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Current effect of endogenous and exogenous uncertainty on the exchange rate in the next two years (ZAR/USD)

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par Frankie MBUYAMBA
University of Johannesburg - Master's articles 2010
  

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University of Johannesburg

Economics and Econometrics

«EFFECTS OF CURRENT EXOGENOUS AND ENDOGENOUS UNCERTAINTY ON THE ZAR/USD FOR THE NEXT TWO YEARS»

Frankie MBUYAMBA Mwana

200839800

MCom Financial Economics

Abstract:

We propose a new empirical specification of uncertainty on the exchange rate. Conditional heteroskedasticity is frequently found in the prediction errors of linear exchange rate models. It is not clear whether such conditional heteroskedasticity is a characteristic of the true data-generating process, or whether it indicates misspecification associated with linear conditional-mean representations. We address this issue by estimating nonparametrically the conditional-mean functions of nominal South African Rand to U.S Dollar spot rates, from January2006-July 2010, which are used to produce in-sample and out-of-sample nonparametric forecasts. Our findings bode poorly for recent conjectures that exchange rates contain nonlinearities exploitable for enhanced point prediction.

Keywords: Nonparametric regression, non-linear autoregressive, Kernel function, exogenous and endogenous uncertainty.

I. INTRODUCTION

The economist's views about the best exchange rate system to adopt have changed over the years, particularly because new evidence has accumulated, as the system has moved through various exchange rate regimes. When analysing the exchange rate and fundamentals, there are a large number of alternative models based on economics that have been used to analyse movements in the spot exchange rate. It's probably known that monetary models in their various forms have dominated the theoretical and empirical exchange rate literature, as we shall see these models have been far from successful in explaining some movement in exchange rate. Indeed there is no consensus among economists on the appropriate set of economic fundamentals that influence the exchange rate and this is in part why policy makers have sought to limit by cooperative arrangements such as the Bretton-Woods and the exchange rate mechanism in Europe which derives today in a common currency.

Several factors have to be borne in mind in looking at the uncertainty implication on the ZAR/USD exchange rate for the next two years. First the exchange rate is endogenous variable, whose values are determined by exogenous shocks. As such, exchange rate changes constitute one important channel through which such exogenous development effect prices.

The source of real exchange rate movements is one of the long debated from the monetary model through Dornbusch overshooting model to Frankel real interest differential model till to Noise trader model. They also of course provide information on the likely sources of movements in order endogenous macroeconomics variables - such as consumer prices and GDP. It useful of taking into account of this information when examining the sources of currency movements.

II. LITTERATURE REVIEW

This section outlines the basic concepts needed to analyse the behaviour of the ZAR/USD exchange rate. Before that, we know that the basic arbitrage relationship's in the exchange market is based on the following conditions:

· The Covered Interest rate Parity (CIP) and the Uncovered Interest rate Parity (UIP). Where the CIP is expressed like: (2.1)

f is the forward rate, s the spot rate, r the domestic rate and r* the foreign rate. The expression (1) is an equilibrium condition based on riskless arbitrage.

The UIP under assumption of risk neutrality is expressed as:

(2.2)

· The Purchasing Power Parity (PPP) which is an equilibrium condition in the market and its view of price determination assumes that domestic currency will be subject to arbitrage and will therefore equal the price in domestic currency units of the foreign currency.

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