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Parity conditions, currency forward market efficiency and risk premium : Australian evidence


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Leong, SuSan 2002 , 'Parity conditions, currency forward market efficiency and risk premium : Australian evidence', Research Master thesis, University of Tasmania.

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The objective of this thesis is to undertake an empirical investigation of three wellknown
exchange rate relationships, namely, covered interest parity (CIP), uncovered
interest parity (UIP) and forward market efficiency (FME), using daily data as it
applied to the Australian and US economies over the period 2 December 1985-29
December 2000. Due to the issue of non-stationary of the regression variables,
ordinary least squares (OLS) results are corrected according to West (1988)'s
procedures and two new estimation techniques — fully modified ordinary least squares
(FM-OLS) developed by Phillips and Hansen (1990) and fully modified least absolute
deviation (FM-LAD) by Phillips (1995) — are introduced and utilised.
Modified versions of the UIP and FME models are also developed to incorporate a
time-varying risk premium to rationalise the rejections of the UIP and FME in their
original forms. Estimation of these modified UIP and FME models is conducted in the
context of three types of generalised-auto-regressive-conditional-heteroskedasticityin-mean
(GARCH-M) processes. An attempt is also made to investigate the effects of
monetary policy actions not necessarily targeted at the exchange rate on the
conditional volatility of the spot exchange rate, that is, the time-varying risk premium
by including the monetary policy target (the overnight cash rate) in these models. While both the full sample (2 December 1985 — 29 December 2000) and the subsample
(2 December 1985 — 31 December 1991 and 2 January 1992 — 29 December
2000) analysis reveal evidence supporting OP over the period December 1985 —
December 2000, the UIP and FME conditions are only found to hold in the 90-day market over the period 2 January 1992 — 29 December 2000. The results of the subsample
analysis reveal no conclusive evidence to support the notion of a time-varying
risk premium over the period 2 December 1985 — 31 December 1991 leading to
rejections of both the HIP and FME models in the 90-day market. However, when the
cash rate is included, the presence of a time-varying risk premium is supported in that
market, suggesting that the Reserve Bank of Australia (RBA)'s monetary policy plays
an important role in influencing the volatility of exchange rates.

Item Type: Thesis - Research Master
Authors/Creators:Leong, SuSan
Keywords: Risk, Efficient market theory, Monetary policy, Foreign exchange
Copyright Holders: The Author
Copyright Information:

Copyright 2002 the Author - The University is continuing to endeavour to trace the copyright
owner(s) and in the meantime this item has been reproduced here in good faith. We
would be pleased to hear from the copyright owner(s).

Additional Information:

Thesis (M.Ec.)--University of Tasmania, 2002. Includes bibliographical references

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