Global Capital Flows, Time Varying Fundamentals And Transitional Exchange Rate Dynamics: An MS-VAR Approach

This paper studies whether dynamic relationship between exchange rate and economic and financial fundamentals vary depending on exchange rate is overvalued and undervalued with respect to its fundamental value. To achieve this, we implement two-state Markov Switching Vector Auto Regression (MSVAR) model with time varying transition probabilities to investigate whether the relationship among exchange rate, interest rate and inflation dynamics depend on overvaluation and undervaluation of exchange rates for the pre-crises period between years 1972-2009. We govern the transition between the undervalued and overvalued states by using Sharpe Ratios of debt and equity investments of the currency to assess whether risk adjusted returns induce overvaluation or undervaluation of the currencies. We employ this model to the bilateral exchange rate, which is defined between US Dollar and four highly traded currencies (AUD, CAD, JPY, and UKS). We provide evidence that the relationship among these variables varies in terms of on magnitude, direction and statistical significance in between the overvalued and undervalued regimes. Furthermore, we show that risk adjusted excess debt and equity returns influence the overvaluation and the undervaluation of the currencies.