Chapter 7: More puzzles and solutions
This chapter examines three lesser known puzzles with regard to the workings of the fx market. In addition, it includes an account of two new suggestions with regard to missing variables in a Fama equation. These are “default risk” as in Coudert and Mignon (2013) and the ratio of the current interest differential (ID) to the average value for ID, as in Wagner (2012). The three new puzzling facts are as follows. First, Bansal (1997), Bansal and Dahlquist (2000), Baillie and Kilic (2006), and Coudert and Mignon (2013) obtain estimates of Fama’s β (using the USA as the home country) that are predominantly positive when ID is positive, and predominantly negative when ID is negative. Second, Clarida and Taylor (1997) and Clarida et al. (2003) find that the term structure of the forward premium has predictive power with respect to future changes in the exchange rate. Third, Brunnermeier and Pederson (2009), Clarida et al. (2009), Moore and Roche (2012), Menkhoff et al. (2012), and Coudert and Mignon (2013) find a relationship between estimates of β and either monetary or fx market volatility. More precisely, they find that estimates of β tend to be positive when the variance is high for: (a) the spot rate; (b) excess returns from carry-trade; and/or (c) the monetary growth rate. Conversely, estimates of β are negative during more tranquil periods. Existing hypotheses to explain these puzzles are given first. Then an attempt is made to explain them via Synthesis Model II.
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