Peter C. Schotman

A Bayesian analysis of the unit root in real exchange rates

We propose a posterior odds analysis of the hypothesis of a unit root in real exchange rates. From a Bayesian viewpoint the random walk hypothesis for real exchange rates is a posteriori as probable as a stationary AR(1) process for four out of eight time series investigated. The French franc/German mark is clearly stationary, while the Japanese yen/US dollar is most likely a random walk. In contrast, classical tests are unable to reject the unit root for any of these series.

Measuring Risk Attitudes in a Natural Experiment: Data from the Television Game Show Lingo

We use data from a television game show involving elementary lotteries as a natural experiment to measure risk attitudes. Unique features of our data set are the substantial monetary stakes and the large sample size. CRRA and CARA utility specifications perform approximately equally well. We find robust evidence of substantial risk aversion. Extensions of the basic model, which allow for a separate utility flow purely from playing the game or for decisions based on decision weights instead of actual probabilities, raise the estimated degree of risk aversion.

Nonlinear Interest Rate Dynamics and Implications for the Term Structure

This paper explores nonlinear dynamics in the time series of the short-term interest rate in the United States. The proposed model is an autoregressive threshold model augmented by conditional heteroskedasticity. The performance of the model is evaluated by considering its implications for the term structure of interest rates. The nonlinear dynamics imply a form of nonlinearity in the levels relation between the long and the short rate.

The Dynamics of Short-Term Interest Rate Volatility Reconsidered

In this paper we present and estimate a model of short-term interest rate volatility that encompasses both the level effect of Chan, Karolyi, Longstaff and Sanders (1992) and the conditional heteroskedasticity effect of the GARCH class of models. This flexible specification allows different effects to dominate as the level of the interest rate varies. We also investigate implications for the pricing of bond options. Our findings indicate that the inclusion of a volatility effect reduces the estimate of the level effect, and has option implications that differ significantly from the Chan, Karolyi, Longstaff and Sanders (1992) model.

Horizon sensitivity of the inflation hedge of stocks

Abstract In this paper, we study the potential of stocks as a hedge against inflation for different investment horizons. We show that stocks can be a hedge against inflation even if stock returns are negatively correlated with unexpected inflation shocks, and only moderately positively related to expected inflation. Depending on the investment horizon, the optimal hedge ratio can be either positive or negative. The crucial parameter for the results is the persistence of inflation.

An empirical application of stochastic volatility models

This paper studies the empirical performance of stochastic volatility models for twenty years of weekly exchange rate data for four major currencies. We concentrate on the effects of the distribution of the exchange rate innovations for both parameter estimates and for estimates of the latent volatility series. The density of the log of squared exchange rate innovations is modelled as a flexible mixture of normals. We use three different estimation techniques: quasi-maximum likelihood, simulated EM, and a Bayesian procedure. The estimated models are applied for pricing currency options. The major findings of the paper are that: (1) explicitly incorporating fat-tailed innovations increases the estimates of the persistence of volatility dynamics; (2) the estimation error of the volatility time series is very large; (3) this in turn causes standard errors on calculated option prices to be so large that these prices are rarely significantly different from a model with constant volatility.

Neglected common factors in exchange rate volatility

The paper proposes a new multivariate model for exchange rate volatility in a system of bilateral exchange rates, using a factor structure of exchange rates one of the common factors is always related to the numeraire currency. Time variation in the volatility is modelled using a stochastic variance approach. The interpretation of the factors provides a new way of estimating risk premia in the foreign exchange market. Empirical results show considerable volatility spillovers among the four major currencies. Risk premia show a major sign reversal for the dollar risk premium around 1978.

The Re-Emergence of PPP in the 1990s

In this paper we investigate purchasing power parity (PPP) in a panel with 17 countries for the period 1972 through 1996. The novel feature of our panel methodology is that results are invariant to the choice of a benchmark on numeraire currency. In the panel we allow individual country effects in the relation between prices and exchange rates. In this way we can identify the currency pairs for which PPP holds or does not hold. We conclude that there is substantive evidence for PPP, although not to the same extent for every currency. Evidence in favor of PPP is strongest for many exchange rates relative to the Dmark, and weakest for the Japanese yen. For this currency a trend-like variable, like productivity growth, is missing.

How to beat the random walk: An empirical model of real exchange rates

Abstract An econometric model is developed for all possible bilateral real exchange rates between the United States, the United Kingdom, Germany and Japan for the period February 1977 to June 1987. We extend the standard Dornbusch–Frankel type of models using an error correction approach with an observable macro-economic determinant of the long-run real exchange rate. For the econometric analysis we develop an efficient estimator by pooling the data for all currencies. Contrary to previous empirical tests on the long-run behaviour of real exchange rates, we find a notable and significant mean reversion component.

Cross Sectional versus Time Series Estimation of Term Structure Models: Empirical Results for the Dutch Bond Market

In this paper we compare time series and cross section estimates of the well known Vasicek [1977] and Cox, Ingersoll and Ross [1985] term structure models for a dataset of daily bond prices and short term interest rates for the Netherlands. The main conclusion of this paper is the great similarity of the cross sectional estimated term structures of interest between the two models. Using the estimated parameters of both models to value bond options, an almost similar result is obtained. It looks as though bonds are priced as if the spot riksfree rate is random walk. From a time series perspective, we find that the two models also provide similar results. For some maturities the data reject the constant volatility Vasicek model and indicate the presence of the CIR volatility effects.