Working Paper: NBER ID: w11517
Authors: Elena Tchernykh; William H. Branson
Abstract: This paper presents techniques for modelling and estimating the behavior of financial market price or return differentials that follow non-linear regime-switching behaviour. The methodology to be used here is estimation of variants of threshold autoregression (TAR) models. In the basic model the differentials are random within a band defined by transactions costs and contract risk; they occasionally jump outside the band, and then follow an autoregressive path back towards the band. The principal reference is Tchernykh (1998). The application here is to deviations from covered interest parity (CIP) between forward foreign exchange (FX) markets in Hong Kong and the Philippines. We have observed that these deviations from the band follow irregular steps, rather than single jumps. Therefore a Modified TAR model (MTAR) that allows for this behaviour is also estimated. The estimation methodology is a regime-switching maximum likelihood procedure. The estimates can provide indicators for policy-makers of the market's expectation of crisis, and could also provide indicators for the private sector of convergence of deviations to their usual bands. The TAR model has the potential to be applied to differentials between linked pairs of financial market prices more generally.
Keywords: covered interest parity; regime-switching; threshold autoregression; financial markets
JEL Codes: F31; C13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| crises (H12) | autoregressive parameters may become econometrically insignificant (C22) |
| deviations from covered interest parity (CIP) (F31) | stochastic process within a defined neutral band (C69) |
| deviations from covered interest parity (CIP) exceed the band (F31) | regress back towards the band (Y60) |
| modified TAR (MTAR) model (C32) | better fit for observed data (C52) |