Regime-switching Behavior of the Term Structure of Forward Markets, Issue 11517
National Bureau of Economic Research, 2005 - Finance - 26 pages
This paper presents techniques for modelling and estimating the behavior of financial market price or return differentials that follow non-linear regime-switching behaviour. The methodology to be used here is estimation of variants of threshold autoregression (TAR) models. In the basic model the differentials are random within a band defined by transactions costs and contract risk; they occasionally jump outside the band, and then follow an autoregressive path back towards the band. The principal reference is Tchernykh (1998). The application here is to deviations from covered interest parity (CIP) between forward foreign exchange (FX) markets in Hong Kong and the Philippines. We have observed that these deviations from the band follow irregular steps, rather than single jumps. Therefore a Modified TAR model (MTAR) that allows for this behaviour is also estimated. The estimation methodology is a regime-switching maximum likelihood procedure. The estimates can provide indicators for policy-makers of the market's expectation of crisis, and could also provide indicators for the private sector of convergence of deviations to their usual bands. The TAR model has the potential to be applied to differentials between linked pairs of financial market prices more generally.
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95 percent return analysis arbitrage Asian crisis Asian data autoregression parameter autoregression process behaviour BFGS-Method Regimes Thresholds Branson Carlo test confirmed CIP deviations classical TAR model coming crises confirm the earlier covered interest parity crisis period Currency deviations from CIP deviations from covered earlier TAR estimates Elena Tchemykh Estimated Parameters BFGS-Method estimates of MTAR Forex Forward-Forward Deviations forward exchange rate forward markets Forward-Forward Deviations DevCIP3-6 gives a half-life Hong Kong data Hong Kong dollar inside the back instructions inside jump process likelihood function likelihood ratio statistic likelihood ratio test Macroeconomics market participants mean reversion Modified TAR model Monte Carlo likelihood Monte Carlo test MTAR Estimated Parameters NBER neutral band null hypothesis Parameters BFGS-Method Regimes Partial Subscription Philippine data Philippine peso Regime-Switching Behavior regression Return T-Stat(1 Ross Levine shown in Graph single area spot-forward Structure of Forward T-Slat(l t-statistic Tchernykh 2002b Term Structure threshold autoregression tranquil period Upper Lower upper threshold