exchange rate models are not as bad as you think...exchange rate models are not as bad as you think...
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Exchange Rate Models Are Not as Bad as You Think
Discussion by
Peter Westaway Bank of England
Presentation given at the 8th Jacques Polak Annual Research Conference Hosted by the International Monetary Fund Washington, DC─November 15-16, 2007 Please do not quote without the permission from the author(s). The views expressed in this presentation are those of the author(s) only, and the
presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the presentation.
88TTHH JJAACCQQUUEESS PPOOLLAAKK AANNNNUUAALL RREESSEEAARRCCHH CCOONNFFEERREENNCCEE NNOOVVEEMMBBEERR 1155--1166,, 22000077
Com
men
ts o
n En
gel e
t al (
2007
)‘E
xcha
nge
Rat
e M
odel
s are
N
ot a
s Bad
as Y
ou th
ink’
by
Mar
k A
stle
y an
d Pe
ter W
esta
way
M
onet
ary
Inst
rum
ents
& M
arke
ts D
ivis
ion
Ban
k of
Eng
land
Plan
•D
etai
l mai
n st
rand
s of E
ngel
et a
l (07
) •
Ban
k of
Eng
land
app
roac
h fo
r ac
coun
ting
for e
xcha
nge
rate
m
ovem
ents
‘Pol
icym
aker
’Foc
us
Mai
n St
rand
s of E
ngel
et a
l•
ER
s are
forw
ard-
look
ing!
•En
gel-W
est (
05) t
heor
em: E
Rs s
houl
d be
clo
se to
rand
om w
alks
if d
isco
unt f
acto
r clo
se to
uni
ty
•C
an g
et re
ason
able
var
ianc
e ra
tios
•(P
erce
ived
) mon
etar
y po
licy
reac
tion
cruc
ial i
n de
term
inin
g E
R r
eact
ion
to n
ews
•Pa
nel r
esul
ts: l
ong-
horiz
on p
redi
ctab
ility
!
Mon
etar
y M
odel
→Su
bstit
ute
out i
nter
est r
ates
by
inve
rting
mon
ey d
eman
d eq
ns.
Tayl
or R
ule
Mod
els
→Fo
cus o
n Ta
ylor
rule
coe
ffic
ient
s & e
xpec
ted
futu
re in
flatio
n &
outp
ut g
aps
→A
gain
subs
titut
ing
out (
path
of)
inte
rest
rate
s
But
Why
Sub
stitu
te O
ut In
tere
st R
ates
?Pr
os o
f not
subs
titut
ing
out i
nter
est r
ates
•Li
nk b
etw
een
ER n
ews &
inte
rest
rate
new
s pre
-re
quis
ite fo
r ER
-mac
ro v
aria
ble
link
•Y
ield
cur
ves f
orw
ard-
look
ing
–no
nee
d to
get
into
V
AR
s or s
urve
ys
•Ti
mel
y in
fo fr
om fi
nanc
ial m
arke
tsC
ons o
f not
subs
titut
ing
out i
nter
est r
ates
•A
ccou
ntin
g fr
amew
ork.
.•
Can
’t ge
t at d
eep
issu
e of
whi
ch sh
ocks
are
dr
ivin
g ER
s
Acc
ount
ing
for
ER
mov
es u
sing
UIP
Nom
inal
UIP
(ign
orin
g ris
k pr
emiu
m):
Inte
grat
e fo
rwar
ds:
→Lo
ng-r
un n
omin
al e
xcha
nge
rate
not
wel
l-def
ined
→C
umul
ated
diff
eren
tials
pot
entia
lly u
nbou
nded
() t
tt
ti
ie
Ee
*1
−+
=+
()
1*
11
−+
−+
=+
−+
=∑
kt
kt
n kt
nt
tt
ii
Ee
Ee
Acc
ount
ing
for
ER
mov
es u
sing
UIP
Rea
l UIP
(ign
orin
g ris
k pr
emiu
m):
Inte
grat
e fo
rwar
ds:
→C
umul
ated
real
rate
diff
eren
tials
bou
nded
→U
nexp
lain
ed c
ompo
nent
refle
cts r
evis
ions
to
“equ
ilibr
ium
rate
”or
risk
pre
mia
Brig
den
at a
l (19
97) B
ank
of E
ngla
nd Q
uart
erly
Bul
letin
.
() t
tt
tr
rer
Eer
*1
−+
=+
()
1*
11
−+
−+
=+
−+
=∑
kt
kt
n kt
nt
tt
rr
Eer
Eer
How
to d
eriv
e re
al ra
te e
xpec
tatio
ns?:
•R
equi
res y
ield
cur
ves
prov
ide
good
mea
sure
s of
inte
rest
rate
exp
ecta
tions
•…
and
info
on
expe
cted
real
inte
rest
rate
sO
utpu
ts:
•D
eriv
e es
timat
e of
‘int
eres
t rat
e ne
ws’
, co
mpa
red
to o
bser
ved
ER n
ews
44.2
4.4
4.6
4.8
55.2
05
1015
US F
orw
ard
Yiel
d C
urve
Mat
urity
perc
ent
Perio
d t
Perio
d t+
1
44.2
4.4
4.6
4.8
55.2
05
1015
UK F
orw
ard
Yiel
d C
urve
Mat
urity
perc
ent
Perio
d t
Perio
d t+
1M
inus
=
00.1
0.2
05
1015
UK
-US
'Inte
rest
Rat
e N
ews'
Mat
urity
perc
ent
How
wel
l doe
s it d
o?
2006
•Ev
ent s
tudy
: clo
se li
nk a
roun
d so
me
polic
y ra
te c
hang
es
How
wel
l doe
s it d
o?
2007
•U
nder
stat
es €
/£m
ove
on U
K ra
te ri
se in
Jan-
2007
.
How
wel
l doe
s it d
o?
2006
•C
an’t
acco
unt f
or sh
arp
$ de
prec
iatio
n in
Apr
il 20
06
-10
-50510
05
06
07
Inte
rest
Ra
te
Ne
ws
$/£
Ne
ws
How
wel
l doe
s it d
o?
•But
bro
adly
acc
ount
s for
$/£
new
s sin
ce 2
005Q
1
•Foc
us o
n va
rian
ce ra
tios:
EW
(200
4) fi
nd c
an a
ccou
nt
for 2
0-40
% o
f ER
var
ianc
e•B
ut b
ased
upo
n V
AR
S –
so c
an w
e te
ll st
orie
s?
Lin
ks to
Eng
el e
t al A
ppro
ach?
Var
ianc
e R
atio
= 0
.44;
Cor
rel.
= -0
.07
$/£,
Wit
h B
eta
= 0.
9
19
75
19
78
19
81
19
84
19
87
19
90
19
93
19
96
19
99
20
02
-20
-15
-10-505
10
15
DS
DS
HA
TH
•Im
pres
sive
per
form
ance
for $
/£at
mon
thly
freq
uenc
y:
Var
ianc
e R
atio
= 0
.88;
Cor
rel.
=0.3
2
-6-4-20246
97
98
99
00
01
02
03
04
05
06
07
IRN
$/£
Mon
thly
% C
hang
esH
ow w
ell d
oes U
IP D
ecom
p. d
o?
•Mor
e im
pres
sive
per
form
ance
for q
uarte
rly $
/£m
oves
: V
aria
nce
Rat
io =
1.0
4; C
orre
l. =0
.44
How
wel
l doe
s UIP
Dec
omp.
do?
-8-404897
98
99
00
01
02
03
04
05
06
07
IRN
$/£
Qua
rter
ly %
Cha
nges
•Mos
t of v
aria
nce
of IR
N re
flect
s lon
g-m
atur
ity e
ffec
ts-A
ccor
ds w
ith E
ngel
et a
l (07
) arg
umen
t
Wha
t is D
rivi
ng th
e R
esul
ts?
Var
ian
ce R
atio
s10
Yea
r$/
£$/
€ €/
£Y
/£19
97-2
007
0.88
1999
-200
70.
820.
260.
220.
52
5 Y
ear
$/£
$/€
€/£
Y/£
1997
-200
70.
2219
99-2
007
0.2
0.08
0.1
0.16
2 Y
ear
$/£
$/€
€/£
Y/£
1997
-200
70.
0419
99-2
007
0.04
0.01
0.03
0.03
•Sim
ilar r
esul
t for
oth
er e
xcha
nge
rate
s•A
lthou
gh v
aria
nce
ratio
s are
low
er th
an fo
r $/£
Var
ian
ce R
atio
s10
Yea
r$/
£$/
€ €/
£Y
/£19
97-2
007
0.88
1999
-200
70.
820.
260.
220.
52
5 Y
ear
$/£
$/€
€/£
Y/£
1997
-200
70.
2219
99-2
007
0.2
0.08
0.1
0.16
2 Y
ear
$/£
$/€
€/£
Y/£
1997
-200
70.
0419
99-2
007
0.04
0.01
0.03
0.03
Wha
t is D
rivi
ng th
e R
esul
ts?
(Rob
ustn
ess)
•Cor
rela
tion
betw
een
ER n
ews &
inte
rest
rate
new
s litt
le
affe
cted
by
mat
urity
use
d•C
orre
latio
ns st
rong
est f
or $
/£
Co
rrel
atio
n C
oef
fici
ents
10 Y
ear
$/£
$/€
€/£
Y/£
1997
-200
70.
3219
99-2
007
0.26
0.18
0.1
0.16
5 Y
ear
$/£
$/€
€/£
Y/£
1997
-200
70.
4119
99-2
007
0.35
0.17
0.16
0.12
2 Y
ear
$/£
$/€
€/£
Y/£
1997
-200
70.
380.
1319
99-2
007
0.33
0.14
0.13
0.08
Rob
ustn
ess I
I: E
cono
mic
Con
tent
-6-4-2024699
00
00
01
01
02
03
03
04
04
05
06
06
07
07
IRN
$/€
Mon
thly
% C
hang
es
•Per
form
ance
less
impr
essi
ve fo
r $/€
at m
acro
hor
izon
s:
Var
ianc
e R
atio
= 0
.26;
Cor
rel.
=0.1
8•B
ut sh
ort s
ampl
e!
How
wel
l doe
s it d
o?H
Con
clus
ions
•En
gel e
t al (
07) i
mpo
rtant
focu
s on
role
of f
utur
e ex
pect
ed fu
ndam
enta
ls…
usef
ul c
ount
er to
nih
ilist
ic
rand
om w
alk
appr
oach
. •
Hav
e sh
own
anal
ysis
bas
ed o
n in
term
edia
te
cond
ition
ing
on in
tere
st ra
tes.
•C
ompl
emen
tary
app
roac
h to
Eng
el a
t al –
exam
ines
one
hal
f of j
oint
hyp
othe
sis
–1)
UIP
/RE
–2)
Inte
rest
rate
rule
•M
ore
wor
k re
quire
d -p
aper
forth
com
ing!
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