kenneth D., 2012. "Econometric analysis of present value models when the discount factor is near one," Journal of Econometrics, Elsevier, vol. 171(1), pages 86-97.
    15. Lucio Sarno & Giorgio Valente & Hyginus Leon, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," Review of Finance, European Finance Association, vol. 10(3), pages 443-482, September.
    16. Thomas Chiang & Sheng-Yung Yang, 2005. "International Asset Excess Returns and Multivariate Conditional Volatilities," Review of Quantitative Finance and Accounting, Springer, vol. 24(3), pages 295-312, May.
    17. Sonia Pangusión Espinosa., "undated". "Testing Uncovered Interest Rate Parity: The Spanish case," Studies on the Spanish Economy 128, FEDEA.
    18. Grossmann, Axel & Lee, Allissa A. & Simpson, Marc W., 2014. "Forward premium anomaly of the British pound and the euro," International Review of Financial Analysis, Elsevier, vol. 34(C), pages 140-156.
    19. Seongman Moon & Carlos Velasco, 2011. "The Forward Discount Puzzle: Identi cation of Economic Assumptions," Working Papers 1112, Nam Duck-Woo Economic Research Institute, Sogang University (Former Research Institute for Market Economy).
    20. Cho, Dooyeon, 2018. "On the persistence of the forward premium in the joint presence of nonlinearity, asymmetry, and structural changes," Economic Modelling, Elsevier, vol. 70(C), pages 310-319.

    More about this item

    Keywords

    Forward premium anomaly; Local Deviation from Uncovered Interest Parity; Kernel smoothing; Uniform inference; Macroeconomic fundamentals; Frequentist model averaging;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:empfin:v:34:y:2015:i:c:p:99-111. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jempfin .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.