Explaining Foreign Exchange Market Puzzles

Evidence from Transition Economies

The paper develops a flow model of the exchange rate with speculative capital flows integrated in a rigorous manner. The model is consistent with five foreign exchange market puzzles: (1) occasional discontinuous jumps in the exchange rate; (2) periodic short-term regimes of persistent appreciation/depreciation that can develop into a long swing; (3) the forward discount bias; (4) volatility clusters in the foreign exchange market that create conditional heteroskedasticity; and (5) the dual profitability of betting in the short run against any official foreign exchange intervention, and betting with the intervention in the long run.
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Volume/Issue: Volume 1999 Issue 027
Publication date: March 1999
ISBN: 9781451844504
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Business and Economics , Exports and Imports , Finance , Investments and Securities-General , WP , interest rate differential , exchange rate , balance of payments , FX market , time horizon , Exchange Rates , Foreign Exchange Puzzles , long term speculator , profit taking , home interest rate , prediction error , differential in favor , Currency markets , Trade balance , Return on investment

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Summary

The paper develops a flow model of the exchange rate with speculative capital flows integrated in a rigorous manner. The model is consistent with five foreign exchange market puzzles: (1) occasional discontinuous jumps in the exchange rate; (2) periodic short-term regimes of persistent appreciation/depreciation that can develop into a long swing; (3) the forward discount bias; (4) volatility clusters in the foreign exchange market that create conditional heteroskedasticity; and (5) the dual profitability of betting in the short run against any official foreign exchange intervention, and betting with the intervention in the long run.

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