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Nonlinearity in the reaction of the foreign exchange market to interest rate differentials: evidence from a small open economy with a long-term peg

Listed author(s):
  • Mahalia Jackman
  • Roland Craigwell
  • Michelle Doyle-Lowe

This article incorporates the Castle and Hendry (2010) portmanteau test into an Exponential Generalized Autoregressive Conditional Hetroscedasticity in Mean (EGARCH-M) model to investigate nonlinearities in the reaction of daily foreign exchange activity to the interest rate differential between the US and Barbados -- a small open economy which has been pegged to the US dollar for over 35 years. The results suggest that changes in the interest differential have a significant and nonlinear effect on the Barbadian foreign exchange market. The linear spread term is positive, and so is in line with a theory of uncovered interest parity for an economy with a fixed exchange rate. But, all other spread coefficients have a negative sign, implying that asymmetry is present. Thus, it is possible that there is a threshold at which foreign currencies no longer conform to the uncovered interest parity condition, but rather are negatively correlated with interest spreads. Finally, these findings were consistent in the pre-financial crisis analysis.

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Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

Volume (Year): 23 (2013)
Issue (Month): 4 (February)
Pages: 287-296

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Handle: RePEc:taf:apfiec:v:23:y:2013:i:4:p:287-296
DOI: 10.1080/09603107.2012.718063
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