Why Economic Theory Fails to Explain Exchange Rates?

8/12/2019 Why Economic Theory Fails to Explain Exchange Rates?

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WHYECONOMICTHEORYOF

EXCHANGERATESFAILSTO

EXPLAINEXCHANGERATE?David Solomon Hadi - Chief Strategist

Financial Services

Rock Star Consulting Group

www.rockstarconsultinggroup.com

1
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EXCHANGERATETHEORYFAILED!

Exchange Rates show random walk and a

fundamental disconnect puzzle.

Random Walk:

Exchange Rate cannot be predicted.

This was first discovered by Rogoff and Meese (1983).

Fundamental Disconnect Puzzle:

Exchange rate show no relation to economic

fundamentals .

This was discovered by several authors. Among them

were Obstfeld & Rogoff (2001).2

Why Economic Theory of Exchange Rates Fails to Explain Exchange rate? David Solomon Hadi - Chief Strategist Financial

Services Rock Star Consulting Group (www.rockstarconsultinggroup.com)
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IMPLICATIONSOFRANDOMWALKAND

DISCONNECTPUZZLE.

As a result of these random walk and disconnect

puzzle:

Economist remain unable to forecast.

Economist remain unable to explain reasons of

changes.

Economist remain unable to engage in policy

advisory about exchange rate.

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WHYTHESETWOPROPERTIESHOLD?

Other than the known problems, for example for

Purchasing Power Parity it is transportation cost,

price index of traded versus non traded goods,

taxes etc, four new or less known problems are

collected:

Missing Behavior of Traders

Rational Inattention

Mistaking Noise as Fundamental Variable

Triangular Arbitrage

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5/13

MISSINGBEHAVIOROFTRADERS

Cheung et al (2000 and 2001) surveyed major

exchange rate markets and found that traders do

not care about economic fundamentals.

They found, among other things, that market in

short run is dominated :

By bandwagon effect.

By New over reaction.

By manipulators who change market.

Trend followers.

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Three crucial questions from Cheung et al (2000

and 2001) survey are given below:

What is meant by Purchasing Power Parity

(PPP)?

63% of respondents claimed PPP as an academic

jargon.

What would be ones reaction to overvaluation?

81.02% of agents replied take no action.

Does PPP reflect exchange rate movement?

Common answer was no for time up to six months.

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A model of behavior of trader is missing.

Models of traders are available for example Lux(1995) and Alfarano and Lux (2007).

These model a noise trader. For example, showherd behavior etc. This in turn leads to themarket whose time series resemble one observed

in real life.

However, they are not embedded into exchangerate models. 7




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RATIONALLYINATTENTIVEAGENTS

Information in exchange rate market is large andfrequency of arrival is high.

Several countries, several goods markets, severalfinance markets change every hour every day.

A rational choice of being inattentive to somemarkets is optimal in order to avoid losing timein information processing only.

Sims (2003, 2005, 2006, 2010) mathematicalpresentation of Rational Inattention could beembedded in exchange rate.

However, this is not done yet.8




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USINGDIFFERENCEDEXCHANGERATEIS

SAMEASMODELINGNOISEWITH

FUNDAMENTALS

Noise is high frequency movement. It is irregular.

First difference of exchange rate on monthly data

is high frequency and unpredictable (Irregular).

Therefore first difference which is commonly used

is noise. Baxter (1994).

Should one model exchange rates noise usingeconomic fundamentals such as interest rate

which is non noisy?

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10/13

USINGDIFFERENCEDEXCHANGERATEIS

SAMEASMODELINGNOISEWITH

FUNDAMENTALS

Answer by Baxter is NO.

Modeling exchange rate using economic

fundamentals would require to focus on non noisycomponent of time series.

Baxter proposed using a frequency domain filter.

Baxter King Filter is one example.

This understanding can be taken to next level.

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11/13

ARBITRAGEFREEMARKETANDITS

IMPLICATIONS

The Triangular Arbitrage is defined as a round

trip of buying/selling currencies that ends up

adding in positive return (Marshall et al, 2008).

Hypothetical Example:

1 Dollar is converted to 1.5 Pounds.

1.5 Pounds are converted to 2.0 Euro.

2.0 Euro are converted back into 1.1 Dollars. Net gain is 0.1 dollars.

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ARBITRAGEFREEMARKETANDITS

IMPLICATIONS

In exchange rate market such situation isexploited quickly.

This moves demand supply of currencies and

moves market to state where this risk free profitdo not not exist anymore.

Therefore, an effect of change in one currency

pair price ripples through whole set of currencypairs.

However, no model of exchange rate considerseffects of this kind of arbitrage.

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REFERENCES

Alfarano, S., & Lux, T. (2007). A noise trader model as a generator of apparent financial power laws andlong memory. Macroeconomic Dynamics, 11(S1), 80-101.

Baxter, M. (1994). Real exchange rates and real interest differentials: Have we missed the business-cyclerelationship?. Journal of Monetary Economics, 33(1), 5-37.

Black, F. (2012). Noise. The Journal of Finance, 41(3), 529-543.

Cheung, Y. W., & Chinn, M. D. (2001). Currency traders and exchange rate dynamics: a survey of the USmarket. Journal of International Money and Finance, 20(4), 439-471.

Cheung, Y. W., & Wong, C. Y. P. (2000). A survey of market practitioners views on exchange rate dynamics.Journal of International Economics, 51(2), 401-419.

Lux, T. (1995, July). Herd behaviour, bubbles and crashes. In Economic Journal-Including AnnualConference Paper Supplement(Vol. 105, No. 431, pp. 881-896). London, 1891-.

Marshall, B., Treepongkaruna, S., & Young, M. (2008). Exploitable arbitrage opportunities exist in theforeign exchange market. In American Finance Association Annual Meeting, New Orleans.

Meese, R. A., & Rogoff, K. (1983). Empirical exchange rate models of the seventies: Do they fit out ofsample?. Journal of international economics, 14(1), 3-24.

Obstfeld, M., & Rogoff, K. (2001). The six major puzzles in international macroeconomics: is there a commoncause?. In NBER Macroeconomics Annual 2000, Volume 15 (pp. 339-412). MIT press.

Sims, C. A. (2003). Implications of rational inattention. Journal of monetary Economics, 50(3), 665-690.

Sims, C. A. (2006). Rational inattention: Beyond the linear-quadratic case. The American economic review,158-163.

Sims, C. A. (2005). Rational inattention: a research agenda(No. 2005, 34). Discussion paper Series1/Volkswirtschaftliches Forschungszentrum der Deutschen Bundesbank.

Sims, C. A. (2010). Rational inattention and monetary economics.

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Why Economic Theory Fails to Explain Exchange Rates?