1

Conventions in the Foreign Exchange Market:

Do they really Explain Exchange Rate Dynamics ?

Gabriele Di Filippo

LEDA-SDFi University Paris IX Dauphine

Third FIW Research Conference in International Economics

2

1 Intuition

Stylised Fact:

De Grauwe (2000) [Statistical Study]

« Market agents look for fundamentals that justify the dynamics of exchange rates »

Examples:

Appreciation of the dollar vis-à-vis the euro between January 1999 and December 2002

→ High growth perspectives in the US economy

Depreciation of the dollar vis-à-vis the euro between January 2003 and December 2004

→ Fears concerning the sustainability of the US debt

Bachetta and Van Wincoop (2005) [Theoretical Study]

Theoretical model based on the idea of De Grauwe (2000) – « Scapegoat Model »

3

Definition:

Financial Convention (Orléan (2002)) = « Particular model based on fundamentals and adopted by the majority of agents in the market »

The Building of Conventions:

Step 1: Research of the Convention => Existence of multiple equilibria => High exchange rate volatility

Step 2: Adoption of the Convention => Adoption of a specific fundamental model => Low exchange rate volatility

Step 3: End of the Convention => Empirical facts against the convention => High exchange rate volatility

2 The Main Pillars of Convention Theory

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3 Identification of the Prevailing Conventions on the Euro/Dollar Exchange Rate

Figure 1 : Dynamics of the Euro/Dollar exchange rate between January 1995 and December 2008

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January 1995 - December 2000 : internet convention

January 2001 - June 2003 : end

internet convention

July 2003 - December

2005: : “the US as a net

debtor” vs “the US as the

engine of the world

economy”

January2006 – June 2007:

“the US as a net debtor”

July 2007 -

December2008:

subprime crisis

Growth Rate Debt

Growth Rate;

Debt

Oil Prices;

House Prices;

Debt

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tUStPIHtopUS

tniipgdpEUtniipgdp

tUSa

tprofitsEUatprofitsUS

tindprodEUtindprod

ts,22423222120

,1,

14,

13121110

BeartS

BulltS

4 Empirical Model

Estimation Period: January 1995-December 2008

Data Frequency: Daily

Estimation Method: EM algorithm (Hamilton (1990))

Endogeneous Variables: Euro/Dollar Nominal Exchange Rate (1 euro = S dollars)

Exogenous Variables: Bull State: Growth Rate of the Industrial Production

Growth Rate of Expected Profits

Bear State: External Debt/ GDP

Oil Prices

US House Prices

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tUStPIHtopUS

tniipgdpEUtniipgdp

tUSa

tprofitsEUatprofitsUS

tindprodEUtindprod

ts,22423222120

,1,

14,

13121110

BeartS

BulltS

5 Results

→ Bull Market : Increase in Growth Rate => Appreciation of the dollar

Surprising result on Expected Profits (multicollinearity?)

→ Bear Market: Increase in Debt => Depreciation of the dollar

Increase in Oil Prices => Depreciation of the dollar

Increase in US House Prices => Depreciation of the dollar

Estimated Model (Recall):

Table 1: Estimation output

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6 Does the Model represent the Variations of Conventions ? E

con

omet

rica

l Res

ult

(F

ilte

red

Pro

bab

ilit

ies)

Con

ven

tion

s A

nal

ysis

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96

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6 Does the Model represent the Variations of Conventions ?

Internet Convention; Bull Market; Appreciation of the dollar

End internet convention; Bear Market Depreciation of the dollar

Domination of the bear convention;

Depreciation of the dollar

January 1995 - December 2000

Two opposed conventions ;

Bull/Bear; Appreciation/Depreciation of the dollar

Figure 2 : Filtered Probabilities and Euro/Dollar Dynamics (January 1995 - December 2008)

January 2001 – June

2003

July 2003 - December 2005

January 2006 – June 2007

July 2007 - December

2008

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7 Exchange Rate Volatility and Conventions VariationsE

xces

s of

Exc

han

ge

Rat

e V

olai

lity

Eco

nom

etri

cal R

esu

lt

(Fil

tere

d P

rob

abil

itie

s)

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7 Exchange Rate Volatility and Conventions Variations

=> Episodes of high exchange rate volatility coincide with conventions variations: research for a new convention (step 1) or end of a new convention (step 2)

=> Exchange rate volatility comes from the uncertainty concerning the prevailing convention in the market

=> When the future becomes uncertain, Public Authorities should intervene in the market to guide agents

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Figure 3 : Filtered Probabilities and Euro/Dollar Excess Volatility

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8 Resolution of the Exchange Rate Disconnection Puzzle

Exchange Rate Disconnection Puzzle (Meese et Rogoff (1983)):

=> Exchange Rate Dynamics is disconnected from the fundamentals

Advantages related to the Convention Model:

=> Asymmetric World

=> Non-Linear Structure

Problems with Traditional Models of Exchange Rate:

Invariance of the coefficients associated to fundamentals

=> Exchange Rate Disconnection Puzzle = Pure Artefact ?

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9 Limits of the Model

Limits:

Daily Frequency Model => Extrapolation of Macroeconomic Data

=> Very Strong Hypothesis => Highly contestable hypothesis

Choice of the Variables ?

Questions:

Is the model correctly specified ?

If the model is badly specified, then why does it provide the expected results ?

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10 Other

Filtered Probabilities in monthly variation with daily data:

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11 Other

Filtered Probabilities in monthly variation with monthly data:

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