Episodic Nonlinearity in Leading Global Currencies
- 122 Downloads
We perform non-linearity tests using daily data for leading currencies that include the Australian dollar, British pound, Brazilian real, Canadian dollar, euro, Japanese yen, Mexican peso, and the Swiss franc to resolve the issue of whether these currencies are driven by fundamentals or exogenous shocks to the global economy. In particular, we use a new method of testing for linear and nonlinear lead/lag relationships between time series, introduced by Brooks and Hinich (J Empir Finance 20:385–404, 1999), based on the concepts of cross-correlation and cross-bicorrelation. Our evidence points to a relatively rare episodic nonlinearity within and across foreign exchange rates. We also test the validity of specifying ARCH-type error structures for foreign exchange rates. In doing so, we estimate Bollerslev’s (J Econom 31:307–327, 1986) generalized ARCH (GARCH) model and Nelson’s (1988) exponential GARCH (EGARCH) model, using a variety of error densities [including the normal, the Student-t distribution, and the Generalized Error Distribution (GED)] and a comprehensive set of diagnostic checks. We apply the Brooks and Hinich (1999) nonlinearity test to the standardized residuals of the optimal GARCH/EGARCH model for each exchange rate series and show that the nonlinearity in the exchange rates is not due to ARCH-type effects. This result has important implications for the interpretation of the recent voluminous literature which attempts to model financial asset returns using this family of models.
KeywordsGlobal financial markets Currencies Episodic nonlinearity Conditional heteroskedasticity
JEL ClassificationC22 C45 D40 G10 Q40
We thank the Editor, George S. Tavlas, and two anonymous referees for comments that greatly improved the paper. We are also thankful to Joko Mulyadi for valuable research assistance in collecting the data.
- Campbell JY, Medeiros KS, Viceira LM (2007) Global currency hedging. NBER Working Paper No. W13088Google Scholar
- Devereux MB, Sutherland A (2007) Financial globalization and monetary policy. IMF Working PaperGoogle Scholar
- Lane P, Milesi-Ferretti GM (2006) The external wealth of Nations Mark II. IMF Working Paper No 06-69Google Scholar
- Mandelbrot BB, Hudson RL (2004) The (mis)behavior of markets: a fractal view of risk, ruin & reward. Basic Books, New YorkGoogle Scholar
- Nelson D (1988) Conditional heteroscedasticity in asset returns: a new approach. Unpublished PhD Dissertation, Department of Economics, Massachusetts Institute of TechnologyGoogle Scholar
- Phillips PCB, Perron P (1988) Testing for a unit root in time series regression. Biométrica 75:335–346.6), 228–252Google Scholar
- Schmittmann J (2010) Currency hedging for international portfolios. International Monetary Fund Working paper No. 10/151Google Scholar
- Tavlas GS (1991) On the international use of currencies: the case of the Deutsche Mark. Essays in International Finance, No.181, Princeton University Press, Princeton UniversityGoogle Scholar