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A research paper analysing the uncovered interest parity and the exchange rate puzzle

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COMMODITY PRICES AND EXCHANGE RATES

Abstract

Exchange rates dictate the global economic arena and are responsible for a great share

of the uncertainty that international businesses find themselves exposed to. While the

Uncovered Interest Parity theoretically explains exchange rate changes, empirical

research has increasingly criticized the applicability of this framework. Considering

the apparent inability to explain exchange rate fluctuations, we set out to establish a

more comprehensive framework that can shed light on the exchange rate puzzle. In line

with previous research we find that UIP does not hold and that interest rate differentials

can at best explain exchange rate changes partially. We prove that other economic

parameters, namely GDP growth, current account growth, and inflation cannot predict

exchange rate movements. The main additional value of this paper lies in the

proposition of a country-specific approach. Every country is subject to a distinct

interplay of commodity prices which influence the exchange rates of countries that are

particularly active in international trade of commodities.

Keywords: UIP, exchange rates, interest rates, inflation rates, GDP growth rates, current account

growth rates, commodities

1

Erasmus University Rotterdam, Rotterdam School of Management Bachelor Thesis, Burgemeester Oudlaan

50, Bayle Building, 3062 PA Rotterdam.

Introduction

The world economy is rapidly changing. In the advent of globalization and increasing

international trade, exchange rates have become key pillars of our financial system. In this

context, the global economy, as characterized by predominantly flexible exchange rate

systems, has increased in complexity and volatility. As a result, exchange rates have on the one

hand become a major driver of competitive advantages. On the other hand, they add substantial

risk to any internationally operating company as well as global investors. Therefore, there is a

multitude of situations in which managers are required to make decisions subject to exchange

rate risk. On a broad level, this risk can impose volatility on businesses through two channels,

as each company is affected by different degrees of transaction and economic exposure.

Transaction exposure is the risk that an exchange rate might change unfavourably after two

companies have established financial obligations. Some enterprises import goods from other

countries and thereby incur payables denominated in foreign currencies. Should the foreign

currency appreciate before the company has made its payments, the business might incur

significant additional costs. Such unfavourable exchange rate fluctuations do not only concern

importers but also affect global exporters, who book receivables in foreign currencies. Hence,

transaction exposure is a serious concern for any business involved in international

transactions. In other cases, globally operating organizations might expect a stream of foreign

currency denominated royalties from a franchise operating in a different country. The home

currency value of each royalty payment is dependent on the conversion ratio implied by the

exchange rate. An example of such problem is the case of the Walt Disney Company, which

has franchised its theme park concept to the Oriental Land Company to open Tokyo

Disneyland. In reverse, Walt Disney Company was entitled Japanese Yen royalty payments. In

this situation, Disney feared transaction risk as the JPY (Japanese Yen) could depreciate against

the USD (US Dollar), which would erode Disneys USD cash receipts.

Another form of international risk results from economic exposure, which can affect businesses

through two channels. On the one hand, the exchange rate exposure of assets represents a

substantial source of risk for businesses that possess assets in a foreign country, as the value of

the asset denominated in a companys home currency fluctuates alongside the respective

exchange rate. On the other hand, economic exposure can result from operating exposure,

which is the effect that random changes in the exchange rate can have on a firms competitive

2

position (NASDAQ.com, 2017). More simply, it can be defined as the extent to which the

firms operating cash flows are affected by exchange rate fluctuations. This risk affects all

companies who face competition from other countries. For instance, an exporter benefits from

a sudden depreciation of his currency, which could enable him to take over significant shares

in the international market.

Considering the multitude of associated risk factors, operational as well as financial hedging

represent suitable strategies to reduce the exposure to exchange rate volatility. Examples of

operational hedging strategies are the alignment of foreign denominated costs to revenues or

the selection of low-risk production sites. Financial hedging involves derivative securities such

as futures, forwards, options, or swaps. The suitable strategy for a specific firm primarily

depends on the size and type of expected currency exposure. To reduce risk exposure as well

as to decide for the most efficient hedging strategy that decreases risks while increasing return,

managers are required to proactively anticipate changes in the foreign exchange market (FX

Market). In light of this complex problem, our paper seeks to identify factors that allow

managers to predict exchange rate changes by examining specific economic parameters.

Therefore, the research question reads as follows:

How much do various economic parameters influence exchange rate changes between

currencies?

In order to find a compelling answer to our research question, we analyse the perspectives of

three interdependent hypotheses2. The first one focuses on the effects of interest rate

differentials (Hypothesis 1), the second one elaborates on the impact of differentials of general

economic factors (Hypothesis 2), and the third one examines the effects of commodity prices

(Hypothesis 3) on exchange rate changes.

Hypothesis 1

One of the predominant theories in academic research is the estimation of future exchange rates

using interest rates. The predominant theory is the Covered Interest Parity (CIP), which directly

links exchange rates to interest rates, whereby the difference in interest rates of two countries

2

A hypothesis is a tentative proposition about the causes or outcome of an event or, more generally, about

how variables are related (Passer, 2014). More simply, a hypothesis is an educated guess regarding the

outcome of the research question.

3

determines the differential between the forward and the spot exchange rate. While this

phenomenon has empirically been widely substantiated at least for developed countries

(Ferreira & Len-Ledesma, 2003), it is not applicable in predicting future spot exchange rates.

Nevertheless, it represents the origin of the Uncovered Interest Parity (UIP), a parity

condition in which the difference in interest rates between two countries equals the expected

change in the respective exchange rate. More specifically, UIP implies that high interest rate

currencies depreciate. In this respect, UIP, if validated, would represent a valuable framework

for the financial management of internationally operating firms. As interest rates are publicly

available, managers could use changes in interest rates to predict exchange rates and thereupon

take the necessary measures to hedge their cash flows. Therefore, this paper will first test the

UIP along the following hypothesis:

Hypothesis 2

Considering the complexity of international economies, we assume that there are further factors

besides interest rates that contribute to exchange rate fluctuations. Specifically, we test for the

impact of three key macroeconomic factors. Firstly, we expect inflation rate differentials

between two countries to have an impact on exchange rate changes, as the relative purchasing

power between two countries should remain constant. According to the purchasing power

parity theory, a country that experiences comparably high inflation will see a drop in its

currency value (Bansal & Dahlquist, 1998). Secondly, the current account, representing the

balance of trade between a country and its trading partners, is expected to have a considerable

impact on exchange rate fluctuations. As an indicator of the future demand and supply for a

certain currency, the differential between the current account growth of two countries

potentially impacts the value of a countrys currency (Dornbusch & Fischer, 1980). Thirdly,

the gross domestic product growth (GDP growth) differential represents an indicator of

economic prosperity. A healthy economy is expected to attract foreign direct investment, which

increases the demand for a currency and ultimately drives up its value compared to other

currencies (Ito & Krueger, 1999). If a relationship between these economic parameters and

exchange rates can be identified, our model could aid managers in hedging their investments,

as data for these factors is publicly available through sources such as the OECD or databases

4

such as Bloomberg and Datastream. The following hypothesis summarizes the previous

reasoning:

Hypothesis 2: Inflation rate differential, current account change differential, and GDP

growth differential have a significant correlation with exchange rates between two countries

currencies.

Hypothesis 3

Hypothesis 1 and 2 seek to explain the exchange rate puzzle through general economic

parameters. However, finding a universal model to predict exchange rate changes by the means

of key macroeconomic factors may not be possible. Therefore, we formulated a third

hypothesis that considers countries individually when determining factors that drive

fluctuations in their exchange rate. Each country trades a different set of commodities, and its

economic health is thus influenced by changes in those commodity prices. By arguing that

economic health mediates a countrys attractiveness for foreign investments we assume that

changes in commodity prices lead to the volatility in returns of the domestic currency. Based

on the previous reasoning, we hypothesize a relation between certain commodity prices and

specific currencies. If this relationship can be found it will help managers hedge against their

currency risk, as commodity price data is readily available.

Hypothesis 3: For countries that are large exporters or importers of certain commodities,

there is a significant correlation between price changes of these commodities and exchange

rate changes.

In the following section, we introduce the theoretical framework that surrounds each of the

three hypotheses. The order in which we discuss the three hypotheses will remain the same

throughout the entire paper to provide the reader a clear structure. After introducing the theory,

we present a critical evaluation of eleven studies that analysed similar concepts as we do. In

the remainder of the first part of this paper, a critical synthesis will summarize the implications

of these papers with the goal to outline the results of previous research in this field. This is not

only important for a comparison of our own results, but also provides a first indication about

the predictive power of each variable that is analysed in this paper. The second part of the paper

5

presents our research project. We introduce an outline of our dataset as well as the methodology

used in conducting the empirical analysis. Afterwards, we will present the results for each of

the three hypotheses and interpret these regarding their managerial relevance. Ultimately, we

will conclude by summarizing the overall findings for managers, elaborate on the limitations

of our study and suggest relevant topics for further research.

Theory

In the following, we will introduce the theoretical framework that underlies the three

hypotheses tested in this paper. This paper evaluates the impact of various economic

parameters (including commodity prices) on the value of currencies. In this respect, currency

is the unit of interest and represents the focal unit in this paper. The theoretical domain is all

currencies in the world, at all times. Although the study is broad in nature and seeks to

determine implications for any currency, we must confine the limits of our study. The

availability of data constraints the feasibility of conducting research on the theoretical domain,

limiting our population to currencies traded on the NYSE3 only.

All three hypotheses seek to derive claims about the value of currencies. However, as the value

of currencies can only be established in comparison to other currencies, its measurement is

conducted through exchange rates. Consequently, spot exchange rates represent the dependent

concept in each of the three hypotheses. Spot exchange rates can be defined as the ratio at

which the principal unit of two currencies may be traded (Merriam-Webster, 2017). Exchange

rates are quoted as the price of one unit of foreign currency denominated in the domestic

currency. The independent concepts vary throughout the three hypotheses. Their effect on

exchange rate changes is measured as the unstandardized regression coefficient, beta. This

impact cannot be assumed to be causal. While associations can be established, we can neither

exclude the impact of other factors that potentially mediate the relationship between the

variables nor a reverse relationship. This limitation cannot be circumvented, as we cannot

conduct an experiment because macroeconomic factors cannot be controlled or simulated.

3

The New York Stock Exchange (NYSE) is the worlds largest stock exchange, based in New York (Wee, 2017)

6

Hypothesis 1:

The first hypothesis tests the UIP theorem, a parity condition that predicts an expected

exchange rate to be equal to the difference in interest rates between two countries. UIP is

derived from the CIP in the following way (Chinn and Meredith, 2004). CIP is expressed as:

","$% 1 + ",%

=

" 1 + ",%

where " represents the value of a foreign currency unit in terms of domestic currency at point

t, ","$% is the market price of a forward contract on S that expires k periods from t, ",% is the

k-period domestic interest rate, and ",% is the equivalent interest rate of the foreign instrument.

Taking the logarithm of both sides leaves us with the following equation, where the logarithm

is indicated by lowercase letters:

","$% " = (",% ",% )

This equation supposes a risk-free arbitrage condition that is valid independently from investor

preferences. However, the forward rate can vary from the expected future spot rate due to risk

aversion tendencies of investors. The resulting premium can be considered a compensation for

the perceived riskiness of keeping foreign instead of domestic assets. The risk

premium, ","$% , is defined accordingly:

","$% = 5 ","$% ","$%

where 5 ","$% represents the expected exchange rate at t for point t+k. Substituting this

expression into the CIP formula gives us the expected change, , in the exchange rate between

the periods t and t + k. The expected change is a function of the interest differential minus the

risk premium:

5 ","$% = ",% ",% ","$%

In line with the assumption of risk-neutral investors, ","$% becomes a constant term zero.

After adjustment for noise and assuming unbiasedness, the following UIP equation results:

5 ","$% = ",% ",%

As the theory suggests, we seek to validate UIP by examining the effect of interest rate

differentials on exchange rate changes. Thus, the interest rate represents the independent

concept of hypothesis 1. Specifically, we test the proposition that an increase in the interest

rate differential leads to a proportionate decrease in the exchange rate. The interest rate

differential is described as the domestic interest rate minus the foreign interest rate.

7

Hypothesis: High interest rate currencies tend to depreciate.

Conceptual model:

Hypothesis 2:

As we do not expect that interest rates can explain all exchange rate changes, our second

hypothesis aims to uncover other macroeconomic factors that potentially influence the return

of currencies (Bansahl & Dahlquist, 1998; Dornbusch & Fischer, 1980; Ito & Krueger, 1999).

We suggest a measurable influence of three additional macroeconomic factors on exchange

rates, namely (1) the inflation rate differential, (2) the current account growth differential, and

(3) the GDP growth differential.

(1) The literature suggests that a country with a comparably high inflation rate experiences

a decrease in its currency value. This assumption is based on two lines of reasoning

(Bansahl & Dahlquist, 1998). Firstly, an increase in the price level of goods in a country

makes the export of its products and services less competitive compared to countries

with a lower price level of goods. Subsequently, international demand for goods and

services decreases alongside a decrease in demand and value of the respective currency.

Secondly, the increasing price level of goods increases the attractiveness of cheaper

products from foreign countries. To buy foreign products, importers must convert the

domestic currency into foreign currency. This increase/decrease in foreign/domestic

currency demand leads to a depreciation of the home currency.

(2) A current account deficit implies that a country is importing more than it is exporting,

or more precisely, that it spends more on foreign trade than it is earning through foreign

trade. To make up for this deficit countries are required to borrow capital from foreign

sources, resulting in a higher demand for foreign currencies than it receives through

8

exports as well as a higher supply of domestic currency than the trade market demands

for its products. Consequently, the domestic currency depreciates until domestic goods

are attractive for the export market and foreign goods are too expensive for the import

market (Dornbusch & Fischer, 1980).

(3) GDP represents an indicator of economic health. Its growth signals future prosperity of

an economy and thereby represents a valuable indicator for foreign investors. In this

respect, a comparatively high GDP growth is expected to attract comparatively more

foreign investment than a low GDP growth. As a result, the demand for the domestic

currency increases compared to foreign currencies of countries with lower GDP growth

(Ito & Krueger, 1999).

Based on the previous reasoning, the three variables represent the independent concepts of

hypothesis 2. The differentials of each of the three additional economic factors are defined as

domestic rates minus foreign rates. The hypothesis entails the following three propositions:

1. A comparatively higher inflation rate in the domestic country leads to an increase in

the exchange rate

2. A comparatively higher current account balance growth in the domestic country leads

to a decrease in the exchange rate

3. A comparatively higher GDP growth in the domestic country leads to a decrease in the

exchange rate

Hypothesis: Inflation rate differential, current account change differential,

and GDP growth differential can predict changes in exchange

rates between two countries currencies.

Focal unit: Currency

Domain: All currencies in the world, at all times

Independent concepts: Inflation rate, Current account growth, GDP growth

Dependent concept: Exchange rate

Relation: Probabilistic

Conceptual model:

9

Hypothesis 3:

The independent concepts of the first two hypotheses comprise key macroeconomic factors

that potentially impact the currency value of any country. Besides these generic influencers,

we expect the exchange rates of countries that are particularly involved in international trade

to be dependent on the price fluctuations of exported and imported goods. As there is no direct

measurement of the export and import of readily finished goods, we use commodity prices as

measurement parameter to analyse country specific dependencies between trade levels and

exchange rate changes.

Bailey and Chan (1993) analyse risk premia of commodity futures in the largest exporting

countries of commodities and provide findings of a positive association of commodity futures

to a countrys systematic risk (specifically to stock and bond market risk). In addition, Baum

and Barkoulas (1996) research the connection between exchange rate changes and time varying

risk premia, stating that currency futures vary positively with the riskiness in a countrys

overall economy. Therefore, one could assume that certain commodities play an important role

in explaining the risk premia of countries that largely depend on the export and import of these

commodities. Based on this commodity-risk relation, there are two eminent theories that

underline the importance of a commodity-to-currency relationship for commodity-exporting

countries. The sticky price model states that increasing commodity prices have an upside

pressure on the countrys real wages and non-traded goods (Chari et. al, 2000). Consequently,

the relative price between traded and nontraded goods is expected to be restored by an

appreciating domestic currency. The portfolio balance model implies that a countrys currency

is highly correlated with foreign asset supply and demand (Lewis, 1988). An increase in

commodity prices ultimately leads to a surplus in an exporting countrys balance of payments

as well as increasing foreign investments in the domestic currency due to attractive growth

opportunities. The resulting additional demand in the domestic currency increases its value

compared to other currencies.

Based on the previous reasoning, we hypothesize a relation between commodity price changes

and exchange rate changes. In this respect, commodity prices represent the independent

concept of our third hypothesis.

10

Hypothesis: For countries that are large exporters or importers of certain

commodities, there is a significant correlation between price

changes of these commodities and exchange rate changes.

Focal unit: Currency

Domain: All currencies in the world, at all times

Independent concepts: Commodity price

Dependent concept: Exchange rate

Relation: Probabilistic

Conceptual model:

In the following two sections, we first evaluate eleven research papers regarding their fit for

our research, before critically synthesizing their results. The aim of such evaluation is to assess

the quality of each paper regarding various key aspects, such as measurement, research

strategy, or population. The studies found to be of high quality during the evaluation are then

synthesized. Their results are integrated to gain a comprehensive overview of the current state

of research regarding the exchange rate puzzle. This enables us to focus our paper on areas

where little research has been conducted, potentially leading to new insights with high utility

for managers. The evaluation and synthesis entails three sets of literatures, each discussing the

theoretical background of one of our three hypotheses. In total, we analyse eleven papers, of

which seven deal with our hypothesis 1, while two articles cover each of the other two

hypotheses. Since the sets of literature concern different hypotheses, a comparison of all papers

across the three topics is not reasonable. Nevertheless, to qualify as relevant literature for our

research question certain aspects are consistent across all eleven articles. These are the unit of

analysis, the dependent variable, the population and sampling method, and with one exception

also the research strategy.

11

Unit of Analysis

The unit of analysis in each paper matches the focal unit of our hypotheses, namely currencies.

This was the main criterion in searching for papers, and thus other studies with different units

of analysis were not considered.

Dependent Variable

Each of the papers analyses effects on expected exchange rates, matching the dependent

concept we defined in our study. This implies that each of the eleven selected papers evaluates

a hypothesis that is related to our research question.

Independent Variable

The independent concept of each of our articles matches one of the independent variables of

our hypotheses. For hypothesis 1, all seven papers use the same independent variable as we do,

interest rate differentials. Regarding hypothesis 2, we selected two additional articles that

discuss the effects of economic growth and current account growth on exchange rate

fluctuations. For the effect of inflation rate differentials, we draw insights from two previously

discussed papers. Each of the four papers uses at least one independent concept that we include

in hypothesis 2. Both commodity-related articles use constructed country specific commodity

indices as independent variables. As we do not use indices but individual commodities, a direct

comparison between the respective results with our findings has to be conducted with caution.

Measurement

The measurement in each article is conducted through the effect sizes of OLS-regressions. The

effect size in each article for hypothesis 1 and hypothesis 3 is described as the slope-coefficient

beta (). This effect size can be described as non-standardized, as the changes in independent

and dependent variables are not standardized by means of the respective standard deviations.

Consequently, one cannot compare the portrayed effect sizes to other effects beyond the

hypothesis. The precision of each effect size is determined by calculation of the confidence

interval (CI), where SE denotes the Newey-West standard error of the point estimates. On the

contrary, the article from Dornbusch and Fischer (1980) evaluates the relationship between

general economic factors and expected exchange rates qualitatively only. Therefore, this paper

has no quantitative effect sizes that could be compared. The article from Ito and Krueger (1999)

applies a OLS-regression without providing standard errors. Although this characteristic

12

renders the articles incomparable to other evidence, they add essential reasoning that underlines

the potential impact of the macroeconomic factors in our model.

Research Strategy

Regarding the research strategies used in the papers, all articles that refer to hypotheses 1 and

3 use the same strategy, a time-series study. These can be classified as panel studies, which

examine changes in a certain number of cases over time and whose hypotheses each suggest a

link between interest rate differentials or commodity price changes and exchange rate changes.

Such research strategy cannot exclude the influence of external variables. By using panel

studies one can merely find proof of associations between the variables, while causality can

only be established through experimental research strategies. Experiments are not feasible on

a macroeconomic scope as manipulation of independent variables is impossible. Regarding the

papers relevant for hypothesis 2, Ito and Krueger (1999) conduct a time-series study, while

Dornbusch and Fischer (1980) deviate from this model by solely reasoning theoretically

without substantiating the line of argumentation with data. While this research strategy is not

preferable as it is not underlined by empirical results, this paper presents a theoretical

foundation for our own research regarding hypothesis 2.

Population

None of the studies explicitly mentions the population from which the samples are drawn.

Nevertheless, we assume that they all try to find broad, universally valid outcomes that are

meant to apply to all currencies in the world, at all times. However, since valid research can

only be conducted for currencies that are publicly traded, we conclude that only these constitute

the population. The only cases that lie within the domain but outside of the population are non-

traded currencies, such as the North Korean Won. Based on the previous assumptions, none of

the studies makes claims beyond its population. Both the domain and the population are highly

heterogeneous, meaning that the instances of the focal unit, currencies, highly differ from each

other. Therefore, it is difficult to find claims that are valid for the whole population based only

on a sample of the overall population.

Sampling

Up to 23 different exchange rates are examined per study. These are selected based on

purposive sampling. While this form of sampling does not permit generalization, it represents

13

an appropriate strategy as complete data is not available for all variables, countries, or every

time horizon. Through this forced choice, the authors inadvertently influence the set of

instances for which they can reasonably make claims, e.g. if mostly developed countries are

chosen it is not possible to make valid claims for emerging countries. This limitation is

highlighted by the authors, who acknowledge this issue by analysing only the effects in the

sample. The resulting implications are only applied to cases that closely resemble those in the

sample. Thus, the sampling techniques and the theoretical deductions in the papers can be

considered legit.

Data

With regards to the data, the measurement of interest rates and exchange rates is regulated by

the markets. For most studies, data is downloaded through databases such as Reuters

Datastream or Bloomberg. Due to the objective nature of the data and the acceptance of

Bloomberg and Reuters in the international science community, the data can be considered

valid, reliable, and trustworthy. The same applies to the data that has been used in the research

papers regarding the macroeconomic factors and the commodities. Only one UIP study

(Lothian & Wu, 2011) does not use downloaded data but constructs its data from various

alternative sources, as the study goes back 200 years and the respective data is not available in

common databases. Therefore, this study resorts to issues of the Federal Reserve Bulletin, two

articles by Michael D. Bordo (The Bretton Woods International Monetary System: A

Historical Overview, 1993 & The Long-Run Behaviour of the Velocity of Circulation, 1987),

one by Milton Friedman (Monetary Trends in the United States and the United Kingdom,

1982) as well as Sydney Homers book A History of Interest Rates (1977) and the IMF.

Nonetheless, incomplete datasets have been remarked as limitations in 4 papers. Therefore,

their findings are evaluated with particular caution as blank spots in a dataset potentially

decreases the validity of outcomes. However, the incompleteness in these datasets is described

as marginal, which is why we do not exclude any paper for this reason.

Conclusion

Overall, most of the literature reviewed is fit for its purpose. Most UIP studies test the

framework exactly along the lines of the parameters specified in the theory of our hypothesis

1. However, the papers concerning hypothesis 2 and 3 differ from our framework. Dornbusch

and Fischer (1980) do not conduct empirical research on the impact of the current account

14

differential but argue qualitatively only. In addition, both papers on commodity currencies

research the effect of country specific commodity indices on exchange rates only, instead of

focusing on individual commodities. However, as the studies are simply intended to provide a

theoretical background for our own research, such differences in methodology are not

considered a reason for exclusion.

Apart from the previous concerns, there are two papers that require additional examination of

data sets. Lothian & Wu (2011) do not use downloaded data but obtain their data from books

instead. As these sources have been found credible and reliable, this study will be accepted.

Flood & Rose (2001) state that one should not take their beta coefficients at face value due to

non-normalities associated with jumps at currency crises. This lowers the value of this paper

for result comparisons regarding hypothesis 1. Nevertheless, we do not completely disregard

the paper, as it contains important macroeconomic findings for our hypothesis 2. Thus, we

choose not to include it as input for hypothesis 1, but only use it as an indicator for the potential

impact of inflation rate differentials on exchange rates.

In the pursuit to find predictors of exchange rate movements, researchers have examined

multiple influences. Especially the highly-criticized interest rate puzzle has been of central

interest. While other economic factors have still received moderate attention, only few

academic articles evaluate more exotic relations, such as the relationship between changes in

commodity prices and exchange rate changes. In this section, we present the findings of the

previously evaluated academic research articles for each of the three hypotheses. We start by

discussing the results from articles regarding UIP, before focusing on the general economic

factors as well as commodity studies.

Due to the popularity of studying the relationship between interest rates and exchange rates, it

is impossible to include all the relevant literature. Since the overall conclusions across studies

are similar, a careful selection of the most pertinent seven papers suffices to give an insightful

overview of findings regarding the UIP theorem. We chose a wide variety of papers, covering

developing and emerging countries as well as various time horizons from 200 years to intra-

15

daily. Table 1, Appendix A outlines effect sizes (slope-coefficients) as well as CIs of each of

the seven papers. In the following, we will discuss each paper individually starting with the

longest horizon (200 years) and ending with an intra-daily study.

The regression for UIP on ultra-long time horizons of almost 200 years as performed by

Lothian and Wu (2011) yields positive beta coefficients for the FRF (French Franc) and USD

(US Dollar) against the GBP (British Pound Sterling). The largest value of beta is unusually

high with 10.05 (SE: 3.63) for the evaluation of FRF/GBP between 1914 and 1949, raising

questions about the validity of the measure. When looking at shorter time frames, the authors

propose to reject the UIP hypothesis in multiple instances across different currency pairs. Thus,

the authors make the case for examining UIP over longer time frames, but are themselves still

not able to prove UIP even for such long-time periods.

Bansal and Dahlquist (1998) do not find any consistent support for UIP in their study of

developed and emerging economies over a timeframe of more than 20 years. The regression

yielded predominantly negative values, with the lowest one being -8.400 (SE: 3.11) for the

AUD (Australian Dollar) and the highest one being 1.350 (SE: 0.63) for the CZK (Czech

Koruna). Due to this high dispersion and inconsistency of results, the implications of this study

are unclear.

Mehl and Cappiello (2007) test UIP for 7 developed and 3 emerging country currencies against

the USD at 10 and 5 year horizons. For the longer time frame, the authors find more support in

favour of UIP for major floating currencies than for emerging market currencies. The lowest

value of is -0.29 (SE: 0.36) for the SEK (Swedish Krona), while the highest value is 0.860

(SE: 0.09) for the DEM (German Mark). On the contrary, the results of the 5-year time frame

yield only marginal support due to higher standard errors for both developed as well as

emerging market currencies. The beta coefficients from the 5-year regression yield the highest

value of =1.57 (SE: 0.33) for the INR (Indian Rupee), while the lowest value found is =-

2.01 (SE: 0.48) for the SGD (Singapore Dollar).

In the paper by Chinn and Meredith (2004), the authors test UIP for the G7 countries on time

horizons of 3, 6, and 12 months as well as 17 years. For each of the three short term regressions

they find negative beta coefficients in 5 out of 6 cases. Below, Table A reports the lowest and

highest values for each of the timeframes. On the long horizon, all coefficients are positive

16

and 4 out of 6 are closer to unity than to zero, providing more support for UIP than the shorter

timeframes. The lowest beta found is 0.197 (SE: 0.151) for the ITL (Italian Lira), while the

highest value is 1.120 (SE: 0.335) for the CAD (Canadian Dollar). The authors explain that

over longer horizons, the temporary effects of exchange market shocks fade and the model

results are dominated by more fundamental dynamics that are consistent with the UIP

hypothesis.

Italian Lira 0.518 (SE: 0.606) 0.635 (SE: 0.670) 0.681 (SE: 0.684)

Japanese Yen -2.887 (SE: 0.997) -2.926 (SE: 0.800) -2.627 (SE:0.700)

Table A: reports the highest as well as lowest regression coefficients for each of the time horizons used by Chinn and Meredith (2004).

Chaboud and Wright (2005) test four developed countries with high frequency intraday data

from 16:30 to 21:00 (morning trading in Tokyo) New York Time and find that the slope

coefficients in the UIP regression are close to unity and precisely estimated. At this 4.5-hour

horizon, the values span between 0.79 (SE: 0.69) for the CHF (Swiss Franc) and 1.44 (SE:

0.72) for the GBP (British Pound Sterling). The positive results diminish if the time horizon is

extended by just a few hours. On a multi-day horizon (28.50 hours) the coefficients change

significantly and range from =1.26 (SE: 1.51) for the JPY (Japanese Yen) to =2.70 (SE:

1.40) for the GBP. Overall, the study indicates that UIP potentially holds over very short

periods of time. Considering the high standard errors and the marginal time frame, the utility

and relevance of the findings appear rather limited.

In conclusion, the results of studies regarding UIP are contradictory. UIP seems to hold over

very short overnight horizons as shown by Chaboud and Wright (2005). Only adding a few

hours to this timeframe diminishes this outcome, and most effect sizes deviate significantly

from unity. While Chinn and Meredith (2004) find that UIP does not hold for time frames of 3

months, 6 months, and 1 year, Bansal & Dahlquist (1998) find support for UIP in emerging

markets in the short term. Consequently, we can conclude that there is no consensus for UIP

for short term horizons of up to one year, indicating that UIP does not hold as a universal

theory. A similar case can be made for timeframes of 5 to 200 years, where the discussed

studies reveal contradicting and opposing results. While Chinn and Meredith (2004) find more

17

support in the long-term of 17 years than in the short-term, Bansal and Dahlquist (1998) do not

find any significant predictive power of UIP in a time frame of 20 years. Mehl and Cappiello

(2007) further underline this discrepancy, as they find support for UIP only for exchange rates

of developed countries, but not for emerging countries. Regarding an even longer time span,

Lothian and Wu (2011) share the scepticism regarding UIP, as they do not find any substantial

support in the ultra-long term of 200 years.

Besides the diverging effect sizes, large standard errors across all studies lower the precision

of the point estimate and further decrease predictive power. Overall, most studies suggest a

statistically significant influence of interest rate differentials on exchange rate movements,

which is generally not close to unity. This discrepancy in effect sizes suggests that UIP does

not hold and one cannot expect the exchange rate changes to equal the interest rate differential.

The divergence from UIP suggests that there are other factors besides interest rates that drive

exchange rates. In line with this conclusion, Bansal & Dahlquist (1998) propose that

differences across economies are systematically related to per capita GDP, inflation, and

inflation volatility. Instead of forecasting exchange rate changes only through UIP, they

suggest considering other economic parameters.

Inflation rate differential

One factor that potentially mitigates the exchange rate change is the differential of inflation

rates between two countries. Generally, the currency of a country with low inflation is expected

to appreciate as the purchasing power increases compared to other countries with higher

inflation rates. As part of their studies on UIP, Flood & Rose (2004), Bansal & Dahlquist (1998)

and Lothian & Wu (2011) test the impact of inflation rate differentials on expected exchange

rate changes. Flood & Rose (2004) find an effect size of =0.31, which is comparable to the

positive effect sizes of =0.36 and =1.03 that Bansal & Dahlquist (1998) find in their two

samples. The corresponding standard errors of 0.4, 0.27, and 0.29, respectively, substantiate

the homogeneous findings of a somewhat positive impact of inflation rate differentials on

exchange rate changes. The 95% confidence intervals run from -0.47 to 1.09, -0.17 to 0.89, and

0.46 to 1.60, respectively. Thereby, they depict a comparatively wide spread, which diminishes

the reliability of the point estimates. In contrast to these two studies, Lothian & Wu (2011) also

find a negative correlation between inflation differentials and expected exchange rate changes.

18

While their findings depict a positive relation of =3.82 for the FRF/GBP (French Franc and

British Pound Sterling), the USD/GBP (US Dollar and British Pound Sterling) depicts a

negative effect size of =-1.53. Although the authors do not provide a standard error the

negative effect size can be seen as considerable, as it lies outside the confidence interval of the

other two papers. Although not consistent in their findings, the sheer observation of sizeable

effects in all three studies implies a potential impact of inflation rate differentials on exchange

rates. These effect sizes can be found in Table B.

-1.53 - -

Table B: outlines the effect sizes of the three respective papers that analysed the relationship between inflation rate differential and expected

exchange rate changes.

Dornbusch and Fischer (1980) state that the current account growth influences the exchange

rate change. Specifically, they point out that a higher current account growth yields a higher

domestic currency demand over a certain timeframe. This increased asset accumulation can be

considered as a predictor of exchange rates. However, the findings are derived theoretically

and are not substantiated by empirical statistics. This poses a clear limitation regarding

comparability. Other studies about the impact of the current account on the exchange rate

differential could not be found. Nevertheless, as Dornbusch and Fischer (1980) reason logically

towards a sizeable impact of current account changes on exchange rates, this factor will be

considered in our hypothesis 2.

In analysing the Balassa-Samuelson effect, Ito and Krueger (1999) discuss economic growth

as a potential determinant of the nominal change in exchange rates. According to their

19

reasoning, economic growth leads to higher investment and thereby to a growth in export,

which results in a current account surplus. In line with Dornbusch and Fischer (1980), the

surplus leads to the appreciation of the domestic currency. As part of their research on UIP and

the forward premium puzzle, Lothian and Wu (2011) and Bansal and Dahlquist (1998) have

quantified the influence of economic growth on the exchange rate change through GDP growth

differentials. Lothian and Wu (2011) study only developed countries, whereas Bansal and

Dahlquist (1998) incorporate emerging countries. Neither of the two studies incorporates

comparisons to other papers regarding the influence of GDP on exchange rate changes.

Lothian and Wu (2011) find an effect size of =1.13 for the GDP growth differential between

the USA and Great Britain. Although they do not report any standard error for the beta

coefficient, the materiality of this value points towards a significant impact of the economic

growth. Bansal and Dahlquist (1998) depict strongly negative effect sizes of =-3.78 and =-

1.42, with considerable standard errors of SE=1.12 and SE=0.96, respectively. The 95%

confidence intervals run from -5.96 to -1.58 and -3.3 to 0.46, respectively (Table C). The wide

spread of these effect sizes reduces the reliability of the findings. Consequently, one could

consider these results a weak indicator of the magnitude of the link between economic growth

differential and expected exchange rate changes. To shed more light on this unclear relationship

we will incorporate economic growth in our hypothesis 2.

0.52 - -

Table C: outlines the effect sizes of the two papers that study the relationship between GDP growth and expected exchange rate changes.

Altogether, the precise effect of the discussed macroeconomic factors is ambiguous. While

logical reasoning provides ground to assume an influence of each of the three factors on

exchange rate differentials, research has not been able to establish supporting effect sizes for

any of the three factors. The considerable difference in slope coefficients for each factor as

20

well as the width of the CIs reinforces the question whether a universal formula for all exchange

rates can be found. Based on this scepticism, we will test for a more country specific effect of

commodity price changes on exchange rate changes.

Chan et al. (2009) consider 4 and Kohlscheen et al. (2016) research 12 major commodity

exporting countries. Both studies find a significant correlation between commodity prices and

exchange rate changes. While Chan et al. (2009) do not impose a causal relationship,

Kohlscheen et al. (2016) suggest commodity prices to be drivers of exchange rates. In this

respect, Chan et al. (2009) make inferences about general commodity indices and heavy

commodity exporters only. Kohlscheen et al. (2016) suggest an effect of the prices country

specific commodity indices on exchange rates, dependent on the magnitude of exports of a

certain country.

Chan et al. (2009) suggest a statistically significant correlation between the currency return of

a commodity-exporting country and broad as well as country specific commodity

indices. They do not report effect sizes but only the coefficient results of the granger causality

test, which are not directly comparable with any of the discussed effect sizes. Overall, a

drawback of the applied methodology seems to be that the authors took three diversified

commodity indices instead of linking individual commodities to specific countries.

Nevertheless, they conclude a heavy correlation between commodities and currency returns,

although they do not claim a causal relationship. Thus, in our hypothesis 3 we will consider

the impact of price changes of individual commodities on exchange rate changes.

Table D illustrates the slope coefficient values of the multiple linear regression model in

Kohlscheen et al. (2016). The paper assigns predictive power to commodity price changes and

thereby rejects the random walk theory. Although their effect sizes cannot be directly compared

to previous data, the authors proved that variables that are more sensible to a specific countrys

economy provide a higher predictive power than general economic factors. On a short- to

medium-term horizon (1-week up to 6-months) the paper concludes that the price changes of

commodities are stronger predictors of expected exchange rate changes than models based on

general economic factors, including interest rate differentials. By defining country specific

commodity indices that contain the 10 most exported commodities of each country,

Kohlscheen et al. (2016) find evidence of a distinct commodity related driver in currency return

21

changes. Overall, the values depict a low beta value span, ranging from 0.050 to 0.579 for

daily, 0 to 0.074 for weekly, and 0.016 to 0.244 for monthly time horizons. This consistent

trend of positive slope coefficients implies a positive correlation between commodity prices

and exchange rate fluctuations. However, many of the effect sizes are marginal. Furthermore,

the beta-values correspond to indices which makes it impossible to trace the effect sizes back

to individual commodities. Consequently, we intend to isolate and investigate individual

currencies as we presume more meaningfulness and higher effect sizes for individual

commodities.

Time horizon

Table D: Exchange rate predictability by commodities. Given currencies have been evaluated against the USD

After all, both papers suggest relevance of commodity prices in predicting exchange rate

fluctuations. Building upon the insights of the two papers, we will investigate the impact of

certain commodities on exchange rate changes. Contrary to the evaluated literature, we apply

a different criterion to select the commodities by using the 10 most traded commodities

22

worldwide. We examine their effect on the currencies of the 10 largest commodity exporters

as well as the 5 largest commodity importers, as we expect these countries to be most dependent

on commodity price fluctuations. However, we suspect that the currency return of the exporting

countries is considerably more affected by commodity price changes than those of importing

countries. This is reasonable to assume as exporters are more heavily dependent on only few

commodities, while importers often trade a larger variety of commodities.

The following second part of this paper is devoted to our own research. This study aims to

identify economic parameters that impact the change of exchange rates. Regarding managerial

relevance, a causal link could ideally allow them to predict exchange rate movements and

thereby reduce economic uncertainty. However, such causal relations can only be reliably

studied through experiments. As one cannot control financial markets or economic parameters

and simulations would not reflect actual reactions, an experiment is not feasible. Thus, this

study will resort to a panel research strategy, which cannot imply causality. Our strategy

examines a group of cases over a certain time frame. Specifically, this paper will conduct

multiple time-series studies. These time series studies will entail three linear regression models.

The findings will be reported in terms of beta coefficients, SEs as well as significance at a 95%

significance level and explanatory power (R). A more detailed outline of the methodology

applied during each hypothesis test follows the description of our dataset. Ideally, the panel

study will result in a data matrix that assigns effect sizes to each independent variable for each

case. A summary of all effect sizes can be found in Appendix C.

Dataset

In the following analysis, we try to evaluate the impact of various economic influencing factors

on exchange rate changes. As introduced before, there is no clear consensus in the available

literature whether certain factors help managers in forecasting changes in currency returns. To

shed light on the exchange rate puzzle, we construct a three-stage framework. By testing our

research question from three distinct perspectives, we aim to find certain patterns in the FX

market, which could help managers in making more certain currency investments and hedging

their international cash flows. The next section outlines the strategy and methods we used to

construct the dataset.

23

Population

Our research aims to determine the impact of various economic parameters and commodity

prices on the value of currencies. Thus, currency is the unit of interest and represents the focal

unit of this research. In this respect, the theoretical domain is comprised of all currencies in the

world, at all times. However, as this domain is highly heterogeneous, the population studied in

this paper will represent only a subset of the overall domain. Regarding the business context

of this paper, we prioritize the currencies that are most relevant to managerial decision making.

Furthermore, the availability of data dictates the feasibility of our research and restricts the

boundaries of our population. As a result, our population consists of all currencies traded on

the NYSE.

Sampling

Although it is desirable to find generally valid implications for all currencies in our population,

this study aims to provide an alternative perspective with country-specific managerial

implications. Past studies tried to derive implications for the whole population but failed in

providing conclusive managerial implications. We do not intend to statistically infer from

single cases to the whole population, but give managers guidelines that are relevant in

forecasting a specific exchange rate. Consequently, we suppose that it is not reasonable to apply

probability sampling, which would allow for generalization beyond the scope of single

countries. As we expect to find stronger effects for countries that are more heavily dependent

on certain commodities, purposive sampling seems appropriate. We examine the two biggest

exporters for each of the ten most-traded commodities as well as the five largest importing and

manufacturing countries. Lastly, the choice of sample is restricted by means of feasibility,

especially regarding the data availability. Even though most if not all exchange rate pairs are

traded publicly, long-term data is often not available, restricting the examinable sample.

Additionally, not all data is recorded and easily accessible through the databases that we can

access, which further restricts the sampling of this paper. The result is a sample of 14 countries.

Due to various reasons described in the remainder of this paper, three more countries are

excluded from this sample, resulting in a final dataset that consists of 11 exchange rates. The

exclusion of each of these three countries will be explained in detail during the following

sections.

24

Measurement

To test our three hypotheses, we construct a dataset that includes the following parameters for

the last 30 years:

Monthly and Quarterly spot exchange rates

Monthly and Quarterly interest rates

Economic data

o Quarterly current account data

o Quarterly inflation rates

o Quarterly GDP data

Monthly Commodity prices

We collected the data from electronic databases that are commonly used in financial research.

Each of the utilized databases is on the universitys list of accepted data sources and has been

proven to be valid and reliable. In the following we will elaborate which databases we utilized

for the extraction of data and how we establish its credibility. Furthermore, we will explain

how the obtained data is prepared to be useful in empirical analysis.

Since hypothesis 1 tests the effect of interest rate differentials on exchange rate changes, we

will begin with an outline of the data construction of these two variables.

Exchange rates

The monthly as well as quarterly spot exchange rates were obtained from Reuters Datastream.

Reuters is one of the largest and most renowned financial news agencies in the world.

Datastream is a broadly utilized database that is a widely known academic source of economic

data. Spot exchange rates are quoted live, as tradable on the FX market. Thus, they are

objectively determined by the markets and economic institutions and are not subject to

measurement error. Consequently, the data obtained from Datastream can be classified as valid

and reliable. Table E outlines the mnemonics for spot, 1-month, and 3-month forward rates that

we used to download the data. The table does not contain 1-month and 3-month forward rates

for the Chilean Peso and the Iranian Rial. Even after searching in Bloomberg, another

renowned provider of financial data, the two rates in question could not be found. Thus, we

decided to exclude Chile and Iran from our list of sampled countries. While this reduces our

sample size to twelve, we do not see any possibility to circumvent this shortcoming. This

drawback does not weigh heavily, as we do not intend to derive general implications for our

25

entire population. The exclusion simply prevents us from assisting managers that aim to hedge

against fluctuations in the Chilean Peso and Iranian Rial. As the EUR (Euro) only exists since

1999, we used the DEM (German Mark) from 1987 to 1999 instead. Although this might appear

misleading in the beginning, it is common practice in exchange rate research. A reason is that

the value of the EUR is a weighted average of the currencies of the twelve initial Eurozone

members, of which Germany was by far the strongest.

Table E: Mnemonics for exchange rate data. All mnemonics market with an asterisk (*) were subsequently reversed to bring them in the

following form: USD / respective currency

The spot rates are utilized to derive the month-on-month exchange rate changes according to

the following formula:

26

"$7 "

"$7 = = ln "$7 ln " ,

"

where " represents the spot price of the foreign currency in units of the domestic currency at

time t.

Interest rates

The interest rates that we use in the empirical evaluation were not directly extracted from any

database, but calculated instead. As there are many ways to derive a fair approximation of

interest rates, we decided to calculate interest rate differentials based on the Covered Interest

Parity (CIP). This theory presumes no arbitrage between spot prices and forward contracts in

the FX market. The theory states that, as long as risk-free arbitrage is not present, the ratio

between forward and spot exchange rates equals the interest rate differential between countries

with similar characteristics (Chinn and Meredith 2004). This can be illustrated as

","$% 1 + ",%

= ,

" 1 + ",%

where ",% is the k-period interest rate (also called yield) in the domestic country and ",% is the

corresponding interest rate of the foreign country. Based on CIP, the interest rate differential

between two currencies can be calculated by subtracting the natural logarithm of the spot rate

from the natural logarithm of the forward rate. This step is illustrated by the following equation:

ln (","$% ) ln (" ) = (","$% ","$% ).

Economic Data

The second empirical analysis tests the relationship between differentials of general economic

factors between two countries and changes in the corresponding exchange rates. Concerning

the differentials of GDP growth, inflation rates, and current account changes, we take a similar

assumption as the UIP theory does. Specifically, we state that an increase in the inflation rate

differential positively influences the exchange rate, while a positive change in the differentials

of GDP growth and current account growth reversely impact exchange rates. We do not

presuppose a specific magnitude of the slope coefficients, as there are too many factors at play

that could falsify such supposition. The raw data of the economic parameters (current account,

inflation and GDP growth) were obtained from the OECD (Organisation for Economic Co-

operation and Development) database. OECD is an intergovernmental economic organization

comprised of 35 member countries that frequently reports economic parameters. As this

organization enjoys high reputation in the academic world and functions as an unbiased organ

27

that has gathered and analysed economic data for years, it is classified as reliable. Through its

online database at www.data.oecd.org we were able obtain the largest part of the economic

data. Only the data for Russia was not accessible, which we extracted separately from

Bloomberg. To make the raw data meaningful for our analysis, we use the following

modifications to derive the final variables necessary for the regression model.

We are interested in the current account growth differential between each of the twelve

countries and the USA. To get this variable, we first calculated the growth of each countrys

current account according to the following formula:

"$7 "

= "

"

where " represents the current account value of a country at quarter t. Afterwards, we

deducted the current account growth per quarter in the respective foreign country from the

current account growth per quarter in the US to get to the differential.

Inflation differential

The inflation differential between a currency and the US dollar in a certain quarter is the

difference between the inflation rates of the two countries in a certain quarter t.

The GDP growth differential in a certain quarter is obtained by subtracting a countrys GDP

growth from the US GDP growth.

Commodity Data

The third empirical analysis measures the statistical relationship between the change in

commodity prices and the change in exchange rates. For a matter of comparability, it includes

interest rate differentials as an additional independent variable. The commodity price data was

obtained from Reuters Datastream. We download monthly data for the ten most frequently

traded commodities. However, as different types of coffee depict high quality differences and

therefore do not conform to the general characteristics of a commodity, we exclude coffee from

our analysis. This leaves us with nine commodities as independent variables. The mnemonics

of the remaining nine commodities can be found in table F.

28

Since we are interested in the change in commodity prices, we modify the raw data for our

analysis by calculating the monthly change of a commoditys price at month t according to the

following formula:

"$7 "

= "

"

Commodity Mnemonics

Coffee -

Copper LCPCASH

Corn CORNUS2

Cotton COTTONM

Crude Oil OILBRNP

Gold GOLDBLN

Natural Gas NNGSM02

Silver SILVERH

Sugar WSUGDLY

Wheat WHEATSF

Table F: The Mnemonics we used to download the commodity price data from Reuters Datastream

Methodology

Having defined and calculated all required variables, we will now test our dataset for

multicollinearity, homoscedasticity, and outliers, before specifying the three regression

models. These three pre-tests are necessary requirements that need to be considered during the

empirical analysis to decide which type of regression can be applied.

Multicollinearity

Multicollinearity refers to the phenomenon that the independent variables are highly correlated

and can linearly predict each other with a substantial degree of accuracy. In the presence of

multicollinearity, the overall predictive power of the regression model would not be reduced.

However, multicollinearity limits the ability to extract the impact of individual predictors of

the dependent concept. In the first regression that tests UIP, multicollinearity is not an issue

because there is only a single predictive variable. Regarding regression two and three,

multicollinearity might pose an issue, as these regressions contain multiple independent

variables. Statistically, the independent variables would be perfectly multicollinear if a linear

29

relationship among them exists. This condition holds if we find the parameters 7 and ?

such that for all observations i we find

X?A = 7 + ? X7A .

This can be statistically tested by calculating the variance inflation factor (VIF), where the

tolerance is defined as:

7

tolerance = 1 R?J and VIF = ,

NOPQRSTUQ

likely if VIF>3 and definitely exists if VIF>5. Running this with our dataset yields that

multicollinearity can be excluded.

Heteroscedasticity

Heteroscedasticity can be defined as a condition in which the variability of one variable is

unequal across the range of values of a second variable that predicts it (White, 1980). The

presence of heteroscedasticity in a dataset implies that the Gauss-Markov theorem cannot be

applied and that ordinary-least-squares estimators will not provide exact estimators of linearity.

This would ultimately imply that the regression model provides an unbiased estimate of the

relationship between the variables but that it will bias the estimates of standard errors. As a

result, heteroscedasticity is likely to lead to a type 2 error. The statistical test used to verify

whether heteroscedasticity applies to our dataset is the White test. H0 for this test states that

homoscedasticity, or no heteroscedasticity, exist. The standard linear regression model used in

this paper is

YA = X + 7 X7 + + T XA + A .

Whites equation for heteroscedasticity tests the relation of A with each of the independent

variables (XA ), the squares of the independent variables (XA? ) as well as all cross products of the

independent variables (XA XJ for i j). The result can be illustrated as:

YA = X + _ X A + _ XA? + _ XA XJ ,

identifier of coefficient slopes. Based on this auxiliary regressions R value, we test the

models statistical significance of

?

nR? ~ Xab ,

where df defines the amount of regressors. The corresponding results imply that H0 is rejected

and heteroscedasticity is present in all samples.

30

White (1980) outlines that an OLS regression model can be used without concern of serious

distortion, as long as heteroscedasticity is not severe. Since this proposition represents a rather

vague guideline, we use the Newey-West standard error, which corrects for heteroscedasticity

and autocorrelation, in each of the following three regression models. Since Lag(0) is free of

autocorrelation, we can simply use Whites (1980) variance estimate formulation:

d = d X = ?i id i ,

i

where i = i i mno and i is the row I in the matrix X, n represents the number of

predictors at g observations. For any lag(m) where m>0, the Newey-West variance estimate is

applied:

v t

d

d = d X + 1 " "rs "d "rs + "rs ,

"

+1

su7 "us$7

where " represents the row in matrix X at time t (Newey and West 1987). We use twelve and

six lags for monthly and quarterly data, respectively, to corrected for autocorrelation and

heteroscedasticity. As a result, we can ensure that the least square residuals of each regression

model are consistent estimators of their slope coefficients.

Outliers

Considering that all data has been drawn from highly reliable and valid sources and exactly

reflects market data, we will not exclude any outlying data points from our models.

In our first model, we test the relationship between two countries interest rate differentials and

the expected change in the corresponding exchange rate, both monthly and quarterly. UIP states

that the interest rate differential between two countries equals the expected change in the

exchange rate. Consequently, H0 holds if the regression of the exchange rate on the interest

rate differential yields a slope coefficient equal to the value of unity ( = 1) and an intercept

of zero ( = 0). The implications of the UIP regression are outlined in Table G below.

The previously introduced risk-free arbitrage condition ","$% " = (","$% ","$% ) requires

adjustment, as the forward rate might entail a premium that compensates for the perceived risk

of holding domestic vs. foreign assets. Following, we derive the adjusted UIP proposition:

31

5

","$% = ",% ",% ","$% ,

5

where ","$% represents the expected exchange rate change at date t+k and ","$% denotes the

risk premium implied in the forward rate to compensate for additional risk of holding the

foreign currency over the domestic currency. This equation implies that the expected change

in an exchange rate is equal to the interest differential of the respective countries. To define the

regression model, we assume that UIP is only operable when considering the assumption of

rational expectations in exchange markets as well as the proposition that the risk-premium is

zero (Chinn and Meredith, 2000). This means that we add a white-noise error term (","$% ) to

our model, which is not correlated with all known and implied information at time t:

5

","$% = ",% ",% ","$% + ","$% .

Consequently, the linear regression model to test the UIP hypothesis is:

5

","$% = + ",% ",% + ","$% .

This model follows both the UIP theorem and the efficient market hypothesis, as the

disturbance variable ","$% , reduces divergences regarding rational expectations.

(, + )

= () (, )

(: )

=1 > = 0 , = 0

<0 > , > () , < 0

>1 > , > () , < 0

=0.5 = ()

Table G: Four different cases of the beta coefficients in the UIP regression.

Having introduced the general model to test the UIP hypothesis, we continue with an outline

of the second regression model that measures the effects of general economic factor

differentials on expected exchange rate changes. The model follows the assumptions we made

for our first model. However, this model differs from the previously established UIP model in

that it contains multiple independent variables. In addition, our second regression model uses

only quarterly data instead of also monthly data. The attributes we rely on in this model are

GDP growth differential (7 ), inflation rate differential (? ), and current account growth

differential ( ). To illustrate how any of these factors can predict exchange rate changes

32

compared to UIP we also include the interest rate differential ",% ",% . The fundamental

assumption for our second regression model is a linear relationship, defined as

5

","$% = + 7 X7,N + ? X?,N + X,N + ",% ",% + ","$% ,

where is the intercept, represents the slope coefficients and ","$% defines the models error

term from quarter t plus k quarters to the next observation point. To estimate , we implement

a least squares analysis, by minimizing

5

A ","$% 7 XA,7 ? XA,? XA, ",% ",% ? ,

which requires

mno = X d X r7 X d Y,

where X d X r7 and XX are p + 1 (p + 1) symmetric matrices and X d Y is a

p + 1 dimensional vector (Williams, 2016). Then the fitted values are defined by

Y = X = X X d X r7 XY

and the residuals are

r = Y Y = I X X d X r7 X d Y.

The variance estimates are then calculated using Newey-Wests formulation for standard

errors, as outlined previously.

In our third regression, we measure the relationship between 9 different commodities and

exchange rates. The estimation equation is a common multiple linear regression model based

on monthly commodity price changes as well as expected exchange rate changes. To compare

its explanatory strength with the results from the UIP regression, we also include interest rate

differentials as an additional independent variable. As we aim to derive country specific results,

we take the most traded commodities as individual independent variables. Including each

commodity separately instead of focused or diversified indices enables us to elaborate more

closely on the predictive strength of individual commodities. The resulting regression equation

is:

5

","$% =+ T PT,N + ",% ",% + ","$% ,

v

where PT,N represents the change in the commodity price of commodity type m at time t and

M denotes the total sum of all commodities included in the model. The OLS estimators as well

33

as residuals are calculated similarly as outlined above for regression model two, except that

model three includes 10 independent variables. Similar to the previous two models, the

variance estimates are calculated using the Newey-West standard error formulation.

Empirical Results

In this chapter, the results of our observations as well as the statistical analyses are discussed.

For each hypothesis, an overview is provided and the most striking outcomes are evaluated.

At this point, our dataset consists of 12 currency-pairs, each with up to 360 measurement points

for the monthly horizon and around 100 when measured quarterly. The number of data points

depends on the availability of data for the different variables. Generally, we set our cut-off

point as April 1987 (30 years before the beginning of our empirical exercise) for all currencies.

Due to the multitude of measurement values, we opted to draw scatter plots instead of filling

in data matrices for the first hypothesis (Appendix B). These visualize the relationship between

the dependent variable (exchange rate changes; on the y-axis) and the independent variable

(interest rate differentials; on the x-axis) and can provide an initial indication about immediate

findings. After the discussion of the scatter plots we discuss the correlation and regression

(Table 2 & 3, Appendix C) outcomes for monthly and quarterly measurements separately,

before drawing a comparison between these horizons as well as with the existing literature.

While most scatter plots depict no noteworthy dispersion, we will discuss the most relevant

observations in the following. Firstly, Saudi Arabias exchange rate (Scatter Plot 11/23,

Appendix B) does not seem to fluctuate significantly, most data points are at 0 on the y-axis.

Upon further investigation, it becomes clear that this results from the Riyal being pegged to

the USD (Raghu, 2016). This means that its value changes together with the value of the dollar.

Thus, there is no change in the exchange rate between these currencies. Results regarding Saudi

Arabia are not representative and will be excluded in the following, as none of the variables

will be able to imply managerial relevance.

For most other scatter plots the data is spread out evenly around the 0 points of both x- and y-

axis. One exception is the scatter plot of Mexico (Scatter Plot 9/21, Appendix B), where most

data points are below the 0 of the x-axis, indicating a negative interest rate differential.

34

This outcome is similar for some other countries (e.g. Great Britain [Scatter Plot 6/18] or Russia

[Scatter Plot 10/22]), with the exception that for these countries more data points are situated

at a 0-interest rate differential on the x-axis rather than below 0. Similarly, most of Japans

(Scatter Plot 8/20) interest rate differential seem to be either at 0 or at 0.005, leading to a distinct

pattern that is worthy of further examination through regression.

Altogether, the Scatter Plots provide a first indication of the distribution of the data points.

Besides the exclusion of Saudi Arabia from our sample they do not allow for any further

judgment regarding managerial relevance. We will therefore focus on the regression outcomes,

discussing them for both monthly and quarterly measurements. The results for the specific

countries discussed in the following can be found in Table H below.

Monthly Data

For the monthly measurements (Table 2, Appendix C), 6 of the unstandardized regression

coefficients are negative and 5 are positive. Of these 5 positive effect sizes, 3 are closer to the

value of unity than to zero, and two are significantly so, at a 95% confidence level (China,

Russia). As these can be considered the most relevant support of our hypothesis 1, they will be

discussed in more detail and can be found in Table H below.

For China, an unstandardized regression coefficient of 0.647 (N-W SE: 0.171) was obtained.

It is the second highest effect size in the sample, and its correlation coefficient is also the second

highest with a value of 0.351. Even though these values do not coincide with the value of unity

as predicted by UIP, they do not suggest to reject the UIP-hypothesis. More specifically, the

unstandardized effect size means that an increase of 1pp in Chinas interest rate opposed to the

US-interest rate is followed by a decrease of 0.647pp in its exchange rate with the USD. The

models explanatory power, as described by the adjusted R, is 0.118. This means that 11.8%

of the variation in the exchange rate change of the CNY/USD (Chinese Yuan Renminbi) can

be explained by the interest rate differentials. While 11.8% is a sizable value, it gives rise to

the assumption that the interest rate is not the only influencer of exchange rate fluctuation of

the CNY/USD. This finding substantiates the importance of this study, as there seems to be the

necessity of finding a model that can better predict exchange rate changes than the UIP.

Similarly, the test for the RUB/USD (Russian Ruble) yields an unstandardized effect size of

1.203 (N-W SE: 0.243), the highest value observed. This value implies a decrease of 1.203pp

35

in the RUB/USD exchange rate upon a 1pp increase in Russias interest rate compared to the

US-interest rate. The correlation coefficient equals 0.413, which represents the highest value

in the sample. The same is true for the models explanatory power, 16.5% of the variation in

the change in exchange rate of the RUB can be explained by the interest rate differentials.

While the interest rate seems to represent a slightly better explanatory parameter in the case of

Russia than in the case of China, both values suggest the presence of additional explanatory

factors of exchange rate changes.

In contrast, the MXN (Mexican Peso) has the lowest unstandardized regression coefficient with

-0.580 (N-W SE: 0.260). The correlation remains negative but less so (-0.124). This regression

model, however, has an adjusted R of 0.011, thus for the MXN/USD only 1.1% of the

variability in exchange rate changes can be explained by interest rate changes. While the

previously discussed results suggest additional independent factors besides the interest rate

differential, this finding questions the impact of interest rate differentials in its entirety. As all

other countries models have a low explanatory power close to 0, they will not be discussed in

further detail. Their results, however, can be obtained from Table 2 in Appendix C.

Quarterly Data

Regarding the quarterly results (Table 3, Appendix C), 5 of the unstandardized regression

coefficients are negative, with one being only marginally so. Again 6 unstandardized effect

sizes are positive, two significantly so at the 95% significance level. However, only the effect

size for CNY (Chinese Yuan Renminbi) is closer to the value of unity than to zero. The

currencys unstandardized effect size is 0.758 (N-W SE: 0.216). While it does not fully support

the UIP hypothesis, this result supports the claim of a sizable impact of interest rates on

exchange rate fluctuation. Specifically, this result suggests that a 1pp increase in the Chinese

interest rate, as compared to the US interest rate, is followed by a 0.758pp decrease in the

corresponding exchange rate. The correlation coefficient is 0.487, a value that is significant at

the 99% significance level (2-tailed). Furthermore, the described model has an adjusted R of

0.224, which implies that in the case of China the interest rate differential can explain 22.4%

of the variation in exchange rate changes with the USD.

Another correlation that is significant at the 99% significance level (2-tailed) is ZAR/USD

(South African Rand). The countrys unstandardized regression coefficient is positive but low

at 0.106 (N-W SE: 0.045), but significantly different from 0 at the 95% significance level.

36

Having an adjusted R of 0.075 the countrys model also has the second highest explanatory

power.

The lowest unstandardized regression coefficient is found for the AUD (Australian Dollar)

with -1.095 (N-W SE: 2.158). When standardized, it remains negative at -0.068. The adjusted

R, however, is also marginal and even negative (-0.007). Once again, as most other countries

models have similarly low explanatory power, these will not be discussed in further detail but

can be found in Table 3, Appendix C.

Country Measurement Correlation Reg. Co. Unstd. N-W SE Significance Adj. R

period 12 & 6 lags

Australia Monthly -.003 -.056 1.309 .966 -.004

Quarterly -.068 -1.095 .2.158 .613 -.007

China Monthly .351 .647 .171 .000 .118

Quarterly .487 .758 .216 .001 .224

Mexico Monthly -.124 -.580 .260 .027 .011

Quarterly -.126 -.435 .259 .097 .004

Russia Monthly .413 1.203 .243 .000 .165

Quarterly .042 .130 .396 .744 -.018

South Africa Monthly .144 .031 .014 .027 .017

Quarterly .291 .106 .045 .019 .075

Table H: Discussed results Hypothesis 1

Comparing our results to other studies, one can conclude that our values are generally in line

with previous findings. While some of our regressions provide supporting evidence, the

majority of our observed currencies do not support the UIP theorem. Even more so, both the

monthly and quarterly data provide evidence of contrasting effect sizes closer to -1 than to the

value of unity. The same is the case for Flood and Rose (2001) and Bansal and Dahlquist

(2000), who tested UIP on a similar horizon and who also measured monthly. Compared to

long horizon results measured monthly by Chinn and Meredith (2004), Mehl and Cappiello

(2007), and Lothian & Wu (2011), our data gives significantly less support for UIP. The same

is the case when comparing our results to the overnight UIP tests as performed by Chaboud

and Wright (2005). Regarding managerial evidence, both, this part of our study and previous

research, are not able to give clear indications. The results of the countries differ greatly, and

most models possess a low explanatory power. Only over extremely short or long horizons

37

there seems to be support for UIP, but this does not provide utility to managers. Further, in our

study the results of the monthly and quarterly regressions differ widely. This ambiguity in

findings in our study as well as other papers implies the necessity to search for other factors

that impact exchange rate changes. Thus, we aim to find new models with higher explanatory

power by adding other variables in the next sections, starting with the macroeconomic factors

of hypothesis 2.

Table 4 in Appendix C presents a summary of the impact of a countrys economic

characteristics (interest rate, current account growth, inflation, and GDP growth) on the

respective countrys USD exchange rate. The table presents the 11 sampled countries whose

economic parameters are measured on a quarterly basis. Linear regression lets us identify the

unstandardized regression coefficients of each parameter as well as their significance values.

The adjusted R presents evidence on how much of the variation of change in exchange rate

can be attributed to the combination of the four factors.

Overall, the regressions show that none of the additional economic factors (current account

growth differential, inflation differential, GDP growth differential) seem to impact the

exchange rate considerably. The unstandardized regression coefficients that indicate the impact

of a 1pp change in either of the three parameters on the exchange rate are close to zero for all

countries across all three factors. Compared to the unstandardized regression coefficient of the

interest rate differentials the other three factors have a marginal influence. While interest rates

seem to potentially have an impact on exchange rate changes, the three additional parameters

seem to have no additional value. The results for the specific countries discussed in the

following can be found in Table I below.

Regarding the current account growth differential, coefficients are both marginally positive

and negative. Even the largest coefficients of the current account growth differential in absolute

terms, namely of the AUD (Australian Dollar) with -0.038 (N-W SE: 0.022) and of the RUB

(Russian Ruble) with -0.016 (N-W SE: 0.016), are negligible. Thus, the current account growth

differential does not depict any noteworthy influence on exchange rate changes, and hence

does not present useful assistance for managers in their attempt to predict exchange rate

changes.

38

Similarly, the inflation differential does not represent more than a marginal influence on

exchange rate changes. The absolute values of almost all coefficients are smaller than 0.01.

Only the coefficient of the EUR (Euro) depicts a slightly larger value in absolute terms, -0.027

(N-W SE: 0.007). This finding is interesting as the inflation rate has fluctuated significantly in

the Euro zone, particularly throughout the last 10 years. Nevertheless, the value does not appear

large enough to provide a useful input regarding the prediction of exchange rates and thus

managerial relevance. Altogether, the inflation rate differentials do not have a considerable

effect on exchange rate fluctuations and can thus not aid managers in their efforts to predict

exchange rates.

The third parameter, GDP growth differential, also does not appear to influence exchange rate

changes significantly. As with the other two parameters, all unstandardized regression

coefficients are distributed closely around zero, with some being marginally positive and others

marginally negative. We can observe the largest coefficients in absolute terms for the RUB

(Russian Ruble) with 0.023 (N-W SE: 0.014) and the AUD (Australian Dollar) with 0.019 (N-

W SE: 0.014). These values are not only small but they are also contrasting our intuitive

judgement that a higher GDP growth would lead to an appreciation of the respective countrys

currency. Consequently, we conclude that GDP growth differentials are no suitable mean to

estimate exchange rates. Thus, the observation of GDP growth of certain countries does not

provide managers with relevant information to predict exchange rate fluctuations.

Country Variable Reg. Co. Unstd. N-W SE (6 lags) Significance Adj. R

Australia Interest rate diff. -.454 2.400 .836 .033

Current Acc. diff. -.038 .022 .123

Inflation diff. -.010 .008 .203

GDP Growth diff. .019 .014 .217

Euro Zone Interest rate diff. .892 2.439 .713 .088

Current Acc. diff. -.001 .001 .416

Inflation diff. -.027 .007 .000

GDP Growth diff. -.013 .012 .292

Russia Interest rate diff. -.072 .608 .880 -.020

Current Acc. diff. -.016 .016 .422

Inflation diff. .003 .004 .417

GDP Growth diff. .023 .014 .159

Table I: Discussed results Hypothesis 2

39

The previous discussion suggests that neither of the three economic parameters has any sizable

effect on exchange rate changes. These conclusions are contrasting the corresponding findings

in our critical synthesis. Concerning the current account differential, Dornbusch and Fischer

(1980) hypothesize that a comparably favorable current account differential should positively

impact the exchange rate of a country. Our data cannot support this reasoning that has simply

been of theoretical nature. Regarding the impact of inflation rate differentials, Flood and Rose

(2001) as well as Bansal and Dahlquist (2000) found a sizable positive effect size within their

population of developed and developing countries. Our data does not support these findings

but suggests no significant impact. Economic growth has been established as a potential

influencer of exchange rate changes by Lothian and Wu (2011) and Bansal and Dahlquist

(2000). However, they find opposing results as Lothian and Wu (2011) find positive effect

sizes, while Bansal and Dahlquist (2000) find negative effect sizes. Our data cannot resolve the

ambiguity as we find only marginally positive and negative effect sizes.

Based on the previous discussion, we conclude that changes in the current account growth

differential, inflation differential and GDP growth differential between two countries do not

have a significant impact on changes in the exchange rate between the respective countries.

Having proven that neither of the tested economic factors can be used as a universal predictor

of exchange rate changes, we now take a different approach as we will focus on more country-

specific combinations of factors. Specifically, we regress monthly changes of the future prices

of 9 commodities on the exchange rates of countries that are either large exporters or importers

of at least one of these commodities. Thereby, we show that commodity prices have a stronger

predictive power than the previously tested indicators in hypothesis 2. Furthermore, we will

establish the notion that certain commodity prices are a valuable addition to interest rates as

predictors of exchange rate changes. Here, one must remark that this commodity based

forecasting factor is country specific and not universal. Every country has a specific

combination of commodity prices that its economy and its currency price is subject to. We first

demonstrate that correlations between certain country specific commodities and exchange rates

are generally higher than the predominant economic factors such as GDP growth, current

account growth, or inflation rate. Thereafter, we regress each of the 11 exchange rates on the

40

prices of the 9 most dominant commodities and illustrate which of these commodities serve as

the strongest predictors for each exchange rate.

Table J illustrates the correlations of each exchange rate to commodity prices as well as the

respective interest rate differential. Strikingly, only one of the twelve analyzed exchange rates

(Chinese Renminbi to US Dollar) appears to be somewhat correlated with its interest rate

differential (r=0.315). In return, the other eleven exchange rates show a considerably stronger

correlation to either one or several of the included commodities. As already hypothesized, the

strength of each commoditys correlation differs across exchange rates, underlining our

presumption that a country-specific analysis will yield a stronger predictive power than the

previous two regressions. Countries that are large exporters of certain commodities mostly

show a strong correlation between its exchange rate and the respective commodity. For

example, it appears that the INR (Indian Rupee) gains in strength when prices of oil or silver

rise, which both belong to the most exported products of the country. Also, the BRL (Brazilian

Real) seems to be highly correlated with price changes in Oil (r=0.248), Sugar Cane (r=0.233),

and Copper (r=0.288), three products that amount to 13% of Brazils total exports, namely

making up $26 billion (Atlas.media.mit.edu, 2017). Interestingly, for Russia, where one would

expect an above average correlation between the exchange rate and the oil price, we find a

coefficient of r=0.081 only. An explanation for this striking finding could be that the USD (US

Dollar) gains in strength by approximately the same rate as the RUB (Russian Ruble) when oil

prices increase, thus keeping the exchange rate flat. Regarding importing countries in our

sample we find that the Gold price is positively correlated to multiple exchange rates

(EUR/USD: r=0.339, GBP/USD: r=0.252, JPN/USD: r=0.294). This observation could be

explained by the fact that the price of Gold has a strong negative correlation with the value of

the USD (Samanta & Zandeh, 2012). Although this evaluation does not help in estimating the

predictive strength of commodity prices, it clearly suggests co-movement trends between

currencies and commodities.

Table 5, Appendix C reports the results of the regression for the entire sample. We find that

the model reports higher adjusted coefficients of determination (R2) for all expected changes

in exchange rates (except for CNY) than any of the previous models. The results for the specific

countries discussed in the following can be found in Table K below.

41

Pearson Correlations

EUR/ CAN/ GBP/ JPN/ INR/ CNY/ SAR/ RUS/ BRL/ MXN/ AUD/ ZAR/

USD USD USD USD USD USD USD USD USD USD USD USD

Interest R.

Differential -0.033 0.009 0.032 -0.038 0.009 0.315 0.018 0.108 -0.076 -0.128 -0.003 0.144

Oil 0.146 -0.346 0.182 0.088 0.164 0.228 0.180 0.081 0.248 0.179 0.325 0.192

Gas 0.082 -0.199 0.083 0.008 0.003 0.005 -0.003 -0.021 -0.013 0.089 0.152 0.007

Gold 0.339 -0.202 0.252 0.294 0.072 0.161 0.074 0.006 0.078 -0.052 0.282 0.001

Wheat 0.022 -0.092 0.063 -0.002 0.115 0.028 -0.017 -0.012 0.178 0.090 0.181 0.076

Cotton 0.128 -0.181 0.105 0.021 0.121 0.045 0.048 0.069 0.167 0.004 0.092 0.077

Corn 0.070 -0.132 0.067 -0.010 0.046 0.128 -0.002 0.021 0.026 0.055 0.095 0.042

Sugar 0.046 -0.115 0.020 0.042 0.002 0.081 -0.009 -0.004 0.233 0.070 0.108 0.086

Silver 0.161 -0.305 0.120 0.113 0.152 0.107 0.073 -0.019 0.203 0.075 0.388 0.059

Copper 0.232 -0.366 0.271 0.065 0.080 0.082 0.053 0.156 0.288 0.200 0.469 0.148

Table J: The Pearson Correlation coefficients of each of the dependent variables against the ten independent variables.

Regarding effect sizes, Australia and Brazil provide evidence of the exchange rate dependency

on the price movements of heavily traded commodities. The countries strongest export

commodities show the highest beta coefficients. For Australia, the three strongest predictors of

expected exchange rate movements are the Oil price (=0.054; N-W SE: 0.012), the Silver

price (=0.082; N-W SE: 0.029) and the Copper price (=0.132; N-W SE: 0.037). In line with

our proposition, this result appears reasonable as Australia is known for its mining industry,

which consists to a considerable part of Silver and Copper. Furthermore, Australia heavily

exported oil with a value of $12.7 billion in 2016 (representing 6.7% of its total exports)

(Atlas.media.mit.edu, 2017). All in all, the model for Australia is a strong proponent of our

framework with a coefficient of determination of 29.6%. Compared to the model one and two,

the commodity model is able to predict 29.6pp and 23.3pp, respectively, more of the variance

of the AUD exchange rate with the USD.

The case for the BRL (Brazilian Real) is similar. Model three allows us to explain about 20pp

more of the variance in BRL/USD than either of the first two models that relied on economic

factors alone. The strongest positive beta coefficients are Silver (=0.194; N-W SE: 0.061) and

Sugar Cane (=0.175; N-W SE: 0.042), while the beta of Gold is the strongest negative value

equaling -0.248 (N-W SE: 0.146). The high beta level of the price of Silver is surprising due

to the inability to justify it by market data of either exports or imports. One possible explanation

could be the inverse relationship of the USD to the price of Silver (Kowalski, 2017). On the

42

contrary, the coefficient of Sugar Cane appears to be in line with our hypothesis, since it is

Brazils 3rd largest export product (Atlas.media.mit.edu, 2017). Considering that the USD is

inversely correlated with the Gold price, it is striking that the model yielded a negative beta

coefficient, meaning that the Brazilian Peso appears to be even more negatively related to the

price of Gold than the US Dollar.

The RUB (Russian Ruble) yields the highest R2 result, where commodity prices and the interest

rate differential predicted 33.3% of the variance in exchange rate changes. This R2 value is

16.8pp larger than the coefficient of determination in the UIP regression model. The interest

rate differential and changes in the oil price show the highest beta coefficients of 1.201 (N-W

SE: 0.199) and 0.160 (N-W SE: 0.056), respectively. Since in total 46% of Russias exports is

represented by oil, this result suggests that our model cannot be applied to every country that

heavily exports one single commodity (Atlas.media.mit.edu, 2017).

As already investigated in the correlation analysis above, those countries with a strong

manufacturing industry and a negative trade balance show high beta coefficients for the price

of Gold. For the EUR/USD sample, the coefficient is =0.238 (N-W SE: 0.040), while for the

GBP/USD and JPY/USD sample the value is =0.158 (N-W SE: 0.034) and =0.260 (N-W

SE: 0.060), respectively. As suggested above, this finding might be explained by the USDs

strong negative correlation with the Gold price, which weakens its value and consequently

increases each of the three exchange rate pairs. For Japan, neither the interest rate differential

nor any other commodity shows any noteworthy coefficient of correlation. However, for the

EU and for Great Britain especially, it is worth noticing that the beta coefficients of Copper

could give managers an idea about future tendencies in exchange rates. The regression found

coefficients of =0.059 (N-W SE: 0.017) for EUR/USD and =0.078 (N-W SE: 0.020) for

GBP/USD. Although only 0.33% of the UKs exports consist of Copper, this finding can be

justified by the fact that five of the ten largest Copper producers are either headquartered in the

UK or are majorly owned by British companies (Atlas.media.mit.edu, 2017) (Barrera 2017).

Applying regression model three to the changes of the CNY/USD (Chinese Yuan Renminbi)

yields another striking result. The worlds fastest growing economy does not seem to be

influenced by the price changes of a specific commodity. While, China exported almost twice

as much as it imported in 2016, there is a very important aspect hidden in the data

(Atlas.media.mit.edu, 2017). Out of the $2.73 trillion exports in 2016, only about 9% or $245.5

43

billion can be attributed to commodities while about 62% of all imports are commodities

($787.4 billion), making China a commodity importer rather than exporter

(Atlas.media.mit.edu, 2017). These findings are in line with our previous argumentation that

importers are considerably less influenced by commodity price changes.

Country Variable Reg. Co. unstd. N-W SE (12 lags) Significance Adj. R

Australia Interest rate diff. .039 1.010 .969 .296

Oil price change .054 .012 .047

Gas price change .017 .012 .155

Gold price change .009 .080 .913

Wheat price change .017 .022 .446

Cotton price change .024 .023 .303

Corn price change .026 .021 .237

Sugar price change .015 .015 .337

Silver price change .082 .029 .007

Copper price change .132 .037 .000

Brazil Interest rate diff. -.024 .138 .865 .203

Oil price change .044 .039 .260

Gas price change -.021 .018 .261

Gold price change -.248 .146 .043

Wheat price change .042 .029 .161

Cotton price change .044 .041 .282

Corn price change .029 .031 .361

Sugar price change .175 .042 .483

Silver price change .194 .061 .002

Copper price change .107 .040 .009

China Interest rate diff. .553 .205 .000 .156

Oil price change .014 .007 .040

Gas price change -.004 .003 .367

Gold price change .022 .014 .014

Wheat price change 9.180E-6 .003 .661

Cotton price change -.001 .003 .544

Corn price change .004 .003 .153

Sugar price change .002 .004 .714

Silver price change -.007 .007 .289

Copper price change -.007 .005 .186

Russia Interest rate diff. 1.201 .199 .012 .333

Oil price change .160 .056 .049

44

Gas price change -.021 .016 .625

Gold price change .035 .057 .293

Wheat price change -.030 .028 .234

Cotton price change .030 .028 .829

Corn price change -.004 .029 .874

Sugar price change -.001 .019 .578

Silver price change -.011 .037 .581

Copper price change .048 .032 .355

Table K: Discussed results Hypothesis 3

The empirical findings from the third regression model match the results from previous

research by Chan et al. (2009) as well as Ferraro, Rogoff and Rossi (2012) and Kohlscheen et

al. (2016). Each of the papers formulates a comparable regression model and concludes a

predictive power of certain commodities or commodity indices for countries that are large

exporters of commodities. In our model, especially the AUD/USD and BRL/USD depict

considerable dependence on the prices of individual commodities. In these cases, we suggest a

relationship between commodity price changes and exchange rate changes, as the respective

commodities represent significant portions of the countries exports. Overall, the values

underline our initial assumption that particularly exporters currencies are considerably

affected by the prices of their major exported goods. Further, the marginal coefficients of the

Chinese Renminbi support our initial suggestion of a negligible impact of commodity prices

on the currency of countries that mainly import commodities. In addition, we obtained similar

findings as Chan et al. (2009) for the ZAR (South African Rand), which appears to be an

exception to our hypothesis 3 as commodities do not yield any predictive power in this case.

Overall, however, even though this hypothesis is barely researched it appears to hold

considerably more predictive power on a countrys expected exchange rate change than any

general economic factor. Further, it seems that the example of commodities proves that a

country specific approach to forecast exchange rate changes is more promising than a universal

formula.

Robustness Test

In the previous section, we found that on average the beta coefficients of commodity price

changes in hypothesis 3 have a higher predictive power on exchange rate changes than the

tested economic factors in hypotheses 2. Furthermore, we proposed to consider commodity

prices changes as an additional influencer of exchange rate changes next to interest rate

45

differentials. To verify the correctness of our test findings, we perform a robustness test of our

hypothesis 3. Testing the sensitivity of our findings is essential because exchange rates are

exposed to an extremely fast paced and complex environment, which might distort any

forecasting effect found in the regression. Testing the robustness helps us make a clear and

valid conclusion of our findings and provides new insights into the overall predictive power of

commodity prices.

In the previous empirical tests, we used exchange rates based on the bilateral base currency

USD. In order to validate that the results from the regression model three are not driven by

correlations between the USD and the commodity prices, but rather due to the price changes

of commodities themselves, we change the base currency to GBP (British Pound Sterling) and

run another regression model. In this, the 10 new spot exchange rates have been downloaded

from Datastream. Contrary to our initial regression model three, we do not include interest rate

differentials and fully focus the measurement on commodity price changes. The main reason

for this change is the fact that forward rates between the GBP and the 10 counter currencies

are not available for the 30-year time frame for all instances. Thereby, we are not able to

calculate the interest rate in the same way as in the regression against the USD exchange rates.

Table K shows the most striking results, while Table 6 in Appendix D outlines the direct

comparison of the results for all currency pairs based on the two different home currencies and

as well as the same nine commodities used before. Overall, the effect sizes in the GBP

regressions are only marginally weaker than in the case where the USD is the base currency.

One reason of the slight decrease in most beta coefficients could be the fact that all commodity

prices are denominated in USD. Hence, a change in the return of the USD would naturally lead

to a change in the USD denominated price of the commodities. In his research on the

relationship between commodity prices Akram (2009) found a generally strong negative

correlation concerning US dollar return and the price of 5 commodities used in our research

(oil, gas, gold, silver, corn). Despite the reduction in overall effect, the results of the robustness

test outperform the random walk theory for all 10 exchange rates. Specifically, for each

currency pair at least one beta coefficient value is above .14 (all except two significantly so).

A striking finding is that all slope coefficients for Gold changed significantly. While the

EUR/USD depicted a beta for gold of 0.239, the EUR/GBP has a beta value of 0.142. A

potential explanation for this difference between the two regression models is the strong

negative correlation between the USD and the Gold price. A similar picture can be drawn when

46

considering the Mexican Peso as counter currency. The beta coefficients change from =-0.185

for MXN/USD to 0.341 for MXN/GBP. These significant changes in the predictive power of

the gold price clearly show that the USD is not an optimal base currency for our assumption,

as its correlations with commodity prices strongly affects the regression results.

On the contrary, a similar limitation is the British Pounds positive correlation with the price

of Silver. When taking USD as the base currency, we only find 1 coefficient of silver prices

that can give managers an indication about an expected exchange rate movement. However,

when taking GBP as the base currency we find 5 out of 10 beta coefficients smaller than -.1,

indicating that the exchange rate weakens when the price of silver increases. For CAN/GBP,

for example, we find =-0.104 (CAN/USD =0.055) and for ZAR/GBP we find a beta of -

0.147 (ZAR/USD =0.023). This is a clear indicator that managers should first check for the

correlations between the base country and commodity prices before making inferences about

the predictive strength of commodity price changes on exchange rate changes.

USD GBP

unstd (12 lags) ce unstd (12 lags) ce

Country Variable

Canada Oil-Price -.035 .013 .011 .108 .017 .000

Gas-Price -.018 .005 .002 .013 .011 .240

Gold-Price .012 .039 .479 .171 .045 .000

Wheat-Price -.001 .010 .903 -.002 .018 .900

Cotton-Price -.023 .014 .129 -.001 .019 .969

Corn-Price -.012 .015 .447 -.003 .025 .916

Sugar-Price .008 .009 .403 -.001 .021 .960

Silver-Price .055 .017 .002 -.104 .029 .001

Copper-Price -.070 .017 .000 .005 .018 .783

Euro Oil-Price .013 .016 .424 .029 .041 .479

Zone Gas-Price .007 .010 .502 .009 .013 .516

Gold-Price .239 .039 .000 .142 .068 .004

Wheat-Price -.018 .015 .235 .001 .022 .947

Cotton-Price .040 .019 .046 .012 .029 .695

Corn-Price .025 .020 .223 .004 .024 .857

Sugar-Price -.006 .014 .659 -.010 .014 .466

47

Silver-Price -.060 .028 .040 -.050 .054 .359

Copper-Price .058 .018 .002 .049 .029 .102

Mexico Oil-Price .047 .017 .008 -.030 .028 .294

Gas-Price .021 .023 .387 -.024 .029 .400

Gold-Price -.185 .078 .018 .341 .087 .000

Wheat-Price .033 .026 .213 -.033 .030 .280

Cotton-Price -.032 .042 .455 .048 .041 .254

Corn-Price -.004 .012 .861 .012 .032 .699

Sugar-Price .005 .031 .867 .000 .036 .989

Silver-Price .070 .029 .020 -.101 .037 .008

Copper-Price .105 .037 .018 .162 .031 .607

Russia Oil-Price .219 .046 .677 .348 .067 .000

Gas-Price -.024 .022 .288 .012 .022 .590

Gold-Price -.119 .119 .322 .301 .165 .051

Wheat-Price -.042 .043 .325 .078 .039 .047

Cotton-Price .012 .044 .787 -.013 .033 .694

Corn-Price .091 .053 .080 -.038 .049 .440

Sugar-Price .081 .082 .325 -.129 .114 .259

Silver-Price .046 .069 .511 -.138 .105 .193

Copper-Price .131 .063 .040 .017 .040 .682

South Oil-Price .067 .035 .058 -.017 .023 .470

Africa Gas-Price -.010 .019 .608 .000 .008 .976

Gold-Price -.073 .066 .273 .095 .0115 .011

Wheat-Price .026 .021 .235 .015 .059 .543

Cotton-Price .013 .038 .742 .000 .024 .999

Corn-Price -.011 .028 .696 .011 .031 .674

Sugar-Price .017 .026 .529 -.014 .026 .731

Silver-Price .023 .039 .561 -.147 .030 .000

Copper-Price .043 .053 .425 -.002 .037 .903

Table L: Results of the Robustness Test regression in direct comparison with results from regression of hypothesis 3. The interest rate

differential has been excluded from this test due to the inability to retrieve reliable forward rates for some currencies against the GBP.

Overall, the robustness test shows that our assumption of using changes in commodity prices

as predictive indicators for exchange rates is valid. However, one must carefully consider the

correlations between the base currency and commodities in order to come to clear and valid

conclusions. In addition, the test also found that using the USD as base currency is not optimal,

as the effect sizes of gold and oil seem to correlate heavily with the return of the USD.

48

Conclusion & Implications for Practice

This paper aimed to provide a framework that can assist managers in hedging currency risk.

Globalization has exposed a wide array of businesses from various countries to international

risk. In line with this development, managers find themselves subject to increasing pressure to

hedge their cash flows and reduce their currency exposure. In this respect, a comprehensive

framework that can predict exchange rate changes would reduce uncertainty and would

increase the competitive position of any internationally operating business. Against this

background, we set out to explain exchange rate changes by testing 3 different hypotheses. We

examined the highly criticized UIP theory followed by a test of three other economic factors

that could theoretically impact exchange rate changes. Lastly, we checked for a country-

specific influence of commodity price changes on exchange rate changes of the currencies of

countries that are highly engaged in international trade.

Regarding the UIP hypothesis, our research substantiates the skepticism of other research in

the field. Both our monthly as well as our quarterly results do not find support for UIP. On the

contrary, most effect sizes suggest to reject the UIP framework. These findings are in line with

the research of Flood and Rose (2001) and Bansal and Dahlquist (2000). Particularly striking

is the inconsistency of the effect sizes. Oftentimes the monthly effect size of one currency pair

provided contradicting implications compared to the quarterly results of the same currency

pair. After all, we conclude that UIP does not hold and that interest rate differentials can at best

partially explain exchange rate fluctuations. Managers in the global environment will thus need

to look out for other influencers in order to be able to actively hedge against unfavorable

exchange rate fluctuations.

With regard to the other economic factors that we tested the predictive effect was found to be

marginal. Dornbusch and Fischer (1980), Ito et al. (1999) and Bansal and Dahlquist (1998)

suggest an influence of current account growth differential, inflation differential and GDP

growth differential, respectively. Our results could not substantiate any of their findings. On

the contrary, all three economic factors reveal negligible effect sizes. Thus, we conclude that

the three economic factors cannot assist managers in their attempt to hedge their international

financial position by forecasting exchange rate changes.

49

In testing our last hypothesis, we found evidence of commodity prices as predictors of

exchange rate changes. In line with Chan et al. (2009) and Kohlscheen et al. (2016) we

established that currencies are to some extent correlated with specific commodity prices. Based

on our effect sizes we conclude a sizable correlation between commodity price changes and

exchange rate changes. This link is expected to hold, especially for commodity exporters. In

our dataset, this hypothesis is particularly substantiated by the effect sizes of the Brazilian Real

and the Australian Dollar, which considerably depend on the prices of sugar cane, and copper

and silver, respectively. While this relationship is not observable for every country in our

sample, the effect sizes suggest a higher impact of commodity price changes on exchange rate

changes than the other economic factors tested in hypothesis 2. In this respect, commodity

prices could represent a valuable addition to all models that attempt to explain exchange rate

changes solely through interest rate changes.

Regarding the dilemma of international managers, the previous conclusions can provide

precious insights. Generally, our findings reinforce the hypothesis that interest rates represent

at best one out of many parameters that can assist managers in hedging their currency risk.

More specifically, our findings emphasize that exporters should closely monitor price

movements of the most heavily exported commodities of their home country. Managers of

importing businesses are affected by the implication of our results as well. We suggest that

they should watch prices of the biggest export commodities of their trade partners home

countries. Otherwise managers could, for instance, be surprised by foreign denominated

payables that translate into increasing home country denominated expenses. After all, this

paper should encourage managers to look beyond the UIP theory in their attempt to hedge their

currency risk. While commodity prices do not solve the entire puzzle, they do add another piece

to the exchange rate picture.

Our study is subject to several limitations that we were not able to circumvent.

Firstly, our research strategy, the panel study, does not allow us to imply causality. As

described above, only an experiment can describe such an effect confidently. However, a panel

study was the only viable research strategy, thus we were only able to argue theoretically based

upon our regression results. Even though this methodology is common practice in

50

macroeconomic research it remains a drawback of our study, as we cannot exclude the

influence of other factors next to our independent variables.

Secondly, we cannot generalize our findings, neither to our population nor to other cases within

our theoretical domain. The high heterogeneity of the domain renders the application of our

findings to other cases that lie outside our population impossible. Further, we chose to use

purposive sampling, which prevents us from safely generalizing any effect size from our

sample to the entire population. However, this was not intended, as we set out to find country-

specific combinations of influencing factors. As purposive sampling provided the highest data

accuracy, this methodological approach still seems appropriate in hindsight.

Thirdly, we were not able to obtain data for all currencies for the whole timeframe that we

intended to study. While most currencies data was available, even beyond our measurement

period, some countries data proved to be only available for around 20 years. While this does

not render our results invalid, it would be preferable to obtain a complete dataset for all

currencies sampled. More severely weighs the unavailability of enough data for Chile and Iran,

which forced us to exclude these two countries from our list. Particularly, in light of Chiles

and Irans strong dependency on their copper and oil exports these two countries would have

represented interesting cases. More generally, one can remark that a larger sample size could

have allowed us to draw more extensive theoretical implications.

Lastly, even though we found an apparent relationship between commodity prices and the

exchange rate changes of heavy exporters of these commodities, this relationship does not seem

to hold in every case. We expected to find significant results e.g. for the oil price and the value

of the RUB (Russian Ruble), however did not obtain such. This inconsistency between

countries emphasizes that the reader should not exclusively rely on our results and that further

research will need to be conducted to illuminate various factors that influence exchange rate

changes.

Following the previous drawbacks, we want to emphasize that our model is not to be considered

in isolation and does not mark the end of the search for a comprehensive model that can predict

exchange rate movements entirely. For this reason, the science community should focus on

finding additional influencing factors instead of testing for the basic UIP hypothesis. Building

upon our findings we suggest that future research should test in the opposite direction, namely

51

if and how exchange rate changes influence commodity prices. Alternatively, a similar test to

ours should be performed using high frequency data, regressing daily changes in exchange

rates on daily changes in commodity prices. Further, one could refine our model and make it

even more country-specific by selecting the main exported commodities of each country

individually instead of taking the 10 most-traded commodities worldwide. As seen in our

results, most currencies seem to be influenced more strongly by prices of commodities that the

respective country heavily trades in. Thus, by forming individual models for each country with

only a small selective number of commodities as independent variables, one could potentially

explain even more of the exchange rate puzzle for that specific country.

52

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55

Appendix

Appendix A

Table 1: Results from past papers

Time Lower Bound Upper Bound

Study Country Horizon Beta SE CI CI

Chinn&Meredith(2004) Germany Monthly 0.924 0.232 0.469 1.379

Chinn&Meredith(2004) Japan Monthly 0.399 0.144 0.117 0.681

Chinn&Meredith(2004) UK Monthly 0.563 0.104 0.359 0.767

Chinn&Meredith(2004) France Monthly 0.837 0.442 -0.029 1.703

Chinn&Meredith(2004) Italy Monthly 0.197 0.151 -0.099 0.493

Chinn&Meredith(2004) Canada Monthly 1.120 0.355 0.424 1.816

Flood&Rose(2001) Argentina Monthly 0.000 0.010 -0.020 0.020

Flood&Rose(2001) Australia Monthly -3.580 2.550 -8.578 1.418

Flood&Rose(2001) Brazil Monthly 0.190 0.010 0.170 0.210

Flood&Rose(2001) Canada Monthly -0.580 0.540 -1.638 0.478

Flood&Rose(2001) Czech Rep Monthly -1.270 0.850 -2.936 0.396

Flood&Rose(2001) Denmark Monthly -0.030 0.700 -1.402 1.342

Flood&Rose(2001) Finland Monthly 7.060 3.800 -0.388 14.508

Flood&Rose(2001) France Monthly -1.420 0.620 -2.635 -0.205

Flood&Rose(2001) Germany Monthly 0.130 1.110 -2.046 2.306

Flood&Rose(2001) Hong Kong Monthly 0.000 0.030 -0.059 0.059

Flood&Rose(2001) Indonesia Monthly -1.190 1.130 -3.405 1.025

Flood&Rose(2001) Italy Monthly 0.290 2.550 -4.708 5.288

Flood&Rose(2001) Japan Monthly -1.710 1.110 -3.886 0.466

Flood&Rose(2001) Korea Monthly 0.000 0.000

Flood&Rose(2001) Malaysia Monthly 2.240 2.080 -1.837 6.317

Flood&Rose(2001) Mexico Monthly -0.770 0.700 -2.142 0.602

Flood&Rose(2001) Norway Monthly 0.590 0.750 -0.880 2.060

Flood&Rose(2001) Russia Monthly 0.220 0.110 0.004 0.436

Flood&Rose(2001) Sweden Monthly -0.440 0.950 -2.302 1.422

Flood&Rose(2001) Switzerland Monthly -2.080 1.400 -4.824 0.664

Flood&Rose(2001) Thailand Monthly -0.830 1.800 -4.358 2.698

Flood&Rose(2001) UK Monthly -1.260 0.970 -3.161 0.641

Flood&Rose(2001) Fixed ex. Monthly -0.930 -0.930 -0.930

Flood&Rose(2001) Floating ex. Monthly -0.200 -0.200 -0.200

Flood&Rose(2001) Pooled Monthly 0.190 0.190 0.190

Bansal&Dahlquist (2000) Switzerland Monthly 1.050 0.600 -0.126 2.226

Bansal&Dahlquist (2000) Hong Kong Monthly -0.010 0.160 -0.324 0.304

Bansal&Dahlquist (2000) Singapore Monthly -1.260 1.500 -4.200 1.680

56

Bansal&Dahlquist (2000) Japan Monthly -2.210 0.530 -3.249 -1.171

Bansal&Dahlquist (2000) Belgium Monthly -0.770 0.400 -1.554 0.014

Bansal&Dahlquist (2000) Austria Monthly -0.760 0.570 -1.877 0.357

Bansal&Dahlquist (2000) Denmark Monthly -0.560 0.340 -1.226 0.106

Bansal&Dahlquist (2000) Canada Monthly -1.040 0.330 -1.687 -0.393

Bansal&Dahlquist (2000) France Monthly 0.000 0.610 -1.196 1.196

Bansal&Dahlquist (2000) Germany Monthly -0.560 0.630 -1.795 0.675

Bansal&Dahlquist (2000) Netherlands Monthly -1.380 0.550 -2.458 -0.302

Bansal&Dahlquist (2000) Italy Monthly 0.080 0.320 -0.547 0.707

Bansal&Dahlquist (2000) UK Monthly -1.550 0.610 -2.746 -0.354

Bansal&Dahlquist (2000) Australia Monthly -8.400 3.110 -14.496 -2.304

Bansal&Dahlquist (2000) Sweden Monthly 0.560 0.570 -0.557 1.677

Bansal&Dahlquist (2000) Spain Monthly 0.670 0.420 -0.153 1.493

Bansal&Dahlquist (2000) Portugal Monthly 0.460 0.200 0.068 0.852

Bansal&Dahlquist (2000) Poland Monthly 0.460 0.500 -0.520 1.440

Bansal&Dahlquist (2000) Greece Monthly -0.380 0.180 -0.733 -0.027

Bansal&Dahlquist (2000) Czech Rep. Monthly 1.350 0.630 0.115 2.585

Bansal&Dahlquist (2000) Malaysia Monthly 0.350 0.580 -0.787 1.487

Bansal&Dahlquist (2000) Argentina Monthly 0.080 0.070 -0.057 0.217

Bansal&Dahlquist (2000) Venezuela Monthly 0.710 0.310 0.102 1.318

Bansal&Dahlquist (2000) Thailand Monthly 0.530 2.970 -5.291 6.351

Bansal&Dahlquist (2000) Mexico Monthly -1.400 0.860 -3.086 0.286

Bansal&Dahlquist (2000) Turkey Monthly 0.280 0.200 -0.112 0.672

Bansal&Dahlquist (2000) Philippines Monthly 0.810 1.990 -3.090 4.710

Bansal&Dahlquist (2000) India Monthly -0.980 1.170 -3.273 1.313

Bansal&Dahlquist (2000) ALL Monthly 0.260 0.140 -0.014 0.534

Bansal&Dahlquist (2000) Developed Monthly -0.320 0.290 -0.888 0.248

Bansal&Dahlquist (2000) Emerging Monthly 0.190 0.190 -0.182 0.562

Mehl&Capiello (2007) Canada Monthly 0.610 0.320 -0.017 1.237

Mehl&Capiello (2007) Germany Monthly 0.860 0.120 0.625 1.095

Mehl&Capiello (2007) Japan Monthly 0.220 0.170 -0.113 0.553

Mehl&Capiello (2007) UK Monthly 0.850 0.230 0.399 1.301

Mehl&Capiello (2007) Australia Monthly 0.530 0.130 0.275 0.785

Mehl&Capiello (2007) Sweden Monthly 0.290 0.360 -0.416 0.996

Mehl&Capiello (2007) Switzerland Monthly 0.400 0.090 0.224 0.576

Mehl&Capiello (2007) Malaysia Monthly 0.210 0.130 -0.045 0.465

Mehl&Capiello (2007) Thailand Monthly 0.730 0.190 0.358 1.102

Mehl&Capiello (2007) Taiwan Monthly 0.250 0.160 -0.064 0.564

Mehl&Capiello (2007) All curr. Monthly 0.500 0.030 0.441 0.559

Mehl&Capiello (2007) Developed Monthly 0.520 0.030 0.461 0.579

57

Mehl&Capiello (2007) Emerging Monthly 0.240 0.030 0.181 0.299

Lothian&Wu (2011)

Short-Term Interest France - UK Annualy 0.97 0.860 -0.716 2.656

Lothian&Wu (2011)

Short-Term Interest US - UK Annualy 0.14 0.160 -0.174 0.454

Lothian&Wu (2011)

Long-Term Interest France - UK Annualy 0.73 0.430 -0.113 1.573

Lothian&Wu (2011)

Long-Term Interest US - UK Annualy 0.39 0.280 -0.159 0.939

Lothian&Wu (2011)

1800-1913 France - UK Annualy 0.35 0.260 -0.160 0.860

Lothian&Wu (2011)

1800-1913 US - UK Annualy 0.42 0.730 -1.011 1.851

Lothian&Wu (2011)

1914-1949 France - UK Annualy 10.05 3.630 2.935 17.165

Lothian&Wu (2011)

1914-1949 US - UK Annualy 1.36 2.670 -3.873 6.593

Lothian&Wu (2011)

1950-1999 France - UK Annualy 0.7 0.490 -0.260 1.660

Lothian&Wu (2011)

1950-1999 US - UK Annualy 0.32 0.640 -0.934 1.574

Chaboud&Wright(2004) Switzerland Overnight 0.79 0.690 -0.562 2.142

Chaboud&Wright(2004) Germany Overnight 1.02 0.730 -0.411 2.451

Chaboud&Wright(2004) UK Overnight 1.44 0.720 0.029 2.851

Chaboud&Wright(2004) Japan Overnight -1 0.840 -2.646 0.646

Table 1: Results from past papers

58

Appendix B

Monthly

Scatter Plot 4: China Scatter Plot 5: EU19 Scatter Plot 6: Great Britain

59

Scatter Plot 10: Russia Scatter Plot 11: Saudi Arabia Scatter Plot 12: South Africa

Quarterly

Scatter Plot 13: Australia Scatter Plot 14: Brazil Scatter Plot 15: Canada

Scatter Plot 16: China Scatter Plot 17: EA19 Scatter Plot 18: Great Britain

60

Scatter Plot 19: India Scatter Plot 20: Japan Scatter Plot 21: Mexico

Scatter Plot 22: Russia Scatter Plot 23: Saudi Arabia Scatter Plot 24: South Africa

61

Appendix C

Table 2: Uncovered Interest Parity Regression monthly data

Country Correlation Reg. Co. unstd. N-W SE (12 lags) Significance Adj. R

Australia -.003 -.056 1.309 .966 -.004

Brazil -.093 -.144 .177 .415 .003

Canada -.009 -.126 .514 .807 -.003

China .351 .647 .171 .000 .118

Euro Zone -.033 -.521 .784 .507 .001

Great Britain .032 .501 .972 .606 -.002

India .019 .024 .094 .800 -.004

Japan -.038 -.489 .628 .437 -.001

Mexico -.124 -.580 .260 .027 .011

Russia .413 1.203 .243 .000 .165

South Africa .144 .031 .014 .027 .017

Country Correlation Reg. Co. unstd. N-W SE (6 lags) Significance Adj. R

Australia -.068 -1.095 2.158 .613 -.007

Brazil .118 .238 .196 .229 -.003

Canada .02 .212 .835 .800 -.009

China .487 .758 .216 .001 .224

Euro Zone -.013 -.133 .867 .878 -.008

Great Britain .016 .155 1.050 .883 -.009

India -.058 -.062 .162 .702 -.01

Japan -.088 -.982 .989 .323 -.001

Mexico -.126 -.435 .259 .097 .004

Russia .042 .130 .396 .744 -.018

South Africa .291 .106 .045 .019 .075

Table 3: UIP Quarterly Regression

62

Table 4: General Economic Factor Regression quarterly data

Current Acc. diff. -.038 .022 .123

Inflation diff. -.010 .008 .203

GDP Growth diff. .019 .014 .217

Brazil Interest rate diff. .270 .182 .137 -.012

Current Acc. diff. -.006 .005 .156

Inflation diff. -.006 .005 .241

GDP Growth diff. -.009 .011 .421

Canada Interest rate diff. .559 .883 .532 .002

Current Acc. diff. -.000 .000 .678

Inflation diff. -.007 .005 .123

GDP Growth diff. .004 .008 .634

China Interest rate diff. .747 .192 .000 .240

Current Acc. diff. .001 .002 .634

Inflation diff. -.001 .001 .064

GDP Growth diff. -.002 .002 .243

Euro Zone Interest rate diff. .892 2.439 .713 .088

Current Acc. diff. -.001 .001 .416

Inflation diff. -.027 .007 .000

GDP Growth diff. -.013 .012 .292

Great Britain Interest rate diff. .336 1.224 .755 .010

Current Acc. diff. .004 .001 .002

Inflation diff. -.004 .003 .172

GDP Growth diff. -.004 .007 .633

India Interest rate diff. -.032 .173 .853 .015

Current Acc. diff. -.002 .000 .000

Inflation diff. -4.078E-5 .001 .969

GDP Growth diff. -.005 .005 .330

Japan Interest rate diff. -.255 1.405 .862 -.038

Current Acc. diff. -.001 .006 .769

Inflation diff. .001 .004 .821

GDP Growth diff. -.006 .009 .532

Mexico Interest rate diff. -.858 .589 .148 -.026

Current Acc. diff. -.001 .002 .749

Inflation diff. .002 .001 .332

GDP Growth diff. -.003 .005 .599

Russia Interest rate diff. -.072 .608 .880 -.020

Current Acc. diff. -.016 .016 .422

63

Inflation diff. .003 .004 .417

GDP Growth diff. .023 .014 .159

South Africa Interest rate diff. .099 .044 .027 .064

Current Acc. diff. .000 .001 .808

Inflation diff. -.003 .003 .334

GDP Growth diff. -.016 .011 .159

Country Variable Reg. Co. unstd. N-W SE (12 lags) Significance Adj. R

Australia Interest rate diff. .039 1.010 .969 .296

Oil price change .054 .012 .047

Gas price change .017 .012 .155

Gold price change .009 .080 .913

Wheat price change .017 .022 .446

Cotton price change .024 .023 .303

Corn price change .026 .021 .237

Sugar price change .015 .015 .337

Silver price change .082 .029 .007

Copper price change .132 .037 .000

Brazil Interest rate diff. -.024 .138 .865 .203

Oil price change .044 .039 .260

Gas price change -.021 .018 .261

Gold price change -.248 .146 .043

Wheat price change .042 .029 .161

Cotton price change .044 .041 .282

Corn price change .029 .031 .361

Sugar price change .175 .042 .483

Silver price change .194 .061 .002

Copper price change .107 .040 .009

Canada Interest rate diff. -.092 .516 .865 .269

Oil price change -.086 .013 .011

Gas price change -.018 .003 .002

Gold price change .083 .040 .740

Wheat price change -.001 .010 .901

Cotton price change -.022 .015 .131

Corn price change -.012 .016 .449

Sugar price change .008 .009 .392

Silver price change -.056 .017 .002

Copper price change -.070 .016 .000

64

China Interest rate diff. .553 .205 .000 .156

Oil price change .014 .007 .040

Gas price change -.004 .003 .367

Gold price change .022 .014 .014

Wheat price change 9.180E-6 .003 .661

Cotton price change -.001 .003 .544

Corn price change .004 .003 .153

Sugar price change .002 .004 .714

Silver price change -.007 .007 .289

Copper price change -.007 .005 .186

Euro Zone Interest rate diff. -.871 .885 .034 .203

Oil price change .014 .016 .304

Gas price change .007 .010 .504

Gold price change .238 .040 .000

Wheat price change -.019 .016 .122

Cotton price change .040 .019 .045

Corn price change .025 .018 .211

Sugar price change -.007 .014 .648

Silver price change -.060 .029 .042

Copper price change .059 .017 .001

Great Britain Interest rate diff. .424 1.134 .710 .101

Oil price change .024 .021 .262

Gas price change .008 .007 .447

Gold price change .158 .034 .000

Wheat price change .001 .017 .960

Cotton price change .022 .019 .264

Corn price change .012 .021 .521

Sugar price change -.014 .019 .478

Silver price change -.051 .028 .072

Copper price change .078 .020 .000

India Interest rate diff. .099 .092 .269 .024

Oil price change .013 .011 .264

Gas price change -.003 .012 .791

Gold price change -.028 .032 .386

Wheat price change .022 .016 .176

Cotton price change .024 .022 .285

Corn price change .002 .015 .905

Sugar price change .011 .010 .324

Silver price change .036 .021 .087

Copper price change .004 .025 .869

65

Japan Interest rate diff. -.444 .622 .476 .072

Oil price change .022 .020 .280

Gas price change -.010 .011 .382

Gold price change .260 .060 .000

Wheat price change -.009 .017 .621

Cotton price change .011 .023 .624

Corn price change -.006 .014 .686

Sugar price change .012 .016 .477

Silver price change -.061 .033 .069

Copper price change -.031 .034 .370

Mexico Interest rate diff. -.497 .225 .028 .184

Oil price change .045 .195 .023

Gas price change .004 .008 .687

Gold price change -.173 .079 .030

Wheat price change .013 .015 .405

Cotton price change .008 .026 .768

Corn price change .013 .017 .440

Sugar price change .027 .026 .309

Silver price change .046 .018 .073

Copper price change .103 .037 .000

Russia Interest rate diff. 1.201 .199 .000 .333

Oil price change .160 .056 .005

Gas price change -.021 .016 .200

Gold price change .035 .057 .551

Wheat price change -.030 .028 .297

Cotton price change .030 .028 .290

Corn price change -.004 .029 .886

Sugar price change -.001 .019 .967

Silver price change -.011 .037 .774

Copper price change .048 .032 .148

South Africa Interest rate diff. .034 .013 .012 .042

Oil price change .067 .034 .049

Gas price change -.009 .019 .625

Gold price change -.070 .066 .293

Wheat price change .026 .012 .234

Cotton price change .008 .037 .829

Corn price change -.005 .028 .874

Sugar price change .015 .027 .578

Silver price change .023 .040 .581

Copper price change .049 .052 .355

66

Appendix D

Table 6: Robustness Test Regression monthly data

USD GBP

Reg. Co. N-W SE (12 Significance Reg. Co. N-W SE (12 Significance

unstd lags) unstd lags)

Country Variable

Australia Oil-Price .034 .018 .066 .112 .018 .000

Gas-Price .087 .012 .015 -.009 .011 .447

Gold-Price .012 .080 .877 .151 .077 .034

Wheat-Price .017 .022 .444 -.016 .023 .505

Cotton-Price .024 .023 .300 -.008 .021 .697

Corn-Price .036 .021 .233 -.020 .012 .466

Sugar-Price .015 .016 .341 -.029 .019 .152

Silver-Price .080 .029 .007 -.120 .031 .000

Copper-Price .132 .037 .000 -.048 .029 .105

Brazil Oil-Price .065 .040 .113 .106 .066 .003

Gas-Price -.015 .018 .397 .032 .027 .245

Gold-Price -.242 .117 .343 .136 .151 .371

Wheat-Price .044 .030 .147 -.078 .042 .069

Cotton-Price .040 .029 .178 .037 .057 .519

Corn-Price .015 .027 .560 -.013 .053 .810

Sugar-Price .174 .045 .108 .169 .065 .451

Silver-Price .191 .065 .166 .089 .087 .655

Copper-Price .128 .029 .001 .129 .082 .039

Canada Oil-Price -.035 .013 .011 .108 .017 .000

Gas-Price -.018 .005 .002 .013 .011 .240

Gold-Price .012 .039 .479 .171 .045 .000

Wheat-Price -.001 .010 .903 -.002 .018 .900

Cotton-Price -.023 .014 .129 -.001 .019 .969

Corn-Price -.012 .015 .447 -.003 .025 .916

Sugar-Price .008 .009 .403 -.001 .021 .960

Silver-Price .055 .017 .002 -.104 .029 .001

Copper-Price -.070 .017 .000 .005 .018 .783

China Oil-Price .008 .004 .074 .004 .028 .867

Gas-Price -.002 .002 .275 .005 .010 .617

Gold-Price .018 .009 .051 .159 .036 .000

Wheat-Price -.003 .003 .431 .022 .017 .186

Cotton-Price -.001 .003 .759 .013 .016 .431

Corn-Price .008 .004 .071 .004 .021 .869

67

Sugar-Price .002 .002 .450 -.016 .018 .396

Silver-Price -.005 .004 .320 -.011 .025 .648

Copper-Price -.001 .003 .830 .082 .027 .004

Euro Zone Oil-Price .013 .016 .424 .029 .041 .479

Gas-Price .007 .010 .502 .009 .013 .516

Gold-Price .239 .039 .000 .142 .068 .004

Wheat-Price -.018 .015 .235 .001 .022 .947

Cotton-Price .040 .019 .046 .012 .029 .695

Corn-Price .025 .020 .223 .004 .024 .857

Sugar-Price -.006 .014 .659 -.010 .014 .466

Silver-Price -.060 .028 .040 -.050 .054 .359

Copper-Price .058 .018 .002 .049 .029 .102

India Oil-Price .037 .009 .448 -.012 .025 .632

Gas-Price -.001 .011 .928 .009 .013 .494

Gold-Price -.009 .029 .756 -.140 .055 .030

Wheat-Price .032 .018 .088 -.009 .019 .650

Cotton-Price .034 .020 .101 .000 .017 .993

Corn-Price -.012 .014 .420 -.004 .022 .866

Sugar-Price -.013 .021 .546 -.009 .021 .689

Silver-Price .029 .017 .097 -.033 .030 .271

Copper-Price .011 .018 .577 .032 .012 .261

Japan Oil-Price .021 .020 .298 .004 .033 .914

Gas-Price -.010 .011 .398 .014 .014 .330

Gold-Price .260 .060 .000 .204 .063 .000

Wheat-Price -.009 .017 .620 .013 .024 .613

Cotton-Price .012 .023 .619 .006 .027 .821

Corn-Price -.005 .014 .703 .007 .028 .794

Sugar-Price .012 .016 .483 -.022 .021 .306

Silver-Price -.061 .033 .067 -.079 .032 .772

Copper-Price -.030 .033 .370 .110 .045 .010

Mexico Oil-Price .047 .017 .008 -.030 .028 .294

Gas-Price .021 .023 .387 -.024 .029 .400

Gold-Price -.185 .078 .018 .341 .087 .000

Wheat-Price .033 .026 .213 -.033 .030 .280

Cotton-Price -.032 .042 .455 .048 .041 .254

Corn-Price -.004 .012 .861 .012 .032 .699

Sugar-Price .005 .031 .867 .000 .036 .989

Silver-Price .070 .029 .020 -.101 .037 .008

Copper-Price .105 .037 .018 .162 .031 .607

Russia Oil-Price .219 .046 .677 .348 .067 .000

68

Gas-Price -.024 .022 .288 .012 .022 .590

Gold-Price -.119 .119 .322 .301 .165 .051

Wheat-Price -.042 .043 .325 .078 .039 .047

Cotton-Price .012 .044 .787 -.013 .033 .694

Corn-Price .091 .053 .080 -.038 .049 .440

Sugar-Price .081 .082 .325 -.129 .114 .259

Silver-Price .046 .069 .511 -.138 .105 .193

Copper-Price .131 .063 .040 .017 .040 .682

South Oil-Price .067 .035 .058 -.017 .023 .470

Africa Gas-Price -.010 .019 .608 .000 .008 .976

Gold-Price -.073 .066 .273 .095 .0115 .011

Wheat-Price .026 .021 .235 .015 .059 .543

Cotton-Price .013 .038 .742 .000 .024 .999

Corn-Price -.011 .028 .696 .011 .031 .674

Sugar-Price .017 .026 .529 -.014 .026 .731

Silver-Price .023 .039 .561 -.147 .030 .000

Copper-Price .043 .053 .425 -.002 .037 .903

Table 6: Robustness test regression monthly data

69

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