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Is Real Exchange Rate Mean Reversion Caused by Arbitrage?


José Manuel Campa


University of Navarra - Madrid Campus - IESE Business School; National Bureau of Economic Research (NBER)

Holger C. Wolf


Georgetown University - Edmund A. Walsh School of Foreign Service (SFS)

September 1997

NBER Working Paper No. w6162

Abstract:     
The presence of purchasing power parity is often attributed to the exploitation of arbitrage opportunities in goods markets. We examine this presumption for a 1960-1996 monthly panel of bilateral exchange rates and trade for the G7 countries. The data exhibit strong mean reversion. However, despite allowing for substantial latitude in specification, we find very limited support for a simple arbitrage view. The deviations of real exchange rates and trade from trend are virtually uncorrelated. Large trade deviations neither trigger nor accelerate mean reversion. Large real exchange rate deviations do not lead to systematic changes in trade. Constricting the sample to eighteen-month episodes of notable mean reversion - large persistent depreciations starting from overvalued levels - does not reveal any systematic relation either. The timing of these episodes does point, however, to an alternative explanation of mean reversion: the majority of episodes occur during periods of nominal exchange rate regime instability, pointing towards exchange rate policy or speculation as the immediate cause of mean reversion. Both may, of course, reflect expectations of trade responses, opening an indirect role for incipient arbitrage in explaining mean reversion.

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Date posted: May 1, 1998  

Suggested Citation

Campa, José Manuel and Wolf, Holger C., Is Real Exchange Rate Mean Reversion Caused by Arbitrage? (September 1997). NBER Working Paper No. w6162. Available at SSRN: https://ssrn.com/abstract=82113

Contact Information

José Manuel Campa (Contact Author)
University of Navarra - Madrid Campus - IESE Business School ( email )
Camino del Cerro del Aguila 3
Madrid, 28023
Spain
+34 91 357 0809 (Phone)
+34 91 357 2913 (Fax)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Holger C. Wolf
Georgetown University - Edmund A. Walsh School of Foreign Service (SFS) ( email )
Washington, DC 20057
United States
202-687-8079 (Phone)
202-687-8359 (Fax)
HOME PAGE: http://georgetown.edu/faculty/wolfhc/
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