Regime-Switching Behavior of the Term Structure of Forward Markets

27 Pages Posted: 7 Nov 2006

See all articles by Elena Tchernykh Branson

Elena Tchernykh Branson

The State University of the Ministry of Finance of the RF

William H. Branson

Princeton University - Woodrow Wilson School of Public and International Affairs; National Bureau of Economic Research (NBER)

Date Written: August 2005

Abstract

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.

Suggested Citation

Branson, Elena Tchernykh and Branson, William H., Regime-Switching Behavior of the Term Structure of Forward Markets (August 2005). NBER Working Paper No. w11517. Available at SSRN: https://ssrn.com/abstract=776005

Elena Tchernykh Branson

The State University of the Ministry of Finance of the RF ( email )

Moscow
Russia

William H. Branson (Contact Author)

Princeton University - Woodrow Wilson School of Public and International Affairs ( email )

409 Robertson Hall
Princeton, NJ 08544-1021
United States
609-258-4828 (Phone)
609-258-5533 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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