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Regime-Switching Behavior of the Term Structure of Forward Markets

  • Elena Tchernykh
  • William H. Branson
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    This paper presents techniques for modelling and estimating the behavior of financial market price or return differentials that follow non-linear regime-switching behaviour. The methodology to be used here is estimation of variants of threshold autoregression (TAR) models. In the basic model the differentials are random within a band defined by transactions costs and contract risk; they occasionally jump outside the band, and then follow an autoregressive path back towards the band. The principal reference is Tchernykh (1998). The application here is to deviations from covered interest parity (CIP) between forward foreign exchange (FX) markets in Hong Kong and the Philippines. We have observed that these deviations from the band follow irregular steps, rather than single jumps. Therefore a Modified TAR model (MTAR) that allows for this behaviour is also estimated. The estimation methodology is a regime-switching maximum likelihood procedure. The estimates can provide indicators for policy-makers of the market's expectation of crisis, and could also provide indicators for the private sector of convergence of deviations to their usual bands. The TAR model has the potential to be applied to differentials between linked pairs of financial market prices more generally.

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    File URL: http://www.nber.org/papers/w11517.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11517.

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    Date of creation: Aug 2005
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    Handle: RePEc:nbr:nberwo:11517
    Note: IFM
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
    Phone: 617-868-3900
    Web page: http://www.nber.org
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    1. Elena Tchernykh Branson, 2004. "Application of a Modified TAR Model to CIP Deviations in Asian Data," Working Papers 192004, Hong Kong Institute for Monetary Research.
    2. Mark P. Taylor & Elena Tchernykh Branson, 2004. "Asymmetric Arbitrage and Default Premiums Between the U.S. and Russian Financial Markets," IMF Staff Papers, Palgrave Macmillan, vol. 51(2), pages 3.
    3. Corsetti, Giancarlo & Pesenti, Paolo & Roubini, Nouriel, 1999. "What caused the Asian currency and financial crisis?," Japan and the World Economy, Elsevier, vol. 11(3), pages 305-373, October.
    4. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    5. Frenkel, Jacob A & Levich, Richard M, 1975. "Covered Interest Arbitrage: Unexploited Profits?," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 325-38, April.
    6. Branson, William H, 1969. "The Minimum Covered Interest Differential Needed for International Arbitrage Activity," Journal of Political Economy, University of Chicago Press, vol. 77(6), pages 1028-35, Nov./Dec..
    7. Peel, David A & Taylor, Mark P, 2002. "Covered Interest Rate Arbitrage in the Interwar Period and the Keynes-Einzig Conjecture," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(1), pages 51-75, February.
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