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Reconsidering Cointegration in International Finance: Three Case Studies of Size Distortion in Finite Samples

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Author Info

  • Marie-Josée Godbout
  • Simon van Norden

Abstract

This paper reconsiders several recently published but controversial results about the behaviour of exchange rates. In particular, it explores finite-sample problems in the application of cointegration tests and shows how these may have affected the conclusions of recent research. It also demonstrates how simple simulation methods may be used to check the robustness of cointegration tests in particular applied settings, and provides information on the potential sources of size distortion in these tests. Three case studies are presented. The first is the literature on cointegration and prediction of nominal spot exchange rates spawned by Baillie and Bollerslev (1989). The second is work on the long-run validity of the monetary model of exchange rate determination, particularly the contributions of MacDonald and Taylor (1993; 1994a). The final case study looks at the evidence presented by Kasa (1992) on common stochastic trends in the international stock market. Our results suggest that Baillie and Bollerslev's results are unaffected by finite-sample problems, but that the opposite is true for the other two case studies.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 97-1.

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Length: 34 pages
Date of creation: 1997
Date of revision:
Handle: RePEc:bca:bocawp:97-1

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Keywords: Econometric and statistical methods;

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References

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  1. MacDonald, Ronald & Taylor, Mark P., 1994. "The monetary model of the exchange rate: long-run relationships, short-run dynamics and how to beat a random walk," Journal of International Money and Finance, Elsevier, vol. 13(3), pages 276-290, June.
  2. Martin D.D. Evans & Karen K. Lewis, 1993. "Do Long-Term Swings in the Dollar Affect Estimates of the Risk Premia?," Working Papers 93-12, New York University, Leonard N. Stern School of Business, Department of Economics.
  3. Gonzalo, Jesus & Lee, Tae-Hwy, 1998. "Pitfalls in testing for long run relationships," Journal of Econometrics, Elsevier, vol. 86(1), pages 129-154, June.
  4. Phillips, Peter C B & Ouliaris, S, 1990. "Asymptotic Properties of Residual Based Tests for Cointegration," Econometrica, Econometric Society, vol. 58(1), pages 165-93, January.
  5. Osterwald-Lenum, Michael, 1992. "A Note with Quantiles of the Asymptotic Distribution of the Maximum Likelihood Cointegration Rank Test Statistics," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 54(3), pages 461-72, August.
  6. Baillie, Richard T & Bollerslev, Tim, 1989. " Common Stochastic Trends in a System of Exchange Rates," Journal of Finance, American Finance Association, vol. 44(1), pages 167-81, March.
  7. Gregory, Allan W, 1994. "Testing for Cointegration in Linear Quadratic Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 347-60, July.
  8. Hali J. Edison & William R. Melick, 1995. "Alternative approaches to real exchange rates and real interest rates: three up and three down," International Finance Discussion Papers 518, Board of Governors of the Federal Reserve System (U.S.).
  9. Toda, Hiro Y., 1995. "Finite Sample Performance of Likelihood Ratio Tests for Cointegrating Ranks in Vector Autoregressions," Econometric Theory, Cambridge University Press, vol. 11(05), pages 1015-1032, October.
  10. Nicholas Sarantis, 1994. "The monetary exchange rate model in the long run: An empirical investigation," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 130(4), pages 698-711, December.
  11. Steven N. Durlauf, 1989. "Output Persistence, Economic Structure, and the Choice of Stabilization Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 20(2), pages 69-136.
  12. Baillie, Richard T & Bollerslev, Tim, 1994. " Cointegration, Fractional Cointegration, and Exchange Rate Dynamics," Journal of Finance, American Finance Association, vol. 49(2), pages 737-45, June.
  13. GONZALO, Jesus & PITARAKIS, Jean-Yves, 1994. "Comovements in Large Systems," CORE Discussion Papers 1994065, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  14. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
  15. Francis X. Diebold & Javier Gardeazabal & Kamil Yilmaz, 1993. "On cointegration and exchange rate dynamics," Working Papers 93-2, Federal Reserve Bank of Philadelphia.
  16. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
  17. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  18. Amano, Robert A. & van Norden, Simon, 1995. "Terms of trade and real exchange rates: the Canadian evidence," Journal of International Money and Finance, Elsevier, vol. 14(1), pages 83-104, February.
  19. Baillie, R.T. & Bollerslev, T., 1993. "The Long Memory of the Foreward Premium," Papers 9203, Michigan State - Econometrics and Economic Theory.
  20. Kasa, Kenneth, 1992. "Common stochastic trends in international stock markets," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 95-124, February.
  21. Graham Elliott, 1998. "On the Robustness of Cointegration Methods when Regressors Almost Have Unit Roots," Econometrica, Econometric Society, vol. 66(1), pages 149-158, January.
  22. Scott Hendry, 1995. "Long-Run Demand for M1," Macroeconomics 9511001, EconWPA.
  23. Stephen R. Blough, 1994. "Near observational equivalence and persistence in GNP," Working Papers 94-6, Federal Reserve Bank of Boston.
  24. Hali J. Edison & Joseph E. Gagnon & William R. Melick, 1994. "Understanding the empirical literature on purchasing power parity: the post-Bretton Woods era," International Finance Discussion Papers 465, Board of Governors of the Federal Reserve System (U.S.).
  25. repec:cup:etheor:v:11:y:1995:i:5:p:1015-32 is not listed on IDEAS
  26. Baffes, John, 1994. "Does comovement among exchange rates imply market inefficiency?," Economics Letters, Elsevier, vol. 44(3), pages 273-280.
  27. Sephton, Peter S. & Larsen, Hans K., 1991. "Tests of exchange market efficiency: fragile evidence from cointegration tests," Journal of International Money and Finance, Elsevier, vol. 10(4), pages 561-570, December.
  28. Park, Joon Y, 1992. "Canonical Cointegrating Regressions," Econometrica, Econometric Society, vol. 60(1), pages 119-43, January.
  29. Gonzalo, Jesus, 1994. "Five alternative methods of estimating long-run equilibrium relationships," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 203-233.
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Citations

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Cited by:
  1. M. Martin Boyer & Simon van Norden, 2006. "Exchange Rates and Order Flow in the Long Run," CIRANO Working Papers 2006s-07, CIRANO.
  2. Amano, R. A. & van Norden, S., 1998. "Oil prices and the rise and fall of the US real exchange rate," Journal of International Money and Finance, Elsevier, vol. 17(2), pages 299-316, April.
  3. Godbout, M.J. & Van Norden, S., 1996. "Unit-Root Test and Excess Returns," Working Papers 96-10, Bank of Canada.
  4. Angela Huang, 2004. "Examining finite-sample problems in the application of cointegration tests for long-run bilateral exchange rates," Reserve Bank of New Zealand Discussion Paper Series DP 2004/08, Reserve Bank of New Zealand.

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