Title

Two essays on the exchange rate disconnect puzzle

Date of Award

2007

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Business Administration

Advisor(s)

Panayotis E. Koveos

Keywords

Exchange rate disconnect puzzle, Markov regime switching, Forecasting

Subject Categories

Business | Finance and Financial Management

Abstract

The two essays of the dissertation address the exchange rate disconnect puzzle from a new point of view. The first essay looks at secularly popular technical analysis and test whether these rules have an ability to predict the exchange rate. The essay notes the fact that technical rules forecast only the future 'direction' of exchange rate movements. Accordingly, by decomposing the movements into three pieces--activity (whether it moved or not), direction (if moved, which direction it moved), and size (by how much it moved)--the study shows that the forecast of technical rules pertaining to the direction of exchange rate movements is, at best, a fair game. In contrast, the absolute 'size' of exchange rate movements is positively related to the aggregate signal of the rules. The combined outcome is the increased price oscillation. Consequently, herding or contrarian trading strategy, which time investment decision to the dictation of these technical rules, do not necessarily improve traders' ability to predict future exchange rate movements.

The second essay is an extension of the first essay but asks a more fundamental question: whether the conventional--both technical and macroeconomic--exchange rate determination theories are suitable for forecasting exchange rate movements or only for shaping our subjective beliefs about the movements. The beliefs are represented by a unique data set of net positions of big players whose unsettled currency holdings exceed 50 billion dollars or equivalent. By modeling their subjective beliefs with chartist and fundamentalist factors as the conventional theories suggest, the study affirms that the theories do play an important role though the same model fails to capture actual exchange rate movements. Reasonably, these big players are often suspected of having power to move markets. The paper tests the possibility by relating their net positions to contemporaneous exchange rate movements, as the behavioral approach does. It identifies the positions as a poor predictor of directional changes but a factor to increase the volatility of exchange rates. The study concludes that understanding the dynamic interaction between different groups of market participants may be a key to solve the puzzle.

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