Estimating Exchange Rate Equations Using Estimated Expectations

29 Pages Posted: 3 Jan 2008

See all articles by Ray C. Fair

Ray C. Fair

Yale University - Cowles Foundation; Yale School of Management - International Center for Finance

Date Written: January 2008

Abstract

This paper takes a somewhat different approach from the recent literature in estimating exchange rate equations. It assumes uncovered interest rate parity and models how expectations are formed. Agents are assumed to base their expectations of future interest rates and prices, which are needed in the determination of the exchange rate, on predictions from a ten equation VAR model. The overall model is estimated by FIML under model consistent expectations. The model generally does better than the random walk model, and its properties are consistent with observed effects on exchange rates from surprise interest rate and price announcements. Also, the focus on expectations is consistent with the large observed short run variability of exchange rates.

Keywords: Exchange rate equations, Uncovered interest rate parity

JEL Classification: F31

Suggested Citation

Fair, Ray C., Estimating Exchange Rate Equations Using Estimated Expectations (January 2008). Cowles Foundation Discussion Paper No. 1635; Yale Economics Department Working Paper No. 33; Yale ICF Working Paper No. 07-18. Available at SSRN: https://ssrn.com/abstract=1080004

Ray C. Fair (Contact Author)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States
203-432-3715 (Phone)
203-432-6167 (Fax)

HOME PAGE: http://fairmodel.econ.yale.edu

Yale School of Management - International Center for Finance ( email )

Box 208200
New Haven, CT 06520
United States
203-432-3715 (Phone)
203-432-6167 (Fax)

HOME PAGE: http://fairmodel.econ.yale.edu

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