The Scapegoat Theory of Exchange Rates: The First Tests

50 Pages Posted: 6 Feb 2012

See all articles by Marcel Fratzscher

Marcel Fratzscher

DIW Berlin; Centre for Economic Policy Research (CEPR)

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Gabriele Zinna

Bank of Italy

Multiple version iconThere are 5 versions of this paper

Date Written: January 24, 2012

Abstract

This paper provides an empirical test of the scapegoat theory of exchange rates (Bacchetta and van Wincoop 2004, 2011), as an attempt to evaluate its potential for explaining the poor empirical performance of traditional exchange rate models. This theory suggests that market participants may at times attach significantly more weight to individual economic fundamentals to rationalize the pricing of currencies, which are partly driven by unobservable shocks. Using novel survey data which directly measure foreign exchange scapegoats for 12 currencies and a decade of proprietary data on order flow, we find empirical evidence that strongly supports the empirical implications of the scapegoat theory of exchange rates, with the resulting models explaining a large fraction of the variation and directional changes in exchange rates. The findings have implications for exchange rate modelling, suggesting that a more accurate understanding of exchange rates requires taking into account the role of scapegoat factors and their time-varying nature.

Keywords: scapegoat, exchange rates, economic fundamentals, survey data, order flow

JEL Classification: F31, G10

Suggested Citation

Fratzscher, Marcel and Sarno, Lucio and Zinna, Gabriele, The Scapegoat Theory of Exchange Rates: The First Tests (January 24, 2012). ECB Working Paper No. 1418. Available at SSRN: https://ssrn.com/abstract=1991133

Marcel Fratzscher (Contact Author)

DIW Berlin ( email )

Mohrenstra├če 58
Berlin, 10117
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Lucio Sarno

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Gabriele Zinna

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

HOME PAGE: http://gabrielezinna.github.io/

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