FIN7016_Applied Financial Econometrics: According to Moosa and Bhatti (1997): “The covered interest parity (CIP) hypothesis — which postulates an equilibrium relationship between the spot exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates — was originally developed by Keynes (1923). In essence, it is the earliest theory of forward exchange, stipulating that the forward exchange rate tends to be equal to its interest parity rate (that is, the spot exchange rate adjusted by a factor reflecting the interest rate differential on domestic and foreign short-term financial assets). Put differently, the forward premium (discount) is postulated to be equal to the short-term interest differential. If the short-term interest rates on domestic and foreign assets with similar risk characteristics are not the same, then covered interest arbitrage will be profitable unless or until the forward premium (discount) is equal to the short-term interest rate differential (the actual forward rate is equal to its interest parity rate). Once equality is reached, any opportunity for arbitrage profit will be eliminated; consequently, the tendency for the movement of funds in either direction will disappear”.
CIP Hypothesis states that (1 + id) = (S / F) * (1 + if), where id is the interest rate in the domestic currency or the base currency, if is the interest rate in the foreign currency or the quoted currency, S is the current spot foreign exchange rate and F is the forward foreign exchange rate.
The formula above can be rearranged to determine the forward foreign exchange rate as:
F = S * ((1 + if) / (1 + id))
- Download monthly data on the GBP/USD exchange rate, the GBP/USD one-month forward rate and relevant US and UK interest rates for the period 1997:1 – 2017:12. Using these data, formulate and test the Covered Interest Parity (CIP) hypothesis employing a regression-based test. Present both the descriptive statistics of your downloaded data including graphs and the empirical estimation results of your regression.
- Critically discuss what your empirical results from part (a) suggest about the informational efficiency of the foreign exchange market, supporting your discussion with relevant literature.
(50 marks) – Minimum words limit (1500 words), excluding all tables and graphs.
According to Malkiel (2003):
“A generation ago, the efficient market hypothesis was widely accepted by academic financial economists; for example, see Eugene Fama’s (1970) influential survey article, “Efficient Capital Markets.” It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of financial information such as company earnings and asset values to help investors select “undervalued” stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks, at least not with comparable risk.
The efficient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. But news is by definition unpredictable, and, thus, resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts”.
- Using daily data and either the variance ratio test or Dickey-Fuller test, test the random walk hypothesis for the natural logarithm of the FTSE100 stock market index for the period of ten years ending December 2017. Present both the descriptive statistics of your downloaded data including graphs and the empirical estimation results of your regression. (25 marks)
- Discuss your results in (a) above, validating or otherwise the Efficient Market Hypothesis and supporting your arguments with relevant literature.
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